Friday, August 31, 2007

The Dow(n) Homes Index

Fact: A house is no longer a home; it has become a financial asset with windows.

Through the ceaseless efforts of financial engineers houses have been transformed into assets - financial assets. In this blog I have written numerous times how a simple mortgage spawned a series of related financial instruments, from simple CMOs all the way to synthetic CDOs, CDO cubed, or even CPDOs. One single mortgage could insinuate itself into literally dozens of such financial constructs, particularly through the widespread use of CDSs. What's more, homeowners frequently used their house as security for home equity loans, which are nothing more than speculative home margin loans. In other words, we have turned the previously conservative housing market into a volatile financial market. Thus the title of this post, a la Dow Jones.

PIMCO's Bill Gross is now frightened of the possibility that house prices will decline by as much as 10%, if the government doesn't step in to bail out homeowners (and bondholders, of course).

But now that we have turned housing into finance, complete with securities, derivatives, leveraged plays and rampant speculation, is there a realistic way to stop the Dow(n) Homes Index from heading...down? In my opinion, no. The process of assetizing, financializing and margining houses is so far advanced that the decline will only stop when housing once again reflects its fundamental value, i.e. when homes are valued as secure places to live and raise families for a long time, as opposed to volatile trading and collateral "sardines". This means that a buyer has to have something like 20% down and obtain long-term predictable financing that requires a reasonable portion of his/her disposable income.

Houses ARE assets; but they are long-term, non-fungible physical assets belonging to one or two individuals that need them to fulfill their most basic human need of shelter. They cannot realistically be used as collateral backing super-complicated, volatile market instruments that go up and down with "the market". Square pegs don't fit inside round holes, no matter how fine you slice and dice them - they are always square.

Meanwhile, despite all the hubbub about the Discount window, accepting ABCP as collateral, providing $25 billion loan exceptions for banks with brokerage subs, etc., it has all had zero effect on the ABS market. As one can see from the ABX and CDX charts below, CDS spreads (i.e. measures of credit risk) are still very high. Given the stockmarket's furious bounce up (another supposed measure of risk) we are currently getting curiously mixed signals. (Arbi, anyone?).
ABX HE BBB- 2007-1

CDX Investment Grade

Can anyone provide an explanation why stocks are signaling "all clear" while CDSs keep yelling "duck and cover"? Is it perhaps because the Dow Jones is followed by 300 million Americans who are suddenly clutching their pocketbooks closer to their chests, while CDS's are followed and traded by only a few thousand professionals?

And something else... I have started following weekly jobless claims as a gauge of what is happening to the "real" economy. The latest figure was announced a couple of days ago and it was significantly higher than expectations (334.000 vs. 320.000) but no one spoke about it. Notice how the latest data from BLS show 5 weeks in a row with higher claims.

Weekly Jobless Claims (from BLS)

FHA To The Rescue?

The White House has officially leaked some elements of what President Bush will announce later today about providing relief to delinquent mortgage borrowers. According to the NYT the FHA will provide its guarantee for an additional 80.000 low-income borrowers, beyond the 160.000 normally expected to use its insurance this year. If I understand it correctly, the plan will allow low-income borrowers who are 90 days past due on their payments to use the FHA's guarantee to obtain better financing terms. They would normally be precluded from doing so, because of their delinquency. However, I note that there are limits to the mortgage amount the FHA will accept: right now the basic standard limit for one family homes is $200.160 and $362.790 for high cost areas.

Secondly, the President plans to "jawbone" lenders into not foreclosing. Given the securitized nature of many, if not most, mortgage loans this will be a challenge. It is one thing to pressure a single banker into granting relief, quite another to get tens of thousands of bondholders dispersed all over the world to agree. If the administration attempts to squeeze the trustees of the various CDO's, CMO's, etc. it will run into the wall of their fiduciary obligations to their bondholders, i.e. if they agree to provide relief without the bondholders' consent they will be legally liable for damages.

This is my first impression, we have to wait for the official announcement.

Thursday, August 30, 2007

East For Income, West For Wealth (and Dow 100.000)

Fed Chairman Bernanke just re-iterated that the Fed is "prepared to act" and urged Fannie Mae and Freddie Mac to step in and help resolve the mortgage difficulties "if able". All these stern words of market succor while S&P 500 is a mere 6% off its all time highs and after being up an almost uninterrupted 100% in the past 5 years. Why? Is the Federal Reserve now a Guardian of The Dow, as well as the sleepless watchdog of US commercial banking?

In a word, yes. This what the once proud institution has succumbed to: being a carnival barker for the hedge fund and private equity interests that now dominate markets, not only in the US but the whole world. But, once again, why? Because asset prices, shares in particular, are now the "be all" and "end all" of the global economy. Income generation as a way to prosperity has been savaged in the West by the pittance wages of the 1.2 billion Chinese ex-peasants, not to mention the mere hundreds of millions of other assorted Asians and near Asians. And let's not forget another 1 billion Indians...

