Saturday, August 30, 2014

05/11/2000 The Wisdom of Dr. Henry Kaufman *

It was a strange week in the stock market, with continued wild volatility and unusual moves in many stocks. For the week, the Dow finished slightly positive and the S&P500 ended slightly negative. The Utilities surged 4%, the Morgan Stanley Consumer index jumped 2%, while the Morgan Stanley Cyclical index was marginally positive and the Transports unchanged. The technology sector was particularly wild with significant selling during the first half and a major rally into week’s end. For the week, the NASDAQ100 dropped 7%, the Morgan Stanley High Tech index 5%, the Semiconductors 11%, The Internet index 6%, and the NASDAQ Telecom index 8%. Interestingly, the financial stocks rallied, with the Bloomberg Wall Street index adding 1% and the S&P Banking index surging 6%.

The gain in the financials was certainly not due to improved conditions in the credit market. In fact, conditions now seemingly deteriorate by the week. After the past two-week’s drubbing, what was a rally attempt faded quickly with today’s very poor showing. For the week, 10-year Treasury yields increased 1 basis point to 6.51%. Two-year yields jumped another 5 basis points this week to 6.90%, and the 5-year increased 6 basis points to 6.82%. Once again, Treasuries outperformed, as the benchmark 10-year dollar swap spread added four more basis points to an alarming 134. The spread to Treasuries for the current coupon Fannie Mae mortgage-backs widened 4 basis points this week to 193. Performing very poorly, the implied yield on the June Agency futures contract jumped 7 basis points this week to 7.69%. This yield has increased 63 basis points in only the past 14 sessions.

The implied Agency yield surged almost 12 basis points today in what could be a problematic dislocation. Interestingly, today’s poor performance in Agency securities, and the credit market generally, was matched by an ominous move lower in the dollar. Today, the dollar dropped almost 2% against both the Swiss franc and the euro. We have thought for some time that there existed a very high probability that the leveraged speculating community has used significant leverage borrowed at low European interest-rates to finance higher-yielding US debt securities. Moreover, we have suspected that leveraged speculation could be particularly prevalent in mortgage-backs and Agency securities. And while prices for these securities have been under significant pressure with the recent jump in interest rates, the surging dollar would have mitigated losses for players that had borrowed funds denominated in the euro and Swiss franc. Now, however, with the dollar’s abrupt reversal, and continued sinking prices for Agency securities, we believe that such trades could now pose a significant problem. In fact, we view leveraged trades funded with low-cost financing from Europe as another likely big – potentially momentous - “domino” now poised to fall, with significant and negative ramifications for the US credit bubble, financial system liquidity generally, and the dollar. We also ponder the possibility that the major US financial institutions have aggressively played the steep European yield curves and, if so, what would be the global consequences if they were forced to begin unwinding these speculations. For sure, the environment is quite unsettled and we do take note that the CRB index jumped more than 2% this week and crude oil surged more than $2.30, almost making it back to $30. Times are changing…

As the daily swings in NASDAQ captivate the attention of so many, and financial “journalists” fixate on Internet stocks and the “New Economy,” the unseemly “big picture” goes completely unnoticed – that our system has gone terribly amiss. Let there be no doubt that we are living in a truly ugly period in financial history, and the evidence is everywhere. On-line brokerages flood the airwaves with commercials to entice the unsuspecting and uninformed, while financial institutions aggressively push over-borrowing. The “grandfatherly” Peter Lynch and the “grandmotherly” Abby Joseph Cohen repetitively condition investors to keep their savings at risk with their implication that there is no risk “over the long-term”. And despite the undeniably high risk the present environment poses for investors, not a single “elf” on Wall Street Week will admit to being bearish. Clearly, “The Street” is working diligently to keep “Joe Six-pack” in the game. Of course, someone has to buy the stocks as the sophisticated “cash out.” On CNBC, a forum is provided for WWF wrestler “Bradshaw” to present his stock recommendations to millions, and Wall Street has a good laugh. In what is a very serious environment, to be serious is apparently to be out of touch. Larry Kudlow, once a seemingly serious economist but more recently crowned “America’s Greatest Living Economist” by CNBC, has become “a used car salesman” for the so-called new economy. Also courtesy of CNBC, Joe Battipaglia has been presented to the public as a stock market guru.

