Author Archives: Lenore Hawkins, Chief Macro Strategist

About Lenore Hawkins, Chief Macro Strategist

Lenore Hawkins serves as the Chief Macro Strategist for Tematica Research. With over 20 years of experience in finance, strategic planning, risk management, asset valuation and operations optimization, her focus is primarily on macroeconomic influences and identification of those long-term themes that create investing headwinds or tailwinds.
Inflation vs. Deleveraging

Inflation vs. Deleveraging

The majority of the developed world is currently dealing with one whopper of a liquidity hangover.  Across the world households, businesses, and government got themselves hooked on the drug of cheap and easy debt.  When the markets inevitably cut the supply the liquidity drug, the Fed quickly stepped in to keep at least the U.S. junkie functioning with a rapid rise in banking reserves through the “toxic asset” bailout.  This bailout created an environment ripe for rampant inflation.  From August of 2008 to January of 2010, big-bank cash balances at the Federal Reserve increased at an unprecedented scale from $10 billion to $994 billion.  Using the historical money supply multiplier, this could result in an increase in the money supply that is 9-10x the increase in reserves, meaning an increase of almost $10 trillion dollars in the money supply.  To put that into perspective, the current supply of U.S. dollars in circulation is estimated to be a bit over $14 trillion.  Clearly an additional $10 trillion entering the economy would cause massive inflation… so why aren’t we seeing any indication of that yet?

For the additional bank reserves to make their way into the economy two things need to happen:  (1) banks need to want to lend and (2) households and businesses need to want to borrow.   The chart below shows an astounding increase in debt as a percentage of GDP from 2000 to 2007.  For the United States, the majority of that increase was in the form of residential mortgages.

If we look at the composition of debt, only the UK and Switzerland have higher household debt as a percentage of GDP.  While I love to gripe about our out-of-control national debt, household debt is currently an significant problem as well..  The BRIC nations have comparatively insignificant levels of household debt, which gave them a lot more wiggle room during the global meltdown.

Household debt in the United States is exceptionally high and unemployment continues to plague the economy.  We’ve got ourselves into quite a pickle.  Businesses are hesitant to expand with consumers unlikely to increase purchasing significantly due to their debt load and the unemployment rate.  With production well below capacity, the need for businesses to borrow when they do begin to expand is minimal.  The unemployment rate obviously impacts households’ ability to pay down their debt is unlikely to improve much as long as businesses hold back on expansion.  Add to this that we have yet to see the true impact of the real estate debacle in the commercial sector AND we still have a good ways to go on in the residential foreclosures.  All this creates a wet blanket on the potential inflation fire and creates an environment in which banks are unlikely to dip much into their pool of reserves.  That being said, I would be very surprised if we don’t experience some type of challenging inflation, but exactly when that occurs is a more difficult question to answer.  The global economy is an extremely complex system with nearly infinite variables whose level of impact is endlessly changing.  We approach this market with humility and caution, knowing that what is unknown vastly outweigh what is known.

So what are we doing about it?  Either way, we expect that with all the debt out there, interest rates will rise so we have significantly shortened the duration of our bond holdings and are underweight in domestic equities.  As I mentioned in an earlier post,  domestic equities are also currently over-valued.  This is an environment in which a good defense is the best offense as we wait for the inevitable opportunities to emerge, holding firm to our principles of valuation and tactical allocation.

The Role of Regulations in the 2008 Financial Crisis

The Unintended Consequences of Regulation and Subsidies

My apologies for the length of this piece, but this is a complex topic and I’ve had a lot of coffee!

In our investment practice, we use tactical asset allocation to vary the mix of assets in a portfolio in response to changing prices, economic and business conditions.  We believe this will both reduce the investment rollercoaster ride and provide opportunities for better returns over time.  We believe that valuation matters most, so we first determine whether an asset class is currently cheap, expensive or fairly priced.  If you pay too much for an investment, all the time in the world won’t fix it, contrary to many popular how-to investment books.  We also believe that we cannot forecast the future, but we can make judgments on whether the macro economic conditions are favorable or unfavorable for a particular asset class and adjust our portfolios accordingly.

Any discussion of investments invariable leads to the broader economy.  Any discussion about the economy invariably leads to politics, as governments have significant influence over the global and domestic economy.  Two of the most impactful tools governments use to impact the economy are regulations and subsidies.

