Monday, July 30, 2007

A Different Kind of Credit Crunch

It is quite obvious that we are in the initial phases of a major credit crunch. However, this is not a "regular" credit contraction, where the Fed tightens in order to prevent or lower inflationary pressures. No, it's truly different this time.

As I have often laid out in previous posts, banking is not what it used to be. Credit institutions no longer loan money; rather, they act as salesmen of loans they have previously packaged and securitized as CDO's, CLO's, CPDO's, etc. The real lenders are the buyers of such securities. This process, combined with the waterfall tranche structure of asset-backed securities, allowed for credit conditions to become ultra loose, irresponsible even. Bankers did not care about loan quality, since they could turn even junk into 80% AAA-AA bonds, with the remainder off-loaded to the dozens of new yield-hungry hedge funds that were cropping up daily.

But just because there were buyers for such products (for a while), it did not mean that borrowers could service their debt. Quite the contrary, in fact. As the weakest individuals and companies were offered more and more debt without their incomes rising commensurately, it was only a matter of time before they would get into deeper trouble, faster. When this became obvious, the bond buyers suddenly disappeared; after all, they were just portfolio investors and unlike experienced bank credit officers they did not want, or have the ability, to gauge each borrower's creditworthiness inside those pools of thousands of loans.

In this crunch, the entire credit process is shutting down fast. It is not the cost for the use of money that is rising, but the cost of risk, i.e. the bond buyers are questioning the safety of their principal and this is the most potent deterrent to lending. The signs are everywhere: for example, if KKR and Cerberus can't get funding, then 99% of all other buy-out funds won't get any, either and the trillion-dollar-a-year LBO business is out of business - at least for now.

Let's look at the price of risk across all asset classes, as measured by their credit default swaps:
  1. Home mortgages, as measured by the ABX indexes, are now trading at spreads at least 2-3 letters below stated, i.e. AAA is trading like BBB, AA like BB, etc. The BBB and BBB- tranches are effectively trading as if already in default.
  2. Likewise for commercial real estate mortgages, as measured by the CMBX indexes. In fact, such mortgages appear even more distressed than residential ones.
  3. High yield bond spreads (CDX HY) have widened from 250 bp to 525 bp literally in days.
  4. Investment grade bond spreads (CDX IG) have widened from 35 bp to 77 bp, also within days.
  5. Syndicated leveraged loan spreads (LCDX) have gone from 90 bp to 370 bp, again in days.
And this is not just in the US - it is happening all over the world. The iTraxx indexes following European, Asian and Australian credit risks are showing similar patterns.

In a recent Bloomberg interview, US Treasury Secretary Hank Paulson acknowledged this fact, but at the same time he underplayed it: "All that is happening is that risk is being re-priced", he said. Well, yes, of course... but risk is being re-priced so fast and by so much that the effective cost of borrowing is gapping up, not rising gradually as in prior tightening events .
  • Look at LCDX - corporate leveraged loans, used for LBO's:
Index charts from Markit

A move of 280 basis points in one month is not a mere "re-pricing of risk" - it is a bona fide crisis. In the past couple of weeks at least 40 deals have been delayed - and will likely be canceled, simply because such huge increases in financing costs in such a short period of time completely destroy their cash flow projections, i.e. the whole purpose for doing LBO's in the first place.
  • Here's another example, the "A" rated tranche of CMBX (commercial mortgages):
I intentionally chose a highly rated tranche to show that tightening is happening everywhere, not just the low end of the quality spectrum. The low end (BB) is a disaster - it has gone from 500 bp to 920 bp. Developing commercial real estate is completely governed by financing costs and there is no way such strong headwinds can be overcome.

To compare what is happening today with "regular" credit contractions of the past, it would be the equivalent of the Fed raising rates by at least 150 b.p. in one move. Looking at Treasurys to gauge medium to long borrowing costs is useless.

As Greenspan would have put it if he was still at the helm of the Fed..."Markets are currently reversing the prior tendency of lenders to accept lower than normative risk premia and are adjusting towards a higher plateau of effective credit pricing and a lower plateau of credit availability, further adjusting of course for perceived creditworthiness. The Federal Reserve is keenly observing this process and as always may adjust its monetary aggregate targets to reflect this fact, though it cannot intervene directly into what is a self-correcting mechanism regulated by the free market". Translation: "I told you so, clean up your own mess".

Bernanke's likely reaction (privately): "Revv the helo".

There is further reason why this credit crunch is very dangerous: total US debt (federal, state and private) as a percentage of GDP is now at the highest level ever. It takes more total debt to create a unit of economic activity than ever before and its sudden constriction is simply going to have a bigger negative effect on the economy.

Data: Federal Reserve

At the same time, there is less available income to back up the debt. The ratio of household debt to disposable income is also at the highest level ever.

Data: Federal Reserve

One final point of opinion: I think this process of credit spread adjustment and tightening is in itself the initial stage of a wider move away from portfolio investments that will take many years. To draw a parallel, just as we have had a long-lasting bull market for such assets that started around 1982 with the inception of trickle down economics, major tax cuts, wealth and income divergences and so many other societal changes, I believe the process will shift to something else. My most likely candidate is a steadier-state economic model based on ecological concerns and depletion realities.

Saturday, July 28, 2007

Get Off The Bong Bus

I started this blog eight months ago when it became glaringly obvious that the global economy was becoming hooked on the high-potency drug of debt-financed asset appreciation. It was like dozens of dope bubbles were emanating from bongs all over the world to create one huge hallucinogenic balloon passed around tens of thousands of speculators who rolled their eyes ecstatically with each "hit" and maniacally kept pushing the BUY button over and over again.

It was a throwback to a Miami Beach college spring break, a lifetime ago. Pinching pennies, I had chosen to travel from NYC by charter bus, packed with other college students. The trip was to last a full 24 hours. The moment the wheels got rolling everyone lit up joints, bongs and paraphernalia such as I had never seen before. What can I say, I had a sheltered childhood and besides, grass smelled to me like dried cabbage leaves on fire - ugh.

Before the bus was out of Holland Tunnel it was so hazy inside you could hardly see two rows back - and it stayed that way as we all floated down South on I-95. It was freezing cold and opening a window was out of the question - until North Carolina, anyway. I was the only one on the bus that did not smoke - but boy, was I forced to inhale... When I pleaded with my seat-mate to at least not fire up his monstrous Cheech & Chong special, he gave me such a dirty look that I shut up for the rest of the trip. I suffered in silence and a week later I took the plane back.

Likewise, for months now it felt like I was inside the Bong Bus all over again, forced to inhale clouds of second-hand dope about "huge liquidity", "innovative finance", "risk and volatility attenuation", "paradigm shift", etc. The window was opened a couple of times and a bit of THC was let out, but it was quickly shut again and the party got even heartier. Everyone was stoned out of their mind and I think I even spotted the driver passing nickel bags around.

But the party is now most definitely over - zooming CDS spreads are evidence the hash bag is nearly empty and that everyone had better sober up before the cops raid the joint. All who are caught with their pupils (and portfolios) dilated will have to spend a few years in speculator slammer, where exposed assets get severely violated.

