Come, come, we fear the worst; all shall be well.
When clouds appear, wise men put on their cloaks;
When great leaves fall, the winter is at hand;
When the sun sets, who doth not look for night?
-Richard III (Act 2,3)
The European Financial Crisis Resurfaces in Greece
Throughout the 3rd quarter of 2011, the European Financial Crisis loomed as the greatest threat to economic growth and stability. In November of 2011, we presented a simplified explanation of this crisis (still available on www.westminster-consulting.com/Publications/Articles), and we will build on the topics and themes from that whitepaper.
The epicenter of the crisis, Greece, has struggled though unpopular austerity measures to secure financing from wealthier nations over the past 6 months. By the first quarter of 2012, it looked like a Greek bailout and bond deal would finally define the scope of shortfalls and, given the additional capital in the European Financial Stability Facility, that there would be sufficient resources to deal with the crisis. Optimism, and the markets, moved higher.
Sadly, the ongoing political turmoil in Greece has called the entire arrangement into question again. The unpopularity of the austerity measures proved a substantial political hurdle. The technocrats were removed from authority with the May 6 elections, and without a majority, the government has fractured without a functioning coalition. The anti-austerity Syriza party has a plurality, although not a majority, of votes which also suggests that the bailouts, the debt deal and Greek membership in the Eurozone are all now in question. Further elections, scheduled June 17, may be required if a coalition government is not possible with the current representatives, further delaying clarity to the economic situation.
The Greek population is unhappy with austerity measures, and recently elected politicians have convinced the Greek population that the austerity has gone too far, but they have yet to convince the creditors in a compelling thesis for growth or a justification for retaining the Euro. Like a bank that is “too big to fail”, newly empowered representatives have reasoned that Greece can get better bailout and debt relief terms from Germany by threatening a full default on debt, thus spreading a financial contagion across the Eurozone. These threats have become more overt in the past few weeks. However, the Greek impact to the system is potentially most important as the template for how other troubled countries will receive support in the future. Rewarding Greece with constant lenience is getting progressively more difficult as it may embolden other distressed countries to use similarly destructive tactics. In the words of the German Central bank, “a significant dilution of existing agreements would damage confidence in all euro area agreements and treaties and strongly weaken incentives for national reform.” The continuous failure of the Greek government to fulfill its obligations to debtors, or other governments, may have finally worn out the patience of its creditors. Political leaders – like Chancellor Merkel - have signaled a softer approach and suggested possible stimulus spending for Greece, but “the future of Greece in the euro zone now lines in Greece’s hands”. Greece may just achieve a Pyrrhic victory, default on its debts completely and be ejected from the Eurozone – at the cost of significant financial aid, access to credit and stability.
An Echo of 2008 US Financial Crisis – JP Morgan
Compared to peers, JP Morgan got through the 2008 financial crisis relatively well. For example, investment bank Bear Stearns lost a lot of balance sheet strength on mortgage backed securities within its proprietary trading accounts. When the subprime mortgage market really began to unravel, the Federal government took an active role to ensure solvent banks bought overextended banks. In March 2008, the Federal Reserve realized that Bear Stearns could not be saved and arranged for its sale, at a substantial discount, to healthier rival JP Morgan.
On May 10th 2012, JP Morgan announced a $2 billion loss in its proprietary account from trades that, in their own words, were “flawed, complex, poorly conceived, poorly vetted and poorly executed.” The loss estimates are incomplete; a full unwind of the trade may take $2 to $5 billion. Several key executives, including Chief Investment Officer Ina Drew, have already resigned for the blunder. Detecting potential wrongdoing, the US Department of Justice and FBI recently began a criminal probe into the trading loss. Shareholders are suing. As a reminder, here is a partial list of the companies that collapsed, sold-off, or required government intervention in the wake of the 2008 financial crisis: Bear Stearns, Lehman Brothers, Countrywide, AIG, Fannie Mae, Freddie Mac, Washington Mutual, Wachovia Bank, Merrill Lynch, Citigroup/Smith Barney, and IndyMac Bank. Several of those businesses (e.g. - AIG, Lehman Brothers) became insolvent by making bets in their propriety trading accounts that undermined the balance sheet of the company. How much more of a warning did JP Morgan need to police its own behavior?
Let’s back up: how much damage is a $2 billion dollar trading loss? To JP Morgan, the loss is manageable; it is less than 1% of their balance sheet. The company can easily absorb the loss. However, investors were understandably disappointed that JP Morgan apparently did not learn the lessons of recent history. The perception of recklessness cost JP Morgan stock substantially more. For the month of May, JPM stock is down about 20% – roughly $26 billion of market capitalization.