Subsidies distort markets in that they artificially increase demand.  This artificial boost in demand raises prices and pushes the market to allocate more resources, (workers, money, equipment, land etc.) into the subsidized industry than it otherwise would have.  When the subsidy invariably ends, those mis-allocated resources have to go elsewhere, but the shift can take considerable time and be very painful.  In the recent housing crisis, the subsidies discussed later in this piece added a lot of workers to the payrolls of construction firms and induced investments that would have otherwise gone elsewhere.  When it all came crashing down, as it always does, those workers had to find jobs in other industries and investments were lost.

Regulations distort incentives.  Regulations are typically implemented to keep a nation’s citizens safer than is believed they would be under free markets.  This theoretical protection can range from hazardous products to foreign competition or financial irresponsibility.   Without regulations, companies will behave according to their individual views on the opportunities and risks in the marketplace.  Their views and corresponding actions may be contrary to what a regulator or regulation deems appropriate.  However, the unfettered behavior in the free markets, which some may argue is more risky, does tends to create a diversified set of positions, which helps prevent industry-wide failure.  All participants don’t put all their eggs in the same basket as companies tend to follow different tactics to gain a competitive edge.  Regulations are intended to force companies to all behave in a similar manner with respect to the regulated area, so now everyone has their eggs in the same basket.  Thus the industry as a whole may be more vulnerable to systemic changes that are not anticipated by the regulation.

Regulations played a significant, although not widely discussed role in the recent financial crisis.  We watch for these distortions in the market place, among others, and adjust our clients’ portfolios accordingly to both protect from and take advantage of the “bubbles” they can cause.

The recent financial crisis was impacted in a large part by a series of well meaning regulations and subsidies designed to make home ownership more widespread and banks stronger.  When piled on top of each other, the combination created a whopper of unintended consequences.  In order to keep this piece as short as possible, I am only discussing what I believe to be the primary regulations and subsidies involved in the recent financial crisis.  Any omission is in the interest of brevity.  There are other factors involved in the recent crisis, but the ones discussed here are noteworthy and I believe have been overlooked by many.

By subsidizing housing with low cost loans, low down payments, and increased access for sub-prime borrowers, good intentions pushed housing prices into the stratosphere.

Increasing home ownership for low income earners has long been a mission for the Federal Housing Authority.  This sounds like a fantastic goal as what politician would say they don’t want families to own their homes?  The problem is that by subsidizing something, you increase the demand for it by effectively lowering the purchase price.  Increase demand and prices go up!  The Federal Housing Authority (FHA) insured around one million no-down payment mortgages in each fiscal year from 1998 to 2001 (England 2002, 73).

Traditionally non-FHA mortgages required a minimum of 20% down, but in 1994, the Department of Housing and Urban Development (HUD) ordered Fannie Mae and Freddie Mac to supplement and eventually to far surpass the FHA’s efforts, by directing 30% of their mortgages to low-income borrowers, which lead Fannie Mae to introduce 3% down mortgages in 1997.   In 2000, HUD increased the Fannie Mae and Freddie Mac low-income target to 50% of all loans! (Schwartz 2009).  In 2005, HUD increased the target again to 52%.

In 2000, Fannie launched a “ten-year, $2 trillion ‘American Dream Commitment’ to increase home ownership rates among those who previously had been unable to own homes.” (Bergsman 2004).

In 2002 Freddie Mac joined with the “Catch the Dream” program combining “aggressive consumer outreach, education, and new technologies with innovative mortgage products to meet the growing diversity of home buying needs.” (Schwartz 2009)

All these subsidies increased the supply of mortgages to low income homeowners, but what was the source of the money to fund these loans?  Welcome to the Mortgage Backed Security.  Banks would pool together mortgages that could then be sold as a mortgage backed security (MBS).  By doing this, banks could sell off the loans they’d given to homeowners and get more cash for the next set of loans.

In 1997 Bear Stearns completed the first private securitization of subprime loans that had been pulled together by First Union Capital Markets.  Normally a bond, including an MBS, needs to be rated so that investors know how secure the bond is likely to be from default.  This issuance was unrated, but since the mortgages in the pool were guaranteed by Freddie Mac, they produced an” implied AAA rating,” according to a news release from First Union.  So here we have sub-prime loans, meaning loans with a higher likelihood of default, receiving AAA ratings because they are backed by GSEs (Government Sponsored Enterprise).  A collection of subprime loans magically became low-risk because of the GSE backing.  Now that is some powerful fairy dust!

So now we have created a way to turn a pool of sub-prime mortgages into AAA rated bonds.  But why was there such incredible demand for these bonds?  For this we have to look at the Basel Accords and the ratings agencies.

