Monday, October 29, 2007

What Do DAP and CDOs Have In Common?

Before proceeding with the main subject of this post, I see that many people are still surprised by the ongoing tumble in the AAA-AA tranches of the ABX indices. I explained why this is happening a week ago in "Remember The Buckets".

Simply put, their terrible performance is not a matter of market psychology but mathematical fact derived from their cascade structure. As borrowers default on monthly payments, the small, lower tranches absorb the losses and leave the much larger AAA-AA portions intact. But once the process inexorably moves to seizure, eviction and auction, loan losses mount exponentially because the hits now come from far larger principal losses, not just interest and amortization. The lower tranches immediately become overwhelmed and spill over the entire losses onto the AAA-AA tranches, which make up 80-85% of the CDO amounts.

Let's look at the 2006-1 series of ABX, which is the oldest and most "seasoned", meaning the loans in the underlying CDOs had the most time to settle down. Think of the following charts as a series of buckets from top to bottom, successively filling up with losses and spilling over into the bucket below: BBB- spills into BBB, then into A, AA and finally AAA. Notice the time lag as the BBB- and BBB buckets first "fill up" with losses and then the "break" in the higher rated A and AA tranches, as the big principal losses suddenly spill over into them.



















































The AAA tranche is still holding up, relatively speaking, exactly as we expect. In this most seasoned series, the AA and A tranches are now taking the hits, with the expected time lag. But it won't be long before the AAA is all that is left...
Do the math... including the origination, pooling and underwriting fees that were originally charged to principal and the fees involved in their ongoing maintenance, I won't be at all surprised to see some formerly AAA-AA CDOs going for a panicky 50 cents on the dollar. If that.

Which brings me to today's subject: delayed consumer goods inflation. First some data; price increases from last year, spot month futures.

Soybeans: +76%
Corn: +66%
Wheat: +60%
Oats: +57%
Milk: +50%
Barley (i.e. beer): +50%
Rice: +33%
Coffee:+20%

Crude oil: +53%
DAP (di-ammonium phosphate fertilizer): +69%

Dry bulk cargo shipping rates: +350% (it's not a typo)

What do these prices have to do with CDOs? Nothing, except that raw material price hikes also follow a cascade structure until they reach the consumer, i.e. it takes time for them to be manifested in our local supermarket. At first, wholesalers may work off their cheaper inventories and absorb some price hikes to keep customers happy. We can view that as the equivalent of safety reserves and equity tranches in the CDO structures. Next come the large food processors, who may also abstain from passing the entire price increases to consumers, accepting instead some profit margin erosion to maintain market share. We can view that as the mezzanine tranche. For example, crude oil is at $93/bbl, but gasoline is still retailing as if it were at $70. Refinery margins are horrible, right now.

But once the various inventory, delivery and crop cycles are completed, the merchants and processors will have no choice but to pass the full price increases to the consumer, creating a sudden spike in consumer prices. If the consumer then balks and goes on a consumption freeze (as he will, unless his income rises faster) it will be corporate profit margins that will get squeezed hard. Until recently the consumer could count on easy borrowing to meet extra expenses and sustain price increases to fatten corporate profits; this is obviously no longer the case.

Consumer Food Price Inflation Chart: St. Louis Fed

In my opinion, we are already at the first critical point: price hikes for food commodities are being passed on to the consumer (chart above). We can also observe profit margin squeeze, e.g. WalMart's recent decision to cut prices on thousands of toy and other discretionary items.

The next 2-3 weeks will show if this year the consumer will snub the pre-holiday shopping ballyhoo and simply wait for retailers to panic and slash prices a week before Christmas. I know that's what I will do...

If this happens, you can bet that retailers and wholesalers are going to blow it all back to their suppliers/manufacturers in the form of smaller orders AND demands for lower prices, or at least a freeze. This is when China is going to feel it and given their tremendous overextension in manufacturing capacity and thin profit margins, I strongly believe they are headed for a heap of trouble.

29 comments:

  1. we have very long and complex supply chains. The fancy ERP CRM software were attributed to the productivity miracle but this improvements were also due to very capacity utilisation rates globally.