The die has been cast: The Economy of The East is based on labor income and The Economy of The West is asset wealth. And just as it was unthinkable in years past for incomes to go down in any given year, it is now absolute anathema for asset prices to drop. It is not only a reason of national importance, but of global balance: we in the West buy lots of their cheap goods, they buy our expensive assets. This is a balance resting on the knife edge of market performance, a global financial accord that is rapidly overtaking entrenched perceptions established decades ago in Bretton Woods.

How is it maintained? By a series of algorithms that are pushed, stretched and if need be kicked into constantly spewing out buy orders for all manner of securities, regardless of fundamentals and it all boils down to one simple parameter: momentum. Buy because the market is up and going higher, period. All the rest is fancy footwork pour epater les bourgeois. Roughly eighty percent of all transactions in US equities are now done by hedge funds, 15 percent by other institutions and a minute 5% by individuals. The name "hedge fund" has long become an oxymoron because they no longer "hedge" anything and they merely follow the latest fashion in trading, which right now is "quantitative strategies". There are exceptions, of course, but the great majority just follow the exact same fake rabbit around the dog track.

It all became exceedingly clear in the recent market drop, when hedge funds reported incredible losses (some lost 30% in one month), from a mere correction, however sudden. Everyone was on the same side: long risk, short volatility, short yen and all leveraged to the maximum.

So the Fed promptly pushed the "panic" button, though it did not wish to appear doing so. First it cut the Discount Rate to show resolve and then (very, very quietly) permitted the large banks with brokerage subs (Citi, JP Morgan, et al) to lend an astonishing $25 billion each of what is clearly depositor money to their said subsidiaries, so that they could in turn provide it to their customers in trouble (i.e. hedge funds). Not only that, but as we have already seen, those "customers" were often nothing more than in-house hedge funds and SIV's.

Does anyone recall that this is exactly how large banks got into the deepest possible trouble in 1929? They kept lending depositor funds to the broker call loan market (i.e. margin), which then simply evaporated within two days. Just like today's margin loans, ABCP's, the yen carry and all other types of financial leverage bets, they did it because the rates were higher than regular loans and could be demanded back within a day or two. Safe until proven poisonous.

Mr. Bernanke surely knows all this - he is, after all, a professor who has written two books on the subject of Fed operations during that period. He is apparently resolved that unlike 1929 no "liquidity need" shall go unmet on his watch to cause anything approaching a significant correction, no matter what the eventual consequences. And what may those consequences be?

Well, if Ben's Balloon Emporium keeps pumping more and more helium into the market it will certainly levitate. And there will be no ill effects, save perhaps a shrilly voice from gulping too much He, because...let's see... if each Chinee were to buy just $10.000 worth of US stocks...(gulp, gulp) by golly mate, that's twelvvve treeeellion dzollarz worth! And why stop there? The oil sheikhdoms are good for another 10 trillion, at least, and then you have the Indians and the Russians (gulp, gulp) - holy cow, Dow 100.000 heeeere vve come!

Wednesday, August 29, 2007

Inflate Incomes, Deflate Assets

Ever since the Great Depression the worst nightmare of all Fed and Treasury officials has been the prospect of deflation gripping the US economy. This fear was the driving force behind Mr. Greenspan's decision to lower rates post the dotcom crash and with even greater urgency after 9/11. The system was flooded with cheap dollars and the ghost of deflation past was exorcised - at least for a while.

The consequence of this largesse was the greatest leap in debt creation and credit-related derivative finance ever seen in history. Real estate and financial assets immediately benefited and leaped to all time highs, not only in the United States but all over the world. Bubbles were created in London, Marbella, Shanghai, Las Vegas, Moscow, Dubai, Mumbai - and all points between. I believe I am not exaggerating when I say that the credit-asset bubble is now much bigger and has greater global reach than the dotcom one.

It is also much more dangerous, because it involves the very core of the world's financial system: credit and asset instruments denominated in US dollars, the de facto global reserve and transaction instruments. US Treasurys are the most widely circulated debt and dollars are used to price everything from crude oil and natural gas to copper, scrap iron and sugar - plus the shipping rates to transport them. "Dollar Hegemony" is not a rhetorical expression but a fact that translates into matchless global power. If the dollar were to be debased, or otherwise overthrown from its position of dominance, it would carry with it the larger part of America's power and supremacy.

