But, as Dr. Niall Ferguson, Professor of International History at Harvard University, points out, “civilization has long had an ambiguous attitude toward lending and interest.”

The Roman Catholic Church frowned upon the taking of interest during the 13th through 18th centuries in Europe, when finance underwent its greatest dynamism. Islamic Sha’riah still proscribes against lending despite the fact that the mathematics of compound interest originated in the Middle East. The uncomfortable coexistence of finance and religion may be due to the parallels between the term of a loan and the term of a life. The word “finance” comes from Old French and shares a common root with the word “finish”. It was used in the 14th century, according to scholars, to imply a final settlement, and referred to metaphorically in medieval poems which described life itself as a loan from God, and death as its final repayment. French theologians considered lenders as “sellers of time” that acted contrary to natural law. For almost a millennium, loans were considered unholy leaps into the fourth dimension that were contrary to divine plan.

Many people today would blame lending for causing the financial crisis and consider credit as the evil plaguing Europe. Yet, throughout history loans have enabled profound life-serving commerce and industry. They supported Spain’s exploration of the New World, made possible the successful colonization of America, and fueled the Industrial Revolution. The immense progress of human well-being would not have been possible without credit.

The lender’s time machine is interest. A lender tries to calculate in advance the likelihood or unlikelihood that he will be repaid all his capital plus the interest. The less convinced he is that a loan will be repaid, the higher the interest rate he will charge. Higher rates enable lenders to profit for their willingness to take greater risks. The practice of charging interest is therefore an expression of a lender’s ability to project the future, to plan, to analyze, to calculate risk, and to act in the face of uncertainty.

Lending is productive to society, and this fact has been made increasingly clear over the centuries. By choosing to whom he will lend money, a lender determines which projects he will help bring into existence and which individuals he will provide with opportunities to improve the quality of their lives and his. Thus, lenders make themselves money by rewarding people for the virtues of innovation, productiveness, personal responsibility, and entrepreneurial talent; and they withhold their sanction, thus minimizing their losses, from people who exhibit signs of stagnation, laziness, irresponsibility, and inefficiency. Loans are fruitful and enable borrowers to improve their lives or produce new goods or services. And contrary to some theological systems that exist today, lending is not a zero-sum activity: both the borrower and the lender benefit from the exchange (as ultimately does everyone involved in the economy). The lender makes a profit, and the borrower gets to use capital-whether for consumption or investment purposes-that he otherwise would not be able to use.

We witness the direct impact that our lending activities have on companies every day. Currently, our loans help companies generate a quarter billion dollars in sales every year, keep nearly 1,000 people employed, and foster growth and innovation that would otherwise be lost. We cannot travel ahead in time, but we are confident that our investments create a better future for investors, our borrowers, and our society.

The post Time Travelling (Q4-11) appeared first on Third Eye Capital.

Canadian banks have been very efficient in building loan portfolios in the large segment of the commercial market and investment grade corporate market. Smaller commercial loans, where credit spreads are benchmarked off the Prime Rate (rather than interbank offer rates or yields on bankers’ acceptances, which apply to larger loans) are typically processed with minimal staff involvement based on internal rating systems that look for positive earnings history, strong tangible net worth, and sufficient collateral. Industry preferences also have an influence on the loans that Canadian banks will approve. For example, we have recently seen a rise in deal referrals from banks that are rejecting loan applications in the upstream segment of the oil and gas industry. A more defensive posture by banks has resulted in sectors like media, construction services, and technology becoming out of favour.

According to Standard and Poor’s, since the early 1990s, large banks have adopted portfolio risk management techniques that measure the returns of loans relative to risk, and have learned that bank loans are rarely compelling investments on a stand-alone basis. Monitoring costs are very high so banks diversify by number of loans to try and lower portfolio risks (see our Q3-2010 letter wherein we challenge this conventional belief). It is not uncommon to have Canadian commercial bank officers manage 200 or more credit relationships at the same time, which requires banks to have a tolerance for some losses but maintain rigidity in the criteria for loan approvals. Non-credit related income sources are driving the relationship banks want with borrowers.

Banks are reluctant to extend credit to borrowers unless the total relationship generates attractive returns, preferably from activities that do not require a capital charge. In Canada, such non-credit related business includes cash-management services, foreign exchange transactions, brokerage services, pension-fund management, employee transaction processing, and capital markets advisory work. The spread on credit has become less important for banks than the amount of fee-driven business that can be captured as a result of a borrowing relationship.

Pricing loans based on relationship returns favours larger and more established borrowers. It was no surprise then that, prior to the financial crisis, U.S. non-bank finance companies held the largest market share of middle-market commercial loans in Canada. The size and concentration of the Canadian banking oligopoly has been the source of structural inefficiencies in middle market lending that have contributed to persistent returns for non-bank lenders and dedicated funds like ours.

