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Money, meddling and meltdown

Financial regulators around the world are desperate to stave off a panic, but if they really want to solve the market’s problems, they need to learn to let things be.

In June 1944, 16 ministers of finance and delegates from 45 countries gathered at the Mount Washington Hotel, New Hampshire. As World War II drew to a close, a new monetary world order was required, and it was the job of the United Nations Monetary and Financial Conference to decide what that order should be.

The monetary system that resulted came to be known as Bretton Woods, after the postal address of the Mount Washington Hotel, and it profoundly changed the financial world.

Prior to 1914, most of the world’s major currencies were either metal coins or convertible into a fixed amount of metal, usually gold. Monetary supply (the amount of cash in an economy) was, in theory, limited to the amount of gold the reserve banks had in the coffers, and the interest rate was adjusted to ensure supply and demand were in balance. ‘Money’ had a value in the form of shiny gold pieces, and if a country spent more than it earned it had to hand over the difference in gold.

This limit on the amount of currency that could be produced kept inflation to a minimum. In A Farewell to Alms, Gregory Clark tracked inflation in England from the year 1200 and it was rarely more than 2% a year (one exception was the late 1500s when ‘an influx of silver from the New World helped drive up prices’).

The gold standard was suspended in the UK during World War I and re-established in the 1920s with disastrous consequences (the exchange rate with the US dollar was set too high) and suspended once more during World War II. Hence the need for a meeting.

Out with the gold, in with the newBretton Woods represented the first major step away

from the gold standard and the first of many towards today’s fiat or ‘faith-based’ currencies. Under the original Bretton Woods system, the US dollar was still backed by gold at the rate of US$35 an ounce, but the rest of the world’s currencies were not. They were exchangeable, through the International Monetary Fund, into US dollars.

This put the US in the unique position of being able to pay for its debts with currency that it alone had the ability to print. In theory, foreign central banks could exchange their dollars for gold (it had been illegal for US residents to own gold since 1933). In practice, most central banks simply invested their US dollars back into the US and for

those, such as French President Charles de Gaulle, that had the temerity to suggest they might actually exchange their paper for gold, the monetary authorities made it increasingly difficult.

By 1971, when Richard Nixon declared that the dollar would no longer be converted into gold at all, there were $50 billion US dollars outstanding against Fort Knox’s $12 billion worth of gold. He was making official what had already become obvious: the gold standard was dead.

God-like powersIt was the end of an era, and the start of a new one where

central bankers around the world were credited with God-like powers to control the monetary and economic cycle.

Unfettered by the cumbersome requirement to actually have something tangible standing behind the currency, central banks would be able to use interest rates, money supply and their own balance sheets to take the cycle out of the economy.

In addition to the ‘pursuit of maximum employment, stable prices and moderate long-term interest rates’ the US Federal Reserve’s role includes, according to its mission statement, ‘supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system’ and ‘maintaining the stability of the financial system and containing systemic risk that may arise in financial markets’.

In other words, every time something goes wrong that has the potential to affect the economy or the stability of the financial system, the Fed is going to use its faith-based currency to do something about it.

LTC Moral hazardThe Fed had put its newfound skills to the test on

numerous occasions before Long-Term Capital Management (LTCM) came along. Together with the US

IN THIS REPORT

ARTICLES STOCK PAGE

The Deere, the dollar and the dux 3Diary of a fi nancial meltdown 4Opportunities amongst the wreckage 6

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Put your faith in a good old panic [ C ONTINUED FROM PAGE 1 ]

Treasury, it put a rescue package together for the Savings and Loan industry during the crisis of the 1980s and slashed rates after the 1987 stockmarket crash to avoid a wider fallout.

But LTCM really showed how far the Fed chairman at the time, Alan Greenspan, was prepared to go to stave off financial contagion. Government sponsored mortgage businesses Fannie Mae and Freddie Mac had long been deemed ‘too big to fail’, but LTCM was the first privately run business the Fed deemed important enough to rescue.

At its peak, it was a US$130bn hedge fund—$5bn of equity and $125bn of debt. Following the Russian debt crisis of 1998, the fund had lost most of its equity and the banks that provided the debt were looking down the barrel of some scary losses. In the words of the Fed:

‘With world financial markets already suffering from heightened risk aversion and illiquidity, officials of the Federal Reserve Bank of New York judged that the precipitous unwinding of LTCM's portfolio that would follow the firm's default would significantly add to market problems, would distort market prices, and could impose large losses, not just on LTCM's creditors and counterparties, but also on other market participants not directly involved with LTCM.