P.S. I was going to write a "serious" post today, recapping what happened this week and connecting to my original posts several months ago - early warnings about CDS's, CDO's, etc. Then I figured...what's the use? I can pat myself in the back all I want and feel vindicated, but that is of (dubious) value to myself only. So, being the weekend, I thought a bit of levity was in order. The bong bus story is absolutely true, by the way. Isn't it amazing how even the looniest experience eventually becomes useful?

Friday, July 27, 2007

You Call This Lower Inflation?

The 2Q2007 GDP numbers just came out (+3.4%), just as expected. Analysts also rushed to hail the PCE price index rise of "only" +1.4% - minus food and fuel, of course.

I have had enough of this absolute "minus food and fuel" baloney. So here is a chart of the full PCE inflation, along with the measure minus food+fuel. Reach your own conclusions, but keep in mind that according to the same release, a full 21.2% of all personal consumption expenditures are made for food, fuel and transportation services. Try minusing those from your real life....

Oh, and something else: Market-based PCE inflation, i.e. excluding items that the government says you get for "free" (like getting money out of an ATM without incurring a charge) rose by 4.6%, the highest in at least 15 quarters.

Swallowing The Hog Whole

Sometimes just one or two sentences are enough. Consider this paragraph, from a Bloomberg story.

The ``golden era'' for leveraged buyouts proclaimed by Henry Kravis two months ago is losing its luster.

Kravis, co-founder of New York-based Kohlberg Kravis Roberts & Co., said on May 29 that there was ``plenty of capital'' to finance acquisitions. Yesterday, Chrysler and Alliance Boots Plc failed to find buyers for $20 billion of loans to pay for their buyouts. Ten banks, including Deutsche Bank AG and JPMorgan Chase & Co., were stuck holding the debt. (bold added)

The last sentence, read in context, literally screams about how far we have come from traditional banking. Imagine... the banks "are stuck holding the loans"! As if banks are not supposed to make loans, in the first place.

It is obvious that in recent years major banks became so hubristically spoiled by making fat origination and securitization fees, that the very idea of loaning their "own" money shocks them. They had turned themselves into sausage factories: in came loans of the worst possible quality - "pigs" - and out came mouth-watering AAA link sausages to suit every taste: CLO's, CDO's, CPDO's, hybrid CDO's, CDO squared and cubed... the variety was captivating.

As any sausage maker knows, the trick is to take the cheapest possible meats, mix in a ton of extenders, flavorings, colorings, preservatives and water and turn them into "charcuterie" at ten times the price. Much better looking and smelling than the fat, dirty hog that originally came in. But, just like cheap bacon, all of the above bank products shrink to 1/3 their original size when things get too hot.

Well, the customers are finally realizing that bank sausages are not as healthy and nutritious as advertised and are passing on their latest offerings. The banks are now stuck with a roomful of smelly loans they don't know what to do with. Guess they'll have to swallow the hog whole - hairy ears and all...

With yesterday's drop in global stockmarkets came fresh upward pressure on credit spreads. The spreads for the CDX indexes calculated by Markit are rising very steeply, significantly including the one that follows investment grade bonds.

CDX Investment Grade Index

CDX High Yield Index

The importance of these moves is very high, given the leveraged nature of markets world-wide and the prevalence of debt-financed LBO's. In other words, first the takeover premiums are going to deflate to zero (no way to finance a deal right now) and then the leverage multiple is going to start working in reverse.

Thursday, July 26, 2007

Liquidity In Emerging Markets: An Illusion

In addition to the ready availability of money (or loans, which is the same thing), liquidity also has another meaning: the ability to readily buy or sell in sizable amounts with little price impact.

Until 2-3 years ago this was certainly not the case for emerging markets: just a few issues (perhaps 10%) traded in decent size on a daily basis and the rest traded "by appointment", more or less. While these markets are still illiquid by US standards, they have progressed. The question is, why? Have local investors jumped in, converting their bank savings into portfolio investments? This is the case in China - and definitely too much so. But in other countries something altogether different is happening.

In many emerging markets locals are passive and the most influential investors/speculators are foreign institutions (usually hedge funds), who are dealing back and forth amongst themselves, ramping up share prices almost at will. Their activity creates volume and the illusion of market liquidity, when in fact there is hardly any underneath. The locals are not active - and why should they be? They are on the sidelines enjoying the gains with whatever participation they already have.

The major question is this: when the foreigners wish to depart, who are they going to sell to? Since there aren't any really sizable domestic investors they will have to sell to one another, like in a game of musical chairs but with Ravel's Rondo played at 10x the normal speed.

It's like this: a wealthy investor identifies a small illiquid stock he thinks is underpriced and starts buying heavily. Naturally, the price goes up and he keeps calling his broker with fresh buy orders every day - after all his mark-to-market profits are bigger every day. He even starts using margin, to boost his returns. His broker, being a broker, front-runs him when he can get away with it (which is all too often) and this adds to the illusion of liquidity. "See", thinks the investor, "there are other smart guys who realize XYZ is such a good investment."

Finally, the price reaches his target point and he calls his broker with the glad news: "Bob, I'm satisfied with my big gains. Sell everything". To which the broker replies: "Happy to hear that, Charlie - but who am I gonna sell to? You are the only buyer".

Don't even think this is a hypothetical story. It happens all too often.

Wednesday, July 25, 2007


(Special Intra-Day Post)

In case you have forgotten your Greek mythology, Cerberus was the three-headed hound, keeper of the gates of Hades. Apt name for a private equity fund, eh? The Dog From Hell? (What were they thinking of when they picked that name?)

Well, they just delayed the Chrysler takeover loan deal - there is simply no demand. In other words, they couldn't find anyone that would stick the loans inside a CDO or CLO and sell them to the public at anything approaching reasonable interest rates.

Just a few days ago I was writing... "Seriously, though: failed offerings are always signs of a top and with good reason. Markets are all about the balance between supply and demand and such failed issues are the best proof of lack of demand."

This is a failed offering and it seems like the bank(s) and Cerberus itself are "eating" the paper.

Oh, and KKR just joined the party. The Boots loans are not selling, either. And you know what's funny? Those alchemists have finally done the unthinkable: they managed to turn gold into lead.Bbefore the LBO announcement Boots CDS's were trading at 27 bp and now they trade at 450 bp. Quick, someone tell me: where exactly is the added value in LBO's?

Default Rates

A reader asked if there is proof about expectations of default rates reverting to the mean. Such expectations are a direct function of default rates themselves, but with a time lag (expectations precede the fact). The creation of the CDS market, however, has provided us with a powerful tool to measure expectations directly. Unfortunately, it is a very new market so we cannot exactly assess its correlation vs. actual default rates. Still, given the sheer size of this market ($35 trillion outstanding), we can be quite sure that its significance is high. With CDS spreads now rising steeply across all asset classes (home and commercial mortgages, junk and investment grade bonds), examining default rates more closely is very important.

The following chart was produced by data from a study by NUY Professor Edward Altman, long considered a leading authority in high yield ("junk") bonds ("About Corporate Default Rates", 2007).

