Dr. Henry Kaufmans Lessons That Should Have Been Learned

September 22, 1999

Admittedly sounding like a broken record, we are in the midst of another wildly volatile week in the financial markets. For example, with rumors flying, today the Internet stocks went on a moon shot, gaining 5%. And despite general stock market weakness, The Street.com Internet index has gained 5% so far the week and has now gained almost 44% from August lows. Throughout the stock market, there continues to be extraordinary volatility and divergence between individual stocks and groups. Interestingly, the "bluechips" are dramatically underperforming, with, once again, many of the more speculative stocks and groups dramatically outperforming. We dont believe this is sustainable. So far this week, the Dow and S&P500 have dropped about 2%. The Transports have also declined about 2%. Losses have been slightly greater for the Morgan Stanley Cyclical and Morgan Stanley Consumer indices, both dropping about 2-=%. The Utilities continue to suffer, falling 3%. The small caps have outperformed so far this week, with the Russell 2000 down just over 1%. And with the technology stocks continuing to demonstrate amazing resiliency, the NASDAQ100 has declined less than 1% this week with the Morgan Stanley High Tech index has been largely unchanged. The NASDAQ Telecommunications index has a slight gain for the week, while the Semiconductors have dropped about 2%. The financial stocks continue to trade poorly, with the S&P Bank index and the Bloomberg Wall Street index both posting about 2% declines.

The dollar continues to trade very poorly against the yen, sinking below 104 today, which is not bullish for US financial asset markets. Yesterdays announcement of Julys $25 billion trade deficit, another record and again larger than expected, was not welcome news. News out of Japan also has led to more nervousness that the Bank of Japan is set to more actively demonstrate its independence. Quoting a Bank of Japan official, "A valuable lesson we learned from policy-making during the bubble period (late 80s) is that if the formulation of monetary policy is directly tied to controlling the foreign exchange market, there is a strong risk that this would lead to incorrect policy decisions." It appears the Bank of Japan is very resistant to the inflationary consequences of continued dollar purchases. We will add that foreign central bank interventions to mop up a persistent flood of dollars overseas, particularly in Asia, has been a key factor over the years fueling the US bubble. It looks to us like times are changing. Clearly, the Bank of Japan has tired of buying dollars, so we are left pondering who might take up the slack.

We believe yesterdays Credit Bubble Symposium was very well received. We certainly were very pleased with the day. An extraordinary group of speakers shared their views and offered great insights as far as where we are in the bubble and how they believe things will likely develop. The legendary Dr. Henry Kaufman was the featured lunchtime speaker. Dr. Kaufman gave an exceptional presentation and concluded with a list of financial lessons that should have been learned from the past.

1.Good times breed the illusion of boundless financial liquidity. Markets that grew up during the happy days of escalating equity prices, modest yield spreads relative to US governments and skinny bid/offer spreads do not provide boundless liquidity in more turbulent times. 2.Marketability is not the same as liquidity. Securitizing financial assets gives the false impression of seamless marketability. Market activity, however, varies considerably over a financial cycle. Consider how easy it was to distribute new large blocks of Russian bonds last year and how difficult it was to disengage from these portfolios without making huge huge price concessions. 3.Marking financial assets to market is an imperfect process. In difficult markets it overstates values and provides a false comfort. Can one really claim that the last quoted prices in an organized market of those quoted by dealers as the market value is the real market value, without taking into consideration such aspects as size, credit quality, and general market conditions. 4.Modeling risk has great limitations. Mathematics allows exquisite refinement of history but is useless when the underlying structure changes. One of the key structural changes is the loss of liquidity. Models that provide good formulas for conducting dynamic hedging under normal circumstances are of no assistance when transactions can not be made without huge price concessions. 5.Contagion is a major force in the modern globalized, securitized market. The rush to shed risk spared no segment of the fixed income markets. It was certainly not limited to the emerging debt markets last year, very briefly. Very high-grade markets rallied dramatically and lower quality markets set back dramatically. 6.International diversification fails to provide much protection to the investor. This was true in 1982, it was true again in 1994 and 1995 and it was true again for a brief period last year. The arithmetic that purportedly provides that diversification lowers portfolio risk assumes normal covariances which go out of the window in periods of contagion. 7.Even lightly leveraged market participants lose access to position financing in gapping markets and certainly in disorderly markets. This was particularly acute in the emerging debt markets. The lesson is that investors can not count on normal business relationships with dealers when conditions turn turbulent. The dealers step back from making markets and bid and offer spread swell. They also stop providing financing for even long-time customers. The implication is that those who might have stepped in as contrarians, had the prices of emerging market debt fell sharply, were really incapacitated which, of course, helped guarantee that the momentum of price decline would persist. 8.Investors can not rely on sell-side analysts to alert them to bad news. They cant rely on governments, IMF or World Bank staff, either. So many have a vested interest in sustaining large flows of capital to the developing world that theres a conscious or unconscious suppression of leading indicators of problems. The answer of course, is that investors have to do their own research but that is difficult because of the pathetic quality of much of the data provided by the governments of emerging countries. 9.Rating agencies are not timely in their analysis. They lag events. The rating agencies were overly generous, almost until the last second, because high ratings put the Asian country dollar debt in the standard bond indices - indexes who do no independent analytical evaluation had to own the paper. Once the ratings were cut, they had no alternative but to sell and magnify the collapse in asset values in the secondary market and making it much more difficult to issue new bonds in the new issue market. 10.What is off-balance sheet is perhaps as important as what is on balance sheet. This is only logical. When leverage is generated off-balance sheet the standard accounting numbers dont begin to describe the full extent of exposures. Korea, for example, was suppose to have had over $30 billion in reserves, when the problem began, but these reserves disappeared quickly because of outstanding commitments in the forward market. More recently, Long Term Capital Management last year was reported to have had a commitment in the derivatives market of about $1.4 trillion. That dwarfed the data reported on its conventional balance sheet. 11.Securitization does not eliminate the important role of commercial banks in the build-up of risks. The Japanese, the European and American banks, which had increased their short-term lending in Asia a few years ago, vastly magnified the risks to bond investors. Most of whom having acquired their bond offering at a time when bank lending was mostly subdued. They figured that the bankers were out of the business and would not return. This assumption proved wrong despite the sorry experience of the 1980s. The bankers believed that short-term loans could be securitized at will because the ratings were so high. None foresaw obstacles to funding which then would lead to the lowering of credit ratings. 12.When default looms, securitization shifts power away from investors towards borrowers. Even more so than years ago when commercial bank lending dominated. This was dramatically revealed in the case of Russia. Securitization meant that collectively lenders had less clout once conditions went badly last August. The Russian government successfully was able to exploit that mismatch in the negotiating position by their unilateral repudiation.