‘In an effort to avoid these difficulties, the Federal Reserve Bank of New York contacted the major creditors and counterparties of LTCM to see if an alternative to forcing LTCM into bankruptcy could be found.’

The banks duly put together a rescue package, the Fed helped out by slashing rates, and crisis and instability were averted. For a time.

Financial Times columnist John Authers this week labelled the LTCM bailout the start of a decade of moral hazard—a situation where one party takes on undue risk because it knows it won’t have to suffer the consequences of failure.

The US authorities have been encouraging

moral hazard for a lot longer

than that. In 1933 the US Government brought the Federal Deposit

Insurance Corporation to life, which

protected depositors from failed banks, and banks

from irrational bank runs (but, in the absence of the risk of a bank run, encouraged them to take more risks with depositors’ funds). But the issue of moral hazard certainly reached a frenzy in the past decade.

Panic suppressed is not panic avoidedWhile the Fed supported the efficient market

hypothesis on the way up, the doctrine didn’t seem to hold on the way down. In the wake of the 2001 terrorist attacks and Enron’s collapse, Greenspan and his board slashed the official benchmark interest rate to 1%. There it stayed for 12 months, and it was at or below 2% for more than three years.

A serious recession was avoided. Or, as James Grant of Grant’s Interest Rate Observer, has put it, suppressed:

‘The financial history of the 19th century was one of intermittent, closely spaced panics; that of the late 20th and early 21st centuries has been one of panics suppressed, postponed or governmentally managed. You pick your poison. Closely spaced panics flushed out bad actors and illiquid structures. By suppressing or postponing panics, the Federal Reserve has prolonged the careers of the bad actors and facilitated the growth of illiquid banks as well as a parallel universe of illiquid insurers, GSEs [Government Sponsored Enterprises] and broker dealers’.

The Fed made it perfectly clear that some institutions were too big to fail, then gave them access to cheap money, and lots of it. It should come as no surprise that a large number of bankers incentivised by short-term bonuses took full advantage of the heads-I-win-tails-you-lose offer on the table.

That has led to the current predicament. Despite new Fed chairman Ben Bernanke’s best efforts to suppress disaster just a little longer, the amount of leverage and moral hazard in the system can no longer be sustained, no matter how far they lower interest rates.

Killing the patient

The poison they’ve chosen is killing the patient. Three of the world’s oldest and largest investment banks have effectively bitten the dust. They’ve been joined by one of the world’s largest insurance companies and two US mortgage companies that were once two of the largest companies in the world.

The financial world is in an awful mess, but don’t blame the greedy investment bankers and high flying executives. They’re only looking after themselves. Instead, blame a system that allows man to think he can control the economic cycle and print as much money as he wants. Grant goes on to say:

‘What the world needs … are more and better panics. Let adjustments occur in nature’s own time. Let the government withdraw from the adjustment-suppression business. Let imbalances not build up to the extent that a largish illiquid broker-dealer can threaten to bring down the global financial system.’

Fat chance of that. For ours, it’s time to head back to the Mount Washington Hotel.

Steve Johnson

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The Intelligent Investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 8305 6000 Fax: (02) 9387 8674 info@intelligentinvestor.com.au www.intelligentinvestor.com.au 3

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The Deere, the dollar and the duxThis crisis has entered unexplored territory, but we’re happy to make a few predictions.

Financial markets and the financial press are prone to making mountains out of molehills, but this crisis deserves its place in the Himalayas. Things were already bad. Back in March, people were so scared of putting their money anywhere else that they were buying US Treasury bills (US government debt) in exchange for an extraordinarily low annualised return of just 0.12%.

This week, that yield turned negative. People were prepared to pay more for a government bond than they were going to get back at the end of the month (the equivalent would be a bank offering to give you $99 in a month’s time in exchange for your $100 today).

It’s genuine panic and, with some of the world’s largest financial institutions falling like flies, justifiably so.

So what’s next? We at The Intelligent Investor try to avoid making forecasts at the best of times, and in the current environment we’re happier than ever to put our hands up and say we have no idea what’s going to happen or who is going to fail next. We will, however, stick our necks out on a few fronts.

Unleveraged, real businesses don’t need to worryA subscriber called this morning to tell me he’s just

spent three months in the United States. He went to the Harley Davidson factory, he told me, and you wouldn’t believe it: ‘They’re still making Harley Davidsons’. Apparently people are still buying them, too. Same at the John Deere factory, so they say.

