2009 Annual Partner Conference Highlights
June 11, 2009
2009 Annual Partner Conference Highlights
We thank the over 200 investors, advisors, managers and friends who joined us for Alternative Investment Group’s Annual Partner Conference, held on April 16th at the Mandarin Oriental Hotel in New York and April 23rd at the Ritz-Carlton Hotel in San Francisco.
We provide below a brief summary of the Conference. For those unable to join us this year, we look forward to seeing you in 2010.
Keynote Speakers
Dr. Martin Feldstein, our keynote speaker in New York, started the conference with an effective summary of the current economic situation and prognosis for the future. Dr. Feldstein was chairman of the Council of Economic Advisors and Economic Advisor to the President under President Reagan and is currently on President Obama’s Economic Recovery Advisory Board. He has been President of the National Bureau of Economic Research almost non-stop since 1977 and is George F. Baker Professor of Economics at Harvard University.
Dr. Feldstein believes the recession will last well into 2010. Although the rate of decline has slowed, the fact is the economy continues to slow, as measured by industrial production, unemployment rates, and other factors. He distinguished this recession from previous ones. In the past, when the economy overheated, the Federal Reserve would raise interest rates to cool things down and cause a mild recession, but this time the recession is worsening despite the Fed lowering interest rates essentially to zero. This recession has already lasted 18 months vs. the recent average of about 12 months and is almost certain to be the worst slowdown since the Depression. While he believes the Administration has made progress and has good, experienced individuals in place to address the problems, he remains nervous about the economy and believes we need further government action.
The recession has three primary causes: a dramatic decline in aggregate demand, dysfunctional credit markets, and a downward spiral in home prices. Dr. Feldstein discussed the problems and the Administration’s response to each.
Demand: Total private wealth has declined about $13 trillion - $9 trillion from lower stock prices and $4 trillion from lower home prices. A decline of this magnitude will typically result in a decline in spending of about $500 billion annually. Including the depressed level of housing starts, which are down about 70%, the total drop in demand increases to about $750 billion, or 5% of GDP. The Obama plan commits $800 billion to stimulus, with 75% to be spent over the next two years. Dr. Feldstein believes $300 billion per year is too little stimulus to attack the demand shortfall. He expects the Administration to seek a second stimulus package but it will meet resistance from Congress.
He also believes most of the stimulus funds provided to states, and tax cuts for lower-income people, will simply be saved or used to pay down debt, not spent. He would have preferred measures that directly encourage spending, such as the Investment Tax Credit for business and similar tax credits for individuals who purchase consumer durables, which he said the Chinese are already doing. He thinks it makes little economic sense during a recession to raise marginal income tax rates and capital gains tax rates on higher-income people, or raise taxes on business through carbon “cap and trade” programs, or tax non-U.S. income of manufacturers, and recommends those increases be deferred at least until the recession is under control.
Dr. Feldstein cites many potential problems brewing. The ratio of government debt to GDP, currently 40%, will rise during 2009 alone to 50%, and is projected to rise to 80% as a result of large deficits over the next 10 years. This will cause large increases in federal interest expense, with the effect of reducing private capital investment and economic growth and requiring tax increases.
Credit issues: Dr. Feldstein repeatedly described credit markets as “dysfunctional.” One problem is that banks themselves do not know the value of their assets, especially anything of a structured or securitized nature. This makes it impossible for anyone, including the banks themselves, to determine accurately their capital base. As a result, banks are motivated to focus on rebuilding capital and not making new loans. Another problem is that if banks sell assets below par, they are forced to recognize a loss and impair their existing capital base, so they are motivated neither to lend nor sell assets, leading to the frozen credit market problem.
Dr. Feldstein reviewed the five goals of the current U.S. Treasury plan for private entities to buy, in auctions, “toxic” assets that are impairing banks’ willingness to lend. While they are good goals, each has a problem. The most significant impediment is that bank assets are down about $5 trillion, so the U.S. Treasury plan is much too small to have a major impact. Instead, the plan should include a vehicle to infuse new capital when banks sell assets at a loss.
Downward housing spiral: The U.S. housing bubble is primarily attributable to loan-to-value ratios rising in the past several years from 75% to 90% or even higher, permitting previously unqualified buyers to qualify for loans, and extraordinary increases in securitization techniques, which artificially enhanced mortgage credits to AAA status. These pushed house prices 60% above the long-term trend line by 2006, when the bubble began to burst.
