For those worried about earthquakes, it’s probably best not to live on a fault line. The gradual build-up of pressure between the earth’s tectonic plates tends to give way rather suddenly in areas with high seismic activity.  Really large earthquakes thankfully occur less frequently and massive ones only about every 100 years.  But the probability rises over time rather than falls.

A recent BIS (Bank for International Settlements) Working Paper by Claudio Borio, Harold James and Hyun Song Shin describes the incidence of financial crises in similar terms. The inability to constrain financial imbalances until they snap, or “financial elasticity” as they term it, is perhaps a result of pro-cyclical behaviour and policy decisions combined with the slightly scary idea that we do not fully understand all of the mechanisms in play.[1]

This seems amazing with all of today’s regulatory oversight and academic literature. The globalisation of financial markets does seem to make the problem more difficult.  But what makes this pressure build up in the first place?  And how can we avoid living on an investment “fault line”?

THE CARRY TRADE IS BORN

Borio et al offer a detailed description of two such financial crises and how the build-up of pressure – that is debts – occurs over years and decades. One problem seems to be that we measure a globalised financial system using methods designed at the national level and consequently miss large maturity and currency mismatches.

The European banking crisis of 1931 and our most recent 2008 debacle are strikingly similar. In the 1920s, cash strapped German companies and banks sourced relatively cheap financing through their foreign subsidiaries in Switzerland and the Netherlands.  The main source of funds was the big exporting country of the day, the US.

These cheap foreign funds were re-lent profitably (carry) in Germany. A “banking glut” (as opposed to a “savings glut”) of excessive lending followed and when the “elastic” finally snapped in 1931, both debtor Germany and its main creditor, the United States, experienced substantial banking crises with large GDP declines and high unemployment.

Interestingly, and in contrast, the UK’s banking system was already separated into distinct merchant (investment) banks and clearing banks, and so did not suffer in the same way. The US then seemed to go in this direction with the Glass-Steagall Act in 1933 until the late 1990s, when financial liberalisation did away with the separation. The pendulum has swung back again with Dodd Frank rules in the US forcing many banks to exit proprietary trading.

ROLE REVERSAL BUT BOTH SIDES SUFFER AGAIN

Interestingly the US and Germany were both prominent in the 2008 banking crisis, though now the US is debtor and Germany the creditor. Both suffered an equally dreadful banking crisis which tends to support Borio et al’s conclusion that being a creditor or debtor does not matter very much in a financial meltdown.

What does seem to matter is the extent of foreign borrowing that is then re-lent domestically. Borio et al find that European banks were highly active in US money markets and had accumulated US assets of some $8 trillion by 2008.[2]

Much of these funds found their way into US subprime debt and related structured products but with much longer maturities than the underlying funding. In particular the state owned German Landesbanks piled into credit products with pristine credit ratings, and omitted to dig into the underlying assets. In contrast hedge funds that did the fundamental research were often on the opposite side of this trade and profited from the credit crisis. Conceptually the maturity mismatch is similar to the German binge in the 1920s though the funds flowed the other way then. Of course maturity transformation has always been an essential function of banks.

When US money markets completely seized up in 2008, European banks found themselves suddenly short dollars. And, as in the 1920s, the form of excessive borrowing was not obvious to regulators at the time.  Basel 3 rules are intended to place stricter limits on bank leverage, and are one factor behind the ongoing deleveraging of European banks.

In this light, the accumulation of foreign currency debts in certain emerging markets today is a worry (Chart). A yawning $798 billion gap has opened up since 2011 between residency and nationality measures of EM private sector debt outstanding. The much higher nationality measure likely captures the true level of debt as it includes foreign subsidiaries. And the Fed is just about to raise rates.  This is significant, as Borio et al note, because total debt and currency mismatch may be much larger than EM regulators perhaps realise.[3] EM DEBT

AVOIDING FINANCIAL “FAULT LINES”

It is common in investment circles to describe investment risk by how much return varies around its longer term mean. But benign markets for the past 4 years probably understate risk measured in this way.

We prefer to focus on fundamental risk measures, particularly leverage, liquidity mismatches and exposure to less liquid or hard to value securities. History has demonstrated these risks are key contributors to permanent capital loss.

We currently favour strategies that emphasise security selection in either event driven or equity hedge. In the short run, event driven strategies, which include merger arbitrage and distressed securities, offer the opportunity to profit from insights into why companies undergoing rapid change may be mispriced.

One such example that we recently discussed with a US based distressed fund is the preferred shares of Freddie Mac and Fannie Mae. These mortgage companies were placed into conservatorship following the 2008 crisis.  The companies have performed quite differently since being bailed out yet the share prices, which moved independently pre-crisis, arguably do not show this.

We also favour a particular category of equity hedge funds which offer highly concentrated portfolios with well under 20 positions. These large positions are the result of extensive fundamental work and a decidedly contrarian view.  There is usually no leverage.  Cash as a hedge is generally favoured and shorts are designed to be profit centres rather than hedges.

A concentrated equity strategy is highly manager specific for obvious reasons and this year not all of our funds are keeping up with the market.

One US manager that we favour this year profited handsomely from the takeover of DirecTV by AT&T. They had owned DirecTV for a year or so based on low valuations and attractive subscriber growth in Latin America.

When the takeover was announced the stock rallied and so they exited. An arbitrageur would have only bought after the announcement, and have stayed in longer, but the fund still made a 3% return that month.

HOW WE CHOOSE TO MEASURE RISK AND BEHAVE AS A CONSEQUENCE

One true worry is that the magnitude of financial crises is getting larger over time. This is perhaps because the remedy is an ever larger dose of fiscal and monetary stimulus each time.

The answers to our earlier questions would seem to be that pressures or debts build up mainly due to biases in the financial system itself. And these have not been resolved despite bank deleveraging, and all kinds of new regulations intended to mitigate risk.  Indeed new excesses appear to be building in certain emerging market debts.  The second answer is that financial “fault lines” are associated with excessive debt and herd behaviour.

There is no way to know when the next financial crisis will hit, but we can definitely control how we choose to measure risk and how we behave as a consequence.

Hamlin Lovell, CFA & Keith Tomlinson, CFA

[1] Caudio Borio, H. J. (2014). BIS Working Papers No. 457. The International Monetary and financial System: A Capital account Historical Perspective. Basel: Bank for International Settlements.

[2] ibid, 18

[3] ibid, 19

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