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Trident Investment Management, LLC
Opportunities Funds Commentary
M O N T H LY UP DATE
November 30, 2007
2007
Performance Summary
The credit rout of October continued through most of November. Most lower-grade credits traded at new high
yields despite lower bond yields and the expectation of further U.S. rate cuts. Equities were down with the S&P 500
down 4.18%, the MSCI Europe Index down 4.95% and the Nikkei also down 6.31%. The U.S. dollar strengthened
against its trading partners, with the dollar appreciating 0.43% on the month. Oil prices fell 4.89% to end the month
at $88.71 per barrel and gold fell 1.58% on the month as well. U.S. bonds rallied dramatically in response to the
credit distress with the U.S. 10-Year Treasury yields falling 0.53% to yield 3.94% (all figures in U.S. Dollars).
Market Outlook & Portfolio Strategy
The crisis in the credit market intensified dramatically in November. The Asset Backed Commercial Paper
(ABCP) market continued to contract and this despite two Fed rate cuts. The Structured Investment Vehicle
(SIV) market was equally moribund with many SIVs that were previously rated AAA trading at 60% or less of face
value. Numerous banks suffered huge losses from their real estate and sub-prime loans and from their alphabet
soup of accumulated derivatives. The Government sponsored enterprises (Fannie Mae and Freddie Mac) which
were supposed to be the solution to the credit problems, themselves disclosed monumental losses that require
further substantial capital increases. In short, things are coming to a head and panic is in the air.
In responding to the real estate and credit crises facing us, policymaker actions so far suggest that they do not
even grasp the nature of the problems. Most of the intelligentsia appears to believe that the problems are caused
due to temporary market risk aversion and that short-term palliative measures might permit us to weather this
storm. That is, many feel that markets are incorrect in assigning very low prices to the real-estate loans and credit
derivatives created by Wall Street and that mechanisms to prevent fire sales at these prices and stabilize markets
would help all participants and the economy in the longer-term. Thus, there has been a clamor for large rate
cuts along with direct lending by the Federal Reserve if need be to the banks whatever be the quality of the
collateral they may provide. The Fed has played along so far, although to nowhere near the extent that Wall
Street wants. The markets-are-wrong thinking extends also to dealing with the problems faced by the physical
real-estate market. The U.S. administration has proposed guidelines to freeze teaser rates for many sub-prime
borrowers who might default on their loans were their rates to reset to higher levels. The implicit assumption in
such proposals is that after a couple of years, a stabilization, if not an improvement in real-estate values can be
expected, even from current price levels.
Watching the U.S. policy responses so far is quite amazing simply because it runs counter to the very nature of the
capitalism that the U.S. claims to stand for. I recall in October 1997 when the Asian crisis was in full swing, most
Asian policymakers had not grasped the magnitude of the problems that they faced. Their U.S. advisers from the
International Monetary Fund, the U.S. Treasury and the banks believed that they did. The policies these parties
recommended were a draconian mixture of very high interest rates, a requirement to let insolvent banks fail, and an
assumption of private sector debt by the sovereign states so that foreign investors, and especially the foreign banks
(who by the way, had barely even bothered to assess the creditworthiness of these private borrowers) could be bailed
out. Japan believed that Asia was facing a liquidity crisis more than one of solvency and offered to set up an Asian
Monetary Fund with $100 billion of its own assets to stem the outflow from the region. The U.S. establishment
worked actively to prevent such an entity from being created. Even worse, the Asian countries were advised never to
put on capital controls on the grounds that this would somehow prove “bad” in the long run.
Fast forward to today, most of the same U.S. policymakers still argue that they were right in 1997 and this despite
the relatively better results achieved by Malaysia which did put on capital controls and even seeing the obvious
fact that after a decade Indonesia (which followed IMF advice to the letter) is not much better off than it was in
1997. Their logic today, as it was then, is that markets are always correct and that interfering with the free markets
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and preventing total transparency is always counterproductive. In fact, many would defend their policies in Asia
even though most would concede that 1997 was more a problem of liquidity that arose when foreign investors
tried to withdraw ten or more years of investments in a matter of days, rather than an issue of solvency. What was
very clear in the Asian crisis was that the selling of Asian assets was indiscriminate – the best companies and the
worst, leveraged or not suffered in a wholesale market crash that left no investors standing.