In 1975 the Securities and Exchange Commission effectively conferred the three rating agencies that were then in place, (Moody’s, Fitch and Standard and Poor’s) oligopoly status by ensured that only these three firms were Nationally Recognized Statistical Rating Organizations (NRSROs) and that only an NRSRO’s ratings would fulfill a given regulatory mandate for investment-grade and AAA ratings.   Thus the success of these entities was no longer based upon the quality of their ratings, but rather the government’s protection.  Without government protection, a rating agency who published inaccurate ratings would suffer financially and potentially go out of business entirely.  Thus there was no competition among ratings agencies that could highlight potential weaknesses in their methods of the various agencies.   The 1975 ruling effectively prohibits anyone else from competing with the 3 ratings agencies for the institutional investors’ mandatory business.

We now know that these bonds should not have been receiving such high ratings.  Why did they?  The NRSROs all used models based on historical default data.  Clearly this data was relatively useless for the mortgage environment in the recent decade.  Never before in our nation’s history had government done so much to subsidize housing and never before had so many loans been given out with low or no down payment.  Without skin in the game, a homeowner is much more likely to walk away from a home that is no longer worth the debt on it!  A low or no money down mortgage effectively makes the home “owner” a renter from the bank, and can just walk away if the “rent” to home value becomes less attractive, especially in the non-recourse states.

Plenty of employees at the three ratings agencies criticized their firms’ models for risk assessment of the GSE guaranteed MBS.  If the government protection of the three NRSROs didn’t exist, these employees could have started competing firms and brought to light the errors they perceived in their former employers’ models.  With this protection, no competitor could take advantage of the three agencies’ mistakes and bring differing opinions to the market.

So why was so much of the MBS risk concentrated in the banks? The Basel Accords.

The 1988 Basel Accord required an adequately capitalized commercial bank to maintain at least 8% capital against its assets in reserve.  Reserve requirements have been around for quite a while, but Basel changed the required capital to reflect differences in risk among different types of assets owned by the banks.  Thus an asset deemed to have zero risk of default, such as a US government bond, required no reserve capital.  Commercial loans were given 100% risk weighting, thus required the full 8% capital.  Mortgages in general were given 50% risk, thus for a $100 mortgage, the bank was required to keep $100 * 8% * 50% = $4 in reserves.

Then the magic of AAA rated GSE backed bonds emerged and since Basel assigned a risk rating of only 20% to any issuance by a GSE, which includes Fannie Mae, Freddie Mac, for a $100 AAA rated GSE backed bond, a bank would only have to hold in reserves $100 * 8% * 20% = $1.60.

Here’s the insanity.  A bank issues a mortgage for $100, which would require it to hold $4 in reserves.  If it then sells that mortgage to Fannie or Freddie, then buys it back in the form of a GSE backed MBS, it would only have to hold $1.60.  This reduction is required capital reserves, which increases the bank’s leverage – its borrowing and lending power, and thus increases its potential profitability by a whopping 60%, simply by round-tripping mortgages!

These regulations explain why commercial banks found it so profitable to originate sub-prime mortgages, sell them off to Fannie and Freddie for securitization and buy them back as MBS.  If Fannie and Freddie weren’t there to buy them OR if the Basel Accords didn’t give a discount for a GSE backed securities, things might have played out very differently, despite the Fed’s artificially low interest rates.  It is interesting to note that five days before declaring bankruptcy, Lehman Brothers held a “Tier 1” capital ratio of 11%, almost three times its effective minimum requirement.

Private securitizers such as Bear Sterns, (as opposed to a bank like Wells Fargo) also became heavily involved in subprime securitization in 2002, because 10 years after the 1991 implementation of Basel I, the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision adopted the “Recourse Rule,” which added to Basel I’s assignment of 20% for GSE-issued securities the same risk weight for privately issued asset-backed securities, include MBS that had received a AA or AAA rating from an NRSRO.

Starting at the end of 2006, Basel II adopted a similar rule for the entire developed rule, thus banks anywhere in the world could dramatically reduce their reserve requirements by purchasing GSE issued or AA or AAA asset-backed securities.

So much for the financial crisis being a failure to regulate, unless by that we mean a failure FROM the regulations in place.

Lastly, was it bankers’ greed? 

It is a popular notion these days to blame the crisis on those evil bankers.  Problem with that assessment is if all this was driven by bankers’ insatiable greed, they would have purchased primarily AA ratings.  These provided exactly the same reserve benefits, but produced a higher yield: same benefit, bigger profits.  But they didn’t do that.  Of the $1.323 trillion in MBS held by banks and thrifts in 2008, 93% were either AAA rated or issued by a GSE.  (Acharaya and Schnabl 2009)  Then to get even more safety, the bankers bought additional insurance against these securities in the form of credit default swaps (CDS), again sacrificing profit for security.  There were a good many mistakes made by the banks during the past decade, as in the case of any business, and not all of the banks took the same level of risk, but blaming it all on those greedy bankers is too simplistic.

