Investing With Caution During a Global Financial Crisis

By Martin Hutchinson
Chief Global Investing Strategist

In the last week, a bank in Germany and another in France got themselves into deep trouble by speculating on the U.S. sub-prime mortgage market. And yesterday (Thursday), the
European Central Bank was forced to inject no less than $130 billion into the world monetary system. Stock prices plunged throughout the world in response to the widening credit crisis.

Rational investors should be demanding to know just what the heck these foreign banks thought they were doing. What business does a bank in Germany and another in France have making bets on the U.S. market for homeowners with lousy credit ratings? It’s become so even a careful investor in stocks has no idea just what he’s buying.

So what’s an investor to do?

Let’s take a look at just what happened and why, and then explore what you can do to protect yourself and perhaps even profit during such a problem-plagued period.

When you buy an international stock, you want to have a clear idea of the risks involved. If the company you’re buying is Japanese (a market I happen to favor a great deal right now, by the way), you will have a picture of the Japanese economy, its strengths and its weaknesses. If that Japan-based company exports its wares to the United States, you’ll know that if the yen strengthens against the dollar the company may have earnings problems.

If, on the other hand, the company does business mostly in domestic Japan, the strength of the yen won’t affect it much, and so you only have to worry about the strength of the Japanese economy and your company’s ability to compete with its rivals in its home marketplace.

Two developments of the last 30 years have messed this all up. First, some idiot invented derivatives. And second, nearly everything is going global.

Dangerous Derivatives

 Thanks to derivatives – some of them quite arcane – the company’s leadership, or the bank management, can take whatever position on interest rates or currency-exchange rates that they want, and you as a shareholder will very likely be none the wiser.

If you’re very lucky, indeed, they’ll disclose what they’ve done in the footnotes of the annual report at the end of the year, but you’ll probably never see a thing listed directly on the firm’s balance sheet or income statement. And most investors never bother to read the financial-statement footnotes – though they should.

Being from Britain, myself, I can remember a particularly poignant example of just what I’m talking about. In the middle part of the 1980s, Jaguar Cars [now part of Ford Motor Co. (NYSE: F)] was a very good way for British investors to speculate on a weak pound sterling. The company manufactured in England and sold primarily in the United States. So when the pound had one of its periodic nervous bouts, Jaguar’s profits went through the roof as its sales soared while its costs didn’t.

[The revenue soared because of so-called “currency translation.” The cars were built at home, so the costs held steady because there was little currency-rate exposure. But they were sold in dollars. And because the dollar was rising against the pound, when the dollar-based sales were translated back into the British currency, the stronger dollar essentially bought more pounds than before, which caused revenue to soar. You combine soaring revenue with costs that remain constant and you end up with a nice jump in bottom-line profits].

Then, long about 1987, Jaguar management discovered currency “hedging.” As a result, its profits suddenly bore no relation to the pound’s value against the dollar – management’s hedging decisions affected profits much more than exchange rates themselves, and management didn’t tell investors what it was doing until after it had done so. Even though management’s hedging was generally profitable, British investors lost interest, because they couldn’t figure out the company’s true position with regard to exchange rates. As a result, Jaguar was ripe for a takeover by Ford in January 1990.

The Global Game

The other development that has made investing more difficult is globalization, the tendency of companies to try to do business all over the world, often even buying foreign competitors in order to do so.

This is particularly a problem when investing in banks. If a bank has a small office in a foreign country, no problem: The bank does a little business with its home-country exporters, makes a lot of introductions, and eats plenty of great lunches (and perhaps even a few lovely dinners….).

But a large foreign operation is much more of a problem because it’s expected to make a profit. Since the bank has very little natural business in the country, it looks for the most profitable business it can find – which tends to be the high-risk, low-quality businesses with high fees and high interest rates attached. If this goes well for a few years, the cautious naysayers at the bank’s Head Office are silenced, and the foreign branch gets to start making some really big bets.

You can almost picture the bank’s internal dealmaker rubbing his hands together in anticipation of this chance to play at “casino capitalism.” When all is said and done, however, this same dealmaker may actually be wringing his hands over the mess he’s created…that is, unless he was lucky enough to be promoted back to the Head Office with a nice raise and expense account because of the new profits he’d reaped (he got out before the deals he’d put in place all soured, sticking his successor with the mess to clean up).

When it goes wrong, nobody’s more surprised than top management back home, who never understood the business in the first place. That’s why a medium-sized German bank, IKB, had to be bailed out from losses on $17 billion in U.S. sub-prime mortgages. Indeed, in IKB’s case, the mortgages weren’t on its balance sheet, at all. Instead, IKB had acquired the risk through derivatives contracts, booked through a tax-haven subsidiary. There was no way an investor could have an idea the bank was speculating in this completely reckless way – until everything want wrong and it had to confess to its losses. Similarly the French bank BNP appears to have made heavy losses on sub-prime mortgage hedge funds it sold to French investors.

This is a total rip-off for investors. If you buy shares in a French bank, you want to invest in its business in France, not its half-witted attempts to outsmart Wall Street in sub-prime mortgages.

Similarly, if you had invested in the Japanese securities house Nomura Holdings Inc. (NYSE: NMR), a stock I happen to like a great deal, your shares would suddenly have dropped about 15% a few weeks ago. As it turns out, Nomura, too, had an exposure to the U.S. sub-prime market. It wasn’t a huge one – and probably isn’t a very dangerous position – but who really knows? Nearly all your analysis about the prospects for a top Japanese investment bank would have been rendered useless.

Here are the key lessons to employ to protect yourself:

  • First, for now at least, avoid the financial-services industry altogether, everywhere in the world, until the current mess quiets down.
  •  Second invest only in medium sized companies with simple businesses – and hope their CFOs aren’t too ambitious!

 

Martin O. Hutchinson is the Chief Global Investing Strategist for Money Morning, as well as an advisory panelist for The Money Map Report. An investment banker with more than 25 years’ experience, Hutchinson has worked on both Wall Street and Fleet Street and is a leading expert on the international financial market.