The New Normal

The New Normal

Following the macro-economic analysis provided by the folks at Pimco, we review Hyman Minsky’s tri-partite concept of debt structure. This topic sounds esoteric, but we guarantee it will seem strangely familiar. We add a fourth category to the Minsky model, however, which corresponds to the conservative and austere mindset that we expect to gradually dominate economics on Main Street as the slow deflation of various asset bubbles progresses.  

Pimco’s think tank expects things to get better on the margins, selectively, on a country by country basis. We believe Brazil and Chile will be among the early gainers. Accordingly, we profile Banco Bradesco (BBD), Brazil’s second largest bank, and Sociedad Quimica (SQM), which has a monopoly on fertilizer production in Chile. We also take a closer look at APAC Customer Service (APAC), a small-cap outfit with a growing presence in the medical field.

Detail

Once a year, the managers from Pacific Investment Management Company’s (PIMCO) global offices converge at the Newport Beach home office for a closed-door conference on the secular trends in the global economy and their implications for asset management. The purpose is to align Pimco’s fixed income strategies with a 3-5 year view of the worldwide investment risks and opportunities. Bill Gross, Paul McCulley and Mohamed El-Erian are the principal managers and spokespersons for the company.

If you watch financial television, you have seen these gentlemen. The only institutions in the U.S. that run more money than PIMCO are entities like the Fed and the U.S. Treasury. El-Erian et al. get paid to see the forest and not get stuck admiring the green-shoots of the trees.

Crack Economics

In our view, Pimco’s three managers have been particularly savvy throughout the credit crisis. For example, McCulley began warning about the risky practices in the “Shadow Banking System” (the world of unregulated derivatives) in August of 2007, when he addressed the Federal Reserve’s annual symposium at Jackson Hole.McCulley shook his finger at the Fed for allowing the Shadow Banking System to create explosive growth in leverage, and therefore in risk, outside the purview of the Fed or other regulators.

According to McCulley, the credit surge applied upward leverage to all asset classes (equities, real estate, commodities and bonds) in the U.S. and around the world, creating a bubble. The asset bubble bequeathed a huge windfall on U.S. consumers, who were encouraged to enjoy the fruits via home equity withdrawals (HEW). The HEW wave was roughly equivalent in magnitude to the entire 2009 Obama stimulus program each year during that period. It fueled virtually all GDP growth in the U.S. from 2002-2006. As crack cocaine was spreading around the country, crack economics was in full flower as well.

Minsky Moment

McCulley cites the “Financial Instability Hypothesis” by Hyman Minsky published in 1992 as the seminal work on the non-linear dynamics of financial markets. He summarizes Minsky’s theory thusly, “The longer people make money by taking risk, the more imprudent they become.” The journey to eventual destabilization progresses in three phases, according to the dominance of three types of debt structures: hedge, speculation and Ponzi.

Hedged debt structures are stable and can pay the entire principal on demand. For example, think of an airline that hedges fuel costs or a farmer who hedges crop income using wheat futures. Hedges (not hedge funds) are bets designed to improve things on the margins; no one is betting the farm.

Speculative debt structures, however, are capable of paying interest, but not principal, on demand. For example, many individuals and businesses carry credit card or loan balances that they cannot pay off in full each month, but they can pay interest and some principal regularly. Certain types of mortgages would represent the more extreme aspects of this category, such as option ARMS that allow for interest-only payments for a few years.

Crossing the ‘P-Line’

Ponzi debt structures, on the other hand, are so highly leveraged that they cannot pay interest unless the underlying assets are appreciating. If the assets fail to rise in value, then Ponzi-based debt structures must liquidate assets to meet demand for payments.

Quite a few hedge funds & investment banks found themselves in this position last year. They are not Ponzi schemes, because they are real businesses, but they fit the definition of Ponzi debt structures according to Minsky, in that they are overleveraged (say 30:1) to the point where they cannot tolerate even a small correction in underlying asset prices. In the consumer sector, mortgages with negative amortization are representative of

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