The End of Equities

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Our trip to the bank proved more beneficial than we expected last week. We picked up a brochure for a new bank account that acts like a proxy for the stock market. The idea being that you put money in this special account and it earns you the stock market’s superior (but volatile) returns.

According to the brochure – and the report it references – Australian shares return 9.9% p.a. (including dividend reinvestment), while savings accounts only return 3.8% p.a. The calculations were based on a 20-year period and factored in taxes and the like.

So, obviously, the investment type account is better than the savings account, right?

Well, it seems the researchers forgot that ‘the most powerful force in the universe is compound interest.’ (There is some debate about whether Einstein actually said that or not, but you get the point.)

Taking into account the fact that savings accounts compound, a very different picture emerges for the analysis. Namely, $1000 in a savings account would outperform $1000 in the stock market after 46 years.

Better still, if you assume term deposits return 1.5% more p.a. than average savings accounts, rolling term deposits would outperform the stock market after only 24 years! And after that, you’re off to the races.

Keeping in mind that the stock market is risky and bank accounts aren’t … supposed to be… you have to wonder what on earth buy-and-hold investors are thinking. Particularly with term deposits available at 7%.

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And it’s not like the last few years have been kind to the stock market investor. Now it seems the bond market investor is about to get their share of the shellacking.

Journalists, bloggers and gurus around the world are taking it in turns to come up with storyboards on how the Greek debt crisis plays out. So here is our attempt:

Bond markets and credit default swap markets will continue to deteriorate, indicating a 70% chance of default by Greece. Even the former ECB Chief Economist (and current Goldman Sachs advisor) Otmar Issing will end up stating the obvious: ‘Greece is not just illiquid, it’s insolvent.’

The Greeks, knowing full well what’s coming, will pull their money out of banks and send it across various borders.

The EU’s political class, central banking community and banking community will be at odds over how to deal with the inevitable. (Never mind the taxpayers.)

The politicians will be in favour of lying, obfuscating and general BS-ing until their career ends, leaving whoever follows to deal with the issues. The IMF will attempt to maintain its credibility by refusing to bail out Greece unless the Greeks comply with IMF demands on austerity. In a bid to secure more funds for less action, the Greek Prime Minister will threaten to take the austerity required for more bailouts to a referendum – EU level politicians fear nothing more than true democracy when their grand plans are at stake. A rejection by the Greeks would bring forward the inevitable crisis, so that has to be prevented, even if the Europeans have to cave in to Greece’s opulent funding demands. If Europe does give in, the Greeks will realise their debt is too big to fail and the opulent demands will only grow.

Countries with control over their own sovereignty and a shred of awareness will ditch Greece following this realisation. (Apparently that doesn’t include the Swedes. Their Finance Minister reckons he would love to join the Euro…)

The central banks won’t want the inevitable Greek restructuring to occur, as this would mean a default as far as the ratings agencies are concerned. And the banks’ balance sheets couldn’t handle that. Lorenzo Smaghi, the next ECB President, will say ‘Time has been lost talking about how to come up with a way to reduce the debt, but if we accept this we’ll jeopardize all of Europe.’ Another ECB board member will call any thought of debt restructuring a ‘catastrophe’. Some commentators will note that the ECB itself would be insolvent if restructuring took place. (Would that make them biased?)

Other respected number crunchers will make it simple: Ifo president Hans-Werner Sinn will ‘bluntly confess that Europe [is] already so far down the path to a transfer union that there [is] no longer any way out.’

The rift between bankers, central bankers, politicians and reality will cause major uncertainty, which will be priced in by falling equity and debt markets. Except for US treasuries, which will emerge as the risk-averse asset of choice once again. Even the sounder PIIGS, like Italy, will have to be downgraded by the ratings agencies as contagion spreads. And the supposedly sound Aussie banks will feel the heat too, with debt downgrades and funding pressures.

To top it all, US credit default spreads will widen rapidly, indicating nowhere is safe.

But wait, all of the above has already happened…

Here is our actual forecast for what happens next:

Greece will default in a way that allows politicians to claim that there was not a default. Ratings agencies won’t toe the line and will downgrade Greek sovereign bonds, closely followed by the remaining PIIGS.

