Commodity prices are on fire. The cost of food in the past twelve months has exploded. To name a few:
Corn +84%
Wheat +76%
Soy Beans +57%
Coffee +87%
Live Cattle +27%
In addition, the prices of some non-food commodities like cotton (+150%) are much higher than one year ago. To the average U.S. consumer, this is inconvenient on the heels of the worst recession in our lifetime. Even though we are seeing a few signs of an improving economy, higher prices for consumer goods are unwelcome with unemployment still hovering close to 10%.
But what is inconvenient in the United States can be a full-blown crisis in less prosperous nations (which is most of them). The U.S. spends close to 15% of its income on food. In many nations, nearly half of a family’s income is spent on food. Combine that with double-digit unemployment and you end up with very unhappy citizens. “Unhappy, hungry and unemployed” is a bad combination for those in charge… as the leaders of Tunisia, Egypt and Yemen have discovered.
Zine el-Abidine Ben Ali, the president of Tunisia for 23 years, was ousted last month. Hosni Mubarak, the leader of Egypt for 30 years, is dealing with violent protests in Cairo and has conceded he will step down at the next election. The unhappy and hungry are pressing for him to leave now. They don’t want to wait until the next election.
And in Yemen, protests have begun and, although they are peaceful, they have caused President Ali Abdullah Saleh, who has been in power for 32 years, to state he will not run for re-election in 2013. We doubt the unhappy and hungry will have the patience to wait until 2013. Don’t be surprised to see similar protests and changes of leadership in other countries. The world is rife with authoritarian dictatorships and now it is rife with skyrocketing food prices. Who would have thought that was all it would take to topple those in power?
The implications for the U.S. are unknown. Egypt has been a friendly ally of the U.S. while Mubarak has been in office. A change in power could result in a less friendly regime of radical Muslims who sponsor terrorism. Not surprisingly, the price of oil is reacting to this uncertainty. Within the past 6 months, a barrel of oil has traded in the low $70s (when cooler heads were prevailing) and as high as $92 on the last day of January when protests in Cairo were in full swing.
The Financial Crisis Inquiry Commission issued a report last month on the “causes of the financial and economic crisis in the United States.” The conclusions of the ten-person commission are questionable since four of the members dissented from the findings of the report. The report concludes that:
- The financial crisis was avoidable.
- There were widespread failures in financial regulation and supervision.
- The government was ill-prepared and its inconsistent response added to the uncertainty and panic in the financial markets.
- There was a systemic breakdown in accountability and ethics (at some point they were going to have to state the blatantly obvious).
- Mortgage lending standards collapsed and the mortgage securitization “lit and spread the flame of contagion and crisis.”
- Over-the-counter derivatives contributed significantly to this crisis.
- Failures of credit ratings agencies were significant cogs in the wheel of financial destruction (my personal favorite).
The report, although it is over 600 pages, is actually a pretty interesting read. A common theme throughout the report is that there was not enough government regulation and supervision…and the supervision that existed was not very competent. No argument there.
In my opinion, the commission listed two of the most important causes of the crisis and refused to list the other most important cause. The two they listed are:
There were widespread failures in financial regulation and supervision.
In 1933, during the Great Depression, Congress passed the Glass-Steagall Act. Among other things, this act created the FDIC and it restricted banks’ activities so they would not take excessive risk.
In the 1970s, non-bank financial companies (like Merrill Lynch and Fidelity) slowly began competing for bank deposits with the creation of the Money Market Mutual Fund (MMF). MMFs are not FDIC insured but have enough diversification to appear relatively safe. Because the MMF rate of return was higher than investors could get at the local bank, money started flowing out of banks and into MMFs. These non-bank financial companies are known as the “shadow banking system.”
Beginning in the early 80s, banks began whining to Congress that things weren’t fair… that they couldn’t compete with shadow banks which didn’t have the same restrictions. Gradually, restrictions which had been placed on banks began to disappear. In 1994, the restriction against banking across state lines was abolished and the mega-bank was born.