So what does all this matter to an investor?

As we analyze the markets, we keep in mind the impact regulations and subsidies can have on the economy and are incessantly skeptical when we see bubbles form so that we can both protect and take advantage of the distortions they create.


  • Acharya, Viral V., and Philipp Shnabl. 2009.  “How Banks Played the Leverage Game.” In Acharya and Richardson 2009b.
  • Bergsman, Steve.  2004. “Closing the Gap.” Mortgage Banking (February): 52-29
  • England, Robert Stowe.  2002.  “Giving it 100 Percent.” Mortgage Banking (February): 68-76.
  • Friedman, Jeffrey. 2009. “A Crisis of Politics, Not Economics:  Complexity, Ignorance, and Policy Failure.” Critical Review Volume 21: 127-183.
  • Schwartz, Anna J.  2009.  “Origins of the Financial Market Crisis of 2008.”  Cato Journal 29(1): 19-23.
Valuation Matters

Valuation Matters

 Many popular investment “gurus” advocate the Buy and Hold Strategy, yet most never discuss valuation.  We believe that valuation matters most, so before we look at anything else, we determine whether an asset class is currently cheap, expensive or fairly priced.  If you pay too much for an investment, all the time in the world won’t fix it, even if you just invest in an index fund.  The chart below shows the S&P500 adjusted for inflation from January 1, 1873 to January 1, 2010.

This chart shows that if an investor purchased the index in 1966, they would have waited until 1991 for it to return to the same value!  For twenty five years their investment was underwater.  This chart also shows that we have yet to come close to the high reach at the turn of this century.

So how can an investor know that in 1966 or in 1999-2000, the S&P was overpriced?  One way is using the price to earnings ratio (PE).  The chart below shows the PE ratio for the S&P for the same time period.  The PE ratio be thought of as how much an investor is willing to pay for one dollar of earnings.  A PE ratio of 20 means that the market in aggregate is willing to pay $12 for $1 of annual earnings.

This shows that in 1966, the PE ratio reached a high near 25 and in around 2000, the S&P again reached a high of nearly 45!  This is just one measure of valuation that we use to help us determine if the stock market in general is over-priced, under-priced or fairly priced.  The mean PE ratio is 16.35 and the median is 12.87.  The lowest PE ratio occurred in December of 1920 at 4.78 and the highest PE ratio so far was in December of 1999, when the ratio reached a mind boggling 44.20. 

On 1/1/1982, the S&P PE ratio was again at a historical low of 7.4 and the inflation adjusted S&P was at 268.62.  If an investor purchased the S&P index at this point, and kept it until the PE ratio reached 43.8 on 1/1/2000, the S&P had risen to 1,823.78, which means the investors after inflation average annual return was 11.23%.  Compare this to the 25 years it took from 1966 to 1991 for an investor to simply get a return of their initial investment and clearly, valuation matters and buy and hold provides little aid for an over-priced investment.

We don’t believe we can time the market.  There was no way to know that the PE ratio was bottoming out in 1982, nor could we know in December of 1999 that the market had peaked, but we could see that in both cases a directional change was bound to occur.  We don’t believe we can get the timing exactly right, but we do see opportunities, both for gains and losses when valuations are above or below historical norms.

By the way, we currently believe that the S&P is again relatively over-priced.  If you remove the insanity that occurred around the turn of the century, the chart above shows that the PE ratio is again near historical highs.

Inflation, Deflation, Interest Rates… What's going on?

Inflation, Deflation, Interest Rates… What's going on?

I like to keep things simple, (my wee little noggin can only handle so much) thus I generally agree with the Austrian School of Economics definition of inflation, which is simply an increase in the money supply.  As I mentioned in my piece on fractional reserve banking, an increase in the money supply, all else held constant, will result in an increase in prices across the board.   This is rather intuitive if you think of money as simply another commodity.  Imagine an economy in which the money supply is just $100 and there are only 30 apples and 20 bananas available for purchase every day.  This economy can be easily modeled as

$100 = A * 30 Apples + B * 20 Bananas (where A is the price of Apples and B is the price of Bananas)

$100 = 30A + 20B

Since Apples and Bananas are the only items available for purchase in this economy, the amount spent on apples and bananas together must be $100.  If the supply of money is doubled to $200, the equation would look like this.

