David R. Kotok
October 24, 2011


Since 2007, the world has worried about defaults. More accurately, the worry began in the summer of 2007, when Bear Stearns announced losses of a couple billion dollars from trouble in their hedge funds. They assured investors that the situation was under control.

Lessons learned during these past four years highlight defaults, meltdowns, and all the other aspects tied to these crises. Lehman-AIG has become the metaphor. The US policy responses of TARP, QE1 and QE2, Dodd-Frank, and now Operation Twist top a list of many government attempts to thwart another Lehman waterfall.

Let’s survey the landscape.

Default risk in Europe remains the ongoing saga on the front page and in TV headlines. Europeans are struggling to manage sovereign debt risk as the sovereign debt-GDP ratio reaches unsustainable levels.

The poster child for Europe’s default risk scenario is Greece. The latest estimates are that Greek debt will soon be 180% of GDP. The Greeks cannot pay. They do not have market access. They are broke. A negotiating process is underway; its purpose is to deal with Greek debt, since that sovereign debt is being held by banking institutions without reserves for default risk. The ultimate restructuring of Greek debt could reach haircuts of 60% (today’s FT website) or even higher. Estimates of this number have increased several times.

In Europe, the issue is not centered on avoiding Greek default but on restructuring Greek debt. All parties know that the process will either be orderly or that a disorderly failure and meltdown will be the “death wish” of the Eurozone. The focus is on finding a way to accommodate the banking institutions by reordering the debt, so as to avoid a systemic banking failure. The process will be combined with a 100-billion-euro infusion of additional capital into the banking system. We are about to see the European version of TARP.

This negotiating process is complex. It requires a cooperative arrangement of the seventeen member states in the Eurozone. And there are overlapping interests of the other ten members of the European Union who are not in the Eurozone but have a serious interest in the outcome.

Besides cooperation, the process also requires the development of agencies and institutions with acronyms like ESM and EFSF. These conduits or holders of Greek, Irish, or Portuguese debt are the headline focus. They attempt to provide a place where sovereign debt-GDP ratios can be balanced, where the austerity budget programs put into effect can reach a sustainable level, and where the economies of each country can reach a level of equilibrium and hope for growth. That is a massive challenge for Europeans.

The Europeans are well aware of the “death wish” alternative. A Greek default without an orderly process offers systemic risk that could rival Lehman-AIG. So, European leaders seem determined to find a way to do this in the middle of very difficult political negotiations. Their structure is based on a treaty that requires all seventeen parties to agree, so unanimity is critical.

At Cumberland Advisors, we understand that the process is not perfect or guaranteed; however, it has a clear goal, and it has structures which can evolve so that an orderly Greek default and restructuring can occur.

Will it happen? We think so, but the final outcome is unclear. The biggest risk we see is a change in a government. The Europeans know the parliamentary system. They worry about a no-confidence vote after which a new government takes over and renounces or repudiates the outstanding debt. We witnessed this in Argentina a few years ago, and it is the model everyone fears in the Eurozone. Papandreou in Greece has been able to hold the majority in his coalition, and the same is true in Italy and other countries dealing with this political threat. To understand Europe, one must follow the local politics in each country and see that the race is on between an orderly Greek restructuring deal and a disorderly and politically messy default.

In the United States, we have witnessed the downgrading of the federal government credit rating by Standard & Poor’s. Two of the three major rating agencies, Fitch and Moody’s, still maintain the AAA rating for the US; one of the two has the US on negative watch for a downgrade. We find this fear to be excessive.

The United States has the absolute capacity to pay its obligations. Its currency is the world’s reserve currency. It is a $15-trillion economy – the largest in the world. Its debt-GDP ratio is certainly below that of many other larger nations. It does have an ongoing large deficit and a rising debt-GDP ratio. It is witnessing an ugly political process that features poor leadership in both Houses of Congress and in the White House.

Meanwhile, US default risk continues to be discussed. When we talk about the word default, we are talking about the payment of principal and interest on notes, bonds, and other indebtedness. Default deals with the debt instruments in the marketplace and not with inflation adjustments or accrual systems. In our view, there is absolutely zero chance that the United States of America will default on any principal and interest payment it owes or has guaranteed.

America’s state and local governments are a different story. The peak default forecast on state and local government debt occurred when Meredith Whitney, a bank analyst, took to the airwaves and issued her famous 60 Minutes prophecy. Whitney predicted there would be “hundreds of billions” of dollars in defaults. Furthermore, she strongly suggested that would occur in 2011. She now disputes the interpretation of her words, and suggests that the defaults will occur over a “cycle.” She based that forecast on the stress municipal budgets would experience from federal aid cutbacks. Notwithstanding the initial alarm and market disruption, so far, Whitney’s forecast has been very wrong.

