Thursday, May 6, 2010

Credit Crisis Round 2 - Ari Paul

The news this week is that Greece will be getting a $145 billion bailout, up from $60 billion just a week ago. With each bailout announcement, the euro sinks lower, stocks sink lower, and Eurozone bond yields rise. Sound familiar? This was the same pattern in late 2008 as every bank bailout just brought attention to the next domino to fall.

I’ve been a broken record for the last year, repeating the story that the recovering economy was a temporary byproduct of shifting debt from companies to countries. The Eurozone is now experiencing the start of a sovereign debt crisis with yields climbing for all the PIIGS (Portugal, Italy, Ireland, Greece, and Spain). Will the Greek bailout push the problems another 3 years down the road? I don’t know, but I wouldn’t count on it. Optimists hope that Greece will undergo a deliberate depression to reduce their deficit. This has virtually no chance of success, rather, the real hope is that Germany and the IMF (of which the US is the biggest sponsor), will simply accept losses on the loan, effectively providing a direct gift to the people of Greece. Even this will be insufficient to cure Greece’s problems since the fundamental problem of Greece’s uncompetitive labor remains.

We are in the 5th inning of a 9 inning global deleveraging cycle. I mentioned 6 months ago that I didn't believe the wave of populist anger against banks was anywhere near peaking. Every banking crisis in modern history has led to a huge increase in regulation and a correspondingly huge decrease in banking profits. The civil and criminal suits against Goldman Sachs are just the beginning. Before this is over, I'll be very surprised if big banks are earning significant profits doing anything other than basic banking. What will take their place? One of the biggest hedge funds, Citadel, is trying to get into the investment banking business. There are many funds with $15 billion+ in assets that could take over the "big balance sheet" services. They'll likely grow quickly by issuing debt once its obvious they can take over a great deal of what was formerly banking business.

How should we position ourselves? I don’t want to guess on inflation versus deflation. I think the most prudent strategy is patience to wait for value opportunities to come to us. If/when we get a severe stock market sell off, we should not expect a quick bounce like last year. Rather, we should expect asset prices to drop and stay down for a number of years until the deleveraging is complete. Therefore, we should be ready to lock in high yields, whether through safe corporate bonds trading far below par value, high dividend paying blue chips trading near book value, or REIT type equities. If the market undershoots to the downside, I expect we’ll be able to lock in relatively safe yields of 20-40% for 2 years. I don’t expect a true bull market to start for 4-6 years. I’ll provide specific investment ideas if/when asset prices fall considerably.

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