The Madness of Crowds

With the countdown clock to the Fiscal Cliff now inside thirty days one does not need my monthly missive to stir fear, panic and depression.  Washington has you covered this month.  Therefore, I will take a more optimistic stance: I believe your Cash and Bonds are well positioned for the current and future environment.

Activity in the financial markets has been slow of late with reduced daily volume not only in municipal bonds but across many (all?) asset classes.  The slowdown provided me with an opportunity, or more like an absence of an excuse, to read Charles Mackay’s classic, Extraordinary Delusions And The Madness Of Crowds.  This book covers centuries worth of financial and other folly, not addressing the why such folly occurred but certainly more than ample examples that folly and humans go together.  Times may change and history may march on but human nature seems to be quite static and repetitive.

Currently Wall Street continues its old ways: ramp up employment in good times and retrench with lay offs cutting excess capacity in bad times.  Guess which one is the current situation?  After growing to nearly twenty percent of the economy pre-crisis, the financial sector is in the process of shrinking dramatically.  This is a long-term plus for the economy but a short-term disaster for the growth of our economy and especially for affected families.

For many years municipal bonds were but a backwater on Wall Street.  One of the main problems in my opinion was the lack of scalability in our market.  The municipal market is all about distribution and in order to do more business Wall Street needed to convince a lot of issuers to issue a lot more bonds.  In large part Wall Street was highly successful at this as municipal debt increased exponentially over the past thirty years.  But we still had tens of thousands of issues and issuers to deal with and profits could be better maximized if one could treat municipal bonds as a commodity rather than thousands of uniquely different issues.  The more municipal bonds could be made to appear to be similar, the easier they could be bought and sold in size.

In the fifteen years prior to the financial crisis, municipal bond insurance served as the catalyst for making the municipal bond market more generic.  “Is it insured?” became seemingly the only question municipal bond buyers cared about.  So great was buyers faith they only cared whether their bond was insured.

This leads me back to my current reading.  The Madness of Crowds provides a history of human’s misplaced faith in various endeavors throughout history.  History as you know is a long time and we have seen a lot of folly throughout history up to the 1852 Second Edition publishing date (yes, 1852).  Unfortunately, we have seen much folly since then as well.  We don’t have to look far back to find numerous instances of misplaced faith which have unfolded right in front of us.

Boom and busts result from our misplaced faith.  Here in Texas we learned early that real estate and oil prices do not keep up with inflation nor do they increase in price every year.  Unfortunately, we failed to teach the several billion other people on the planet of this useful fact.  For those folks they got the chance to learn the lesson in the mid-2000s, but enough of that as I agreed to keep the Letter on the optimistic side.

You and I have lived in the Boom/Bust period for the ages.  Not only do we have Boom/Bust periods often, we have Boom/Bust periods in numerous (soon to be all) asset classes.  “Just give me one more Boom” is not just a bumper sticker but instead is an almost daily quest of those on Wall Street and their followers.

Perhaps this helps explain why so many people and their money have piled into municipal bonds of late. Tired of Boom/Bust elsewhere on Wall Street perhaps they think the utter dramness of municipal bonds will spare them from the Boom/Bust cycle.

Fat chance!  Talk about Madness of Crowds!  Today’s municipal bond buyer no longer asks “Is it insured?” Today’s municipal bond buyer asks “Is it tax-free?”  Who would have thought that the removal and utter destruction of the municipal bond safety net, municipal bond insurance, would not hinder but perhaps propel municipal bond prices to further heights?

If I wanted to lead you into the next Boom I would have chosen to work on Wall Street.  To have a Boom one needs a crowd, The Madness of Crowds, and Wall Street is crowd central.  But unfortunately every Boom is followed by a Bust and this is why you and I choose not to play.

Capital preservation is my main goal and I feel blessed to be able to find municipal bonds consistent with this goal that also have the potential to pay a nice return.  Yes demand does outstrip supply (unlike Wall Street where they create more and more “product”) but I believe supply will take care f itself in the coming months.

Municipal Bonds are in a bubble (the midst of a Boom) but your municipal bonds should not go bust.  How do I know?  First, because we chose not to play in the municipal bond boom.  Booms need crowds and crowds on Wall Street attract and generate more supply, here the creation on more and more new bonds.  New bonds as well as long-term and lower quality bonds are the areas we have purposefully avoided the past several years.  Indeed we have watched as the crowds continue to pour funds into new long-term and lower quality credits.

The second reason why our municipal bonds should not go bust is because we continue to look at credit quality first and foremost before looking at structure (call features, sinking funds and maturity).  In an age when seemingly no bond defaults and even when they do the assumption is a full monetary recovery, looking at credit quality seems to be an unneeded, redundant step,  This harkens back to the mortgage boom in the early-to-mid 2000s when bond insurers and their Wall Street brethren also felt they could skip this important step.  Many of those firms no longer exist; many who still do have the government to thank.  We are closer to the Municipal Bond Bust than anyone suspects.

You should feel calm and confident about your municipal bond portfolio.  We have assembled and continue to assemble your Cash and Bond portion of your portfolio not only to survive the Fiscal Cliff but also to take advantage of the coming Municipal Bond Bust.  This is why your maturities are short.  This is why your portfolio continues to generate much Cash.

We anticipate Boom/Bust behavior because we are in the midst of multiple Boom/Bust cycles.  This is not new.  The Madness of Crowds tells the history; you and I are experiencing the present and oh the stories you can already tell your children and grandchildren.  But when it comes to municipal bonds the Bust is still in front of us.

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