Junk Bond Default Rates

I have added the arithmetic average, weighted average (by amount), and a band of +/- 1 standard deviation (σ) around the arithmetic average. Even a cursory glance at the chart shows that 2006 defaults were near the bottom of the band. Coupling that with the recent poor performance of the CDS market, I have a high degree of confidence that default rates will rise significantly in the near to medium future.

Tuesday, July 24, 2007

Who Needs PPT's When We Have LBO's?

Sometimes I hit upon a chart so powerful that it literally makes me gasp. This is the case with the following one, taken from the Bank of International Settlements 2007 Annual Report (click to enlarge). The amounts are in trillion dollars and are adjusted for inflation (constant 2005 dollars).

Value of announced LBO's in trillion $US (constant 2005 dollars)

In 2007 thus far, global LBO's are running at a rate 33% higher than 2006. So, it looks as if we may easily surpass $1 trillion in LBO activity this year - assuming the current rate is maintained. Total global market capitalization was $55 trillion as of May 2007; withdrawing almost 2% of market value in one year does wonders for stock prices.

However, there is an absurdity lurking here: private equity and LBO firms are taking dozens of listed companies private, but they are going public themselves. The whole process does not make any sense at all: we are being asked to pay a premium over and above what the LBO firms paid themselves in order to end up owning the same assets. It is little wonder that their IPO's are not faring well, so far.

Add the recent widening of credit spreads which is raising borrowing costs (e.g. the CDX High Yield index has jumped from 275 bp to 455 bp in the past 45 days) and we may already have seen the peak of the LBO activity, which translated into high takeover premiums being placed on stockmarkets.

Saturday, July 21, 2007

Sigma Happens

Are you comfortable with probability and risk mathematics? I don't mean a passing acquaintance with the principles of throwing dice and winning at Monopoly, or figuring out the odds at a roulette table. I'm talking about a PhD in financial engineering, or at least a Master's in Mathematics with a Thesis in Probability Theory. No? Then you do not belong to the brave new world of finance and are herewith relegated to the status of dinosaur. Don't worry, you have plenty of company, Warren Buffett included.

At least that's what the new crop of frightfully (I choose my words carefully) bright kids populating the halls of finance would have us believe. I know, because sometimes they make me feel like a brontosaurus: big size, small brain.

This whole string of thought started when a reader (thanks "Kicker") asked me if I had any insights into CPDO's, or Constant Proportion Debt Obligations, a highly leveraged bet on default risk that sells Credit Default Swaps (CDS) on CDX and iTraxx indexes to generate income and capital gains to pay coupons of Libor+200 to 300 bp. It also has this rather unique feature: if the CDS premiums and capital gains don't generate enough cash flow to pay the stated coupon, this instrument is designed to automatically sell even more CDS's to make up for the difference. In gambling they call it "doubling down" after a loss. Polite society calls it "throwing good money after bad". Modern finance calls it "innovative".

The whole concept is based on the notion that if default risk rises too much above the level designed into the CPDO structure (itself calculated from historical default data), then it just has to revert back to the norm. Thus, selling even more CDS is the proper way to recoup the losses and eventually make a profit, too. In math terms, 3-sigma events are considered so rare as to be comfortably ignored - so comfortably, in fact, that rating agencies give this type of structure a AAA rating, despite leverage of up to 20 times (Oh, Brave New World!).

Let's stop it right there and use our common sense for just a minute. A AAA-rated bond that pays Libor +200? Ok then, I'll go ahead and arbitrage it against another AAA bond and just keep the spread. Being a dinosaur and all, I can think of several more such quaint and safe strategies, so when my bright banker calls recommending this CPDO I'll just throw them at him and see if he will just agree to pay me 2-3% on whatever amount I choose, without me putting up any money at all, of course. He should have no problem with that - what do the rest of you lizards think? Free lunch? Money for nothing? Chicks for free?

All right, time to get serious. This is a product that depends on two assumptions:

a) The low-default experience of the recent past will continue and,
b) If defaults rise they will quickly fall back.

But, here's the rub: the ultra low default expectation environment we are experiencing right now is ITSELF a 3-sigma event and will revert to the mean, too.

Here's a chart of the yield spread between junk bonds and Treasurys, showing exactly how far away from the mean we have moved in default expectations (i.e. the yield premium is way too small and has stayed that way for too long).

The bottom line is that the CPDO structure is a recipe for disaster.

Note: the CDX IG spread just hit 52 bp and CDX HY 430 bp. Both are new reaction highs. iTraxx is now at 35.

P.S. If you are interested in the discovery and application of probability and risk mathematics, I highly recommend Against the Gods by Peter Bernstein. It is very enjoyable and a good reference, too.

Friday, July 20, 2007

Banking: Unsafe At These Margins

Banking has always been considered a license to steal, assuming you could get a banking license to begin with. Because of the multiplier effect inherent in low regulatory deposit reserves, banks essentially create money and profits out of thin air, if they keep their operating costs low enough and their lending practices sound.

Global banking has changed radically in the past 20 years. Commercial and investment banking have once again become closely related, as corporate customers no longer wish to pay banks a spread for their traditional intermediation role (take deposit-make loan) and tap the securities markets directly for debt and equity capital. It came as no surprise that the 1933 Glass-Steagall Act separating commercial from investment banking was repealed in 1999.

Faced with rising competition, banks across the US merged in increasing numbers. There are now some 7.000 commercial banks vs. 14.000 22 years ago.

US Commercial Banks (St. Louis Fed)

But even as banks got fewer and bigger, competition for the remaining business - lending to households and small businesses - got even more competitive. Net interest margin (NIM), the most commonly followed gauge of banks' lending profitability, has come down dramatically, even as the risk profile of the borrowers has theoretically deteriorated. It is one thing to lend to solid blue chip corporate customers (however, note: are there any left?) and quite another to Mr. and Mrs. Jones, as the current mortgage mess clearly shows.

Net Interest Margin (St. Louis Fed)

Even as NIM came steadily down, return on assets (ROA) stayed high, but flat. Increased fee and trading income balanced the steady erosion in net interest margins. Remember this when you get hit with a huge fee for being even one day late with a credit card payment

Despite the steady reduction in core lending profitability and stagnation in ROA, US banks found another way to boost reported profits: they simply cut loan loss reserves to the bone.

Loan Loss Reserves/Total Loans (St. Louis Fed)

Banks weren't without justification for doing so, however. Reported net losses also came down at the same time - though not as fast, or as much, as loan reserves.

Net Loan Losses/Total Loans (St. Louis Fed)

To see how much faster banks cut down on reserves vs. actual losses, I constructed a chart of the difference between the two, i.e. (reserves minus losses)/total loans. This is the banks' cushion against further losses and it is now at the lowest level in 22 years.

Therefore, it is no wonder that Return on Equity (ROE) for banks has stayed high, though it seems to be turning down a touch recently.

