Tuesday, 15 October 2013

Credit versus Equities - a farming analogy

"Italians come to ruin most generally in three ways, women, gambling, and farming. My family chose the slowest one." - Pope John XXIII 

In ancient times for agricultural exploitation, you could distinguish two forms of contracts : tenant farmed land (fixed income) and metayage (shared risk). 

Using this farming analogy we intend to indicate the implications of both systems from their respective "flexibility" in relation to boom/bust credit cycles and "instability" generated by the recourse to "tenant farmed land".

"A tenant farmer is one who resides on and farms land owned by a landlord. Tenant farming is an agricultural production system in which landowners contribute their land and often a measure of operating capital and management; while tenant farmers contribute their labor along with at times varying amounts of capital and management. Depending on the contract, tenants can make payments to the owner either of a fixed portion of the product, in cash or in a combination. The rights the tenant has over the land, the form, and measure of the payment varies across systems (geographically and chronologically). In some systems, the tenant could be evicted at whim (tenancy at will); in others, the landowner and tenant sign a contract for a fixed number of years (tenancy for years or indenture). In most developed countries today, at least some restrictions are placed on the rights of landlords to evict tenants under normal circumstances." - source Wikipedia

"The Metayage system (French: métayage) is the cultivation of land for a proprietor by one who receives a proportion of the produce, as a kind of sharecropping.
In Italy and France, respectively, it was called mezzadria and métayage, or halving - the halving, that is, of the produce of the soil between landowner and land-holder. Halving didn't imply equal amounts of the produce but rather division according to agreement. The produce was divisible in certain definite proportions, which obviously must have varied with the varying fertility of the soil and other circumstances and did in practice vary so much that the landlord's share was sometimes as much as two-thirds, sometimes as little as one-third. Sometimes the landlord supplied all the stock, sometimes only part - the cattle and seed perhaps, while the farmer provided the implements; or perhaps only half the seed and half the cattle, the farmer finding the other halves. Thus the instrumentum fundi of Roman Law was combined within métayage. Taxes were also frequently divided, being paid wholly by one or the other, or jointly by both.
In the 18th Century métayage agreements began to give way to agreements to share profits from the sale of the crops and to straight tenant farming, although the practice in its original form could still be found in isolated communities until the early 20th Century." - source Wikipedia

In the first case, the farmer would pay a fixed rent but would enjoy the ownership of the production of the land. (bonds) and the landlord did not share the risk ineherent to farming (bad crops, drought, etc.).
In the second case the "metayer" would be sharing with the land owner the production of the exploitation of the farmed land and the risks (equities). 

For us, this roughly equates to today's difference between a financial claim or bond and equities.
-Bonds = Tenant farming
-Equities = Metayage

Therefore when ones look at credit volumes, you need to not only include the total of financial claims but as well equities.

When there is a recession or even worse a depression, equities will fall towards zero, in the case of bankruptcy. It is a very painful but it is a very fast adjustment.

The increasing recourse towards bond issuing by companies will be increasing "difficulties" at the end of the on-going credit cycle, when entering a recession or depression.

What has made the resounding success of the US economy throughout many decades was its capitalistic approach and recourse to equities issuance for financing purposes rather than bonds.

We believe the global declines in listings is indicative of growing instability in the financial system and increasing risk as a whole. For instance the latest Chart of the Day from Bloomberg from the 11th of October is clearly indicative of this growing unnerving trend:
"Stock markets worldwide are faced with the same issue of declines in listings that surfaced in the U.S. a decade and a half ago, according to Jason Voss, a content director at the CFA Institute.
 The CHART OF THE DAY shows the number of listings in the U.S., Europe and the Asia-Pacific region each year from 1975 through 2012, which Voss compiled from data supplied by the World Federation of Exchanges and other providers.
The decline in public equities is unquestionable and should be of grave concern to both investors and policy makers alike,” Voss wrote in a blog posting on Sept. 30. Having fewer listings may hamper asset allocation, make stocks too expensive and send improper signals to companies looking to go public, he said yesterday in an interview.
European markets listed the most stocks in 2007, when a bull market ended. The total fell 23 percent during the next five years. Asia-Pacific listings peaked in 2010, and last year’s figure was 4.7 percent lower.
Stock listings in the U.S. reached their highest total in 1997, in the midst of a bull market fueled by demand for shares of Internet companies. Last year’s figure was 47 percent lower than the record.
Increases in the number of companies being acquired, going private or filing for bankruptcy may explain the declines, Voss wrote in the posting. Declines in initial public offerings are another possibility, the New York-based analyst wrote." - source Bloomberg.

The consequent burst of the internet bubble meant that the US economy which had been financed by equities issuance have meant a much faster rebound than the European economy due to the past flexibility of the American economy in equities issuance. In that case "tenant farmed land". The cut in interest rates under Alan Greenspan which lead to cheap credit and more mortgage back debt issuance leading to the housing busts, has no doubt led to outflows from the equities markets towards bonds, which are inherently more destabilizing from a long term perspective. The famous road to serfdom? Probably.

When one looks at the cumulative flows into bonds and equities since 2000 in billion US dollars as displayed by Bank of America Merrill Lynch, in their recent note entitled "The biggest pictures" from the 11th of October, clearly the "road to serfdom" has been the road of "tenant farming":

We can therefore make this over-simplistic yet provocative conclusion that:
Equities = Freedom
Debt = Road to serfdom

And as we argued before, "there is life (and value) after default!", there is freedom as well. 

So we will eagerly wait for "the mother of all equities bull market" after some much needed "debt" defaults...

"It is difficult to free fools from the chains they revere" - Voltaire 

Stay tuned!

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