He’s probably right. Our first prediction is that the world will go on. If you own real businesses and they don’t carry much debt, then you don’t have much to worry about. ARB Corp is still selling bull bars, Infomedia is still selling parts catalogues and JB Hi-Fi is still selling flat-screen TVs (apparently you don’t have to be an investment banker to afford them these days).

Some of these businesses, especially Infomedia, have even been enjoying recent conditions because of the plunging Aussie dollar. Unfortunately for those of us that own Infomedia shares, that is unlikely to be a permanent state of affairs.

Bad news for the US dollar

The second prediction we’re prepared to hang our hat on is that the crisis of 2008 is unequivocally bad news for the US dollar. So far the dollar has strengthened as hedge funds unwind carry trades and punters around the world flock to US government bonds.

When the dust settles, however, this is going to be one very expensive saga for the US taxpayer. Fannie Mae and Freddie Mac’s US$5.4 trillion of mortgage guarantees have already been added to Uncle Sam’s list of liabilities. How much he will actually lose is unknown—the latest government estimate is US$200bn—but alongside Bear Stearns and AIG it’s going to be an expensive year and it looks far from over yet. The Federal Reserve is certainly doing its bit as the lender of last resort.

The cost of these government bailouts will be added to the expected budget deficits of US$407bn

this year and US$438bn in 2009, and unfunded healthcare liabilities mean the long-term future doesn’t look

any brighter. We expect the depreciation of the US dollar to resume.

A reallocation of resourcesThis final prediction might

be based more on hope than conviction, but with some luck

this crisis will result in the financial sector consuming less of the world’s

resources. The outsized rewards from being a custodian of capital have resulted in

more brain power than ever being devoted to shuffling capital around and proportionately less than ever into actually creating it.

A functioning financial system is essential to any modern economy, but it doesn’t need all our would-be teachers, doctors, scientists and engineers to make it tick. To the extent that our youngest and brightest start thinking about an alternative career, this crisis will have been a blessing.Disclosure: The author, Steve Johnson, owns shares in Infomedia. Other staff own shares in ARB and Infomedia.

PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 8305 6000 Fax: (02) 9387 8674 info@intelligentinvestor.com.au www.intelligentinvestor.com.au

The Intelligent Investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 8305 6000 Fax: (02) 9387 8674 info@intelligentinvestor.com.au www.intelligentinvestor.com.au4

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2002

21 Nov ‘Helicopter Ben’—Future Federal Reserve chairman Ben Bernanke makes a speech in which he refers to the government’s ability to fight deflation by means of a ‘helicopter drop’ of money (as previously described by Milton Friedman). It earns him the nickname ‘Helicopter Ben’.

2007

2 Apr America’s second largest subprime lender goes bust—New Century Financial declares bankruptcy as an increasing number of borrowers default on their loans and banks demand their money back. In the quest for high growth, more than half of the subprime loans were made in the last two years of the company’s life, leading to its eventual downfall.

16 Jul Basis Capital belly up—Basis Capital is the first Australian hedge fund to reveal losses from its investment in subprime loans. In a letter to investors, the manager wasn’t able to estimate how much it had lost in one of its funds but was sure it would exceed 50%. Basis Capital suspends applications and redemptions from its funds.

17 Jul Major hedge funds collapse—Two hedge funds run by Bear Stearns collapse after losing almost all their value from betting on mortgage securities. This requires the investment bank to pump the hedge funds with $1.9bn in cash to meet the demands of the funds’ creditors, whilst attempting to unwind positions in subprime securities.

25 Jul Absolute Capital the second Australian casualty—Absolute Capital, a hedge fund specialising in collateralised debt obligations, closes one of its funds after losing money as the subprime market tightens.

9 Aug Debt markets shut down—BNP Paribas announces that it can’t value assets in three of its funds because of a ‘complete evaporation of liquidity’.

14 Aug RAMS gets sheared—RAMS Home Loans announces that conditions in global debt markets, especially the commercial paper market, are making it difficult for the company to find suitable funding. Management predicts lower earnings, but the troubles for the company have barely started.

14 Sep On the rocks—Depositors queue on the streets to withdraw funds from the UK’s Northern Rock.

18 Sep Fed cuts rates and extends terms for discount window—US Federal Reserve cuts the federal funds rate and its discount rate by 0.5% each to 4.75% and 5.25% respectively. The maximum term of loans made at the ‘discount window’ is extended from overnight to 30 days. This was the first in a series of six moves over seven months that took the federal funds rate down 3.25% to 2% and the discount rate down 3.5% to 2.25%.