Return On Equity (St. Louis Fed)

It is pretty clear from the above that bankers and their shareholders are betting that losses won't increase much from these record-low levels. Given what is already happening in the residential and commercial mortgage market, plus the stirrings of higher credit spreads in the corporate market (see yesterday's post), such a bet carries long odds, in my opinion. And there is, unfortunately, more: the largest banks have vastly increased their exposure to hedge and private equity funds, lending lots against little and low-quality collateral. One of Bear Stearns' funds that went under used 17+ times leverage; an incredibly aggressive ratio of debt to assets that unfortunately in not all that uncommon in this "high liquidity" era.

Bottom line: In their quest to produce ever higher returns for their shareholders, banks have done away with considerable safety features in their lending practices and balance sheets. Thus the title of today's post, a throwback to Ralph Nader's 1965 book (Unsafe At Any Speed) dealing with the US auto industry.

Thursday, July 19, 2007

Joe's Greasy Spoon (Ask For Our CDS Special)

In closing yesterday's post on the plunge of the AAA, AA and A rated ABX indexes tracking Credit Default Swaps (CDS) on mortgage-related CDO's, I said:

"And did you know that at least 60% of all CDS's are held or sold by hedge funds?"

A friend soon called and wanted to know what I meant by that question. As an old finance hand, I often treat such comments as being obvious when, in fact, they are nothing but. Market inter-connections can be quite convoluted and confusing to the non-pro, so here is a bit further on the subject of CDS's and hedge funds.

Let me first start by saying that, in my opinion, CDS's and the yen carry trade are responsible for most of the additional leverage we have piled on markets during the last 2-3 years. So, the performance of the CDS market is extremely important right now, given that CDS's have been written against ~$35 trillion and their gross market value exceeds ~$500 billion, according to BIS and ISDA statistics.

As we know, CDS's are insurance contracts written against the default of an issuer's bonds. The seller of the insurance (the person who sells the CDS contract) undertakes the obligation to pay full face value in the event of default (up to an amount specified) and in exchange receives an agreed-upon annual premium for the duration the CDS contract, usually 5 years. The buyer of the insurance pays the premium regularly and supposedly hedges his default risk exposure. Neither buyer nor seller of the CDS are related to the bond issuer and can issue many times more CDS's than bonds outstanding. It is not uncommon to have 10 times more CDS outstanding than bonds in existence.

The crucial point I wanted to make with my original question/comment about hedge funds is that insurance contracts are not fungible. It is one thing to buy default insurance from The Rock of Ages Insurance Co. and quite another to buy it from Joe's Greasy Spoon and CDS Emporium. What is the real worth of credit insurance, when most of it is underwritten by notoriously risky, leveraged and unregulated hedge funds that can literally evaporate within days? The latest episode with Bear Stearns's funds makes this perfectly clear. How good is that credit risk hedge you have on your books if you bought it from "Joe's"?

The theoretical notion that underpins the creation of the CDS market is that it spreads credit risk around and thus makes the whole financial system more robust. This is very clearly questionable, in practice: all we did is that we created one more fat layer of risk in the system, constructed by and populated by the most volatile and leveraged residents in the financial universe: hedge funds. And yet, for a while, the market treated CDS's issued by "Joe" as being just as valuable as ones issued by "The Rock". Overall credit spreads plunged to historic lows, as hedge fund "Joes" muscled into the CDS market, venally cutting premiums to the bone in order to collect extra cash and boost their performance numbers, so crucial to their annual bonuses.

But if Mr. Market may on occasion become and stay irrational far longer than seems logical, he ALWAYS sobers up and almost always does so in violent fashion. That's what Crashes and Panics are, after all: sudden re-adjustments in reality perceptions. The ABX indexes are now re-adjusting to reality across their full spectrum, from AAA to BBB-, as we saw yesterday. And so are their less well-known commercial real estate counterparts from Markit, the CMBX indexes. The CMBX charts below track yield spreads, so the higher they go the higher the implied risk.

First, the AAA CMBX tranche:
Next is the AA tranche:
...and finally the A tranche (for comparison, the riskiest tranche rated BB has gone from 477 bp to 697 bp)
In layman's terms, the abrupt rise in CMBX spreads means that commercial real estate loans are suddenly becoming much more expensive to obtain. Given the sensitivity of commercial real estate projects to financing costs, this will very quickly lead to a gap-down in commercial real estate activity, the last vestige of relative strength in the otherwise reeling construction business.

On to my final point: credit spreads are rising in the corporate bond market, as well. This is where the big, ugly dragon of credit risk still sleeps: the risk of corporate defaults, so intimately and incestuously linked to the stockmarket. As the charts below make perfectly clear, the dragon is finally opening his eyes and, oh boy, does his fire-breath smell bad.

The CDX index for high yield bonds has widened from 260 bp to 400 bp. This means that financing risky LBO's and related M&A activity has become that much more expensive, likely killing for good any and all deals still in their early phases. Deals in the final stages may get re-priced, reduced in size or cancelled altogether, depending on a) how much "room" they have in their financial projections and b) how much "pull" the customers have with their bankers. Either way, I wouldn't put a single cent into such deals right now.
CDX High Yield

The CDX index for investment grade corporate bonds (they average just BBB+, read post from July 7th below) has widened out to 50 bp vs. 30 bp in January (unfortunately the chart below doesn't go that far back). A "mere" 20 basis points (0.20%) in financing costs may not seem all that much to a casual reader, but it is not chump change to a corporate treasurer counting his nickels and dimes, particularly since it is happening fast and shows every sign of going higher.

Besides, what is more important to the overall market right now is that it signals a sudden rise in implied risk and volatility for corporates, threatening the puzzlingly stellar performance of stocks.
CDX Investment Grade

Wednesday, July 18, 2007

AAA CDO's and Other Myths

(Special Intra-Day Post)

As trouble in the mortgage-backed securities market is deepening, the effects are suddenly widening out to the supposedly rock-solid A to AAA tranches. Readers who have been following this blog for a while are fully aware that the problems lie exactly with the tranche structure and the assumptions made to turn junk obligations into a AAA bonds. As they say, the truth always outs.. we should probably stop calling them CDO's and choose GIGO, instead (garbage in, garbage out).

Here are three eye-popping ABX charts from Markit, following the various tranches' CDS's.

First, the AAA tranche:
Next is the AA tranche:
And, finally, the A tranche:
Obviously the market is not waiting for the rating agencies to downgrade the referenced bonds from CDO to GIGO - it is doing it all by itself and in a huge hurry. Who was it that said the sub-prime problem is contained and will not affect other segments? Well, the market, that final arbiter of fact from fiction, is very clearly telling all concerned to quit fooling around with mythology and sauve qui peut.

And for what must be the Nth time, I will repeat: the next trouble spot will be on the "regular" CDS market connected with corporate bonds, which in turn is joined to the stockmarket and linked to the yen carry. And did you know that at least 60% of all CDS's are held or sold by hedge funds?

Le Bons Temps Roulent Pas

Seems some white shoe investment banks are suddenly not able to sell the junk bonds they so recently arranged for LBO's and have to keep them on their own books. This cuts into their profits big time, because investment banks do not have cheap sources of funding (i.e. deposits) and must continually "move the merchandise" to earn fees.