$200 = 30A + 20B

Since the quantity of apples and bananas has remained unchanged, their prices (A & B) must go up.

So what’s all the talk about potential hyper-inflation these days?

Starting with the collapse of Lehman Brothers in September of 2008, the Federal Reserve more than doubled its balance sheet in only three months by financing its credit extensions using the electronic equivalent of printing money.  At the beginning of September 2008 the Fed has $894 billion in assets, by December 17th that number rose to $2.24 trillion and now stands at $2.17 trillion.  This unprecedented expansion resulted in an increase in the reserves credited to banks and a corresponding increase in the Fed’s assets.  To create these reserves the Fed essentially purchased mortgage securities from the banks for 100% of the original loan amount by giving the banks credit for those mortgages in their reserve accounts as part of the bank bailouts.

As I mentioned in an early blog post, typically in the U.S. we see a 10x multiple on reserves, meaning for every $1 increase in reserves, we expect to see a $10 increase in the money supply.  That has not yet occurred because for an increase in reserve funds to make their way into the economy, lenders need to be willing to lend against their reserves and borrowers need to be willing to borrow.  With unemployment continuing at record high levels, households shifting from consumption to savings, and paying down outstanding debts, the demand for consumer loans is lacking.  With corporations cautious about future expansions, commercial lending demands are also lower.  Once demand for loans increases and banks are more confident in their own balance sheets, we could see significant increase in the money supply, which means inflation.  The Fed claims to be watching for indications of this and have stated that they are willing to respond quickly by raising rates.  An increase in the rate the Fed pays banks decreases the supply of money in the economy because banks and more willing to leave money in their reserves, earning interest from the Fed, rather than lending it out.

Now back to the Federal Reserve’s balance sheet.  The loans the Fed “bought” from the banks are expected to be worth less than the original loan amount.  Nearly 10.7 million households, or about 23% of U.S. homeowners owe more on their mortgages than the properties are worth.  In addition, the states with the highest rate of underwater mortgages are, and most likely not coincidentally, non-recourse mortgage states, meaning borrowers are not held personally liable for more than the home’s value at the time that the loan is repaid.  It is also highly unlikely that the Federal government will go after individual homeowners to recoup losses on underwater loans.  This calls into question the quality of the assets owned by the Federal Reserve, which is of great concern to holders of U.S. debt.  As we’ve seen the quality of sovereign debt globally come into question, the interest rate at which the United States is able to issue debt could rise if the perceived quality of our debt is lowered.  With 71% of the marketable debt held by the public due by 2014 AND 40% individual income tax receipts already going to pay the interest on existing debt, an increase in interest rates on US debt could harm the economy, which puts the Fed in between a rock and a hard place when it comes to raising rates.

As of December 16th, 2009 the total outstanding public debt was $12.1 trillion while interest on the debt for 2009 was $383 billion (source Treasury Direct).  Individual income tax receipts are estimated to be $953 billion for 2009, which means interest payments accounts for 40% of individual income tax receipts.


Data Source:  Office of Management and Budget, Budget of the US Government FY 2010, Historical Tables, Table 7.1

Source:  November 2009 GAO Financial Audit, Bureau of the Public Debt’s Fiscal Years 2009 and 2008 Schedules of Federal Debt (GAO-10-88)

The Markets Love Bernanke?

The other day while I was organizing my office for the umpteenth time, (how is it that someone as obsessively organized as I am consistently has a messy desk?) I heard a reporter on the television say, “The markets love Bernanke.” I immediately glowered at the screen. After a few annoyed minutes and some distracted paper cuts, I realized, she’s right. Clearly if talk of him not getting reappointed causes the markets to drop, they must have some affection for the man. But how can this be? I come from the school of thought that increasing the bank reserves from $10 billion to $980 billion in a few months is not the best solution for an economy in turmoil and of course believe that any rational human being would agree with me, (note wry grin) so why do the markets seem to love him?

Then it dawned on me as I cleared away the seriously overused coffee mugs that hold my precious nectar of the Gods every morning. The markets love liquidity, thus Ben Bernanke. It is a bit like the love an addict has for their dealer, or me for my espresso machine. I highly recommend the Jura Capresso for those suffering from the same affliction. The recent talk that he might not get confirmed briefly sent the markets into a tizzy as their liquidity dealer might get kicked out of the neighborhood.

So why does an increase in liquidity cause asset prices to rise? You can think of it like a seesaw, with the price of money on one end and the price of assets on the other. As the price of money (interest rates) goes down, the price of assets goes up. If Bernanke is replaced with someone who is less likely to keep their side of the seesaw down, asset prices will drop.