With this introduction, we now turn to the present, i.e. the credit contraction and asset deflation currently in progress. The debate as to what is likely to occur as a consequence in the near to medium future is delimited by two extreme positions: "super-inflationism" and "super-deflationism". The former is closely related to devotees of gold as a storehouse of value (a.k.a. gold bugs) and the latter is often associated with survivalists, autonomists, Die-Off theorists and the like. There are many positions in between, the two most common being stagflationism and navel-gazing market Nirvanism (all will be well if we just let Mother Market take care of things).

My opinion (which will buy you nothing, unless you also have a one euro coin, in which case you can knock down an espresso in Rome) is that hyperinflation is out of the question, at least to the very considerable degree that monetary and fiscal policy can influence matters. I am certain that no President, Treasury Secretary or Fed Chairman will knowingly and willingly sacrifice the dollar's standing as global reserve currency in order to gain temporary relief for highly leveraged speculators. Officials will certainly provide assistance so that the transition to lower asset valuations is accomplished in as orderly a manner as possible, but there will be no massive monetary bailout. The Fed, at least, has already signaled its intentions along these lines and - significantly - so have the ECB, BOJ and PBoC.

Instead, I believe, we have already entered a period of drawn-out asset deflation which will last as long as it takes to reduce the massive debt accumulated over the past decade and repair the damaged balance sheets and income statements of households. The personal saving rate (the percentage of income that remains after expenditures) will need to rise substantially above zero, by a combination of lower consumption plus higher wage and salary income. This will pressure corporate profits, which, however, are at record levels as a percentage of GDP and can be reduced with little damage to the overall economy. Overstretched speculators will suffer, but that is part of the de-leveraging process.

The bottom line is that we should follow a process that gradually repairs middle America's finances, with the objective of achieving a three-way stability between incomes, debt and asset valuations. If we do not we may end up at one of the extremes described before, which will be a real disaster.

Monday, August 27, 2007

Home Depot Goes To The Movies

When the credit squeeze started to become obvious several weeks ago, one of the first things I said was that pending LBO deals would be canceled, delayed or re-negotiated. One of the largest was the sale of Home Depot's construction supply unit to a private equity consortium; it originally carried a price tag of $10.3 billion.

This deal has now been re-negotiated down 18% to $8.5 billion, plus Home Depot itself is participating in the financing of the deal with $1 billion. Therefore, on a net cash basis, the price is really $7.5 billion, or 27% lower than what was originally agreed upon on June 19, just two months ago. There are approx. $400 billion of similar deals in the pipeline and as the NYT commented in a very interesting article:

The stock prices of companies involved in other pending buyouts are near their deal prices, suggesting that investors expect them to be completed as originally agreed upon. However, when one participant in the Home Depot battle was asked what would happen to the next series of deals, he said: “Study what just happened here. You’ll see this movie again soon.” (bold added)

This is a "real economy" development in the credit market with pretty obvious consequences for asset valuations - in this case stocks and LBO debt, which is no longer available "at the snap of my fingers". And keep in mind that the people involved were the creme de la creme of the PE/LBO business: Carlyle, Bain and Clayton Dubilier. If the banks had to strong-armed them, what are they going to do to the B-team?

P.S. The effective Fed Funds rate is currently much lower than the target set by the Fed (5.25%), as can be seen from the chart below (click to enlarge). This is the rate at which large banks lend one another O/N money in the interbank market.

One observation: The drop in effective Fed Funds below target does not mean that everyone's borrowing costs are now lower - far from it. It actually signals that credit is getting much tighter, or even completely unavailable, for those borrowers that are suddenly being re-classified as risky. This results in large money center banks finding themselves with excess cash that was previously loaned out to the now riskier credits - and nothing to do with it. Therefore, rates go down. Not a good sign...

Saturday, August 25, 2007

The Inflated Asset Economy

They say a picture is worth a thousand words and I agree, so here is a post of a few thousand. The focus is on how the US economy was transformed over the decades from an industrial economy to virtual reality one, based on assets and debt. Sadly, it doesn't require too many "pictures".

  • The Demise of The Industrial Economy
The demise of manufacturing has been spectacular, both as a percentage of GDP and jobs.. This is what we really mean when we say "globalization".

What about the service economy? Great, as long as we also keep the industrial base intact, not out of some sentimental reasons but because it is the creator of technology upon which we all depend.
  • The Rise of Assets and Debt
Making things as a way of adding value to the economy has been replaced by pumping up financial and real estate assets and borrowing against them, in order to replace income that has been lost from de-industrialization. Look at the way household debt has zoomed versus income - a double in 15 years.

*Total financial assets minus deposits and un-incorporated business equity

It does not take a rocket scientist to figure out that what is happening is dangerous. How is all this debt going to be serviced? So far we are doing it by issuing even more debt, purchased essentially by China, Russia and the Oil Cartel. I don't think they will keep the pyramid scheme going for too much longer and a global superpower cannot and should not depend on the lending practices of others.