No more than 3 months ago private equity firm honchos boasted they could raise $100 billion with a snap of their fingers. No more, as the market for junk has turned sour with awesome speed (just look at ABX, CMBX and CDX). To add insult to injury, those self-same honchos are telling the bankers that holding on to unsold (and unsellable) merchandise is their problem, because that's what bankers are paid for: to assume risk.

Oh, my! How extremely wrong. I mean, really, really immensely wrong. In the eyes of the bankers, arranging deals and raking in fat fees has absolutely nothing to do with risk. It is all about stamping a deal with their version of the Good Housekeeping Seal of Approval (the usual tombstone reading "BullyBank acted as Lead Underwriter in this transaction"), for which they expect to get paid a bundle. A form of very polite extortion, really. Finding customers to buy the stuff? When les bons temps roulent such customers are supposedly the bankers' very own: cherished, pampered, wined-and-dined, gold dust-covered. But when the music stops, the bankers - to a man - yell at the issuer to go find his own god-damned buyers for the obviously crappy crap he wants to foist on the poor, poor public. And they get all huffy, incredulous and hoity-toity if you tell them it's their job, too: God forbid they should soil their hands with such base tasks. (Here's a trick to play on such an august person: call his firm "a broker" and watch as he turns blue and tries to murder you with his "if looks could kill" stare. I did it once and it cost me his business, but it was worth it. He was just an obnoxious piker in my market, anyway).

Hell hath no fury greater than a lead banker told by an issuer to "stuff it Webster, you own 'em now", when he demands a regular underwriting issue to be reduced in size a posteriori. Naturally, he's talking about the part still sitting in his books, screw everyone else. Bulging eyes, beet-red face, choking sounds as the banana-nut muffin misses the esophagus...

Seriously, though: failed offerings are always signs of a top and with good reason. Markets are all about the balance between supply and demand and such failed issues are the best proof of lack of demand.

Tuesday, July 17, 2007

The Wages of Sin...

... are pretty darn good, particularly if you are well connected.

Continuing from yesterday's post on manipulating markets, making very serious money in markets (measured in the 100's of millions) is neither for the faint, nor pure of heart. And don't let some paid mouthpiece fool you: every market is a zero sum game, in the short run. In the long run we are all dead and if I am to win you have to lose. Like I said of market adversaries a long time ago: "I want to make their children starve" (I beg forgiveness for such crassness, I was younger and much stupider once). Guess what? Turned out they also wanted to make my children to starve, so it all balanced out.

Playing by the rules is most certainly an admirable quality - if you are a man of the cloth. But if you want that cloth to come from Saville Row you better learn how to play dirty - or at the very least recognize that the dirtiest players are also the ones making up all the rules. Designed chiefly for their benefit, not yours. I have to laugh at the various regulations that exist in various exchanges around the world, designed solely to fleece the unaware: limit-up rules for stocks, shorting on a downtick, no position limits on futures, etc, etc. And how about closer to home? US authorities are fighting tooth and nail to limit hedge/private fund regulation and disclosure.

I have not met ONE person involved professionally in markets who has not bent the rules. Some do it a little, some do it a lot and some do not even recognize that rules apply to them at all. All everyone cares about is making as much money as possible, as quickly as possible. That's just the nature of the business... And those are the good guys. Because there are also some really, really good guys involved in markets. As in Goodfellas. At least the plain old "good" guys will not threaten to physically harm you - except if you are overly late with a margin call (just kidding).

Speaking of margin, there is an apocryphal story : a customer had a margin account and got hit with a margin call. He did not have the cash, but told the broker he would try to scrape it together. The first day he sent the broker $10.000 and the broker told him he had to try harder 'cause they would sell him out. The customer went about in a frenzy calling on every relative and acquaintance, raided the children's education fund and borrowed against his life policy. He got together another $10.000 and sent it on the second day. He had to come up with just another $1.000, but try as he might he could not get his hands on the money.

Despirited he finally called his broker on the third day: "That's it, you've had me. I can no longer meet the call - sell me out". You can imagine what the broker thought... Goes with: "one born every minute".

But since I mentioned "man of cloth", I also have a very true story to tell. Some years ago I baptised my daughter and met with the priest beforehand. We chit-chatted idly for a while as he obviously sized me up for possible donations to his church's needy fund. "What do you do for a living?", "oh, really?"... that sort of thing. He was one heck of a capable salesman and I found out later that while studying at the seminary he sold encyclopaedias door-to-door to make ends meet. He was top salesman in the whole region and when he left to become a priest his manager thought him a fool. (But the Divine had other plans, as it turned out many years later.)

Anyway, as soon as he found out I was professionally involved in markets he popped the usual question: "Where's the market going?"

"Father", I said, "why do you, a man of God, care where stocks are going?"

He smiled rather mischievously and revealed he had amassed over $1 million, starting with just $50.000, TWO YEARS ago. I was shocked, to say the least, and started thinking that I, too, should try prayer instead of analysis. He saw my amazement and fessed-up: two years before he had blessed the opening of a broker's new branch (can you imagine a temple to Mammon being blessed by the Church? This should tell you something...). The manager/owner of the firm (it was a small one) came to him after the ceremony and asked if he had any savings. He had truly taken a liking to him and wanted to help out. The priest trusted him blindly and - for once - it all worked out beautifully (this is where praying must have helped).

The broker was totally plugged in with the artificial rally I described yesterday and had the priest's account move in and out of every skanky deal, doubtlessly using it as a "front" account for various washes, etc. (what better front than a priest?). Bottom line is, the priest made a bundle out of other peoples' wages of sin. He must have eventually figured out that such riches were not normal and had the immense good sense to pull out just before it all went to pot.

So there he was, asking me if maybe he should push some money back into the game or just buy some real estate for his old age. I told him that he, of all people, should recognise a miracle when he sees one and not push expectations for divine intervention too far. He took my advice and bought a couple of apartments - I know because we stayed in touch through my annual donations to his church fund (I told you he was good!).

Monday, July 16, 2007

PPT - Fact or Fiction?

The current run-up in stocks has spurred much speculation about the actions of the so-called Plunge Protection Team (PPT), real or imagined.

As we all know, the US economy is now highly dependent on the smooth functioning of financial markets. Indeed, almost all markets have now become financial in nature as commodity, real estate prices and even pollution permit prices are set via derivatives and a tangled web of securitizations. Even "communist" China has become hooked on share speculation - an obviously oxymoronic situation.

Thus, the PPT has an increasingly important role to play: market movements are manifestations of fickle human psychology - a dangerous situation at all times and more so today, given the supreme importance of markets relative to the shrinking "real" economy. Confidence must be maintained at all times. What seems to be true is infinitely more important than what is true. Perception is reality, since most of us do not have the means or ability to independently verify what we are told is true.

There is a steady stream of negative developments coming from the US economy: real estate plunge, devastated manufacturing sector, rising costs for food and energy, weakening retail sales, negative saving rate, extreme household debt, zero growth in non-financial corporate profits. Even total after tax corporate profits, when financial firms' are included, are now rising just 7.5% y/y. This means that corporate profitability growth is very narrow and contained within just the financial sector, which is now also coming under pressure from the mortgage crisis and the widening of risk spreads.

