“I think that the Internet is going to be one of the major forces for reducing the role of government. The one thing that’s missing, but that will soon be developed, is a reliable e-cash, a method whereby on the Internet you can transfer funds from A to B, without A knowing B or B knowing A. The way I can take a $20 bill hand it over to you and then there’s no record of where it came from.”

Bitcoin is a digital currency whose value is based upon two things: the first is the use of the payment system, or how many people buy into the story, and the second is the volume and velocity of payments running through the ledger. Many people are confused about where the value in Bitcoin comes from; Bitcoin currency does not have some arbitrary value that people are trading. Bitcoin is valuable because it is frictionless and people can exchange it with no fraud and very low, or no, transaction costs.

Bitcoin at its most fundamental level is a breakthrough in computer science. It is the first practical solution to the “double payment problem”. This longstanding problem in computer science is not new, and was originally derived from what many call the “Byzantine Generals Problem”, where a group of Generals of the Byzantine army camped with their troops around an enemy city. The troops were communicating only by messenger and the Generals needed to agree on a coordinated battle plan. Since the Generals did not trust each other, they were faced with finding a method to reach a common agreement. How can one build a network with a secure consensus with parties that don’t trust each other? The answer lies in combining cryptography and economic incentives, the foundations of a network that builds consensus in a secure fashion, or Blockchain.

This is far from the calls of a fad or Ponzi scheme. Could the value of Bitcoin go to zero? Yes! Will it be a bubble? Yes! However, the technology derived from solving the above problem is about to profoundly effect the way our society operates. Keeping an open mind is key.

The practical consequence of solving the “Byzantine Generals Problem” is that Bitcoin gives us a way for one internet user to transfer property rights to another user. The transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and no one can challenge the legitimacy of the transfer. The consequences of this breakthrough are hard to overstate.

As the Second World War was ending, economic experts of the Allies met in a New Hampshire resort to hammer out an international monetary system that would help prevent a recurrence of the Great Depression. The ensuing debate centered around two main proposals. John Maynard Keynes, the greatest economist of the 20th century, presented the British case while Harry Dexter White, one of Franklin D. Roosevelt’s key economic advisors, presented the American one. Keynes’ point was not to repeat the past. The global economy is closed and it needs a global currency and a fixed adjustment process to force the economy to deal with trade imbalances in real time, while having incentives for countries to adjust.

Keynes lost on most key points and the result was the Bretton Woods system, named after the small town in which the conference was held. As part of the agreement, it also created what would later become the International Monetary Fund and the World Bank. This served as the system of managing international trade and currencies for nearly three decades. The die was cast and it was predicted that the global economy would have another major structural adjustment in approximately 80 years, that period is upon us now.

Keynes suggested that a global medium of exchange, called Bancor, be introduced. Bancor was country agnostic. The Americans wanting the U.S. dollar to replace the Pound Sterling as the global medium of exchange refused. Keynes foresaw that the U.S. would slowly evolve from a creditor nation to a debtor nation. He also predicted that the U.S. economy would no longer be able to absorb the excess capacity that the global economy was producing and the rise of populism was going to be a certainty.

The basic problem with international trade is that imbalances can develop, with big winners and big losers. Some countries get big export surpluses, while others develop major trade deficits since the world cannot be in surplus or deficit with itself. The global economy has found it very difficult, if not impossible, to go through any needed structural adjustment without breaking out in war.

President Trump ran his election campaign on a populist agenda. Many question the ability of a centralized authority to focus on the common good of society and the desire for decentralized systems is now becoming a global phenomenon.

Bretton Woods was disassembled in 1971 when President Richard Nixon suspended the convertibility of the dollar into gold. The introduction of a digital currency, in a perverse way provides a solution that Keynes would have preferred in 1945. Bitcoin may not last, but the technology behind it will. The consequences of solving this important computer science question cannot be underestimated.

No one knows who will be the winners during this new phase of evolution, but we do know this new regime will be life changing for many. The global economy continues to evolve from a world based on analog to an economy based on its true native digital state. We can be sure that too much capital will be allocated and a bubble will be created, just as it happened during the internet of information in 1999, as well as the building of the railroads throughout the 19th century. That is the normal part of the evolutionary process. This time it is not different.

Dr. James E. Thorne

Chief Capital Market Strategist & Senior Portfolio Manager

Simply put, any transaction in the old economy that requires an intermediary (to complete the transaction) has the potential of disruption. Industries that contain a high number of intermediaries are ripe for upheaval. As more decentralized networks become marketplaces the global economy will be transformed and will create a massive shift in wealth.

In a Blockchain network, it is the network that establishes trust, verifies identity, clears transactions and records transactions in a distributed public ledger that is transparent and secure. It is the notion of a shared digital public ledger that is rewiring the global economy, from analogue (opaque) to digital (transparent) and reducing the time and capital needed to complete basic transactions.