24 Oct Merrill Lynch writes down US$7.9bn from mortgage securities in its third quarter results

30 Oct UBS writes down CHF4.2bn from its subprime exposure in its third quarter results

31 Oct Fed cuts rates—Fed funds rate cut 0.25% to 4.5%.

26 Nov Citigroup raises US$7.5bn from the Abu Dhabi Investment Authority

3 Dec Worried about property trusts—Doubts are raised that listed property trusts (LPTs) aren’t the conservative cash cows they used to be because they’re loaded with debt. As interest rates rise, many LPTs won’t be able to afford the higher cost of borrowing.

11 Dec Fed cuts rates—Fed funds rate cut 0.25% to 4.25%.

13 Dec Central banks man the pumps—Reserve banks around the world pump billions into markets over several days.

14 Dec More worry in LPTs—Centro Properties Group can’t refinance $1.3bn in debt without paying a significantly higher interest rate. This knocks the operating earnings forecast by management down 13.6% to 40.6 cents per share and, as a result, it decides not to pay a dividend to conserve cash. Two Centro-controlled funds choose to halt applications and withdrawals.

19 Dec Morgan Stanley raises $5bn from China; Crisis spreads to ‘monoline insurers’—Morgan Stanley raises $5bn from China Investment Corporation alongside a fourth-quarter loss of $3.6bn and a writedown of US$10.3bn in mortgage securities. S&P downgrades the credit ratings of ‘monoline insurers’, which guarantee loans in the mortgage markets.

21 Dec Citigroup raises $3.5bn in public offering

2008

15 Jan Citigroup and Merrill Lynch tap ‘sovereign wealth funds’—Citigroup announces a US$10bn fourth quarter loss, after writing down US$18.1bn in subprime securities, and raises $12.5bn from investors including the Singapore Investment Corporation, the Kuwait Investment Authority and Prince Al-Walid of the Saudi royal family. Merrill Lynch raises $6.6bn, principally from Korea Investment Corporation and Kuwait Investment Authority.

17 Jan Merrill Lynch writes down US$14.1bn from its mortgage exposure in its 2007 fourth quarter results

18 Jan MFS splits up—After considering a takeover offer from City Pacific, MFS (now known as Octaviar) announces it will split into two listed companies, Stella and MFS Financial Services, in an attempt to reduce debt. The company also announces an underwritten renounceable rights issue to raise $550m for shares in Stella. In response to the news, the stock falls 69%.

22 Jan All Ords drops 7% as global markets tumble; Fed slashes rates—Emergency meeting of US Federal reserve cuts the federal funds rate 0.75% to 3.5% and the discount rate 0.75% to 4.0%.

30 Jan Fed cuts rates—Fed funds rate cut a further 0.5% to 3.0%.

14 Feb UBS announces US$13.7bn in losses from its subprime exposure in its fourth quarter results for 2007

17 Feb UK government nationalises Northern Rock

Diary of a financial meltdown

The Intelligent Investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 8305 6000 Fax: (02) 9387 8674 info@intelligentinvestor.com.au www.intelligentinvestor.com.au 5

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25 Feb Allco Finance Group comes late—Allco releases its half-year results late and announces that banks are reviewing the company’s debt position after triggering a market cap review. It is also trying to sell assets to reduce the debt, especially its home loans business.

7 Mar Fed pumps $200bn into markets

16 Mar Bear Stearns rescued; Fed cuts discount rate and extends terms at discount window—JPMorgan buys Bear Stearns for $240m, the deal being sweetened by $30bn of loans from the Federal Reserve. The Fed also cuts its discount rate to a premium of just 0.25% above the federal funds rate and agrees to lend to primary dealers as well as banks, for terms up to 90 days instead of 30, and for collateral including a range of investment-grade debt securities.

18 Mar Fed slashes rates again—Federal funds rate cut 0.75% to 2.25%.

1 Apr UBS announces CHF15bn rights issue—following US$38bn of subprime-related writedowns.

17 Apr Merrill Lynch writes down US$4.5bn from its mortgage exposure in its first quarter results

18 Apr Citigroup writes down US$6bn from its subprime investment in its first quarter results

22 Apr Royal Bank of Scotland announces £12bn rights issue

30 Apr Fed cuts rates; Citigroup raises another US$4.5bn—Fed funds rate cut 0.25% to 2.00%.

6 May UBS writes down US$19bn from its subprime exposure in its first quarter results

12 Jun Babcock and Brown up for review—Babcock and Brown’s market cap falls below $2.5bn, after its stock declined 27.5% to $6.90 the previous day, triggering the possibility of a review event by a consortium of lenders. Ratings agency Standard and Poor’s lowers the investment group’s credit rating, which affects the company’s cost of borrowing. The stock falls another 23.9% the next day.