House prices have fallen some 19% over the last 12 months, with no relief in sight. About 30% of homes today have negative equity – the borrower owes more than the house is worth – with an average of about 130% loan to value. Unless the decline is halted, the downward spiral will soon see 50% of homeowners in America owing 50% more than the house is worth. This presents a tremendous incentive to walk away, especially since the U.S. is the only major country where virtually all home mortgages are non-recourse loans.
The solution is not to make the mortgage more affordable over several years, as the Administration plan seeks, but to address directly the issue of negative equity as a permanent solution. Otherwise, the downward spiral threatens to widen and further destabilize credit markets and reduce aggregate demand.
In the Q&A period, Dr. Feldstein pointed out that while the 8,000 banks in the United States have total assets of $11 trillion, Citibank alone has $2 trillion and the top ten banks have about 50%, so the solutions must depend on the circumstances of each bank. The “stress tests” currently being prepared cannot very well give failing grades to any bank, so the testers will be “soft graders.” The government twisted arms to bring Goldman, Wells Fargo, JP Morgan Chase and others into the TARP and other programs without warning of the control Congress would require on compensation and other areas, so he is sympathetic to these institutions wanting to get out from the TARP as soon as possible.
The GM/Chrysler situation is very difficult and it will be costly to carry these companies for a long period with uncertain benefit. The tremendous increase in the money supply and bank reserves means inflation is likely to rise significantly, especially as Congress will favor cutting unemployment over controlling prices. Inflation is artificially low today as a result of the 30% decline in commodity prices, especially oil, which is 2.5% of GDP.
Dr. Laura D’Andrea Tyson, our keynote speaker in San Francisco, kicked off the meeting by discussing various aspects of the current U.S. and global economic environment, and the effect of various government responses to the problems facing the world economy. Dr. Tyson is a member of President Obama’s Economic Recovery Advisory Board. She chaired the Council of Economic Advisers during President Clinton’s first term. She was previously the Dean of the London Business School and Dean of the Haas School of Business, University of California, Berkeley. Dr. Tyson is an authority on U.S. economic competitiveness, global markets and the high tech industry, and has written numerous books and articles on these topics.
The current economic crisis: Dr. Tyson describes this recession, the deepest and most synchronized since the end of World War II, as being caused by the global financial crisis and the collapse of world trade. The stock of wealth declined by $13 trillion in the U.S. alone and $50 trillion globally. This is the first time output in the global economy has fallen since World War II. The output gap (difference between potential output and what is actually produced) is 8% globally – the highest since the Great Depression and twice that of the 1991 recession. Three factors caused this – the housing crisis, which started in the U.S. and is also taking place in other countries, the financial crisis, and the collapse in demand (primarily driven by U.S. households). With regard to the third factor, consumption as a share of GDP reached a high of 71% in 2008 vs. a historical average of 67%. The U.S. consumer was overleveraged and undercapitalized, the savings rate was at zero and debt to household income was at 133%. Household demand was driving both the global and U.S. economy, but in an unsustainable way.
Impact of global imbalances on the current crisis: While the global financial crisis may have started in the U.S., it was aided and abetted by policies in the rest of the world. The U.S. was the market to which everyone wanted to sell. Global imbalances resulted when the rest of the world amassed huge amounts of savings without generating domestic growth and demand at the same time. Global investors wanted better returns than could be earned in government paper, so financial institutions generated new securitized products to provide the world with investment alternatives. Going forward, the world has to change. Demand generation will need to shift to other countries or world economic growth will slow significantly. Right now, the two most responsible actors in the global economy are the U.S. and China. China is currently trying to stimulate domestic demand and shift to a domestically-driven economy.
Why extraordinary government intervention: According to Dr. Tyson, we need government intervention because simultaneous downward spirals are preventing the financial and credit markets from stabilizing and achieving equilibrium on their own. For example, declining asset prices cause financial institutions to deleverage to improve their balance sheets; this in turn causes further declines in asset prices. Lower asset prices mean less capital which leads banks to decrease lending activity, hence driving asset prices lower. Lower income for households means less consumer spending, which leads to lower employment and lower income.
To address these downward spirals, the government has had to implement temporary, but significant changes, in government policy. The four sources of demand are consumption, investment, exports and government spending. Increasing consumption is not an option because consumers lack confidence and income. Increasing business investment is not an option due to weak consumer spending – even if businesses have capital to invest, they will not commit to new projects. Increasing exports is not an option because the world economy has slowed down. This leaves government spending, either through direct programs or tax incentives, as the only option left to stimulate demand.