Blockchain enables what we refer to as the “Internet of Value”. What if value could be exchanged as quickly and as cheaply as information? Information moves around the world instantly with a very low transaction cost. The problem for decades has been “How do you transfer value in a digital world?” Early in the internet’s evolution, researchers could not solve what they referred to as the “double payment problem”. Blockchain finally solves this problem. The “double payment problem” solution lies in cryptography, the art of writing or solving mathematical codes for secure communication in the presence of a third party referred to as an adversary.

Through a process referred to as mining, Blockchain ensures that property rights are transferable. When a transfer is made everyone in the network knows about it - including who now owns the property right. The verification process is key, participants in the network are motivated to solve a mathematical problem, the first one to solve the problem is compensated with a portion of cryptocurrency (e.g. Bitcoin).

This is an over simplification of the process, but for our purposes it illustrates that the process of our global economy is slowly beginning to evolve from an analogue world to a digital world. It took farmers over 40 years to replace the horse with the tractor in our economy. With Blockchain we are entering a regime that is substantially larger than the mania we experienced when just the
internet of information was upon us.

Dr. James E. Thorne

Chief Capital Market Strategist & Senior Portfolio Manager

As Judge Janice Rogers Brown noted on April 15, 2016 in a passage of her dissent that analyzed the government’s treatment of Fannie Mae and Freddie Mac, “when assessing responsibility for the mortgage mess there is, as economist Tom Sowell notes, plenty of blame to be shared. Who was at fault? ‘The borrowers? The lenders? The government? The financial markets? The answer is yes. All were responsible and many were irresponsible. But that does not mean more irresponsibility is the solution’...What might serve in a Banana Republic will not serve in a constitutional [country]”. Meanwhile, during the Republican National Convention (“RNC”) on July 21, 2016, President Trump was focused on portraying a narrative of being the “law and order candidate”.

The Pendragon Fund has been looking for investment opportunities and the aftermath of the Financial Crisis, as well as the climate President Trump has created in Washington, has created potential. Shareholders may have been wronged by government action and our research suggests that the actions taken by the U.S. government putting Fannie Mae and Freddie Mac into conservatorship and then sweeping all of their profits is a case worth investigating.

Homeownership is ingrained in people’s minds as the American Dream. Citizens from Europe came to North America on the hope of eventually being able to own land. Before the Great Depression, mortgages in the U.S. looked very different than they do today. With single family home mortgages only available for a very short-term, (typically 5 years, and featured bullet or balloon payments at the end of the 5-year period mortgages were not pre-payable) refinancing was out of the question. Initial down payments were 50% and home ownership was only at 45%.

During the Great Depression home values fell over 50%, resulting in mass defaults. Defaults on real estate loans reached 25% and foreclosures were as high as 10%. Interest rates were cut but home owners were not allowed to refinance. Many building and loan societies went bankrupt. In 1933, Franklin Roosevelt created the National Housing Act which then created the Federal Housing Administration (“FHA”). The FHA offers to insure lenders against default on long-term mortgages with low down payments. The National Housing Act contained a provision to create a privatively owned National Mortgage Association that would buy the new FHA issued mortgages from lenders. This allowed banks to turn the loans back into cash.

This program reduced the risk that banks would face in originating mortgages. Down payments were reduced from 50% to 20%, interest rates were fixed, the life of the loan was 30-years and the amortized schedule was set so that at the end of 30-years the loan was paid off. Today, these features are taken for granted, but in the period after the Great Depression, Roosevelt’s plan meant that middle class families could own a home. This program also allowed the middle class the ability to use leverage to create wealth. Forced savings allowed low income citizens to accumulate wealth and home ownership became the foundation of the American Dream.

The mortgage acts as the nucleus of financial products. A 30-year loan has significant interest rate risk, prepayment risk, and credit risk. Roosevelt’s plan could not generate any interest from the private capital markets of banks and he was forced to set up a government entity, the Federal National Mortgage Association (“Fannie Mae”) to fill the critical role. Simply put, the 30-year fixed rate mortgage would not exist if the government did not create Fannie Mae.

In the 1960’s, Fannie Mae was transformed by President Lyndon Johnson under the recommendation of the Budgetary Commission into a private company whose stock could be bought and sold. If Fannie Mae was to remain a government entity, then the debt it guaranteed should have been put on the government books as debt which would increase the budgetary deficit. In 1968, President Johnson signed the Housing and Urban Development Act. Fannie Mae was given special status and the Treasury Department could buy its debt, signaling an implicit government guarantee. Fannie Mae could borrow money at rates offered to the government, an advantage that ensured a functioning mortgage market. In the early 1970’s, Wall Street introduced a new product based on the securitization of loans. This new product allowed Fannie Mae the opportunity to package all the mortgages it purchased into a single product, known as mortgage backed securities or “MBS”. MBS over time became a staple of the global fixed income market. MBS, issued by Fannie Mae, were implicitly backed by the U.S. government, international pension funds and financial institutions. Foreign governments purchased billions, if not trillions, of these securities. MBS offered a 30-year fixed rate mortgage to help workers achieve the American Dream, and evolved into a major part of global finance sold as securities with an implicit government guarantee. Simply put, the mortgage market evolved from a dependency on local banks to absorb all the risk in lending to homeowners, to a system that was implicitly guaranteed by the U.S. government and financially supported by global capital. Homeownership increased to 65%. The American Dream was achieved. Fannie Mae and Freddie Mac were the backbone of global financing in the U.S. housing market. What could go wrong?

