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One of the lesser known consequences of the First World War was the official collapse of the Latin Monetary Union (LMU). This was a currency union that had been formalized in December 1865 and its members included France, Belgium, Greece, Italy and Switzerland. Other countries such as Spain, Romania, Austria, Serbia, and the Papal States later joined or became informal members. The LMU served the function of facilitating trade between different countries by setting the standards by which gold and silver currency could be minted and exchanged. In this manner a French trader could accept Italian liras for his goods with confidence that it could be converted back to a comparable amount of francs.
The LMU eventually failed for a number of reasons. Some members, notably the Papal State's treasurer, Giacomo Cardinal Antonelli, began to debase their currency. This meant he minted coins with an inadequate amount of silver and then exchanged them for coins from other countries that had been being minted correctly. More importantly, because new discoveries and better refining techniques increased the supply of silver, the fixed LMU exchange rate eventually overvalued silver relative to gold. German traders, in particular, were known to bring silver to LMU countries, have it minted into coinage then exhanged those for gold coins at the discounted exchange rate. These destabilizing tactics eventually forced the LMU to convert to a pure gold standard for its currency.
The modern day Meditteranian countries can perhaps view the devaluation of the Euro caused by their fiscal largesse as payback, with a century's worth of interest, to those Teutonic currency traders that forced the LMU off it bimettalic roots. |
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Market Commentary
SECOND QUARTER SUMMARY
The global equities sell-off continued in June with U.S. markets, which had been outperforming, hit hard amidst fears we could be heading toward a double dip recession. Our biggest concern is still the lack of jobs growth. While the headline unemployment rate has dropped to 9.5% - don't let the numbers fool you. This has been a function of people dropping out of the workforce rather than new job creation. A measurement we prefer to watch is the Bureau of Labor Statistics count of total employment in the U.S., which had been rebounding in 2010 after bottoming out last December, but has rolled over again in the last couple of months.
This weakness in labor markets has several knock-on effects. It reduces total consumer spending among those without employment. It even limits spending among the employed as it creates uncertainty about job security. On a longer term basis, sustained unemployment tends to reduce the skills and earnings potential of job-seekers. We think the possibility of a rapid 1982-1983 style recovery in jobs is remote and we are more likely to get the slow, sputtering rebounds seen after the 1991 and 2001 recessions.
Another area of ongoing concern is the housing market, most notably upon the expiration of the federal home buyer tax credits. The National Association of Realtors Pending Home Sales Index, which is a fairly reliable indicator of future sales, hit a record low in May.
While we have previously written about our low expectations for price appreciation in home values we do not expect them to undergo another collapse. We think the home buyer credits brought forward a significant amount of sales that normally would have happened later in the year and those who are still in the market for a home might be inclined to wait and see if Congress will reinstate the credits (already extended and expanded twice in the last year). Record low mortgage rates mean that even if you consider home prices somewhat inflated, the relative affordability of houses is as good as it has been in the last 15 years.
There have also been noted declines in some well known leading economic indicators, especially the ECRI Weekly Leading Index. Combined with headwinds coming out of Europe (sovereign debt issues) and China (trying to cool an overheated property and investment market) these factors have resulted in higher expectations of a relapse into recession. We expect growth to be much slower or even flat in the second half of the year but we are optimistic that a number of factors will help us avoid another decline in GDP. Keep reading, we make our case for optimism in the next two paragraphs.
Primary among these are the continued benign outlook for interest rates. Rates on 10 year Treasury notes recently got below 3%, a rate last seen when we were still recovering from the worst of the financial panic. While this is partly explained by investors moving to the safety of US Government bonds (don't laugh) it is also a result of low expectations of inflation. One measure of this expectation is the difference in rates between Treasury Inflation Protected Securities and regular Treasury securities. This has declined by over 1/2% in the last three months. In addition, government measures of inflation have continued to decline. The following table shows the change in year over year inflation (CPI) for 2010. The bottom three rows are show adjustments made to the headline CPI number that often give a better indicator of future inflation tendencies.
Generally speaking, deflation is not a desired property in the economy (and if you are a Paul Krugman fan, it is the end of days) but we believe this means it will be a long time before the Federal Reserve will look to raise interest rates and in fact we would wager a pint or three they will act to loosen policy in some form (perhaps by reinstating their mortgage back securities purchase program) before they tighten. This loose monetary policy will help economic growth both here and in the rest of the globe which brings us to our second cause for optimism - emerging markets. The developing world has continued to grow throughout this financial crisis. We mentioned earlier that China has been trying to cool speculation in its markets while still looking to grow by nearly 10% a year. As these economies continue to grow in size and wealth they become ever more important markets for goods and services from the US and other developed nations. We see emerging markets continuing to be a prime factor in the remarkable earnings rebound shown by public companies in the US and Europe.
For now, we remain relatively defensive in most of our portfolios. A further 10-20% pullback in the S&P 500 would give us reason to get more exposure to equities on a valuation basis. We are hopeful that fears of a double dip are overblown and, if so, a sustained move above 1100 in the S&P would give us confidence to reallocate the portion of our portfolio we moved into fixed income in May.
As always we welcome any comments or questions.
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Asset Class Returns
2nd Quarter 2010
Performance information for asset classes is for total return assuming reinvestment of interest and dividends. It excludes management fees, transaction costs and expenses. 
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Financial Planning Highlight
*Special thanks to Matthew Albert, our summer intern, for his significant contributions to this piece.