The U.S. government created the stimulus package as a way to create demand where it has collapsed and to help individuals who are hurt the most, including through food stamps, healthcare, and unemployment benefits, and states with budget problems. The government is also focusing the stimulus on items that would help future growth, such as information technology, infrastructure, education and research, alternative energy and improvements to the U.S. electricity grid in to reduce our dependence on oil and carbon.
Dr. Tyson said economists believe about $700 billion of the $787 billion bill is focused on stimulus. The stimulus package will have a significant effect in the second and third quarters of this year, adding about three percentage points to GDP each quarter and an additional $3.5 billion jobs this year. The overall assessment of the package from economists is that it was well put together but too small relative to the problem. There is also concern that tax cuts for households will not increase consumption because consumers are not spending due to lack of confidence. Finally, there is the possibility that we will go quickly from fiscal stimulus to fiscal drag in the first quarter of 2010.
The cost of government intervention: Dr. Tyson believes the U.S. can afford what it is doing. Federal government debt as a percentage of GDP was above 40% but under 50% before the crisis. While it will most likely rise to 60%, the U.S. government has run federal debt previously above 100% (and 120% during WW II). Dr. Tyson believes the government must stimulate demand to avoid losing potential output. Otherwise, capacity will be left unutilized which is a huge waste of resources.
Monetary policy also plays a role in this recession. In late 2008, the Federal Reserve’s focus was on liquidity. Since then, the Fed has been taking non-traditional steps to stimulate the economy. The Taylor Rule, a model used to evaluate monetary policy, has two objectives – keep inflation rate in a range of 0 to 2% and maintain a target output rate. In this economy, the Taylor Rule does not work – i.e. the Federal Reserve would have to follow such an aggressive monetary policy that interest rates would be negative. This is the reason why the Fed is employing untraditional methods. The Fed has purchased both private and public assets and made loans to public corporations, acting as both a direct lender and direct purchaser. The Fed is trying to recreate securitization in markets that have closed down, and has expanded its balance sheet by $1.4 billion. The amount of the government’s commitment, including TARP, loans to institutions and bank guarantees, is $4.4 billion. So far, the government’s actions seem to be working - there is marked reduction in spreads between risky and non-risky assets, some signs of life in equity markets, and improvement of consumer confidence.
There is a strong commitment from the U.S. government to keep systemically significant banks in business. The government also believes that the problem in financial sector is a liquidity problem, not a solvency problem, but there is a big debate on this issue. There is a tension between incentives of banks to hold on to what they have and wait for markets to come back and the government forcing them into recapitalization – this issue still needs to be resolved.
Regulation: With regard to regulation, the general view is that greedy financial players in the U.S. made irresponsible bets on the market, destroying jobs, wealth, and countries, with taxpayers now being asked to foot the bill. Dr. Tyson says the reality is much more complicated – CEOs, politicians, consumers, and mortgage purchasers were also part of the problem. We were in the midst of an asset bubble with complex instruments that made people believe they were shedding or laying off risk. For example, it was thought that investment banks self-regulated leverage and risk, but in reality, investment banks were taking on more risk as they competed with each other. Credit default swaps were not regulated by the government and 80% of this market was based on speculating on the price of a security the investor did not own.
There are some definite changes to regulation that will take place in the future. Since systemically significant institutions, including large hedge funds, will not be allowed to fail, they will need to be regulated more closely. Very large institutions will either be broken apart or have to pay a price for being so large, such as high insurance premiums. Dr. Tyson expects we will have FDIC-like mechanisms that provide a safety net for customers when non-bank financial institutions fail. There will be more consumer protection so that consumers do not make decisions regarding things they do not understand, as happened in the mortgage crisis.
What the future holds: Global growth is normally between 3.5% and 4%, but will likely be negative in 2009. Dr. Tyson predicts modest positive growth for the U.S. and the rest of the world in 2010, with a shift of income growth and wealth to Asia and emerging markets. Although large emerging economies will also slow down, growth in these companies will likely stay positive. The economies of advanced industrial countries, such as the U.S., Europe and Japan, will shrink the most. The U.S. will lose $3 trillion in potential output between 2009 and 2010. The U.S. economy will have more investments in energy, infrastructure and healthcare, higher exports as a share of GDP and less consumption. Just as investors underpriced risk dramatically from 2002 to 2007, they will be much less willing to embrace risk for a considerable period of time. This will change the cost of capital and types of investments going forward.