Excerpted from Third Eye Capital Management Inc.’s Q3 2011 Investor Letter.

The post Banking to the Relationship, Lending to the Business (Q3-11) appeared first on Third Eye Capital.

The Great Depression brought the orthodoxy of government involvement in smoothing out business cycles. Policies of easy money, a weaker dollar, and fiscal deficits became accepted tools to boost demand during times of economic contraction. After the tech bubble burst in 2000, the U.S. Federal Reserve lowered interest rates to 1% in mid-2003 even though nominal GDP in the U.S. grew to 5%. The government was successful in averting recession. Eventually, low rates, combined with government stimulus (including policies to democratize housing ownership), caused a housing mania and a cyclical bull market in stocks. Consumers took on enormous amounts of debt between 2000 and 2007 on the mistaken belief that their homes could never decline in value. Household savings rates went from 9% of disposable income to zero in ten years, and household debt as a percentage of GDP doubled from 50% to 100% by 2008. When the housing bubble burst, a recession loomed, and over-indebted households and over-exposed lenders fostered the greatest financial crisis since the Great Depression. Monetary and fiscal reflation by the government was enacted on an epic scale. Enormous bailouts of the largest financial institutions in the U.S. and tsunamis of liquidity from various government programs including TARP, the stimulus plan, QE, and QE2, pushed interest rates to zero and started another cyclical bull market in risk assets.

This time, however, policy tools have failed to encourage the private sector to take on more debt, which, in the absence of high savings, have been and will continue to be a headwind to higher economic growth. Households are consuming less and savings rates around the globe have jumped: in the U.S, to 5% in Q1-2011, and even in Canada, which has experienced a much milder recession, the savings rate is expected to rise to 5% next year. Corporations have retrenched spending since the financial crisis, with the financial balance of the corporate sector strongly rising from a deficit of 1% of GDP in 2005 to a surplus of 4% of GDP in Q1-2011. Investment spending has rebounded but so too have earnings, leaving the financial balance at elevated levels. According to a proprietary study by BCA Research, there has been a strong negative correlation between the unemployment rate and business investment. So with the unemployment rate in the U.S. not likely to recover until the middle of the decade, capex should remain subdued.

As the private sector has retrenched, it is not surprising that fiscal deficits have increased. The U.S. Federal Reserve’s extreme monetary actions have not restarted credit growth so the U.S. government has had to step in to help boost aggregate demand. U.S. government debt to GDP climbed from 36% in 2007 to 69% this year; more federal debt has accumulated over the past four years than during the previous entire history of the U.S. It will take years to know whether this experiment in fiscal reflation succeeded in boosting the U.S. economy, but as some countries in Europe have already found out, markets may riot against further fiscal stimulus and force fiscal consolidation before it has a chance to work.

For instance, the recent deadlock in Washington over raising the debt ceiling was not resolved until rating agencies and stock markets warned of the consequences of not dealing with long-term fiscal trends. The legislation that ultimately passed was done under duress and while much of it backloads the majority of spending cuts to the outer years of the ten year plan, there are spending cuts that when combined with the temporary fiscal measures such as the payroll tax holiday and accelerated depreciation, could cause the U.S. economy to exhibit zero, or even negative, growth in 2012.

It does not help that the political brinkmanship in Washington has cast doubt on the ability of the U.S. government to function. This dysfunction was specifically cited by S&P in its recent history-making downgrade of the U.S. credit rating. There is no global alternative to U.S. Treasuries as a risk-free benchmark, and any impact of the downgrade on bond yields, in our opinion, will be short-lived. Moreover, yields should stay low admist falling confidence and flagging economic growth. Japan lost its AAA credit rating in 1998, and its 10-year bond is at a meager 1%. Canada is the only country in the Western Hemisphere, and just one of eighteen globally, to still have a AAA credit rating from S&P. Canadian bonds should benefit from some substitute buying from U.S. investors but the potential of an economic slowdown in the U.S. will also calm inflation fears and keep yields low. If bond yields rise without a better economy, then we can count on the U.S. Federal Reserve to quickly resume asset purchases. Of course this will spur further asset inflation and could sow the seeds for the next crisis unless economic growth is seen to be improving on a sustainable basis.

Excess debt always leads to crisis and investors only need to look at the areas where leverage is growing to spot the next bubble to burst. Government finances appear to be a pending source of instability for global markets. The U.S. is fast approaching its borrowing limit and the fiscal trend is reversing toward restraint although the economy is still weak. In Europe, senior EU officials are already calling the European Financial Stability Fund, which was given EUR 440 Billion by EU governments to bailout peripheral Europe, too small. Risks to investors have intensified along with the shortage of safe assets in which to seek harbor.