The Impact of the Fannie and Freddie on Homeowners
Imagine you had two separate cousins call and ask you to co-sign on a loan for a house so they could get a lower rate on their mortgage. Being a loyal family member you agree to their request on the belief it would cost you nothing only to find out later your cousins were outbidding each other on the same house and have now walked away from the mortgage. Leaving you with the bill.
In the world of residential mortgages, those two cousins are Fannie Mae and Freddie Mac. These two government-sponsored enterprises (GSE's) were established to stabilize and expand the residential mortgage markets. As of mid- June they controlled roughly three quarters of the existing U.S. home loans. Their function in the mortgage market is as follows: when a bank lends individuals money to purchase a house, that mortgage is sold to one of the GSE's. These mortgages are then packaged together into a tradable security that the GSE's either keep in their own portfolio or sell to institutional investors around the world from whom the GSE's collect a fee for guaranteeing the principle. Because the GSE's were viewed as being implicitly backed by the federal government, they were able to borrow money at rates almost as low as the US Treasury. In turn, the GSE's could offer mortgage loans (indirectly through your local bank or mortgage broker) at much lower rates than any private sector competitor. In effect, the US taxpayers were lending their triple-A credit ratings to these GSE's while at the same time acting as the ultimate guarantor of their debts. The benefit was the reduced interest rates available to buy homes that conformed to the GSE lending standards.
This system worked for years as Fannie and Freddie came to dominate their markets due to the low interest rates they could offer and the shareholders and management of the GSE's were able to privatize the profits generated by their organizations without acknowledging the risks they were laying on to the public. By 2007, the GSE's either owned or guaranteed nearly $5 trillion dollars in mortgages. In order to fuel this growth Fannie and Freddie had begun buying riskier loans (they lowered their loan-to-asset ratio from 10-1 to 30-1 or allowed the home buyer to borrow 30 times their assets). When the housing market faltered in 2007 these homebuyers began defaulting in record numbers. As insurers, Fannie and Freddie had to step in to back these mortgages. Investors comprehended they were seeing the most significant decline in US home values since the Great Depression and began selling Fannie and Freddie stock as well as the debt issued by the agencies. The federal government, recognizing the possibility of system wide default if the widely held GSE bonds were even thought to be in danger of default, placed them into conservatorship on September 6th, 2008 wiping out the shareholders but making the GSE creditors whole. The losses for both Fannie Mae and Freddie Mac totaled $93.6 billion in 2009 and $18.2 billion in the first quarter of this year.
So what do these huge loses mean to you? You get to pay for them! Perhaps the most disingenuous statement of the entire financial crisis was made by Rep. Barney Frank in March of 2010 when he claimed he did not want people to believe that the GSE debt was backed by the US government. The Obama Treasury Department has issued a blank guarantee on all GSE debt until 2014 and no administration can allow a real default because the probability of widespread financial panic following such a move. While these huge losses are not officially on the books of the government you can be assured that we taxpayers are responsible for ensuring payment on all of Fannie's and Freddie's outstanding loans and guarantees. The Congressional Budget Office estimates it will cost a total of $400 billion to bail these two companies out. Bloomberg estimates the cost at $1 trillion.
Even with these financial difficulties, Fannie and Freddie continue to play an integral role in the US mortgage market. Since they provide insurance on individual homeowners' mortgages, they are able to maintain low mortgage rates. Currently, an option that does not include the GSE's does not even exist because private sector lenders have not competed in this market sector for years. Judging by jumbo mortgage rates, if Fannie and Freddie were to stop buying loans tomorrow, you could expect interest rates to increase 1%-2% and the 30 year fixed rate mortgage to disappear. Obviously those would have very negative consequences on home sales and values.
The overreach of Fannie and Freddie and the size of these financial institutions played a major role in the biggest housing bubble in U.S. history. This actually counteracted the original intent in their creation; making housing more affordable by lowering borrowing costs. Instead the lower mortgage rates helped inflate the value of housing so the primary beneficiaries of low rates were real estate speculators and those few homeowners who downsized during the bubble. In our view the Federal government's efforts to make products affordable (whether housing, education or healthcare) often has this perverse effect. It is an example of what the French economist Frederick Bastiat would call the "unseen" consequences; those that only emerge subsequent to an action. In that spirit we hope the next incarnation of Freddie Mac and Fannie Mae are developed with greater foresight than the last ones.
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What We Have Been Reading
An interactive guide to the European economic problems
Ours may not be the most overpaid but they might be the most overvalued
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What's New With Us
InnerHarbor Advisors was featured on the June 28th post of The Nierenblog. Andrea Nierenberg, "the Queeen of Networking", is a master at helping companies build their businesses by improving employee and client relationships. She has been featured in major publications including The New York Times and The Wall Street Journal. She is also a top-selling author of "Nonstop Networking: How To Improve Your Life, Luck and Career".
John is on "summer break" from his work towards a Masters Degree from Baruch College. He has completed two-thirds of the Quantitative Methods and Modeling program at the Zicklin School of Business. He and Denise, his wife have been taking weekend trips to their house in Vermont with their little boy- Sean who will be two in September.
Mike is set to move to the leafy suburbs of Westchester County, New York. After nine years in Manahttan, he and his wife, Andrea, hear the siren call of a backyard, a swingset and a playroom for their two children, Nolan (4) and Clara (2).
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