US Non-financial corporate profits - Y/Y % change

Therefore, the run-up in share prices is indeed puzzling and so the "invisible hand of the market" is being suspected of belonging to the PPT and to be manipulative in the extreme. Can this be true? Would the government of a democratic country fully committed to the principles of free markets, manipulate share prices? And if so, how?

I will answer not with speculation, but fact. I have first-hand experience of how the democratically elected government of a western, free-market country (not the US) became in the past heavily and directly involved in market manipulation. It did so for two reasons:

a) It needed to claim the economy was vibrant in order to achieve several important milestones.
b) There were elections coming up.

But, for this discussion, what is most important is not the why, but the how.

This is how it was done:
  1. State-controlled banks and the mutual funds they sponsored bought heavily on the opening and closing of each trading day. They smashed bid-offer spreads by lifting all offers, causing shares to gap up. They did this almost exclusively with index-heavy issues.
  2. Ditto for state-controlled pension funds.
  3. Major speculators, though formally unconnected with the state, also saw the opportunity for quick gains and jumped on the bandwagon by heavily manipulating smaller issues. This broadened the artificial rally.
  4. Through friendly media, government and speculators embarked on a huge PR campaign of hot tips, innuendos and general market boosterism.
  5. Market regulators were encouraged to avert their gaze and shut up.
  6. The government publicly credited the rising market on its policies and predicted much higher levels after the elections - provided they won, of course.
  7. Anyone that questioned these practices was immediately branded an enemy of the Nation and the People. The main opposition party tried to object at first, but quickly shut up fearing losing votes from the "investing" public.
These actions were obvious, amateurish and crude - but, for a while, successful. The ruling party won the elections and met the milestones, even if it was all done by smoke and mirrors. Alas, what quickly followed was a relentless 3 1/2 year market drop that slashed 75% off the top.

Is something similar happening in the US today? I honestly don't know and if I did I certainly wouldn't say. One can, however, connect just the visible dots and come to some valuable conclusions.

Saturday, July 14, 2007

How Industrial Is Dow Jones Anyway?

It is common knowledge that the US has gutted its industrial base and now depends on inflating financial and real estate assets, borrowing against them and spending the proceeds on imported goods. As such, the Dow Jones "Industrials" is clearly a misnomer. But, how much of a misnomer?

To help answer this question, here is a chart tracking the ratio of Dow Jones Industrials Index to the Industrial Production Index.

No Dorothy, this most assuredly isn't Kansas anymore.

Friday, July 13, 2007

Purity In Charting

For those pure chartists amongst you (I am not, but frequently a picture is worth a lot more than babble), here is one to ponder: $TNX, the yield of 10-year Treasurys (click to enlarge). I have marked a couple of patterns that chartists will immediately recognize:
  1. An inverted head and shoulders that has already broken conclusively on the upside.
  2. A flag, trend- continuation, pattern.
The first "reads" to a yield of 5.40% (essentially already reached) and the second to 5.90%-6.0%.

OK, some more fun with this chart, from a longer perspective (click to enlarge).

Another couple of patterns being formed here, both of which are on the "cusp" of resolution, but have not yet confirmed:
  1. Another inverted H&S - reads to 8%
  2. A down trendline penetration - reads to 8.50%
It all boils down to this, IF you are a pure chartist: both short and long-term chart patterns are coming together to form a powerful technical picture, arguing for significantly higher long rates.

I'll shut up now and let the pictures talk.... OK, I can't resist just one comment: with all this debt sloshing around, money has got to get expensive at some point.

Thursday, July 12, 2007

Margin Debt

Today, one simple chart that mostly speaks for itself. Click to enlarge.

Two comments:
  1. It is apparent that the market's move up in the last 6-8 months has come on the heels of a vertical rise in margin.
  2. When margin increases vertically, as right now, the market becomes toppish and vulnerable to forced liquidations (margin selling).
Common sense? Of course...

P.S. Below is an updated version of the chart, current to May 2007 (latest data available from NYSE). In just one month margin debt jumped by $35 billion, or 11%. Vertical, indeed. I have also added an exponential trendline, for comparison.

Also, notice this interesting coincidence:
  • In the previous period of near vertical margin growth (Oct. 1998- March 2000 = 17 mos.) margin balances grew by 113%, or 80% annualized.
  • In this current run (Aug. 2006 - May 2007 = 9 mos.) margin balances grew by 56%, or 75% annualized. .. and we don't have the June data yet.
We all know what followed March 2000 and I think we are now experiencing the same sort of speculative frenzy, albeit with a different cast of characters.

P.P.S. The nature of the NYSE margin data is such that it portrays mostly retail and small money manager borrowing. Hedge funds and other large sophisticated speculators usually borrow from other sources (e.g. they use bank credit lines and trading limits).

Therefore, I must conclude from the above chart that the retail speculator is jumping back into action in a serious way. Just in time to take advantage of the serious underpricing in equities, eh?

Wednesday, July 11, 2007

Raindrops Keep Falling On My Head...

Once again... credit spreads are widening:

The CDX index tracking CDS's on junk bonds has reached 375 bp...

...and the one tracking investment grades to 47 bp.

In the greater scheme of things this is still a light shower, a pitter-patter of summertime raindrops on a tin roof. But it feels as if the barometer is dropping, too, so this may well be just the beginning of a major storm. Best to cover and ask questions later. Because if the raindrops turn into golf-ball sized hail, as often happens in the summer, those caught in the open will hate the title song forever...

P.S. I have rarely, if ever, commented on the performance of individual companies. Today will be an exception, given the news from Sears. I won't go into the whole story, just remember that it was taken over by K-Mart and chose to keep the historic Sears name. K-mart had just prior gone bust under allegations of management's misleading shareholders and gutting the company through loans, large bonuses, etc. It emerged from Chapter XI in 2003 and, through the magic of leverage took over Sears a year later. The stock went from $20 to $200 (give or take..) and everyone in the business turned green with envy. Ain't debt grand?

Until retail sales start notching down and the bank/bondholder/CDO-CDS holder demand their pound of flesh, regardless.

Look up the SHLD price chart and ponder if Fama's monkey is a good way to pick stocks...

Monday, July 9, 2007

Fama's Monkey

The random walk theory of equity prices (and everything else that trades in a so-called "efficient market") has been a perennial favorite of financial academics since it was pronounced by Eugene Fama in his doctoral dissertation in 1965. But it has also been the target of just about everyone else involved in markets. After all, how can you possibly justify mega-million bonuses if your job can be relegated to a monkey throwing darts at stock tables?

Despite reams of analytical data supporting Fama's theory during the last four decades, the finance industry has raked in trillions of dollars in research, management and performance fees. It seems thatit is not so difficult, after all, to continuously convince the gullible that the financial profession is always in possession of a better mousetrap. As for the suspicious, there is the ultimate weapon: no-load, low-fee index funds and other passive products: the industry's lucrative version of a (well-paid) monkey.