The U.S. that placed the value of free markets and transparency above all else even when faced with what was over a
20% contraction in the economies of some of the poorest countries in the world, is attempting to do the exact opposite
when faced with the crises of today. The present situation, however, is fundamentally different from that faced by Asia
in 2007. The U.S. has to deal with a problem of exceptionally complex financial instruments which were valued at
mythical prices thanks to rampant optimism at best and outright fraud at worst. These securities were purchased
moreover with a degree of leverage never before observed in human history. Unfortunately, the market’s correcting of
overvalued asset prices with attendant losses to highly-leveraged investors are expected outcomes for any capitalist
system – this in fact is the destructive phase of the creative destruction that defines capitalism. The U.S. credit market
corrections this year moreover, have been entirely rational. Consider for example that even after a credit rout, the
highest grade industrial credits are trading at close to the tightest spreads we have ever seen, while companies which
hold toxic assets and have opaque financial statements (read the banks, brokers, insurers and the like) have spreads
trading at multi-year highs. Markets in fact, have been models of efficient pricing. Unfortunately, the U.S. financial
system is hugely levered and correct market pricing of the rubbish on its books threatens its earnings power if not its
very solvency.
I cannot stress enough that what we face today in the U.S. financial system is not a problem of liquidity but one
of solvency. Markets are pricing credit more rationally now and the lock-up in the SIV market and in sub-prime
lending are all symptoms of a market that has finally come to its senses. More liquidity courtesy of the Fed cannot
solve this problem unless it re-ignites a bigger asset price bubble which is undesirable given the pain we are
already feeling with the one that is just deflating. What we need is an acceptance of the solvency issues facing
our financial system and direct fiscal measures to deal with the rash of bank problems that have already surfaced
and should continue for several years to come.
To understand the situation better, it would be instructive to consider some of the lessons from introductory
economics. The standard pedagogic approach to determining a money supply function is to consider a banking
system with fractional reserves. If the Fed injects $100 of high powered money into the banking system and the
reserve requirement for the system is 20%, this means that 80% of every deposit made into the system can be
loaned out. With some algebra it can be shown that the maximum amount of new loans that could be created by
the by the new $100 injection would be $400. In this case, we would have the balance sheet below for the system:
Assets
Liabilities
Loans:
$400
Vault Cash: $100
Federal Reserve deposit: $100
Customer deposits:
$400
TOTALS:
$500
$500
Any easing of monetary policy above that led to an injection of high-powered money (Fed deposits) would result
in increased credit and thus a possible improvement in conditions of illiquidity created in markets because of
sudden credit revulsion.
The above banking example, while used in all standard economics textbooks is no longer reality. What is not
well known is that most large banks in the U.S. today are not really bound by reserve requirements at all! This
came about after 1990 when the Fed exempted all but a few classes of transaction deposits from reserve
requirements. As such, banks are free to lend almost all of their deposits and any needed liquidity to cover cash
withdrawals can be dealt with by borrowing from the Fed. The operational constraint on banks today is no longer
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an asset side constraint that requires that they keep a certain amount of vault cash against their deposit liabilities,
but a liability side constraint that requires that they keep a certain amount of capital against loans made.
2007
We need to expand our example above to allow one to understand how the capital constraint works with the
banks. Assume that our banking system has been set up initially with $50 of equity capital. With this, and no
reserve constraint, our system can theoretically lend as much as the market wants. These loans however, have
risk and by the capital requirements established by the Bank for International Settlements, our bank has to
ensure that it has enough capital to back the risk it takes in making a loan. That is, if our capital requirement
were 10%, our banking system could not support more than $500 of loans at the maximum. Any more than that
would require additional capital. At the maximum, our system’s balance sheet would be as below:
Assets
Liabilities
Loans:
$500
TOTALS:
$500
Customer Deposits:
Equity:
$450
$50
$500
Any additional injection of high powered money here by the Fed would result in an increase in the balance sheet
by increasing both deposits (by the Fed now) and vault cash (which has no capital requirement). However, no more
lending by our bank is possible since it has no capital available to back lending. Fed policy has become ineffective.
Consider now what happens above if our bank sustains a loss on its loans of $25. This means that the capital of the
bank declines from $50 to $25 above, even as loans decline from $500 to $475. However, the $25 capital that the
bank now has can support a maximum of $250 in loans. That is, the banking system needs to contract its loan book
by an additional $225 (from $475 to $250) because of its reduced capital. Any amount of money that the Fed injects
into the banking system against any type of loan collateral that the bank provides (however illiquid these loans are)
will not allow for an increase in lending but will only increase the amount of cash available to the bank while still
requiring that it reduce its loans outstanding. If the bank were to park its free cash in risk-free short-dated Treasuries,
the net result would be to depress Treasury yields while the actual lending rates in the economy (such as LIBOR)
would remain elevated because of the need for balance sheet reduction. In fact, the worse the loan losses and the
more the Fed injects money into the system, the worse the discrepancy between LIBOR and short-term sovereign
rates can become. This is exactly the situation that has occurred since July in the global money markets. The Fed
here is in more of a bind – it cannot even reverse a massive decline in credit creation by the banking system. The
balance sheet below illustrates this situation with a $100 injection of high powered money by the Fed. The banking
system’s balance sheet increases, but a loan contraction is still needed.