Meanwhile the “shadow banks” were growing as Smith Barney acquired Shearson, PaineWebber purchased Kidder, Peabody, etc. etc.
Bank holding companies owned various banking and shadow banking subsidiaries that basically let them get around most of the restrictions of the Glass-Steagall Act. So in 1999, Glass-Steagall was virtually overturned and the path to our financial self-destruction was laid before us.
Failures of credit ratings agencies were significant cogs in the wheel of financial destruction.
What happened at the credit rating agencies is absolutely stunning. They are the final stop, the final checkpoint. A flawed product can make it through the planning stage and the production stage but at point of inspection, trained and qualified inspectors should provide the backstop and safety net so that flawed products are not foisted on naïve and unsophisticated customers.
An argument can be made that some customers were sophisticated and should have known better… that they should have done their due diligence and not relied upon the ratings of Moody’s, S&P and Fitch.
Nevertheless, the report states that, from 2000-2007 Moody’s rated nearly 45,000 mortgage related securities triple-A (AAA). AAA status is reserved for the elite, safest securities. In 2010, only six private sector companies carry an AAA rating from Moody’s. So it seems a little out of character that Moody’s would assign that rating to 45,000 mortgage related securities. In 2006 alone, Moody’s gave AAA status to 30 mortgage related securities every working day!
One of the causes of the crisis that the commission stated they believed was NOT a cause of the crisis was:
There was too much improper government interference in proper capitalistic behavior (my words, not theirs).
Much of the report details the lack of government regulation in all things financial. And to be sure, proper regulation was severely lacking in many areas. We don’t disagree with that.
However, although the commission mentions the policy that created the atmosphere… a policy initiated by Bill Clinton and perpetuated by George Bush… the commission dismisses it as a cause of the crisis. We disagree with that.
In 1995, Bill Clinton established an “initiative to boost home ownership” from 65.1% to 67.5%. This initiative was continued under George Bush and the mentality that everyone should have the right to own a home became pervasive.
The ability to bundle similar mortgages together and sell them to investors (securitization) made the Presidents’ initiatives much easier to accomplish. It was a slippery slope which eventually led to esoteric forms of mortgages designed to help the unqualified buyer become a qualified buyer.
At the peak of the mortgage insanity, homebuyers were able to get mortgages WITHOUT having a job or income, WITHOUT making any kind of down payment, WITHOUT making principal payments and WITHOUT having to pay market interest rates.
Without a governmental blessing that we should do whatever we can to make sure everyone owns a home, these mortgages were much less likely to exist.
Some people point to the economic crisis as proof that capitalism is a flawed system that doesn’t work. Just the opposite is true. The economic crisis proved once again that socialism (giving homes to people who cannot afford them) is a flawed system and does not work.
Capitalism needs regulation, not interference.
January was another good month for the stock market, the fifth in a row. The S&P 500 index rose 2.37% giving it a return of 22.07% for the twelve month period ending in January. Virtually all of the gain was in the last five months. It is still 11.55% below the stock market high set in October, 2007.
There were 257,747 new home foreclosures in December, the second month in a row below 300,000. Although we may have one or two months in excess of 300,000 ahead of us, I think it is safe to say the worst of the home mortgage crisis is behind us. There are still going to be many more foreclosures yet to be filed throughout 2011 and home prices are not going to begin appreciating for a long time.
We continue to feel that the municipal bond market has taken an unwarranted beating and we feel we are finding unusual investment opportunities. Pundits and investment “professionals” have appeared on television business shows to warn investors of the wave of imminent defaults in the municipal bond market. It appears that this has caused the average investor to liquidate his/her investment in tax-free bond mutual funds. In order to meet those redemption requests, the mutual fund manager has had to liquidate the municipal bonds in the fund and this sell-off is resulting in some interesting municipal bonds trading at unusually low prices.
Although we typically try to find investments with rather short durations, prices in the municipal bond market are so ridiculously low, we are making an exception and extending our durations. We’re not sure when we will ever be able to purchase tax-free bonds with an interest rate of 6.5% again.
~Richard W. Boyer, CFP, CFA
Chief Investment Officer
This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.