Lehman and the financial crisis

It started innocently. Around the turn of the century Congress decided to make home ownership accessible to more Americans, on the idea that owning a home made families happier, more prosperous and more law-abiding. It put Alan Greenspan in charge of supervising more liberal bank mortgage lending but–he later said in Congressional testimony–told him not to look too hard at what was going on.

Banks of all stripes had long since learned that although they might want to hold some mortgage loans on their books the real money would be made by fees from processing loans that would be put into large packages and sold to institutional investors. So they amped up their efforts when they got Washington’s encouragement. Trouble started when the banks exhausted the most creditworthy mortgage applicants. In order to keep the fee income rolling in, the mortgage industry did the following (my analysis/perception of what happened):

–banks lowered their credit standards and began to focus on apparently lucrative “sub-prime” borrowers

–lenders began to take mortgage applications with little credit information on them/independent mortgage brokers began to be, shall we say, less vigilant in putting down accurate information about the borrower on applications

–banks split large packages of mortgages into tranches according to perceived risk levels, using academic theory to argue this magically made all the tranches less risky

–as the quality of these packages deteriorated, issuers successfully pressured credit rating agencies to override their normal assessment protocols and issue over-optimistic ratings

–the financial press reported that toward the end, banks were using bait-and-switch tactics to resell mortgages to institutional clients, showing them one list of mortgage security contents before sale but delivering instead an inferior set. I have no direct knowledge of this. It is the case, though, that at some point these transactions, even involving a US seller and US buyer, began to be executed in London rather than in New York. My, cynical, take is this demonstrates that the banks knew clearly that what they were doing violated the law in the US but was apparently permissible under the “regulation lite” regime in the UK

–in mid-2007, seriously overborrowed consumers began to fall behind on their loan payments and to default. By early 2008, it was clear that despite having laid off much of their exposure to the ultimate dumb money in world banking, Continental European heavyweights, the overall US banking system was in tatters and needed to be bailed out by Washington

–press reports from 2008 show that Washington decided it couldn’t simply bail everyone out and pretend that nothing bad had happened. So it chose Lehman, an avid participant in sub-prime mortgage trading, but not a firm crucial to the US financial system as a whole, and allowed it to fail.

How does this differ from Evergrande in China? We’ll see as the facts about Evergrande come out. As things stand now, Evergrande appears to me to be one company pushing the boundaries of the Party patronage system. Its calculation was that no matter how high its financial leverage might be, the mayors and bank presidents who arranged its loans would continue to provide it with more money. Its mistake, I think, was to make itself so much of an outlier and to borrow large amounts from the individuals who bought its condos. This last likely violated unwritten rules of conduct and made it more of a social threat.

The sub-prime mortgage crisis in the US, in contrast, is, to my mind, not a case of one reckless company, but rather of large-scale, systematic fraud.

shifting gears

Late last year and earlier in 2021 I began to shift my portfolio away from stay-at-home beneficiaries to companies that would benefit from reopening. The stocks I reduced or sold completely were generally the right ones; the ones I bought, however, didn’t do me much good.

I’ve noticed in the past few days that this latter group has begun to perk up. I think this change is for real. How so?

–for one thing, although anti-vaccine propaganda will likely continue, and the human toll from political posturing will likely continue to be high, it’s probably not going to get any worse (as a human being, I hope; as an investor, I’m betting)–the Fed now thinks the economy is strong enough that it can begin to lessen the downward pressure it has been putting on the long end of the bond market and that short rates will begin to rise art a somewhat faster clip than it imagined a few months ago

–temporary Federal stimulus aimed at offsetting some of the pandemic’s economic damage to incomes, has already begun to shrink. Absent action from Congress, it will continue to do so. As/when this tightening of policy begins to affect financial markets, rates may begin to rise–and because of this, PE ratios will start to contract a bit. That’s a bad thing for financial markets. At the same time, however, equity investor interest will begin to rotate away from “story” stocks, where profits are an aspirational goal, toward more conceptually mundane economic-cycle-sensitive ones. That’s because the latter group will begin to show rising sales and earnings–some of them will doubtless be surprisingly good (I’m tempted to write “shockingly,” because that’s the way I think things will play out, but I think that’s too emotion-laden).

In any event, this shift is how I read recent price action.

Evergrande vs. Lehman and Long Term Capital Management (LTCM)

Evergrande hysteria seems to have been a one-day wonder on Wall Street, as investors began to look deeper than over-the-top media coverage to realize that, while a big deal for China, it’s really only a worry for the rest of the world to the extent they’re Evergrande creditors.

The comparisons being made with Lehman and LTCM were headline-grabbing (which I guess was the intent) but way off the mark. I thought I’d write a brief recap of my take on both of these.

