Contagion Risk, Big Banks, Junk Funds

Author: David Kotok, Post Date: January 12, 2016

When Currencies Collapse” is the title of a Peterson Institute essay by Simeon Djankov (December 30, 2015). Djankov discusses the drivers of recent currency devaluations in Azerbaijan, Georgia, and Russia, along with the fallout that lies ahead. In addition, there are violent currency adjustments visible in Asian currencies including China.

Our observations follow, with an eye toward the potential risk of contagion.

In order to dampen that risk, we have taken the financial sector to underweight and specifically lowered the large banks. Some bullets follow.

1. We remember 1997, when the very first currency in crisis was the Thai baht. Markets dismissed the baht’s collapse as an aberration. But by 1998 a major hedge fund had failed; the big banks were in retreat; and the Fed was intervening to avert a meltdown. Many currencies and their related debt were in trouble. What began as a seemingly isolated incident morphed into a contagion. The players in the Asian crisis of 1997-8 hadn’t learned from the Mexico crisis of 1994 or the European Monetary System crisis of 1992.

2. The Djankov essay names several currencies in trouble. Since that essay, China has made headlines with its problems and its use of reserves to defend its currency. Many of these currencies have or had managed links to the US dollar. Those links are now broken or are breaking. So debtors owe in dollars and attempt to earn in the local currency. When the link breaks, all hell can break loose. It may be doing so now.

3. History shows many examples of broken links and resulting shocks. Here are two. Argentina was once linked to the US dollar and then broke the link. Twenty years later, the country is still attempting to recover. I personally visited Argentina several times after the dollar-peso linkage dismembered. I personally watched the closure of the banks. And I personally witnessed what transpired after the banks were closed. Financial chaos and rapid deterioration of government ensued. Another recent example is when The Swiss National Bank broke its managed link to the euro and set off a financial market shock. That abrupt and extraordinary break caused a unique 38-standard-deviation move in the euro-Swiss franc currency exchange rate (math credit to Citigroup’s Brent Donnelly). The list of broken currency links in history is long. An attempt to peg exchange rates inevitably fails once the pressures to maintain them grow too costly. And the outcomes are never pretty.

4. The sequence of a meltdown in a contagion is unpredictable. Someone owes and cannot pay. But who is owed and how much is leveraged is not visible until the situation blows up. That is what the high-yield fund scandal is all about. So which sector of junk suffers first is not the issue. The linkages among institutional holders like the Third Avenue fund reveal the trouble spots in the system. Stephanie Pomboy (MacroMavens) notes that, “In the six years since 2009, junk-rated debt has doubled to $2t from $1t, taking it to one-third of the US corporate market.” Last year, after the Third Avenue revelation, we quoted research by Morningstar that listed some high-yield funds that were troubled. Some of them had exposure to foreign debt with currency hedges. We quoted from a Nuveen public document that permitted 20% of the fund to be positioned in this way. Those Nuveen funds were near the top of the Morningstar list. The Third Avenue fund was at the very top. It now has gated investors. “Gated” means the fund will not pay investors immediately if they redeem.

5. Gating by a fund is a tendency to induce contagion. We only learn of a gating when it is announced. The day before a gating there is no public information to help the investor front run a gating. We do not know who is considering gating, but we do know that fund investors do not place money in a fund with a plan to leave it there when adverse circumstances arise. Mutual fund investors expect to be able to redeem if and when they want or need cash. When the gate closes, it is the investors who suffer and may have to resort to some other action. It is those follow-on actions that start a contagion snowballing. Each action is followed by a reaction and a new action. The sequence is unpredictable … until it becomes visible. For a serious research discussion on Gates, Fees, and Preemptive Runs see the Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, staff working paper 2014-30 by Cipriaini, Martin, McCabe and Parigi (April 3, 2014). Here is the original link; serious readers may wish to read the updates to this work.

6. The contagion risk in the world seems to be rising. And the rating agencies are seeing it and acting prospectively, so we see fast action by raters, and warnings. One of the legacies of the financial crisis is that rating agencies now move faster. This is true for larger agencies like Moody’s or Standard & Poor’s or Fitch, and it is true for a specialized rater like Kroll. Credit rating changes are to be heeded in this post-crisis and newly regulated environment.