25 Jun Barclays announces £4.5bn rights issue and £1.7bn injection from the Qatar Investment Authority

26 Jun ‘IndyMac’ collapse begins—Leaked letters questioning IndyMac’s solvency trigger a run on the US mortgage bank. In less than two weeks, $1.3bn of IndyMac’s $18.9bn deposit base is withdrawn, and on 11 July the bank is placed under the ‘conservatorship’ of the Federal Deposit Insurance Corporation.

27 Jun City Pacific reports bad results—City Pacific revises its forecasts down because of the deteriorating market conditions. To create a cushion from lenders, management decides to stop the dividend and sell assets. The company had already entered into an agreement to sell some Townsville assets to realise $30m. City Pacific’s First Mortgage Fund stops investors from redeeming their units.

13 Jul Discount window opened to Fannie Mae and Freddie Mac

17 Jul Merrill Lynch writes down US$7.7bn from its subprime exposure in its second quarter results

18 Jul Citigroup writes down US$3.7bn from its mortgage securities in its second quarter results

21 Jul HBOS rights issue flops—Only 8% of HBOS’s rights

issue is taken up by shareholders, with the remainder left with underwriters.

31 Jul Crisis spreads to Alt-A—The subprime crisis has spread to the Alt-A market, a rung above subprime in quality. For example, 25% of Alt-A loans made in 2006 are more than 60 days overdue; for 2007, it is 21.4%. In an indication of where things could be headed, Standard and Poor’s Rating Services have increased their assumptions on losses for Alt-A loans made in 2006 and 2007 from 35% to 40%.

4 Aug Biggest subprime lender in US announces writedowns—HSBC’s US mortgage book has been written down by $7.3bn, an increase of 85% from a year ago. The company’s chairman, Stephen Green, says that a recession in the US is a ‘real risk’, but a recovery won’t come soon.

12 Aug UBS writes down US$5.1bn from its subprime exposure in its second quarter results

26 Aug US house prices continue tumbling—There have been 23 consecutive months of declining prices in the United States, as measured by the S&P/Case-Shiller House Price Index. House prices have declined a total of 18.8% over that time, bringing the index to a level not seen for 4 years. Goldman Sachs predicts house prices will decline another 10%, indicating plenty more pain to come for homeowners.

3 Sep RBA cuts rates 0.25% to 7.0%

7 Sep Freddie Mac and Fannie Mae nationalised—US Government, via the auspices of the Federal Housing Finance Agency, takes control of the famous quasi-governmental mortgage providers, sacks their boards and issues itself 80% shareholdings—as well as agreeing to lend them a ton of money of course.

10 Sep Lehman on the brink—Lehman Brothers announces quarterly loss of US$3.9bn, with US$5.6bn of writedowns in subprime securities, while the Korea Development Bank pulls out of funding talks with the bank.

14 Sep Fed offers to take equities as collateral at discount window—The Federal Reserve says it will again broaden the range of collateral it will accept at its discount window, this time to ‘closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks’. That means equities, though the Fed apparently can’t bring itself to say so.

15 Sep Lehman collapses; BoA buys Merrill Lynch—Barclays and Bank of America fail to get the guarantees they need from the Fed to persuade them to buy Lehman Brothers, and the world’s ninth-largest investment bank is forced into ‘Chapter 11’ bankruptcy protection (Barclays later buys some of the healthy bits from administrators). The fourth-largest, Merrill Lynch, is bought by Bank of America for US$50bn. Former Fed chief Alan Greenspan describes Lehman’s failure as ‘probably a once in a century type of event’ and warns that more will follow. AIG may be the first as it scrabbles around for $20bn to tide it over.

16 Sep Fed rescues AIG—The Federal Reserve shows what it really means to be too big to fail: in a rescue package it takes over 80% of AIG’s equity in return for providing liquidity, in the form of a two-year US$85bn facility at the almost usurious rate of three-month LIBOR (the London interbank rate) plus 8.5%.

18 Sep HBOS agrees merger with Lloyds TSB

19 Sep Markets rally as central banks pump in US$180bn

The Intelligent Investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 8305 6000 Fax: (02) 9387 8674 info@intelligentinvestor.com.au www.intelligentinvestor.com.au6

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Opportunities amongst the wreckageWhere there’s risk, there’s often opportunity. That’s the theory, anyway. So how should you approach the current market meltdown from an investment perspective?

‘Carefully’ is the short answer—even if the financial sector lies outside your ‘circle of competence’ and you have avoided it. Here’s why.