Despite the above, there are stellar exceptions to Fama's "you can't beat the averages" rule: Warren Buffet has been doing so consistently for nearly half a century. (Rumor has it that he is an alien in possession of time travel technology. I mean, c'mon... what sort of billionaire prefers Omaha over the Bahamas?) But, seriously, assuming that consistent market outperformers are not from a galaxy far, far away, how can their success be explained given Fama's theory?

As usual, the devil is in the fine print: Fama said that his theory holds for "...randomly selected securit(ies) of the same general riskiness". And within these last three words there is enough room to hold an ocean of water. When John Templeton was making a name for himself by investing in foreign and emerging markets, a Japanese automobile stock was considered so exotic as to constitute a whole different class of risk vs. GM. Likewise, when Buffet was buying small private companies at huge discounts to market multiples (See's Candy, anyone?), no one would include them with regular equities.

The secret of the game is to be early, patient and possess enough staying power so that properly selected "exotic" investments eventually become re-classified as "regular" risks and get re-priced accordingly (notice the word "properly": not applicable to monkeys). But this is a blog about the pernicious dangers of excessive debt - what is Fama and his monkey doing here? Hang on...

The connection between debt and risk assessment has always been there, of course. But until the emergence of Credit Default Swaps there were no pure-play instruments in existence to trade business risk (i.e. default risk). They were either connected to interest-rate risk (bonds) or equity market risk (stocks). The latent hunger for such pure plays was so huge that CDS's went from $1 trillion to $32.5 trillion in just 5 years. Now, that's what I call a growth business.

And this development, dear reader, has collapsed all risk categories into one: a bubbling stew of exotic and regular risks, all thrown together into the same pot. All of a sudden, a zero coupon bond issued by a private equity fund to finance the takeover of a listed company at 10+ times EBITDA is considered to be in the same general risk category as a bond issued by General Electric. Or, how about a synthetic CDO - a "bond" made up from CDS's? Or a curve steepener, a bet on the shape of the yield curve, also dressed up as a "bond"? All are considered bonds, so into the same pot they go. And since Fama's efficient markets are supposed to immediately and perfectly discount all available information, all that is needed is a monkey and a set of darts. Result? Down went all risk premiums, willy-nilly...

It gets more interesting: because of CDS's, the connection between credit instruments and equities has become very tight. It is a sort of self-perpetuating, self-reinforcing loop, with equity traders looking at CDS's for risk assessments and CDS traders looking at stock performance to price CDS's. As long as business prospects look bright the system keeps chugging upwards, pressuring risk premiums and volatilities to record lows. All are happy.

But it seems logical that when prospects dim, the process will work in reverse: we may experience a grinding, remorseless and long-lasting drop in financial asset prices as risk premiums and volatilities go higher, churning inside the loop. The current system is so new that it has never been tested during a bear cycle, so no one really knows what will happen.

Where does this leave us today? The defining characteristic of all markets right now is exactly that collapse of all risk premiums, i.e. the convergence of just about every investment instrument into one hyper-category, connected through the CDS market. In other words, Fama's monkey is throwing darts onto one huge board containing everything from Brazil ethanol producers and Zimbabwean gold miners, to US Treasurys and CDO bonds made up of Polish mortgages priced in yen. The proof lies in the way risk, volatility and equity markets now trade in tandem all over the world. Nothing seems to diverge - everything goes up or down together.

But, as the success of Buffet, Templeton et. al. make abundantly clear, the secret for superior investment returns is to predict which kinds of seemingly dissimilar risk categories are going to converge and be re-priced upwards - or seemingly similar ones diverge and be marked down. For example, back in 1999-2000 most dotcom stocks were not equities per se, but enormously overpriced lotto tickets. Once it was made clear, dotcoms got a massive haircut.

I believe the emergence of this global hyper-category of investment instruments is an important contrarian signal and we should be paying close attention for any signs of (a) its working in reverse and/or (b) sharp divergences within it.

Saturday, July 7, 2007

On the Beach

Given the overwhelming importance of CDS's to the current credit and equity markets, I think it useful to examine the relevant indexes (CDX) a bit more in depth.

The CDX.NA.IG index tracks CDS's for 125 investment grade bonds issued by North American corporations and it is followed closely by traders for indications of credit risk perceptions. But just how solid are the ratings of the underlying bonds? It turns out that on average this is essentially an index of BBB+ bonds, as the pie chart below shows. In years past such a rating would hardly be considered "real" investment grade, being just a couple of notches above junk. (I know of several pension funds that refused to buy bonds rated below AA; this is almost impossible right now, if any sort of name diversification is to be achieved.)

So, not only are investment-grade credit spreads abnormally low by historical standards (though rising during the past two weeks), they currently apply to bonds that barely qualify as investment-grade in the first place. This clearly poses a double potential risk for CDS prices, should business conditions weaken.

If this was storm insurance, it would be akin to setting premiums to rock bottom prices, even for houses located in the second row from the beach. Why? Because there hasn't been a storm in several years and underwriters are greedy. Or, think about it in cinematic terms, as the title implies...

Friday, July 6, 2007

Is The Tide Turning?

The first half of 2007 saw a record $1 trillion in junk bond issuance (up 70% from last year), almost all of it going to finance massive LBO's by private equity firms. As the envelope was stretched, more shaky deals made it through until such old stand-by's like PIK bonds (payment in kind, i.e. interest is paid in more bonds, not cash), zero coupons and toggles had to be used to make the deals possible. And then something snapped - as it always does.

A combination of sharply higher interest rates for long Treasurys, a junk mortgage bond meltdown and a slowdown in the US economy is finally pushing on the breaks from the demand side. And not a moment too soon: almost 27% of all new bonds issued were rated CCC, really malodorous junk. In my experience, such highly risky paper almost always runs into serious trouble - and rather sooner than later.

But where was all this demand for junk coming from, at least until recently? Desperate pension fund managers? Greedy 2/20 hedge fund managers? Colluding foreign central banks? Yes, to an extent... But the real boost has come from CLO's, structured finance's equivalent to CDO's for corporate junk, complete with heroic default assumptions, the usual tranche structure and the ultimate transformation of lead into gold by teams of apprentices sorciers. Oh yes, the usual game of turning CCC junk into AAA bonds... and the rest was easy, as we all know by now.

As I wrote in the previous post on CDS's, the tide now appears to be turning. During the past two weeks buyers are less willing to buy junk, driving risk premiums higher. The CDX index tracking high yield bonds with an average B rating has gone from a spread of 250 b.p. to 325 b.p. - a very large move in such a short time. Several deals were altered, re-priced, postponed or cancelled altogether. I am convinced that we have seen the high water mark for high-yield finance, at least for this economic cycle.

What comes next? The buy-out premiums for stocks should narrow significantly, since takeovers and LBO's are now harder to finance. The significance for equities, worldwide, is obvious.

Have a very nice week-end.

Thursday, July 5, 2007

The Coming Demise of Growth Economics

"Growth is the Holy Grail of Economics."

I will let that statement stand on its own. I am certain that informed readers need no elaboration, with the proviso that I am referring to the last 150 years, or so.

Economic growth (positive or negative) is simply a measure of the rate of change in human activity and thus directly related to global population growth. So, here is a simple population chart with decennial population growth rates (click to enlarge).