Worse, JP Morgan’s recent scandal fits into a larger, ongoing discussion regarding the crisis of overextended banks and the need for increased regulation. A thorough discussion of the merits, efficacy, and disadvantages of increased regulation - such as implementing the Volcker Rule to ban proprietary trading – could easily fill a book. To summarize, the proposed regulations would prevent a lucrative business practice that can strengthen the financial sector, which is still eager to restore profits and repair the damage caused by the 2008 crisis. We know, from his many apologetic press interviews, that CEO Jamie Dimon did not want to have this conversation right now. The largest, surviving institutions of the financial crisis have already been tarnished with nearly constant scandals and depictions of unethical trading practices (robo-signing, fiduciary lapses, mortgage practices), so scrutiny and criticism was already high. Given the current threats of increased regulations, JP Morgan management should have done a better job in policing the company’s activities or, at least, setting guidelines for behavior that could minimize collateral damage – to their balance sheet and, much more importantly, to their business operations.
Past Performance Does Not Guarantee Future Results
The problems of 2Q 2012 do look familiar. Are the problems in today’s market really unique or are we experiencing an echo of previous troubles? If history is repeating, should we brace ourselves for another financial crisis?
There is a danger of extrapolating the future based on previous results. A famous example of using previously identified patterns to infer future results is the “Price of Butter in Bangladesh” stock market indicator. In 1993, researcher David Leinweber went through an encyclopedia of data to figure out which data set most closely correlated with the stock market. He determined that the price of butter in Bangladesh had the highest correlation (99%) to the annual movements of the S&P 500 for the previous 10 years. Not surprisingly, once his paper was published, that relationship broke and some other random, arbitrary data set became the new winner. Identifying a pattern, or a cycle, in the data does not guarantee a good result.
More recent history is littered with investment luminaries who were right, until they weren’t. Hedge fund manager John Paulson had a tremendous winning streak in 2007 betting against subprime mortgages, and is now defending poor trades which took his flagship fund down 40% in 2011. Banking analyst Meredith Whitney rose to fame in 2007 by correctly inferring the pessimistic state of Wall Street financial giants but has since struggled with the fallout of a highly public, incorrect prediction of widespread municipal failures. Legg Mason CIO Bill Miller famously beat the S&P 500 for 15 years in a row, only to underperform in 5 out the 6 most recent years. So, simply counting on the judgments of previously successful investors is also no guarantee of a good result.
Forget investments; try baseball. Albert Pujols capped an 11 year winning record with the St. Louis Cardinals by becoming the National League home run champion for 2 years running (2009 & 2010). He was drafted by the Los Angeles Angels for a 10 year contract in starting 2012 and paid a record $254 million dollars to deliver home runs to the L.A. Angels. After all that, Pujols managed go to 33 games and 139 at-bat opportunities – the longest drought of his career - without a home run. By the time Pujols finally got a home run in early May 2012, his batting average slipped to a paltry .194.
On the other hand, Pujols hasn’t hit many home runs lately, but his addition prompted fans to buy an extra 5000 in season tickets. That offsets some of the pain of the recent underperformance. I can’t guess if he’ll recover a home run title, but Pujols has pushed through droughts of performance before. In 2011, he didn’t get a home run for 27 straight games and 105 at-bat opportunities. This statistic was assuredly in the mind of the Angel’s management team when they hired him. I suppose they reasoned that past performance does not guarantee future results – good or bad.
Let’s go back to the markets. Maybe JP Morgan did not learn their lesson and they are, in fact, making it difficult for their peers to avoid increased regulation, but few analysts suggest that the scope of the difficulties are as dire as 2008. The probable medium term scenario for the US financial sector includes increased regulation, poor public relations, continued housing weakness, slow economic growth, and the isolated bank failures. It’s an unattractive future, but certainly not as bleak as the 2008 bear-investor consensus of systematic failure, imminent collapse, and Great Depression era economics. JP Morgan’s issues are emblematic of issues facing the financial sector, but they do, at least, have precedent.
Greece is a bigger worry. At this point, the social-political advantages of a European Union are secondary to the economic disadvantages of the Union and the previously “unthinkable” option of dissolution is rapidly becoming inevitable. Germany, France and the more solid members of the Eurozone have been developing contingencies for a Greek exit, but there is no precedent for a break-up of this scale, and the mechanism for separation doesn’t exist yet. If and when Greece removes itself from the European Union, neighboring countries may tacitly support the country to prevent a spreading contagion of weakness across the continent. Even now, high level meetings include discussions of how to support Greece’s economy once it has left the Union and contingencies for managing the breakup.
Should we be looking for history to repeat itself or are these unresolved issues that were put aside? Certainly, the Eurozone crisis does not promise an immediate resolution. If the European Union really does break-up without proper planning, we may expect the United States to become a relative safe harbor, as it was during 2008. Alternatively, if the economy starts to show more optimism, we expect the return of price inflation, like the energy price spike in 2007 or the first quarter of 2012.
We have shown examples where successful prognosticators make bad predictions. It is not our goal to predict when the data is sufficiently bad to suggest another recession or merely an overdue, mild correction to an overenthusiastic market. Rather, our goal is to tell you that storms will come occasionally, so pack an umbrella. Make sure your long term, strategic portfolio is designed to handle occasional bouts of bad weather, but make sure that you have appropriately diversified it to take advantage of fair weather when it returns.