It’s clear that we’ve entered a new phase of both the business and credit cycles. Survival and prosperity in this environment will require a different mindset for many investors. Quoting the authoritative James Grant, once again, from an article in September 1990:

‘In the depressive phase, credit contracts, asset values fall and business slows down. Among financial institutions, failures proliferate. Failure begins at the margin but eats its way into the middle, like a mouse … In a severe contraction, even the strongest lenders are tested, as the process of shrinkage and deflation nullify the financial assumptions that, in the boom, had seemed conservative.’

From that brief description and a survey of recent events, the dangers faced by financial businesses and highly-geared investment funds in the current environment are clear. But Grant’s words also contain warnings for a broader swathe of the business community.Don’t catch the falling knives

If you’re like many of our analysts, you’ll find a perverse joy in the challenge of trying to figure out where and when the current situation will end up. But you’d be best advised to resist trying to time a run into the falling knives of the financial sector for two reasons.

The first is the inherent unpredictability of the current crisis. Anyone who believes they can accurately determine how the current mess will play out is dangerously deluded. The second reason is that there are plenty of investment opportunities in securities which might actually benefit from the current situation.

A value investor’s first priority should always be to protect their capital. But that doesn’t mean worrying about short-term stock price falls—they’re an inevitable part of sharemarket investing—and nor should you expect every investment move you make to be successful.

The idea is to build a diversified portfolio of businesses that you understand. The bulk of this portfolio should consist of businesses that are highly likely to prosper over the long term and build up assets on your behalf, and/or pay out increasing dividends. The trick, of course, is to find them, and that’s no easy matter given the extent of the current crisis.

First in lineThe most immediate effect of the crisis was to increase

the cost of funding in debt markets around the world, thereby destroying the businesses of companies like Allco Finance, City Pacific and the original RAMS Home Loans (now RHG Group). Highly indebted companies like Centro Properties, MFS (now Octaviar) and A.B.C. Learning Centres suffered from what might be termed ‘second-round effects’.

Entire business models are now being called into question in this ‘second round’. Babcock & Brown is on its knees and making drastic changes to its business. Macquarie Group has also suffered, but its size, diversity and banking licence make its business somewhat more resilient. At the end of the day, though, banking is a business of confidence and time will tell whether the current turmoil will permanently scar Macquarie or whether, as it has in previous (less severe) downturns, it will emerge with a bagful of bargains—quality assets bought at rock-bottom prices from distressed sellers.Managed funds face the music

In the former era of cheap and easy credit, Australia’s financial wizards spawned a litany of highly geared, externally managed funds. These vehicles are now being called into question. They range from infrastructure funds like Macquarie Infrastructure Group, Babcock & Brown Infrastructure and Australian Infrastructure to the formerly conservative listed property trust sector (now called A-REITS) including GPT Group, Macquarie CountryWide and Goodman Group.

Even the mighty Westfield Group carries a hulking debtload. Its interest bill is comfortably covered by operating income at the moment. But, in a harsher world than today’s, a severe economic contraction combined with higher interest rates (due to an outbreak of inflation) might conspire against Westfield.

The MIS sector, including Timbercorp and Great Southern, is also facing severe pressure. The substantial but illiquid assets these companies own are largely financed by debt. Should the bankers become less friendly in future, their viability could be threatened. In such a situation, Timbercorp’s more regular cash flow might see its bankers take a more lenient view. But they might not.

Private equity train smashPrivate equity funds—all the rage just a couple of years

ago—are likely to be performing very poorly in the current environment. Three main factors were previously propelling private equity returns: strong economic growth, plentiful and cheap finance, and a strong sharemarket enabling highly leveraged floats to be sold at bull market prices to a willing public. Those factors have all now reversed, or at least moderated.

We foresee a looming private equity train smash. And nobody should consider themselves safe just because they have no direct exposure to unlisted or listed private equity funds such as Allco Equity Partners or Souls Private Equity (both of which may, ironically, be current opportunities).

Today’s Wesfarmers shareholder has de facto exposure to this sector. The modus operandi behind the Coles takeover was pure private equity—and horrifically timed, too. The private equity funds’ financiers (including the big banks) are also likely to share the pain if things go seriously awry.

These are all ‘second-round’ effects of the credit crisis. And the shockwaves are unlikely to stop there. You can count on there being third-, fourth- and fifth-round impacts,

The Intelligent Investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 8305 6000 Fax: (02) 9387 8674 info@intelligentinvestor.com.au www.intelligentinvestor.com.au 7

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and they’re a lot harder to predict. But let’s take an educated guess at what they might be.

