Keeping Perspective During Panic

The entire financial world seems to be in panic, lurching from one side of the economic ship to the other, rocking the whole thing. It's all madness, becasue it equates stock prices, or the vlaue that people place on companies, with the performance of the companies themselves. But look at IBM, a strong quarter and emphasis that management expects to hit its previous guidance for the rest of the year. Johnson & Johnson beat expectations. To get lost in the running crowd is to miss where you are, and that means missing the opportunities around you.

Norway's Sovereign Wealth Fund and Ethical Investing

It's always nice to think that you could maintain an investment portfolio while strongly taking ethics and social justice into account. Apparently Norway is doing just that. It's pulled out of Wal-Mart (labor issues), BAE Systems (nuclear weapon production), and almost two dozen other companies whose behaviors it has found wanting. And yet it's worth almost $406 billion. Nice work if you can get it ... and, apparently, you can.

Companies Paying Bond-Holders "In Kind"

In the non-profit world, there is a term called "payment-in-kind." That means an individual or company has supported a non-profit not with cash payments, but through donations of goods or services that the non-profit needs if it is going to operate. But when you bring payment-in-kind to the world of investing, you might also bring along the non-profit label - as in, this can be a great way of making nothing. According to the Financial Times, many companies have sold bonds with a PIK feature that allows borrowers to pay bondholders with shares or bonds rather than cash.:

During the buy-out boom, Standard & Poor’s Leveraged Commentary & Data estimates 43 bond deals were done with a PIK feature. Some analysts suspect, however, that the actual number was higher.

And now some of those companies are turning the concept into practice. This should be pretty damn disturbing to people who lend money to corporations. It's a credit crisis of a different kind.

In the past, when times were flush (at least on paper), companies often did not want to dilute ownership and its control and value. But what happens when a company can say, "Oh, that money we owed you? Here's another bond to make up for it." The bonds then effectively become IOUs, and when you expect to get cash, instead there is more paper. Companies may avoid default, but to what end? This turns credit ratings on their head, since, I'd argue, this lets borrowers effectively walk away from obligations in a legal manner. If compaies can, then often they will - and if they do, then the credit ratings that attempted to quantify how safe an investment was become meaningless.

Risk Won't Get Repriced

One of the problems with the credit crunch was that risk wasn't proportionately priced. Relatively risky investments didn't pay all that much more than safer ones, and so investors couldn't get that last visceral hint that they were writing a check for real danger. The problem was that there is just too much money in the world seeking a home, and that hasn't changed. For example, D&O (directors and officers) insurance premiums have actually been dropping in price for years, even though the chances of corporations getting sued by shareholders aren't dropping equally quickly. According to brokers I've spoken to, the reason is that there are always new sources of money trying out this type of investment, creating competitive pressures. I've heard the same from an economist who consults to upper management at large corporations.

And that money hasn't all disappeared in the recent market thrashings. Look at a Wall Street Journal article today about hedge funds bouncing back:

Through the end of the third quarter, hedge funds have seen $164 billion in new asset flows this year, already a record for a full year, according to Hedge Fund Research Inc., based in Chicago. The previous record year was 2006, with $126 billion in new asset flows. As much as $45 billion was invested in hedge funds in the third quarter, when markets were the most turbulent. Some 71% of that went to big hedge-fund firms -- those managing more than $5 billion each.

A lawyer at a major real estate firm told me that his clients in Europe were about ready to start a buying spree in the US because they have cash and because the exchange rate between the Euro and dollar gives them even more leverage.

The money goes pouring in, and it all has to find homes, so the differential between high risk and low risk will continue to remain small, not because the risks are that close in nature, but because the supply of money outstrips the demand. So people will continue to invest, largely ignoring the real risks, because they can't afford to be picky. They're all at a dance where they want to get picked, it's getting late, and being choosy means being alone. It's only in the morning that they see what they've done, but by then it's too late.

Some Financial Companies Get It Right

The Wall Street Journal has an article about some financial companies - Goldman Sachs, Lehman Brothers, and Deutsche Bank - that have managed to largely ride out the credit crunch. What was the common theme? They all knew risk when they saw it and didn't let their desire for easy profits undermine intelligent management. Some of the strategies included shorting the mortgage collateralized debt obligations (CDOs), greatly limiting exposure, and choosing carefully from among opportunities. In other words, this is old fashioned prudence governing recklessness. None seem headed for the massive write-offs some of their competitors are facing.