During the Global Financial Crisis in 2008, Fannie Mae and Freddie Mac were put into conservatorship by the Bush Administration. Secretary of Treasury Hank Paulson’s thesis was these two companies needed a temporary time-out to help them rebuild capital. The assumption was that all of the mortgages that Fannie Mae and Freddie Mac guaranteed would default. The cost of protection from the government was that all of the cash flow from these entities would go to the treasury, forever. The shareholders lost everything. The government found cash flows that could finance programs that congress would not appropriate funds for. At the same time, the backbone of the U.S. housing market and the global mortgage backed security market were unable to build up any capital buffer.

The accounting of these assets proved to be extremely conservative. As the dust settled, it was found that bankruptcy rates during the period after the crisis were well within the assumptions modeled by the firms. Fannie Mae and Freddie Mac were not in a death spiral as suggested by many in the government. Shareholders who saw their rights violated sued.

What is the fair value of the Canadian dollar? Why would policy makers of an export led economy desire a stronger currency? With private debt to Gross Domestic Product (“GDP”) close to 180%, won’t higher interest rates hurt economic growth? Will policy makers be able to generate a soft landing in the real estate market? Meaning, the real estate bubble will pop without generating a significant decline in housing prices. We are entering a new phase in the commodity super cycle. All of the above questions communicated by many pundits over the past few weeks implicitly assume that the basic laws of economics don’t apply to the Canadian economy. We beg to differ.

Remember last year, the global economy was dealing with the crash of prices in the commodity complex. In Canada, wild fires in Alberta added to the problem by forcing a shut down of oil production. The fires in Fort McMurray were a major international story. Yet today, few anchor their expectations about the future on this fact.

The Canadian dollar has rallied over the past few months. The Bank of Canada is claiming victory from the appreciation of the Canadian dollar, caused by the recent interest rate hike. The Canadian dollar has now reached a point where one of the world’s most efficient railroads, the Canadian National Railway (“CN”), stated in its quarterly report that the strength of the Canadian dollar is now a headwind for economic growth. As the economy enters into a period where data gets normalized, those bullish expectations will subside. Looking at the Citigroup Economic Surprise Index, we can see that investors have extremely bullish expectations about the Canadian economy, while having extremely bearish views about the U.S. economy. Mathematics suggests that those expectations should reverse as we get into the fall.

The Bank of Canada has a single mandate: to target inflation. Data released in July 2017 revealed that inflation was at a 20-month low. Fundamentals suggest that the Canadian economy is lapping very easy comparisons, meaning growth looks better than it actually is in Canada, an additional point that CN makes in its quarterly report. Furthermore, basic economic theory suggests that an appreciating dollar is deflationary. So while all the cheerleaders are happy about the strong Canadian dollar, international investors most likely see Canada in a more objective light. The Canadian economy has had the benefit of two super cycles, one in commodities and other in real estate. To many observers, it looks like the Bank of Canada is targeting the real estate bubble. Popping the real estate bubble will not come without consequences, a decline in real estate prices will have a negative effect on economic growth. Some may suggest that the housing bubble can be popped without a decline in housing prices, however we do not see any evidence to support this. In theory, it could happen, but practically speaking, assuming an economy with private debt to GDP of 180% will not see a significant decline in economic growth in light of a decline in housing prices is a very dangerous position to hold.

The Bank of Canada raised interest rates. Was it justified? Were they targeting the real estate market? Is an appreciating currency good for an export led economy? Why are the rest of the world’s central bankers concerned about being below their inflation targets? The Bank of Canada is sure that the long shadow of the global financial crisis and secular stagnation has been defeated. Retail sales (not including the automotive sector) that were reported in July 2017 were negative. Job growth in Ontario was negative. Yet, the Governor of the Bank of Canada, Stephen Poloz, and his team are claiming victory. The Bank of Canada may just be taking back the two emergency cuts they did when oil crashed. Governor Poloz acted as Governor John Crow did to pop the housing bubble in the early 1990’s. Real estate prices declined by 50% at that time and Canada went into a recession. Instead of acting as cheerleaders, many pundits should be sounding the alarm bells. A major policy mistake is at hand. Canada is no longer competitive in manufacturing on a cost basis with the southern United States and Mexico. Canada has just experienced the benefits of two super cycles, commodity and real estate. A strong Canadian dollar is the last thing the Canadian economy needs at this juncture.

It seems that many in Canada don't think that cycles repeat, fundamentals do matter and policy mistakes can happen. Shakespeare was right, The Past is Prologue, but only for those that take a moment and reflect.