Assets
Liabilities
Vault Cash:
Gross Loans:
Loan Losses:
Net Loans:
$100
$500
($25)
$475
TOTALS:
$575
Federal Reserve Deposit: $100
Customer Deposits:
$450
Equity:
$50
Loan Losses:
($25)
Net Equity
$25
$575
The above example is only a first approximation. The more the Fed strives to inject liquidity, the more creative our
banks can get. Specifically, they can lend money to their private equity or fund clients who in turn will purchase new
issues of the banks’ equity. That is, banks will find a way to create even more capital with Fed largesse, but the
inherent problem with such capital is that it is essentially fictitious. The banking system can fabricate as much capital
as it might need it in collusion with its non-bank financial system partners essentially making a mockery of all the
regulations that the Fed, the BIS and other agencies created to prevent excessive risk-taking and collapse.
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The “capitalist” approach to the current crisis which would have been the formula for the U.S. of the late 1980s
would have been to let numerous institutions fail, force pricing transparency for assets held, tightly regulate the
institutions “too-big-to-fail” to prevent even bigger problems and finally conduct fire sales of assets to investors who
are willing to take the risk. With these measures, the banking system would be considerably more robust because
new capital then injected into the banking system can go to capitalizing new, clean banks without the legacy
problems. This may prove much more effective in getting credit flowing to the overall economy rapidly.
The approach of today is contrary to everything that the U.S. has so long preached for. The corporate chieftains
presiding over these rubbish assets are trying hard to avoid disclosing the losses while finding ways to cash in on their
golden parachutes. The Fed has been cutting rates blindly and finding ways to prop up failing banks through creative
lending directly from them. The Treasury has floated ideas of a “super-SIV” to purchase SIV assets from banks to allow
them to transfer the risk without taking the associated write-down to values and capital – a mechanism to obfuscate
the true risks and exposure of the banks to these instruments. The rating agencies have yet failed to downgrade credit
and bond insurers who potentially face bankruptcy – in fact, it is deemed somehow “patriotic” to keep these
essentially insolvent companies at AAA ratings, virtually guaranteeing that the public will take even bigger losses
ultimately. The media shouts for quick fixes by the policymakers while refusing to highlight the sordid reality we face.
And the investment community, which is arguably the most to blame, continues to believe in fantasies rather than
taking an activist role in disciplining the managements of the companies they own. The main actors in the debacle
all have a lot to lose if the truth were to come out. It is so much better to live the fantasy because in the end it will
result in the public’s paying for all the losses. In an ironic twist now, we have capitalism when things are good and
our corporate chieftains get over-compensated, but any losses bring out cries for socialism and the need to share pain
to “protect the system”. In retrospect, Japan’s fixes for its banking problems of the 1990s look like a model of clarity
and effectiveness.
We are continuing with our major investments - being short in credit and real estate and now increasingly the U.S.
consumer. We are also long short-term sovereign fixed-income instruments and remain short the U.S. dollar. The
mess in the real-estate and credit markets has not been cleaned up – in fact, we are still at the stage where the reality
is sinking in slowly and no real policy prescription is yet forthcoming. The longer the blundering goes on, the more
opportunities we expect for profit.
Performance Summary at November 30, 2007
Trident Global Opportunities Fund
1 Mth.
3 Mth.
6 Mth.
1 Yr.
2 Yr.
3 Yr.
5 Yr.
10 Yr.
YTD
Since Inception
(Feb. ‘01)
10.4%
33.7%
91.8%
88.9%
39.9%
25.2%
15.9%
N/A
87.6%
12.4%
CI Global Opportunities Fund
1 Mth.
3 Mth.
6 Mth.
1 Yr.
2 Yr.
3 Yr.
5 Yr.
10 Yr.
YTD
Since Inception
(Mar. ‘95)
9.1%
38.9%
105.4%
107.7%
46.5%
27.1%
16.2%
17.2%
110.5%
21.2%
Nothing herein should be read to constitute an offer or solicitation by Trident Investment Management, LLC or its principal to provide investment
advisory services to any person or entity. This is not to be construed as a public offering of securities in any jurisdiction of Canada. The offering of
units of the Trident Global Opportunities Fund are made pursuant to the Offering Memorandum only to those investors in jurisdictions of Canada
who meet certain eligibility or minimum purchase requirements. Important information about the Funds, including a statement of the Fund’s
fundamental investment objective, is contained in the Offering Memorandum. Obtain a copy of the Offering Memorandum and read it carefully
before making an investment decision. These Funds are for sophisticated investors only. ®CI Investments and the CI Investments design are
registered trademarks of CI Investments Inc.
2007
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