Battening down the hatchesNow the banks are battening down the hatches, credit

is harder to come by. This will affect companies in a couple of ways. The first is directly, through higher prices for credit leading to a larger interest bill (and therefore lower profits). In more extreme cases, some companies with what may have once been ‘manageable’ debt burdens, could struggle to refinance their debt as it matures.

The second, less direct, effect of a credit rationing is the impact on consumers. At the height of the easy money cycle, some consumers began shuffling credit card balances between different providers, riding a merry-go-round of ‘interest-free periods’. This game is much tougher to play now. Higher mortgage rates and a requirement for bigger home loan deposits are also putting the squeeze on many people.

Personal credit growth (non-housing) falls off a cliff

The latest New South Wales state government budget revealed that stamp duty—a proxy for activity in the property market—is expected to fall significantly. The Victorian government is also budgeting for a decline, though less severe than the one in New South Wales.

Job losses and smaller bonusesThis downturn in activity will surely mean more

unemployed real estate agents, at least in those two states. And they may be looking for a job alongside a fair few investment bankers. Those who retain their jobs will certainly be expecting their annual bonus to shrink, if not dry up altogether. Luxury car dealers and (again) real estate agents in wealthy suburbs who had grown fond of bonus season in the financial community will now be looking to it with trepidation.

The economic importance of the financial sector itself should not be underestimated, especially in Melbourne and Sydney. The local economies of our two largest cities will be hit hard by any large scale lay-offs in the financial world. Bringing this back to the sharemarket, it doesn’t take much imagination to see tougher times for businesses exposed to high-end consumers, such as David Jones, Oroton Group and Nick Scali. Residential property developers with heavy exposure to Sydney and Melbourne are also likely to find the going much tougher, including Becton, Mirvac, Australand and AVJennings.

From there you can move out into building materials companies and keep the thought experiment going to other sectors. There are only a minority of companies that the current scenario might be beneficial for. So let’s

consider some of them.

Dropping the carry tradeExporters are currently breathing a sigh of relief after

suffering during the seemingly relentless climb of the Aussie dollar against the greenback. The ‘carry trade’ was one of the biggest games in town for hedge funds in recent years. It involved borrowing money in countries with low interest rates (such as Japan and Switzerland) and investing the funds in high interest rate currencies (like the Australian and New Zealand dollars).

Any university finance lecturer will tell you that there are no free lunches in such a strategy. There is the risk (indeed, the theoretical likelihood) that the currency you’re investing in will fall.

Hedging that currency risk (through a forward transaction) should account for and eliminate any interest rate differential. But many of these hedge funds were conducting a ‘naked’ carry trade—simply borrowing in one currency and investing in another, with no hedging.

The funds made a killing while the game was on. Not only did they receive high interest rates while paying low ones, they also made huge profits on the foreign exchange trade as the high-rate currency (the Aussie dollar) actually strengthened. And, by reports, hedge funds weren’t the only ones involved. Mrs Watanabe (the Japanese equivalent of ‘Mrs Jones’) also got in on the act, with housewives across Japan borrowing record amounts of yen and buying record amounts of foreign currency (especially New Zealand and Australian dollars).

AUD/JPY - Mrs Watanabe gets carried away

When the upward trend changed, it did so quickly (fans of George Soros may recognise his cherished notion of ‘reflexivity’ at work). The Aussie dollar has plunged from more than 95 US cents at the start of this financial year to less than 81 US cents today. In terms of yen, it has fallen from more than 101 to less than 85. Mrs Watanabe, and not a few hedge funds, will no doubt be nursing some nasty losses.Boosted by the falling dollar

The end of the carry trade—and the metaphorical rushing to the other side of the financial boat—explains how the currency market came to change so quickly, or at least a significant part of its move. But the stockmarket doesn’t seem to be paying attention.

Stocks on our buy list which will be boosted by the sudden fall in the Aussie dollar include Cochlear, ARB Corporation, Infomedia, Roc Oil and Sigma

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The Intelligent Investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 8305 6000 Fax: (02) 9387 8674 info@intelligentinvestor.com.au www.intelligentinvestor.com.au8

Opportunities amongst the wreckage [ C ONTINUED FROM PAGE 7 ]

Pharmaceuticals should also benefit to some degree as competing products from overseas become less cost-effective (although Sigma’s substantial debt pile is costing more to service).

Businesses such as Westfield and Servcorp are more complicated on this score. Other things being equal, a lower Australian dollar means profits repatriated from overseas translate into more for shareholders at home. But other things are far from equal. Both businesses are intricately connected with economic activity, so the benefit from the weaker currency must be weighed against the cost of an economic slowdown.