Playing the market and pontificating is all “fun and games,” particularly now that the stock market and financial system are seemingly the “spoils of war,” won by the bulls for the enrichment and pleasure of Wall Street and insiders. Derivative desks take sport in “ripping the faces off” of clients to ensure big year-end bonuses. As for research, serious analysis is largely an anachronism, with research departments little more than support for investment bankers’ efforts to sell securities. Moreover, today it would be considered a strange notion that individuals on Wall Street and the leadership of the Federal Reserve take responsibility for what over time has regressed into virtual financial anarchy. And the more ridiculous it has all become, the clearer it is that our financial industry is sadly bereft of serious leadership (SEC Chairman Arthur Levitt Jr. excluded).

Fortunately, there remain a few serious “old timers” whose lives and experiences in the financial markets would provide Tom Brokaw excellent material for a new book, “The Greatest Generation on Wall Street.” Coincidently, last Friday afternoon while writing my commentary “Mr. George Soros,” I received a parcel from Amazon containing Henry Kaufman’s new book, A Wall Street Memoir on Money and Markets.” I very much enjoyed Dr. Kaufman’s first book, Interest Rates, the Markets, and the New Financial World (view our updated recommended reading list), and was certainly fascinated as I listened to his talk at our Credit Bubble Symposium last September. I had great expectations for his new book that were easily surpassed. Although last week I did advise reading Mr. Soros’ The Crisis of Global Capitalism, after reading “A Wall Street Memoir…” I suggest you put “Mr. Soros” aside for now. Dr. Kaufman has gifted us a truly great book.

We have the utmost admiration and respect for Dr. Kaufman, and I am personally very appreciative of his efforts throughout his distinguished career and now in writing an outstanding book. Indeed, as far as I am concerned, Henry Kaufman is a true American hero and his life’s story an inspiration. Upon reading about his upbringing and honorable life - born during 1927 in a small town in Germany, he, at age 9, fled with his family from Nazism to relocate in New York – I could not help but to recall the very touching ending of Saving Private Ryan where Tom Hank’s character, in his dying breath, tells Private Ryan to “make it worth it.” Henry Kaufman, facing great adversities in his youth, worked diligently, was a dedicated student, a great professional at Salomon Brothers and with his own company, as well as a great philanthropist. Importantly, Dr. Kaufman has demonstrated an unrelenting dedication to integrity, professionalism and quality and objective research, a worthy combination dearly missed today on Wall Street. We certainly commend him for the brilliance and integrity conveyed so vividly in his memoir. His book provides invaluable insight for students, investors, investment professionals and, importantly, the governmental oversight community that presently appears so out of touch. From his upbringing and years of Wall Street experience, Dr. Kaufman provides a unique and powerful perspective. Quoting from Paul Volker’s forward, “One recurrent theme in this memoir is the inherent tension for those trading securities and managing money between the need to compete, to prosper, to grow, and the need to treat clients fairly, to maintain high fiduciary standards, and to respect the broad public interest reflected in regulation and supervision.”

Above all, Dr. Kaufman is virtually alone today as a “financial statesman.” He has deep convictions rooted in his extraordinary experience, as well as a keen knowledge and appreciation of history. From Dr. Kaufman’s book,“My strong anti-inflationary views, which in later years I expressed in writings and press interviews, were rooted in the stories told over and over again by my grandfather about the devastation that the hyperinflation inflicted upon him and his homeland. In those desperate times, barter more and more became the medium of exchange, and debts were paid off by worthless currency. The financial system could not carry out its fundamental function, the efficient allocation of resources. These stories also suggested to me that it is dangerous to disengage the middle class, which inflation certainly does.” With such a background, there is no mystery why the financial markets are anything but “fun and games” for Dr. Kaufman.

”…I can never forget the powerful lesson from childhood about how the debasement of money and the credit structure can wreak havoc on the social and economic structure. All of this led me to conclude: Money matters, but credit matters more. This is especially true in our dynamic financial world, where the linkage between money and credit is looser than economic theory suggests.”

Near and dear to our analysis, Dr. Kaufman is one of the fathers of US credit system research with his focus on what is today the “Flow of Funds” data of sources and uses of credit produced by the Federal Reserve. After getting his start and mastering bank credit analysis, receiving a Ph.D. from New York University and spending several years working for the New York Fed, he joined Salomon Brothers in 1962 and was a key contributor to the tremendous growth and success of the firm. At Salomon, he teamed with the eminent Sidney Homer (author of A History of Interest Rates) to build the preeminent market research department on Wall Street before founding his own firm. Dr. Kaufman sat in the “cat bird’s seat” as the American bond market grew from “outstandings of $485 billion in 1970 to an estimated $13 trillion at the end of 1998.” Chapter three of Dr. Kaufman’s book is entitled “The Growth and Transformation of Markets” where he addresses globalization, derivatives and the spectacular growth in the securitization of credit. There is simply no one with greater experience and expertise in what is today’s most critically important - although grossly under appreciated - subjects of credit and the soundness of US financial system.