LTCM is easier. The important thing to realize is that while there’s tons of liquidity in the trading of the Treasury bonds that are selected to be the constituents of T-bond derivatives (called “on the run”), there isn’t in very similar bonds that aren’t (called “off the run”). Because of this, off the run bonds trade at slightly higher yields than virtually identical ones that are lucky enough to be on the run. For years, investors of all stripes–banks, brokerage houses, wealthy individuals–have shorted on the run bonds, used the money to buy nearly identical off the run ones and held to maturity. Under normal circumstances, this was like picking up $100 bills on the street.

In 1994, a famous Salomon Brother bond trader decided to execute this bread-and-butter strategy on an heroic scale. He founded LTCM, put a couple of Nobel Prize-winning financial academics on the board to enhance the brand, and raised a ton of capital.

Investors more than tripled their money in the first three years. Then came the implosion of the Russian economy in 1998, which triggered a flight to safety–meaning on the run bonds went up in price while off the run went down. Suddenly, LTCM, which was reported to be borrowing as much as 25x it’s equity, was bankrupt.

The “crisis” wasn’t about rich people losing money. It was about how to sell tons of highly illiquid securities that LTCM had (incredibly recklessly, in my view) bought, with nary a peep–that I heard anyway–from its eminent directors. The Fed cobbled together a consortium of banks to hold them and gradually sell them off.

Lehman tomorrow.

Evergrande …vs. Lehman and LTCM

To be clear, I’m not an expert on mainland Chinese real estate companies, nor am I 100% certain (in the way I am about Jack Ma) that I know why Hui Ka-yan is on Xi’s bad list, but here’s what I think is going on:

The mayor of every Chinese city/town is a high-ranking member of the Communist Party. He/she has economic growth targets to meet in order to remain the mayor and to become a higher-ranking official. The easiest way to get economic growth is to build something. So the mayor, with a developer in hand, goes to visit the head of the local bank. The bank president is also an important member of the Party, but lower in status than the mayor, who may be key to getting the bank president promoted. So a loan gets arranged, a big project gets built, no one looks too closely at the financial underpinnings and everybody wins.

My take on Hui is that he continuously gamed the system by being very aggressive with the amount of financial leverage he was using, to the point that he was always flirting with bankruptcy. His idea was likely that this gave him the greatest profit potential and that the mayor and the bank would always prefer to bail him out than to have an important project blow up.

Last August Beijing introduced the “three red lines,” a set of rules for maximum allowable financial leverage for property developers. Hui has been either defiant or unable/unwilling to make a satisfactory effort to comply.

This is by no means a new story for anyone interested in China or Chinese stocks. The two open issues are:

–how much exposure to a potential Evergrande default non-China financial institutions have, and

–what efforts (probably none, in my view) China will take to continue to prop up Evergrande.

Given that the story is so well-known, except to western financial TV, and that Evergrande represents less than 5% of the local property development market, the current talk of Lehman-like or Long Term Capital Management(LTCM)-like damage to financial markets seems wildly over the top.

the debt ceiling, Evergrande and September market blues

I think there is an issue for us as investors with the debt ceiling. But this may be less a fiscal issue and more a manifestation of the fracturing of Washington since Trump’s revelatory performance demonstrating the shockingly large amount of money that can be raised by politicians advocating white racism and political dysfunction. More about the fiscal side tomorrow.

Evergrande’s gigantic borrowing will doubtless be found to have reached far more deeply into bank loan portfolios outside China than markets are now aware. But this the case with any major potential bankruptcy. For the US, this is certainly nothing of the magnitude of the 2008-09 financial crisis, nor even of the savings and loan crisis, where the “Keating five” senators actively worked to stop the government investigation of crooked S&Ls. For China, though, the problem is potentially more serious.

What to do?

Day traders have a field day during a time like this. Most of us, however, have a much longer time horizon. So high on my list is avoiding doing something dumb that will mess up my long-term strategy. This implies that in most cases the best thing to do is nothing.

For me, though, a selloff is a chance to upgrade my portfolio. Typically, the clunkers I have among my holdings (everyone has them, it’s a fact of life), start to outperform–if they never went up, it’s hard for them to go down a lot. They also become more visible psychologically. So I’m on the lookout for stocks I’ve wanted to own but thought too expensive, which are typically sold off the hardest in a downturn, and trade out of clunkers.

I realized long ago that I have no ability to time the market’s ups and downs. So I’m looking for a stock that I already own that’s, say, 5% cheaper than it was a couple of weeks ago and a clunker that I’ve suppressed memory of–and which I should have sold long ago (or never bought) that’s suddenly up by 5%. If I see this situation, no matter where the market is (put another way, I’m ignoring the possibility that the spread between the two might widen), I’ll sell the latter to buy the former.