AUD rises, then slumps against the USD

Looking further afield than our current positive recommendations, businesses such as ResMed, CSL, Leighton Holdings and Foster’s Group may also be beneficiaries of the sharply lower Aussie dollar due to their significant overseas revenue.

Another interesting company is Berkshire Hathaway, although it’s outside our advisory scope and, in Aussie dollar terms, it’s more expensive than it was a couple of months ago. Warren Buffett and Charlie Munger have been contemplating, if not preparing for, the current meltdown for years.

In 2003, Buffett famously described derivatives as ‘financial weapons of mass destruction’ and noted that ‘large amounts of risk have become concentrated in the hands of relatively few derivatives dealers … which can trigger serious systemic problems’. Today he surely has the ‘elephant gun’ ready to bag any significant opportunities that arise.

Aside from directly owning Berkshire shares (as a few of our analysts do), you can gain indirect exposure through a couple of small Australian-listed stocks. One is Global Masters Fund (a fund which owns a mixture of Berkshire shares and bonds) and the other is Peters MacGregor, which has a portfolio holding of Berkshire (around 5% according to its annual report). In our opinion, both stocks

are far too small to justify their listings—the costs of which eat up too much of shareholders’ returns. But if they became available at a very large discount to net tangible assets, they might be of some interest to Berkshire fans.

Plain old cashFinally, we shouldn’t neglect plain old cash. Investors

are currently being compensated at the highest rate in years for holding the government’s paper money. Though, as you may have read in the first chapter of our book, Value, cash isn’t the best place for your money over the long term—no doubt for many of the reasons Steve has given in today’s other feature, Money, meddling and meltdown. But it can certainly offer comfort and flexibility in turbulent times like these.

Regular readers will know that we’ve been worrying about a range of economic problems for some time. These have included risks in the banking system (Macquarie being the only financial institution to earn a positive recommendation from us over the past four years), an overpriced property market, an overstretched consumer, a possible outbreak of inflation and profit margins which are still quite some way above their long-term average.

Opportunities in income securitiesGenerally, today’s lower prices in blue chip stocks like

the banks, Woolworths, Brambles, QBE Insurance, and Tabcorp are now compensating for some, but not all, of those risks. It’s a different story when it comes to income securities and the smaller end of the market. After thumbing our noses at practically every income security that was issued in recent years, we’re now seeing significant opportunities in that area.

In smaller stocks, there are clear signs of panic. Psychologically, one of the hardest things for an investor to do is buy more of a stock they already own after it has fallen significantly. But experience teaches us that this is a difficulty well worth overcoming. Do your best to remove market-generated emotions and focus on the business performance.

It may feel ‘cleaner’ starting afresh by opening a new investment position in a stock you don’t already own, but you’ll typically have less chance of being blindsided by an unexpected risk in a business you’ve owned and followed for some time. In circumstances like these, it’s usually better the devil you know.

Disclosure: Interests associated with the author, Greg Hoffman, own many of the shares mentioned in this article, as do other staff members. For a full listing, see below.

WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all people. DISCLAIMER This publication has been prepared from a wide variety of sources, which The Intelligent Investor Publishing Pty Ltd, to the best of its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we strongly suggest you seek advice before acting upon any recommendation. COPYRIGHT © The Intelligent Investor Publishing Pty Ltd 2009. The Intelligent Investor and associated websites and publications are published by The Intelligent Investor Publishing Pty Ltd ABN 12 108 915 233 (AFSL No. 282288). PO Box 1158 Bondi Junction NSW 1355. Ph: (02) 8305 6000 Fax: (02) 9387 8674. DISCLOSURE As at 19 Sep 09, in-house staff of The Intelligent Investor held the following listed securities or managed investment schemes: AEA, AHC, ANZ, ARP, BNBG, CBA, CDX, CHF, COH, COS, CRS, CXP, DBS, FLT, GFF, GLB, GNC, GTP, HHV, HVN, IAS, IDT, IFL, IFM, IMF, IVC, JST, KRS, LMC, LWB, MFF, MFG, MLB, MMA, MOC, MQG, NABHA, NHF, NVT, OEQ, PTM, REX, RHG, ROC, SDI, SFC, SFH, SGB, SGN, SHV, SIP, SLM, SOE, SOF, SOL, SRV, STO, TEN, TGR, TIM, TIMG, TLS, TRG, TRS, TTS, VBA, WAN, WBC and WDC. This is not a recommendation.DATE OF PUBLICATION 19 Sep 09

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