This will reclassify the debt that European banks hold to comply with capital adequacy standards (Basel I, II …) and will imply their insolvency. The laws determining how those assets are valued will have to be changed to prevent the banks from being legally insolvent and in breach of Basel requirements.

The estimated 1 trillion Euros committed by Europe to bailouts will spread the risk and insolvency instead of abating it.

By this time, Europe will be in a major crisis. And crises are notoriously difficult to predict. So from this point on, we’re speculating on one way things could play out. Just to be intriguing, it’s a really bad-case scenario:

The troubles in Europe will infect international credit markets from one minute to the next. Just like in 2008, inter-bank lending will freeze. That will prevent commerce from continuing, as much of the world’s business activity is based on short-term lending. Put simply, oil will stop flowing and food will stop being stocked on shelves. Banks will experience ‘technical issues’ when their customers try to access their cash. The Aussie banks, reliant on cheap overseas funding, will feel the heat too. Not to mention the bursting of the housing bubble and China’s tightening turning to a massive overshoot.

Of course, the politicians who put entire nations at risk with their response to the 2008 crisis won’t be frozen with fear. Unable to fund themselves this time around, they will turn to the law as their tool. Nationalisations and legalised accounting fraud will be the norm.

Central bankers will do their best to flood the market with liquidity, as in 2008, but what they can accept as collateral in their transactions will no longer include those assets that are most at risk – sovereign bonds – which also happen to be the traditional tool for injecting liquidity. Like in 2008 when the Fed purchased mortgage backed securities, central banks will have to purchase assets they normally wouldn’t. (The Europeans just voted unanimously to accept gold as collateral in these transactions!

Where the world goes to from here is a guess. But you have to wonder what equity markets will look like amongst nationalisations and mass QE. Equities won’t matter much. If money makes the world go around and money is debt and debt markets collapse, where does that leave depositors?

For those of you looking to make some profits out of the crisis, beware of whom you deal with.

Credit Default Swaps (CDS) are one way to bet on the demise of bonds at risk. They act similarly to insurance, where one party pays another to accept the risk of default. But you don’t necessarily have to own the asset that is being defaulted on in order to enter into CDS. That makes them the perfect gambling tool for the pessimists. They become simple bets with large payouts if you are right.

But here is the concern for people who invest in CDS. If banks issuing the CDS fail because their capital is wiped out by defaulting sovereign bonds, the very asset they issued CDS on, do they have to pay out on those CDS?

Believe it or not, a similar situation struck close to home not so long a go. An Aussie funds-management company invested in collateralised debt obligations (CDO) created by Lehman Brothers and also bought CDS from a Lehman subsidiary to insure against any default on those CDO.

In effect, this is like an insurance company insuring against its own default.

So, when the default occurred, the question was whether the CDS payout would simply become part of the bankruptcy proceedings, or whether it was payable in full before creditors got their hands on any assets.

The UK courts okayed the CDS payout to go ahead, but US courts ruled that US bankruptcy law rendered the CDS payment as being in line with all other creditors of Lehman Brothers. In other words, Lehman were paid money for a contract they would never have to fulfil. The matter was settled outside of court confidentiality, so nobody knows what the law is in these situations.

Now imagine a bank that begins to go insolvent due to Greek-debt restructuring. It may or may not be expected to pay out on the CDS it issued over that same debt to other parties.

For those of you who think CDS are obscure things you don’t have to worry about, consider that they were a causal factor in the collapse of Lehman and Bear Stearns. CDS are supposed to be the way large institutions reduce risk. If those institutions that need CDS to insure themselves against default find themselves without payouts, that would be like 2008 without the bailout of AIG. Goldman would be gone, among others.

Enough seriousness for one day. Let’s move on to something more light hearted.

Last week we mentioned the solar-power debacle, with government reducing subsidies for the gullible involved by 1/3. Believe it or not, safety checks have uncovered that the same wiring issues that caused the insulation scheme to go up in smoke apply here too. Hopefully the protestors will have a home to come back to.