In discussing the major consequences of securitizations, Dr. Kaufman writes: “Perhaps the most important of all, widespread securitization has had the broad effect of loosening the credit process. Credit standards have been lowered, and the credit market has grown enormously. This should not be surprising, given the role of the investment banker in the securitization process…A securitized investment also encourages the investor to believe that he can quickly sell the obligation when a credit problem brews, thereby passing off the problem to someone else. Again – in this instance at the time when the investment is undertaken – we see the making of the liquidity illusion…By transforming trading practices, by fostering the creation of a dazzling array of new instruments, and by facilitating the explosive growth of modern financial markets, securitization has emerged as arguably the most potent and influential development in the financial history of our times.”

Dr. Kaufman’s writing also supports our view of the profound role of what we refer to as the “leveraged speculating community.” “…A new breed of institutional participants has come to the fore. These institutions are distinguished by their emphasis on short-term investment performance, their heavy use of leverage, and their willingness to move in and out of markets – whether equities, bonds, currencies, or commodities – in a relentless quest to maximize returns. The new breed includes the often-reviled hedge funds, although they are neither the sole nor the leading contestants. In fact, most prominent banks, securities firms, and even a few insurance companies possess departments that emulate the trading and investment approach of the hedge funds. Even the corporate treasuries of a number of nonfinancial corporations are engaged in this activity. Once arcane and exotic, the hedge fund approach to investment has been mainstreamed.”

With the leveraged speculating community as major employers of derivatives, these instruments and related strategies have come to play an overly dominating and dangerous role in our financial system and economy. Dr. Kaufman provides brilliant insight in this area as well. Chapter four is titled “The Derivatives Revolution – How will derivatives perform under a less favorable set of conditions? That question haunts the future of the derivatives revolution.” Dr. Kaufman, as we do, believes that derivatives have destabilized markets, including increasing volatility. Also, “some varieties of derivatives have irreversibly changed the behavior of the underlying financial markets on which they are based.” As derivatives have become the vehicle of choice that provides investors and speculators an easy means of transacting and switching long or short positions in various markets, “in doing so, they also introduce phenomenal leverage into the system. It is this insertion of greater leverage that can make for greater volatility in the system…like securitization, derivatives – which also multiplied rapidly in recent decades – encourage a more relaxed set of credit-granting standards.”

Dr. Kaufman also addresses what we see as a dangerous proliferation of options and “dynamic hedging” derivative strategies. “Moreover, because financial options create risk that cannot be hedged perfectly without, in effect, undoing the transaction altogether, investors often turn to dynamic hedging to manage the new risks. But dynamic hedging is an inexact science, one that relies on extraordinarily complex computerized models, which themselves are far from infallible (because they are built on historical data). Moreover, “…the astonishing growth of floating-rate financing and interest rate swaps – innovations at the margins of traditional finance – clearly has fostered credit and business volatility.”

As for derivatives’ general impact, Dr. Kaufman makes some most interesting and pertinent observations. "There is little agreement in the financial community about what, if any, impact derivatives have on broader economic and financial performance. How do derivatives affect the business cycle, and thus the course of monetary policy? …What the proponents of the benign impact view miss is the potential for derivatives to amplify the business cycle by introducing more leverage into the system and thus expand credit availability, especially for marginal borrowers. During an upswing in the business cycle, this additional borrowing capacity allows the private sector to withstand monetary restraint for a longer time. As a result, the central bank eventually will need to engineer considerably higher interest rates – with correspondingly lower asset values – than are normally expected in order to cool down the economy to achieve noninflationary growth.” This particular point could not be more apropos.

“Indeed, since most financial derivatives, especially over-the-counter options and related instruments, are scarcely a decade old, the market has yet to be tested under any number of difficult scenarios – most notably, by a period of extreme stringency in monetary policy.”

While his book is brilliant from cover to cover, chapter 11, “Shortcomings of Fed Policy” is particularly timely and valuable reading for garnering insight into today’s extraordinary environment. “One of these shortcoming has been the Fed’s inability to recognize early on the impact that structural changes in the financial markets have had on financial behavior, and the significance of these behavioral changes on the conduct of monetary policy.”

”As banking was beginning to open up to greater competition in the early postwar period, the Federal Reserve failed to recognize the significance of the chance. No one in authority stepped forward to address the unleashing of entrepreneurial forces, or the shifting balance of fiduciary responsibility among financial institutions…The Fed was also slow to recognize the implication for monetary policy of an important related development: securitization,” and faces another challenge in the need to clarify its “lender-of-last-resort” responsibilities.

