Reposted with permission: What Has QE Wrought? By John Mauldin December 21, 2013
Leverage Giveth and Leverage Taketh Away
What Does Tapering Really Mean?
What Will the Stock Market Do?
Corona del Mar, Dubai, Saudi Arabia, and Canada
Now that we have begun tapering, we will soon see lots of analysis about whether QE has been effective. What will the stock market do? The US economy seems to be moving in the right direction, but the Fed has forecast Nirvana (seriously) – do we dare hope they can finally get a forecast right? Or have they jinxed us? This and a few other dark thoughts crossed my path on a beautiful day in San Diego; so in a very different Thoughts from the Frontline, I offer a number of small gifts rather than an overarching theme, and we will see if we can keep it short.
Let’s start with a wicked-brilliant essay by Dr. Woody Brock. It is way too long and penetrating to cover fully in this letter, but we can glean some bits of wisdom.
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The world has been focused on central banks and the ending of QE. But Woody muses about a second dimension to this issue. If the true winner under a zero-interest-rate policy (ZIRP) has been the shadow banking system (as many, including your humble analyst, have observed) what distortions are baked into the market? What will happen as ZIRP finally goes away?
Woody asks questions not unlike those Jonathan Tepper and I ask in Code Red:
But what about the second dimension to the unwinding of ultra?easy monetary policy, namely, higher Fed funds rates and an upward shift in the entire yield curve – for reasons having nothing to do with QE? This is seldom discussed. From the research we have carried out, it is this second dimension of the end of easy monetary policy that is the more important of the two. The nation has never experienced six years of hyper?low interest rates. What impact has this had on the restructuring of the balance sheets of insurers and banks? In striving to match assets and liabilities across 24 consecutive quarters of near?zero rates, what tricks might financial institutions have played (reaching?for?yield via derivative positions) that could backfire and occasion a financial crisis once the yield curve rises from the dead? In particular, what about the increased utilization of new “collateral and maturity transformation” schemes that could occasion future panics?
And yet, the latest Fed papers are all about “forward guidance.” They suggest that, rather than QE, it is forward guidance promising a low-rate regime that is far more effective in producing the Fed’s desired ends. So if I read those papers and speeches correctly, we could be in a ZIRP-type policy for another three years. Where rates are starkly negative and investors are forced to seek yield in new and creative ways if they do not want to see their buying power eroded. But where we have little or no experience, and there might be a serious mismatch in duration.
Rewind to 2008-2009. What follows comes under the heading of full disclosure about painful lessons and a warning to those currently reaching for yield in new places. Without going into details, some (ok, a lot) of us had money invested in hedge funds that were part of the shadow banking system. There were all sort of creative funds invented to take private credit sources and circumvent normal banking functions. Life was good for a time, as “small” investors were able to get the returns normally reserved for banks. Except in cases of extreme leverage, we are not talking about lights-out numbers, just nice and steady high single-digit or low double-digit returns.
You could analyze the risks of the underlying investments and decide whether you were comfortable with the focus of the manager or fund. But as it turns out, the main risk you were taking had less to do with the actual investments but more to do with your fellow investors and their fetish for liquidity in times of stress.
Many of the funds in the shadow banking system had relatively short-duration money, which was invested in longer-term loans and financial structures. When everyone tried to redeem at once, the exits got crowded. Chaos ensued. It was not unlike – or maybe in some cases it was exactly like – an old-fashioned bank run.
Funds were forced to sell assets that were technically “good” but for which there were no buyers, except for investors who were picking up distressed debt. It was common to get assets at 50 cents on the dollar or less if you had ready cash. But those sales locked in significant losses for the sellers, and there was often modest leverage involved, which compounded the losses. Leverage giveth and leverage taketh away.
Other than the distressed-debt funds, which had a field day, there were only a few funds where the investors ended up OK. But those were funds where the investors’ money was locked up so they were forced to sit through the crisis. Yes, if you looked at the mark-to-market returns over the short term, it was ugly (VERY ugly in some cases) on paper; but during the next few years, as price normalcy returned, valuations climbed back to normal and interest rates pushed returns over time to what should have been expected.
Two lessons here:
One is that you need to make sure the credit funds (and actually, any funds) you are invested in have the ability to match the duration risk of the source of their funds AND of their (your fellow!) investors, with their underlying investments. As an easy example, if you are invested in a fund that makes three-year loans and offers daily or monthly liquidity, if that fund has sudden demands for withdrawal, it will be forced to sell assets in the open market and take immediate losses to return that money. That is clearly not good!
But if there is a three-year hold or lock-up for withdrawals, the fund can manage withdrawal requests in a normal fashion as the underlying investments mature. Investors who want to stay in the fund do not suffer from the need for liquidity of their fellow investors.
In today’s environment, the reach for yield is once again pushing investors into creative practices. Some funds are built to withstand a crisis, and others will get crushed. You must do your homework up front, and that includes thinking about what would happen to the underlying assets if another crisis comes along.
And the second lesson? You have to think about your own need for liquidity. If I came to you and told you that I loved your work, I might go on and on about the quality of your product, your work ethic, your productivity, etc., and then say I wanted to offer you a job. You might at least be interested and want to hear the offer. But if I then offered you minimum wage, you would just laugh and walk away, wondering what planet I was on.
But so many investors are willing to invest their money for minimum wage and maximum risk because of a personal fetish for liquidity. The last two bear markets have made us (appropriately) concerned about the safety of our money and left us keenly aware that we need to be able to run for the hills when the time comes to do so. But the pain of two bear markets has also caused us to seek protective mechanisms that might not be helpful in terms of our longer-term objectives. Liquidity is one of those protective mechanisms.
Liquidity costs money. Providers of liquidity have to provide either lower-return vehicles in the form of credit-type funds or increased risk in by way of equity-focused funds.
This is a theme I am going to visit a lot in 2014. You need to divide your investable assets into “liquidity or time buckets.” Very few of us actually need access to all our funds at a moment’s notice. We can take some of our funds and tie them up for longer periods of time; and if we think through what we invest in, we can get more than minimum wage for our investments.
In essence, for a portion of our money, we should be sellers of time or of liquidity risk. When you begin to think of your investment process as selling the time value of your money and seeking areas where people will pay you the most for your time, as we do in our work-related activities, I submit you might have more long-term success.
We are going to explore this idea at length in the next year and look at actual ways we can do this. I have been working for six months with a new associate, Worth Wray, developing a new focus on actual portfolio design; and shortly after the first of the year we will begin to publish. We are still dotting the final i‘s and crossing the last t‘s of the regulatory issues surrounding the process, but I am excited about what we will be able to do for you. What we hope to provide is a practical approach to investing in Code Red world.
But back to QE and ZIRP. After the Fed announcement last week, I was asked in one interview, “What will tapering really mean?” My honest answer is, I don’t know, and I don’t think the Fed does either, not in their heart of hearts. And if they think they really know – scout’s honor –, then they are delusional.
We can guess. Draw analogies. Play thought games. Try to “war game” the process. I have had some intense debates with people who are way smarter than I am, trying to come to some certainty. But at the end of the day, this has been an experiment without precedent. Has QE distorted foreign reserves in emerging markets, and will its withdrawal be an issue there? Is the stock market dependent on new reserves? We simply don’t know. We are getting ready to find out. Does the Fed’s buying of massive amounts of mortgages really make a difference? We don’t REALLY know,