Data: UN

We immediately understand why we chose "growth" to describe economic activity in the 20th Century: human population has been rising fast. The peak decade of 1960's even saw population rise by an astonishing 22% - the Baby Boom. More mouths to feed, more clothes, more of everything - "Growth", made entirely possible by cheap and abundant fossil fuels.

But this is not a posting about Peak Oil, though it is obviously of overwhelming relevance. Rather, I am making a more basic observation: if the UN's population projections prove accurate, in the next few decades we will witness a fundamental growth slowdown, simply because global population will rise at a much slower rate. Indeed, by 2040 global population will be growing at almost half the rate it grew between 1800 and 1850.

Certainly, one could argue that higher economic activity could be sustained by making fewer people work harder, but this is an apparent oxymoron. Work harder for what? If the number of consumers is not rising fast enough to use the goods and services of this more productive labor, there will simply be no sense in doing so. High productivity is a boon when the number of potential buyers is rising fast, but a curse when it is not.

What I am trying to say is that we should all start thinking hard about what is inexorably coming down the road. Population dynamics is like a steamroller: slow and deliberate, but also possessing immense inertial force. Pension funds, who by nature are forced to think long-term, are sweating bullets about covering retiree benefits and are already going out on a limb in their risk/reward profiles, investing in hedge and private equity funds, CDO's of sub-prime mortgages, structured finance bonds, etc. But it is a fool's errand, of course. They may patch things up for a short while, but the steamroller will eventually first reach and crush exactly those portfolio holdings that depend on consistent growth: equities and residential real estate.

If anyone thinks 2040 is too far away to worry about, just ponder this: it is as far in the future as the US Bi-Centennial celebrations are in the past. I bet lots of you clearly remember 1976 and Jimmy Carter getting elected President. Or, for those younger and just starting their families: a girl born in the US today will have another 50 years to live by 2040.

Bottom line: Growth economics is going to get crushed by the population steamroller, even if we avoid resource crises and environmental disasters. What's next? I think we need a whole new paradigm. Medieval Economics, anyone?

P.S. A comment by a reader (thks miju) prompted me to include a chart of the regional breakdown of population projections, also by the UN (click to enlarge).

Contrary to popular wisdom and based on population dynamics alone, Asia may be the worst place to invest, given that it will be the region with the fastest drop in population growth rates.

Wednesday, July 4, 2007

Gorillas In Our Midst

While the Debt Bubble was getting pricked here and there for several months (sub-prime, commercial real estate loans), I patiently awaited the next shoe to drop: Credit Default Swaps on corporate bonds. As I have written ad nauseam in this blog, within "modern" finance CDS's are the equivalent of a 3-ton gorilla raging inside a rather shoddy cage.

It is my firmly held belief that the explosion of CDS trading since 2000 was responsible for pushing long-term rates lower, even as the Fed kept raising short rates. In simple terms, risk premiums collapsed and produced what Greenspan termed "a conundrum" just before he left the Fed. This development produced truly monumental effects: it created the ocean of cheap liquidity that sloshed from Shanghai to Brazil and lubricated the dealings of thousands of hedge and private equity funds, pushing asset prices higher. But if this faux-bijoux liquidity (cheap & ugly) is taken away, the ocean will turn into a mudhole.

Indeed, this may be happening right now: CDS spreads are rising fast, as can be seen from the various CDX indexes that track them. Investment grade CDS's have jumped 10 basis points and high yield (i.e. junk) almost 90 b.p.

CDX-US Investment GradeCDX - US High Yield

CDS premiums are an excellent indication of effective interest rate spreads, i.e. what businesses and other non-government borrowers have to pay to finance their operations, from making mouthwash to placing multi-billion takeover bids. And the sheer size of the CDS market ($34 trillion at the end of 2006) is such that its effects cannot be ignored or be swept under the carpet, as was attempted with the sub-prime mortgages a few months ago.

Market "visitors" are therefore warned to quickly leave the grounds and let the attendant "pros" deal with the gorilla. After all, it was the latter that brought him in: I am reminded of the scene from King Kong where the beast is being exhibited to New York's tuxedoed and frocked social elite, chained on a Broadway theater stage. In this most American of films, the chains proved flimsy and the gawkers got the equivalent of a sharp lesson on the dangerous effects of low risk premiums.

Enjoy the fireworks!

Tuesday, July 3, 2007

The Ratings Game

The bond rating agencies are taking a lot of heat lately because of their unwillingness to downgrade various mortgage-backed bonds whose collateral is clearly in distress as delinquencies and foreclosures climb to 10-year highs. Various money managers, bond traders, et. al. are blaming them for not taking more decisive action. Sadly, however, this is yet another instance of lack of understanding of how the system really works: rating agencies are not in the prediction business. They analyse the here and now and thus their ratings actually reflect the past since financial statements, defaults, etc. are historical data. At the top of the economic cycle everything is firm: defaults are low, collateral prices are rising and thus a high percentage of loans go into the AAA tranches. That and the explosion in derivatives trading created the massive structured finance sector.

So what are rating agencies doing now as things are softening? They are sitting on their hands and waiting. The whole mortgage default process, from late payment to foreclosure and final sale at auction takes many months - almost a year. There is no way for the rating agencies to predict what the bond holders will recoup in the form of sale proceeds, i.e. how adequate the collateral is and therefore what the new ratings of the various CDO tranches should be, particularly within the "cascade" structure all of them use. Over the next 6+ months there will be a full set of historical data and the rating agencies will act.

Knowledgeable finance professionals have long been aware of the lagging nature of bond ratings, particularly when it involves securitizations of various loan obligations. We can all argue that rating agencies "should know better", but in truth that's not their role in the game. It is the various money managers who buy the stuff that are supposed to be able to interpret a particular rating as being ex post facto, rather than containing firm evidence of financial strength.

But in this era of waning pension fund contributions, higher life expectancies and zooming medical costs, what is a money manager to do to get an extra 10 basis points and still maintain the minimum required average rating for his/her portfolio? Holding his nose firmly closed (some even shut their eyes...) he buys the stuff and prays.

Bottom line: yes, rating agencies are complicit in this developing MBS mess - but only to the extent that they did not alter their usual practice, developed over decades of professional experience. Their "crime" is more one of omission rather than commission. For real "perps" we should be looking elsewhere - but this is a subject for another post.

Monday, July 2, 2007

A Bear Bit Them

Troubles are back in CDO-land and the various indexes tracking credit default swaps for mortgage securities are all making fresh new lows. You can follow all the charts at Markit - here are just a few.

This one tracks residential mortgages, the tranches with BBB- ratings. Collapse is a fair description.
But the better quality A rated stuff is taking it on the chin, too.
Things are not much better on the commercial mortgage side.

These charts are inverted because they track yield spreads, so the higher they go the worse things are. Merely for comparison purposes I have included charts for the same ratings as above.
The reasons for this new debacle are easily found by reading the financial press. A certain investment bank, highly involved in the issuance and trading of mortgage-backed securities, is presently living up to the first part of its name.