You’d think these people have had enough of the government by now. But even if they get rid of their solar panels to save their house from burning down, they may encounter government provided electricity. According to The Australian, for Queensland and New South Wales, that means getting ripped off and experiencing blackouts. Victorians and South Australians can rest assured that their privatised power supply does much better.

Nick Hubble
Daily Reckoning Australia

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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Comments

  1. Nick: Wtf… how is the equities account not compounding, if you reinvest every year? If you count it as a ‘dividend’ then you could say that the savings account has no dividend and is therefore inferior.

    Stupid argument.

    Reply
  2. By the way, I don’t disagree that savings accounts are better at the moment though. Equities are looking horrible. I was merely disagreeing with your poor mathematical illustration.

    Reply
  3. Hi Nick.

    I have to agree with Pete’s comment. You aren’t comparing apples with apples. Extremely poor analysis.

    Now to the solar scheme. It amuses me that shoddy workmanship is blamed on the government. The people installing these systems are all from the private sector. They are supposed to be qualified and licenced tradesmen. If they want to do sub standard work, that’s just good old market capitalism at work.

    And as for the cost of these systems, a contract is a contract, is a contract. Disclaimer. I am one of the people that has been royally shafted by Fatty O’Barrell.

    alan Hughston
    May 30, 2011
    Reply
  4. I couldn’t agree more with Pete.

    Terrible analysis. I was shocked to get something this amateurish from Daily Reckoning.

    That being said, I also think equities are overvalued now.

    Reply
  5. Thanks for the comments.

    The 9.9% is annualised and includes dividend reinvestment.

    In the same “annualisation” of the cash rate, cash’s compounding was not factored in.

    The brochure claims to be comparing like for like, but it ignored cash’s compounding, while including dividend reinvestment.

    Consider where 9.9% p.a. would compound to over 20 years (the selected timeframe for the annualised return calculation.)

    Nick

    Reply
  6. Nick: I can see where you’re coming from, and I agree. But based on your original wording it didn’t really add up.

    Just like the banks to sell this kind of crap though. They’ll be looking to pounce on those retirees getting their superannuation lump sums or people who have just got out of the property merry-go-round.

    Preying on financial illiteracy is quite unethical/immoral in my opinion. But the financial sector has been doing it long enough that it seems ‘normal’.

    Reply
  7. For those that don’t get what Nick is saying by ‘annualised’, I believe it means a calculated total gain then divided by time (years).

    For example, a 100% gain over ten years, annualised, is a 10% gain per year.

    A term deposit on the other hand can get to gains beyond the linear 10% gains above as it operates on an exponential scale (as per Nick’s chart).

    Going by the chart though, you would do more-or-less equally well until about the 25year mark, which is a very long time in today’s hyperactive attention deficienct investors mind.

    Reply
  8. “Believe it ir not An Aussie funds-management company invested in collateralised debt obligations (CDO) created by Lehman Brothers and also bought CDS from a Lehman subsidiary to insure against any default on those CDO.”

    Nick, this is incorrect, and I do not “believe it”. The fund/investors never bought any such insurance. The documentation attached to the CDO investment you refer to stipulates that should Lehman Brothers Special Financing (the swap counterparty) default, then the deal is unwound and all monies (collateral) will be returned to investors first, a so called flip clause. Lawyers for Lehman are playing the ipso-facto argument to overturn this agreement. It has nothing to do with ‘buying additional insurance’, simply Lehman’s lawyers having deep pockets (from the Lehman estate) and basically bullying investors to settle with them (or get dragged thru the courts for 5 years). Perpetual Trustees, representing investors for the Mahogany listed CDO, were pussies and basically gave in to Lehman despite a favourable decision pending in the US bankruptcy courts. Why they did so is probably because it was the quickest exit for them, but who really knows. Watch this space. There is still further action pending regarding oter Aussie Lehman CDOs (where Bank of NY is the Trustee) and should Aussie investors win in the UK courts and the US courts, investors in the Mahogany series could look to sue Perpetual. I know becasue I was an investor in Mahogany.

    Alby Mangled
    May 31, 2011
    Reply
    • Quoting from the case:
      ‘… had entered into a credit default swap contract with Lehman Brothers Special Financing Inc.’

      As stated in the article, CDS ‘act similarly to insurance.’

      Reply

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