One of the questions raised during the Q&A session was why the government does not lower corporate taxes as a way of generating more creativity and demand than the government can generate through infrastructure projects. Dr. Tyson thinks our corporate tax rates are high compared to competition. However, given the urgency of the crisis, the government’s strategy is to spend money and create demand quickly. In contrast, lowering corporate tax rates will not have a significant immediate impact because corporate investments are driven by expectations of demand. Companies will not make significant investments unless demand expectations improve, along with cost of capital.
Another question related to Dr. Tyson’s outlook for inflation in three, five and ten years. She responded by saying that the Federal Reserve has been asked this question a lot, and she finds the Fed’s answer to be credible. The Fed says its policies are temporary and it can reverse any of the tools that have been put in place should it be necessary to take liquidity out of the system. The Fed sets an inflation target and monitors indicators for inflationary expectations. At the present, the Fed’s main problem is deflation, not inflation. Looking forward, as the U.S. economy begins to gain momentum, government debt will start to compete with private sector debt, which leads to higher interest rates and cost of capital. Dr. Tyson sees this as a five-year phenomenon.
Dr. Tyson agreed with Dr. Feldstein that increased taxes, whether on individual income or capital gains, or on corporate profits, would slow the economy and taxes should therefore not be raised until the economy stabilizes.
Manager Panels
In New York, David Einhorn of Greenlight Capital and Pasco Alfaro of Miura Capital shared their views on investment opportunities in a challenging economic environment. David Einhorn pointed out that in a volatile and uncertain economic environment, maximum flexibility is key for an investment manager, thus giving long/short equity funds a tremendous advantage over a long-only equity strategy. Given his serious concerns about the country’s overall fiscal situation, he has invested in gold and gold mining stocks. On the short side, he is short sectors including financial institutions, real estate and REITs. David also talked about his experience dealing with Allied Capital, a company whose stock he shorted. He found himself dealing with a regulatory system that protected the wrongdoer and wrongdoing even when properly brought before the appropriate authorities. David believes his experience in dealing with issues such as fair value accounting, fire sales, and the right value of assets is a microcosm of what we are dealing with in the current financial crisis.
Pasco Alfaro also talked about the benefits of long/short equity investing in an uncertain environment. While many investors have come to expect an environment in which markets go up, he gave the example of Japan which is down 77% from 1990 to the present, a disastrous result for someone invested long-only in Japanese equities. He contrasts this approach with long/short equity which gives investors the ability to take market risk out of the equation and focus on individual stock picking. He then talked about investment opportunities, including financial shorts in Spain where 25% of loans in the financial system are to real estate and construction companies and another 32% are in mortgages.
In San Francisco, Sang Peruri of Seligman Spectrum Focus talked about how Seligman’s differentiated strategy, team and risk management approach allowed Seligman to navigate through the difficult markets in 2008 and actually earn a positive return. In July 2008, Sang saw an increase in equity correlations and realized there was very little alpha to be made in this type of environment. He lowered exposures in the fund for remainder of the year and was able to preserve capital while most hedge funds suffered big losses. As a market neutral manager, Seligman invests in fundamental sectors including consumer and technology, and avoids macro sensitive sectors like energy, financials and utilities. Sang believes the sharp reduction in the number of hedge funds post-2008 bodes well for the remaining fundamental long/short equity managers.
Due Diligence Panel
Randy Shain, founder of BackTrack which is now part of First Advantage, spoke in San Francisco about how investors can better protect themselves against fund blow-ups. One of the three steps in due diligence includes a background check on potential managers that includes verification of manager credentials and a search of court records, news sources and regulatory records. Background checks help investors detect potential fraud before it happens, unlike regulatory bodies that, in his opinion, are set up to prevent the problems from getting worse. Randy discussed the advantages of using a background investigation firm in this process, including knowing which databases to use and sifting through the data to filter critical information.
Alternative Investment Group Partners’ Forum
In both New York and San Francisco, many of the participants stayed for lunch and joined their colleagues, managers and Alternative Investment Group partners.
Dr. Martin Feldstein
Stu Greenfield and Dr. Laura D'Andrea Tyson
Managers David Einhorn and Pasco Alfaro
Manager Sang Peruri
Randy Shain