Persistently high savings rates in the private sector, low economic growth, and fears of a looming government debt catastrophe, will encourage investors to seek yield with low volatility. The Fund should remain a core allocation within most investor’s fixed income basket.

Excerpted from Third Eye Capital Management Inc.’s Q2 2011 Investor Letter.

The post Fiscal Follies (Q2-11) appeared first on Third Eye Capital.

There is a wide divergence of expert opinion on the outlook for inflation, even among policymakers. In Canada, the Bank of Canada expects prices and wage growth to be restrained by the strong loonie and sees both consumer and core inflation figures easing in the second half of this year. In the United States, the Kansas City Federal Reserve president voted against fellow members of the central bank by calling for tighter monetary policy to curtail future price inflation. For some economists, unprecedented money supply, mounting government deficits, and rising commodity prices are sure signals of a serious inflation problem on the horizon. Others believe there is ample slack in the economy evidenced by drops in industrial production and spikes in unemployment. Recent data from the OECD shows that developed economies are experiencing the lowest negative output gap since World War II. While the output gap is difficult to quantify, other measures of excess capacity such as capacity utilization and unemployment highlight continuing slack.

For investors, the inflation debate is more about timing. Most of the endowments, foundations, and pension plans we speak to do not perceive the threat as immediate but believe price pressures are forming in certain economies and that the secondary inflation effects of rising commodity prices has the potential to surprise on the upside. Asset-allocation decisions are increasingly taking inflation expectations into consideration, and investors are probing for insights on how to maintain the purchasing power of their assets over time and achieve real returns consistent with their investment objectives.

Conventional wisdom says that equities, real estate, and commodities are the most effective hedges against inflation. Bonds, and other debt instruments, according to the traditional view, are the worst because, in a rising inflation environment, fixed coupons and principal repayments are received with funds that have less purchasing power. But theory does not always match reality.

Equities represent a claim on dividend streams of corporate assets that are supposed to be able to pass on inflation in the form of higher prices. Inflation, however, can cause volatile earnings depending on the price elasticity of demand for a company’s products, and increase the risk-premium required by investors. Under these circumstances, equities may have a negative correlation to rising inflation. Take the experience of the 1970s, when inflation rose but most equity markets suffered negative real returns.

Real estate can be valued in a similar manner to equities and bonds, by discounting the expected future stream of cash flows by a required rate of return. These cash flows, in the form of rents and sale values, tend to move in line with inflation. However, a research paper published in the Journal of Real Estate Finance by Joseph Gyourko and Peter Linneman, entitled “Owner-Occupied Homes, Income Producing Real Estate, and REIT as Inflation Hedges”, concluded that real estate in its securitized form (i.e, REIT) exhibits the same negative relationship found with equities. The effectiveness of purchasing private real estate as an inflation hedge is also dubious if excessive leverage is used and if the timing of purchase is wrong.

There has been a lot of analysis about the inflation-hedging properties of commodities, and research does provide strong evidence that, at least in the short-term, commodities do provide effective inflation protection. In April 2009, the IMF sponsored a study that found, over the long-term, the effects of inflation caused commodity prices to fall gradually over time. The reasons were best described by Professor Jeffrey Frankel at Harvard University, who argued that higher real interest rates in response to an inflation shock caused commodity prices to fall due to three main factors: by increasing the discount rate for future extraction and growth in current supply; by raising the carry cost of inventories; and by encouraging speculators to shift out of commodity contracts and into treasury bills.

All the empirical evidence seems to support the theoretical arguments that bonds are a poor inflation hedge. However, bonds are a heterogeneous asset class and certain offerings like private credit can be very effective at outperforming inflation. Private credit instruments are typically short-term, so are less susceptible to duration risk, and have floating rate structures that reduce reinvestment risks that can erode purchasing power. Equally important, private credit instruments are over-secured, usually by a factor of 2 to 1, by business assets with visible values, which means that debt outstanding in notional terms is actually secured by assets valued in real terms. In an inflationary environment, private credit intrinsically becomes less risky and more valuable at the same time. What other investment can make that claim?

Milton Friedman, the Nobel Prize winning economist, stated “inflation is always and everywhere a monetary phenomenon.” Given the massive liquidity injections and ultra loose monetary policies employed over the past few years, inflation hedging should be an important component of any investor’s investment policy. It is difficult for a long-term strategic asset allocation to protect a portfolio against unexpected inflation, especially using traditional asset classes. However, there is an opportunity to enhance inflation protection in any portfolio through the tactical use of private credit.

Excerpted from Third Eye Capital Management Inc.’s Q1 2011 Investor Letter.

The post Keeping it Real (as in “Real” Returns) (Q1-11) appeared first on Third Eye Capital.