Dr. Kaufman also discussed the broad ramification of “The bubble.” “The bubble has contributed to the rapid growth of the financial infrastructure. And because investors tend to emphasize the market value of businesses, the bubble has concealed the highly leveraged position of business.” Clearly of the view that central bankers must incorporate asset prices into their monetary policy, Dr. Kaufman states, “The other challenge that confronts the Federal Reserve is the role that the sharp increase in financial wealth should play in determining monetary policy. …Increased volatility of asset values may have important – and difficult-to-measure – consequences for economic fundamentals such as consumption, business fixed investments, home building, and so on.” Dr. Kaufman also makes the critical point that “the Fed has mistakenly assumed the discipline of the market would sufficiently limit large problems from erupting.”

Dr. Kaufman provides simple yet profound insight into the special characteristics of financial markets. “…There are meaningful differences between the efficient allocation of goods and services through intense competition, and intense competition among financial markets and intermediaries. In the nonfinancial world, intensive competition encourages innovation and improved delivery of goods and services. In the financial world, intensive competition encourages lower profit margins for intermediaries, along with the search for investment and lending opportunities with higher profit margins – opportunities that typically entail greater risk, which can endanger not merely the banking institutions but the well-being of the larger society. This is because financial markets and institutions deal in a very essential and fungible commodity – money and credit – that cannot be copyrighted or patented.”

Dr. Kaufman leaves little doubt that he views the present as a critical juncture in financial and economic history. ”At no time in the post-World War II period has the economic well-being of the U.S. and the rest of the world hinged so importantly on the performance of the American Stock market.” Recognizing the extraordinary leverage and financial fragility existent in today’s enormous financial bubble, Dr. Kaufman provides his usual cogent analysis. ”Interest rate increases to combat inflation will be more tentative and protracted because the central bank naturally will fear that premature, hasty, or unexpectedly forceful increases in officially determined short-term interest rates will precipitate a sell-off in the markets and a major erosion of asset values.”

As we do, Dr. Kaufman sees a severe problem with the Fed’s repeated efforts to intervene to support markets. “The basic problem with bailing out markets and holding up prices is that such an approach does not remove the underlying problem: overstated financial values. If an economy is to move ahead efficiently, they must be wrung out of the system… Central banks that have acquiesced in, or abetted, high inflation are practicing a form of financial corruption that eventually destroys national unity and leads to financial ruin.”

As a true financial statesman, Dr. Kaufman also provides “An Agenda for Change.”

“To begin with, I believe that the primary objective of a central bank should be to maintain the financial well-being of society in the broadest sense. That means establishing stable financial conditions by exercising careful oversight over financial markets, institutions, and trading practices; anticipating potential problems; and taking remedial action before those problems can do widespread damage.”

“I do not agree with those who maintain that the central bank should have only the most single-minded of objectives – specifically, the pursuit of price stability, perhaps defined as a target range for the inflation rate…Indeed, I would argue that this objective is deceptive, because it fails to give precedence to maintaining the financial well-being of society. Why? First, low inflation, for all of its virtues, is no guarantee against the emergence of financial excesses. History proves this conclusively.”

“…The proper responsibility of the central bank – assuring the financial well-being of society – requires an intimate involvement in financial supervision and regulation. In fact, I have long believed that it is only the central bank – among the various regulatory agencies that share responsibility in this area – that can represent the perspectives of the financial system as a whole.” Dr. Kaufman also has his “precepts for sound regulation”. Sharing his great wisdom, he states, “financial market participants will always push risk taking to the marginal edge, unless prevented from doing so. This is because the marginal edge holds special appeals, for it is there that competition is least, profit margins are greatest, fees are most lucrative, and ancillary business is easiest to line up…deregulated financial institutions face intense competition in their core businesses, and therefore feel greater pressure to move toward the marginal edge. “…By encouraging financial entrepreneurs to test the marginal edge of risk taking, deregulated markets exaggerate the credit cycle and the business cycle.”

Dr. Kaufman warns against the “excessive concentration of economic power,” and also writes “financial institutions have a crucial public responsibility, one that sets them apart from other business enterprises… As repositories of large pools of savings, banks (and indeed many other financial institutions) possess an awesome fiduciary responsibility – one that should temper the institutions’ entrepreneurial drive…by their very nature they are leveraged heavily, and for them to survive and succeed, they must balance their fiduciary responsibility with their entrepreneurial drive. According to those who hold this view – myself among them – this balance is virtually impossible in the absence of government supervision and regulation.”

“Hat’s off” to Dr. Kaufman!