    The sudden demand deficiency in US will have cascading effects and expose some productivity gains
    as illusionary ie falling cap utilisation will prove devastating
    for many companies in asia.

    you are one of the very few who really understands what is going on.

    best regards

    kaan
    istanbul

    ReplyDelete
  2. good description of the price chain. And I agree on the conclusion : consumers will ask for bargains. So commodity inflation is not a problem per se. It is this time a leading indicator of a consumer recession !
    regards
    Miju

    ReplyDelete
  3. Dear Hellasious,
    yes you have already covered the plunging ABX indices. but it seems that the contagion is spreading rapidly to the commercial real estate sector as well. Charts supplied by mark it are dreadful. I remember that in April you already pointed the finger on this problem. but looking back now the rise you were mentionning in April looks nearly ridicculous compared to what is happening today. Is this index on CRE insurance premium as pertinent as the one on Residential RE ? i think anyway that the market is ready for a big challenge is the weeks ahead. What do u think ?
    Miju

    ReplyDelete
  4. As you recall, I was critical of an earlier post of yours about AAA tranches. I argued that even if every single loan defaults, the 'recovery' on the collateral will be enough to pay back the AAA and supersenior holders.

    Then I saw a program on British TV last night about foreclosures in Cleveland (Ohio). They showed rows and rows of empty houses, whole neighbourhoods of nice looking homes that are derelict. Many of them have been occupied by gangs and used drug manufacture and distribution. Some have been empty for more than a year.

    Quite clearly, these have no 'recovery value'. This is quite serious.

    ReplyDelete
  5. No one is talking about commercial real estate yet in the media, except for condo developes. But at these interest rate spreads it means zero new office buildings etc. are going to be going up in the future. Be prepared for some CRE developers going belly up. They are even more highly leveraged and dependent on cheap financing than RRE developers.

    ReplyDelete
  6. ocham said..."clearly, these have no recovery value".

    This is going to be our era's Dustbowl. Plus all those "holiday homes" in Costa del Sol, in Spain. CNN already called it Costa del Con, a couple of days ago.

    Regards

    ReplyDelete
  7. no reason for Fed to cut, unless they want to start currency crisis. i think we are at the start of it. Aside from that, I think Fed will do at least 50bp or more cut in FOMC to bail out this banking buddies. Expect dollar to drop below $70.

    ReplyDelete
  8. i mean his banking and hedge fund buddies

    ReplyDelete
  9. Don't forget that demographic trends re going to put a crimp in consumption as baby boomers move past their peaks earning and spending years.

    ReplyDelete
  10. The news that the cyclic supply chains will cause even more food price inflation could curtail consumer spending over the cold winter. The psychological effect of the price increases on food and gas to working class people is definitely something that can't be ignored, but is it enough that effect consumer spending?

    So far, no.

    I wrote on my blog about how at the grocery store in LA: a 1/2 gallon of milk, a loaf of wheat bread and a dozen of large eggs each cost nearly $3 a piece. Anyone remember early last year when you could buy them for $0.99 at Safeway? That’s already a huge increase.

    Perhaps only a credit constriction will curb exuberant consumer spending. Lots of working class people still seem to be willing to eat Top Ramen in order to buy the C-students they're raising, video game-boxes for Christmas.

    ReplyDelete
  11. Unilver (UK) recently announced 3% price increase for all their processed food products from Jan 08. There was also a newspaper (Irish Times) report last Friday detailing a 40% increase in bread price due to an increase in wheat price. Petrol and diesel have both increased recently.

    Brian Woods

    ReplyDelete
  12. Hi!

    Please accept my congratulations for your analisys.

    You are absolutely right.

    In my 10 years experience in investment banking, I never saw such well articulate reasoning.

    On behalf of those who do not have so much knowledge, thank you for sharing it.

    Congratulations, and please go on with the good worf

    ReplyDelete
  13. Interesting how reality works..... Especially with such a strong dollar.... Oops, sorry, I was holding my chart upside down.... Never mind....

    Econolicious

    ReplyDelete
  14. Good post Sudden dude !! I like this supply chain argument.

    Check stocks of dry shipping companies today BTW. Someone is smelling something ??

    ReplyDelete
  15. i don't recall how i stumbled across your blog, but it has become a daily habit. on a few occasions i have taken the liberty of posting some of your material, with attribution and a link, at itulip.com. just wanted to say how much i appreciate your work.

    ReplyDelete
  16. Its true, Mr. H, very good analysis. Keep up the good worf - er, I mean woof! A big tail-wag to you!

    ReplyDelete
  17. And you can see the changing dynamic in food prices reflected in companies such as Sas Wheat Pool, ticker VT.TO and CRESUD, ticker CRESY, as both companies stocks have broken out to the upside. With respect to oil, the highs are likely in, and we should expect to see $70 a barrel before we see $100 as oil begins to reflect the impending recession.

    As for a consumer recession, a consumer recession means a recession. And speaking of sales, between now and late spring, shares are going to have a 30% off sale. More sales to follow.

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