What Meredith Whitney missed is that state and local governments have pulled back their reins. Markets and economics have forced their hand. State and local government employment is down by approximately 500,000 in this cycle. Month after month, the employment report shows state and local government entities cutting their labor force. They are pulling back, reordering themselves, and attempting to work within budget.

Clearly, Meredith Whitney’s forecast and the revisions of her forecast have been numerically wrong. According to Distress Debt Securities, there were 12 defaults totaling $126 million in the 3rd quarter of 2011. The total defaults are under 1 billion dollars for the first nine months of this year.

Now, it may be possible for there to be another $99 billion worth of defaults in the next couple of months, but it certainly does not seem likely. Furthermore, as you can see by events in Jefferson County, Alabama, and in Harrisburg, Pennsylvania, there is huge momentum against municipal bankruptcy and default. Why? The penalties are severe on the municipality, on the citizens, and on the users of municipal services. In addition, the legal system upholds the claims of bond holders under most circumstances. The payment of principal and interest occurs even when municipal bankruptcy is underway. We have disagreed with Whitney’s forecasts for a year, and we continue to disagree with them. We believe there is huge strength in well-selected state and local government credit. The research to support our view is available and the evidence exists. It is there to be viewed by anyone who is willing to spend the time and energy to find it.

Defaults in the housing market – mortgage foreclosures and short sales – have dominated the public discussion for several years, and for good reason. The result has been a decline in housing prices and a rise in affordability. Some of the measures of affordability of housing are now at pre-recession levels, and mortgage interest rates are exceptionally low by historical standards and are being held in that position as an outcome of the Federal Reserve’s interest-rate policy, known as “Operation Twist.” The Fed has said it is going to continue this policy for a protracted series of months. The Fed has indicated what the policy will be, how much will be involved, and which maturities or securities will be used.

Fed Chairman Bernanke has pledged to continue this policy into 2013. Beyond 2013 is unknown, as Bernanke’s term expires in 2013. Whether he will be reappointed chairman or whether a new president will replace him remains to be seen. What is sure is that Fed policy is known for two more years. A majority of the Federal Open Market Committee members have committed themselves to the policy. They have done it in the face of dissenting votes by three of their colleagues. The dissenters are known and their views are known. The debate continues; however, absent some shock, the commitment to this policy structure will continue into 2013.

We are starting to see some projections of housing making a bottom. 2011 may be the peak of the default risk in the housing sector. Most recently, some forecasts have suggested that the housing price level could actually improve in 2012 (Barclays).

Housing prices and housing price changes are regional and local. Gradually, one market after another eases, the weight of decline of prices slows, and then the price level begins to stabilize. Buyers are coming in and replacing distressed sellers.

Concurrently, the rental forum is experiencing a huge increase. As people are unable to purchase homes, they rent, causing a transition in which rental rates are rising while house prices are falling. There will be a point when this cycle will stabilize, promoting a more favorable attitude towards home buying. That entry point will be facilitated by low interest rates.

There are programs being considered to accelerate this process. Whether the programs become law or are implemented remains to be seen. The process itself takes time, and time is passing. We think 2011 is the worst year for foreclosures and for default risk in the housing sector. We think 2012 will be better, and when it is better, it will lower default risk tied to housing and in our banking system as well.

Default risk has characterized the last four years of the financial crisis. It is on everyone’s mind. Assumptions about creditworthiness and expectations about the future of creditworthiness are at their lowest, and distrust for rating agencies and credit evaluation is at its highest. The sentiment among market participants is acutely cynical.

All this says to us that the surprises during the coming years are more likely to be on the positive side. Default risks in the realms of sovereign debt, the housing sector, and state and local government have been identified. Concerns about the United States and its default risk have also been identified.

We think the default risk is peaking and is on its way to improvement that will have substantial, long-term strategic benefits for credit and equity markets. In our equity accounts we are fully invested, and we expect the stock market to work higher. In our managed accounts of debt instruments, we favor spread product and careful examination of the risk. There are great credits and terrific bonds available, and they are inexpensive when compared to the treasury market. However, we do not look favorably on the treasury market; we think it is nearly fully priced for almost all the types of outcomes one could reasonably expect from the present circumstances and from present Federal Reserve policy.


David R. Kotok, Chairman and Chief Investment Officer

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