"So let me conclude by identifying a number of lessons for official economic and financial policy-makers. One, policy can not be predicated on the assumption that reasonable financial behavior is the norm. To the contrary, we have learned, and official policy makers should have learned that during times of market prosperity, when asset values are advancing and good times are being extrapolated by the market, analysts and government officials alike, cautionary words are disregarded or even ridiculed. Asset values can be driven to unwarranted levels. Risk can be systematically underestimated. Credit quality yield spreads can be compressed far below what would be adequately needed to compensate investors. The flip-side is that when the bubble is to burst, and investors take flight, modest changes in policies that would have had the useful effect in dampening enthusiasm during the rally have virtually no impact whatsoever in restoring market conditions. In other words, reasonable financial behavior is lacking in the downside as well as on the upside

There are lessons for our own central bank, the Federal Reserve. The backdrop is the following: It is always going to be the case that the basic objective of monetary policy is to achieve a balance of sustainable economic growth and stability of prices. Price stability is almost always thought of as the stability of prices of goods and services. But there is another dimension, as we all heard the price of financial assets and real assets. The dilemma for monetary policy is to what extent the Federal Reserve should take into account inflation in asset prices as it formulates monetary policy. Inflation in asset prices is highly popular as we hard this morning. Whereas inflation in the prices of goods and services usually hurts the individual or the average family. However, excessive inflation in financial asset prices sets in motion a series of forces which over a period of time can undermine the foundation of a stable economy. For one thing, it stifles the incentives to genuinely save. The past few years, as you all know, we have had an enormous increase in financial wealth while fresh savings, meaning out of income of individuals, has amounted to very little. In the meantime, excessive inflation in financial asset prices can breed excessive business investment, contribute to undue economic and financial concentration, and encourage questionable flows of funds into risky markets on the part of inexperienced investors and others. In its policy decisions the Federal Reserve has not yet placed any weight on the huge increase in financial asset values. Indeed, there seems to be an asymmetrical approach. The record shows that when asset prices have suddenly fallen, as in 1987 and again in the fall of last year, the Federal Reserve eased monetary policy to take account of the need for the financial markets for greater liquidity at a time of stress. Also, it may have wanted to counteract the potential compression in domestic spending that might have been caused by the loss of financial wealth. But there is very little evidence of a symmetrical response when asset prices have advanced strongly and financial wealth has escalated. Thus, there is the expectation in the market, rightly or wrongly, that as a result of the 1987 experience and that of last year, that faulty investments will be bailed out by the central bank.

Political support for such an asymmetrical monetary policy approach is growing in the United States. Households have a new profound interest in the success of the stock market. Now that they are perceived as directly strengthening their net worth and therefor oppose any monetary tightening that could keep them from enjoying those rewards. In contrast, years ago households put most of their savings in simple bank deposits and thus many risk-averse people, especially among the elderly, actually had a preference for higher interest rates. Businesses never favor anything that will restrain their sales or their profits. And, in recent times, those on both ends of the political spectrum have developed an antagonism to prudence in the pursuit of monetary and financial policy. No matter how the Fed responds to the bubbling in the market from here on, one thing is clear to me, it has missed its timing. A bubble is already very big and there has been a Fed failure to understand and to recognize the significance of the bubbling for economic and financial behavior. Alan Greenspan indicated that the Fed must know more about the interaction between the changes in financial asset values and the economy, back in his presentation at the Jackson Hole conference last month. And I sat there listening to his presentation very carefully. He also intimated that once a bubble bursts, the Fed has the capacity to deal with it. Nevertheless, I believe the response by the Fed to a busting of the bubble is a very difficult judgement call. If the market responds to an easing of policy, and rallies again, as it did, for example, last year, excesses in the financial markets are upheld and a bigger bubble is surely likely to emerge.

On the other hand, the Fed may hope that just a modest deflation of the bubble will allow economic performance over time to catch up with the overvalued financial assets at the present. That would be quite an achievement in markets which today have a very near-term, short-term orientation. Unfortunately, when you miss your timing, whether it is in personal, in business or in financial life, theres always a cost to bear. When official policy, when monetary policy misses its timing, we all have to share that cost."

-- Ponzi (Dow@36000.com), September 26, 1999