7. A. Gary Shilling’s INSIGHT dated January, 2016 makes two important observations. He notes that “as of last September 30, the Focused Credit Fund had 28.4% of its assets in its top holding of illiquid junk bonds.” Focused Credit Fund experienced large withdrawals in the fourth quarter of last year. Shilling reports that “in an unprecedented step, the fund suspended redemptions without SEC approval and fired David Barse, the fund‘s manager, after stating that it couldn’t meet redemptions. Instead, it transferred all of its investments to a liquidating trust.”

Gary shilling and his superb research team note that this is not only a mutual fund problem. He wrote that while “junk mutual fund assets reached a high of $305 billion in May 2014, triple their 2009 level, insurance companies joined the throng. Allstate more than doubled its portfolio of junk securities from 2008 to a level of $8.4 billion. That equals 11% of total investments and 41% of shareholder equity. AIG had 35% of its shareholder equity in junk as of last September 30.”

Note: we applaud Gary Shilling and his research team for assembling and presenting this important research. See: And on a personal note we applaud the highest quality honey Gary obtains from his bees and are pleased that he has joined us in Maine with fishing rod in hand.

8. In December of last year (2015), Standard & Poor’s downgraded the credit ratings of the non-operating holding companies (NOHC) of all eight US global systemically important banks: Bank of America Corp., Bank of New York Mellon Corp., Citigroup Inc., JPMorgan Chase & Co., Morgan Stanley, State Street Corp., The Goldman Sachs Group, and Wells Fargo & Co. Of note is that S&P divided those eight into two categories depending on the structure of the operating components in each company. S&P stated, “We are keeping our ratings on the core and highly strategic operating subsidiaries of Bank of America Corp., Citigroup Inc., Morgan Stanley, and The Goldman Sachs Group on CreditWatch with positive implications….” Readers may note that the other 4 are BNY-Mellon, JPMorgan Chase, State Street & Wells Fargo. Also note that Cumberland has some type of business activity with all eight banks. Some of the eight banks host or use our services. Some act as custodians for Cumberland clients. And some may be the successful counter party in a transaction we do for our clients. Also, note that we only manage separately managed accounts at Wells Fargo at the specific direction of the client.

Let’s sum this up. (1) There is a developing credit concern focused on energy debt, emerging-market debt, and the conduit form of mutual fund investments. Such mutual funds have blended US high-yield with currency-hedged emerging-market debt. (2) A contagion is possible at any time. Whether we are heading for a contagion in 2016 is unknown. It will not be known until it is visible. If it happens, it is likely to develop without warning.

At Cumberland, we are avoiding the use of these high yield mutual funds. We avoid Nuveen funds. We strongly recommend that investors read the fine print and details in the disclosure documents of any money manager or any wealth management adviser. That includes our firm. We will gladly furnish our disclosure documents (ADV2) to anyone who asks and certainly make it available to every client and prospect.

At Cumberland, we only focus on high-grade credit, and we mostly use individually researched and selected bonds. Debt-related ETFs may be used for special purposes and only after research and selection reflecting our proprietary work.

In the corporate bond holdings at Cumberland, only about 1% of the bonds held in our clients’ accounts are issued by the 8 banks listed above. Those holdings are running off with maturity. They may be sold at any time. We are not actively buying bank debt.

We believe that the recent troubling stock market behavior reflects activity in the Asian markets (China) and geopolitical risk premiums (Iran-Saudi) and political uncertainty in the US. Weakness is exhibited strongly in the energy sector and in financials. We are underweight financials but are positioning in the energy sector for a strategic and positive recovery. Oil and gas are now cheap. They may become even cheaper for a temporary period but they have reached levels that are discounting wholesale bankruptcies and failing business entities. The selloff of energy related ETFs is becoming extreme, in our view.

Clients often ask us about choices for custody and about safety of their assets. This is a valid concern. At Cumberland, the decision regarding custody is the client’s choice. We have favorable relationships with many firms. That list is extensive.

We have numerous client custody relationships and client consulting relationships and will discuss them with clients and consultants on a case-by-case basis. Under Cumberland’s policy, custody and consultant decisions are the client’s to make. Cumberland will not take custody of a client’s assets. Cumberland is not a broker and does not sell any product. Cumberland is a fee-for-service investment advisor only.

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