Friday, August 24, 2007

"Get 'Em While You Can"

I spoke to a dealer who is on the front lines of equity derivatives trading yesterday and the very first thing he told me was that everyone now thinks markets are going to rush to new all-time highs, so the battle cry is "buy before it's too late". Pundits are already suggesting that smart money should get right back into the yen carry game, embrace risk, etc. Oh my, how quickly panic is transformed into greed... This vertiginous emotional roller-coaster is well known to yours truly, having observed it amongst speculators many a time.

Managing the rebound after a plunge like the recent one takes significant skill in market-making, particularly in dealing with the real money sell orders that come in mixed with the hot money buys. The skill consists of downplaying the importance of the sell orders in relation to the buys when arriving at the prices that cross the tape. It is not easy, but market makers are helped by the fact that real money investors usually place "limit" orders, whereas hot money always goes for "at market". The trick is to slowly work the "limit" sell orders, executing them against carefully controlled bids, while causing the "market" orders to be executed at once - as requested - but at ask prices that are immediately widened out. In this way prices jump more than the balance of buy-sell orders would suggest and specialists and market makers can usually recoup what they lost on the way down. Everyone is satisfied, except for the "market" buyers who see their fills come in higher than they expected. But they are usually so hot under the collar, they are still happy. (There always has to be a "sucker" in a "sucker rally", no?)

I vividly remember my first encounter with a NYSE specialist (the important members on the floor posts who make markets in stocks). The firm I worked for at the time had brought him in for one of our formal training sessions. He was impeccably dressed and groomed and while the head of training introduced him and explained his function on the floor as part antagonistic, part helpful to our customers' and firm's interests, he stood with his hands clasped and calmly scanned the audience. When the introduction was over he cracked a wide smile and let four Dracula teeth show through his grin - everyone burst out laughing and the point was well made: his function was to make a profit for himself, first and foremost.

He proceeded to hold a short simulation of how order execution takes place on the NYSE floor, with our hapless selves as floor brokers for our firm instructed to execute various market, limit, stop, etc. orders and himself in his usual role of specialist. We got.. whomped, to put it mildly. It was a very worthwhile initial lesson in how markets really work. There have been many more lessons since - I taught some of them myself.

Anyhow, what I am trying to say is be extra careful of wide price swings. "Real money" pros don't crash headlong through an ice cream parlor window, if all they want is a second scoop of vanilla. When the store is being trashed by a bunch of hungry yahoos, they are perfectly content to step out and wait until they all go away. The result of real money pulling sharply back can be best observed in the primary market, i.e. the issuance of new securities, which has now slowed down dramatically. Various announced but unfunded LBO deals can't sell bonds and plans from private equity funds to go public are being "delayed".

Finally, how about a top Swiss banker as commentator? Jean-Pierre Roth, the head of the Swiss National Bank (the country's central bank) had this to say: "We're certainly not at the end of the story. There are question marks surrounding the development of the American economy. Something unbelievable happened. People who had neither income nor capital got credit with very attractive conditions. Now reality is striking back".

Thursday, August 23, 2007

Of Parties and Shotgun Weddings

The top four US banks tapped the Fed's Discount window yesterday for $500 million each (what a coincidence, each wanted exactly the same amount!). In fact, the banks had absolutely no desire to borrow, so Citi, BofA, JPMorgan and Wachovia were frog marched to the window and told in no uncertain terms by Bernanke and Dodd to borrow on behalf of their customers facing insolvency, or else. The banks did the absolute minimum they could get away with and took their leave, saying the will come back...soon.

The Discount Window is open to banks, but the credit and liquidity problems currently reside mostly with their leveraged customers (mortgage originators, hedge funds, etc). The banks are supposed to take their customers' collateral (loans, ABS, CDO's, etc.) and back-to-back it with the Fed, thus becoming a "liquidity intermediary", since the Fed cannot deal directly with such riff-raff. In money broking this is called a "switch".

Problem is, the customers could decide (or be forced) to default on the bank loans, sticking them with the obligation to repay the Fed and to keep the collateral in exchange. But who wants that collateral...

The whole show was intended to exhibit the smooth co-operation between government, banks and the liquidity-challenged, but ended up looking like throwing a party where one showed up, forcing the organizers to rustle up four gents in rented tuxes to pose for the society photographers and make comments, like: "We are ever so pleased to be here, at such a wonderful bash. Oh, quick everyone, look over there - is that Clint Eastwood I spot over by the exit? Let me go and see..."

When I first commented on the Discount rate cut a few days ago, I pointed out that only around $200 million were outstanding on average, thus the rate cut was meaningless unless the amounts started going much higher, allowing the money to reach those that needed it. A couple of days passed and the big banks were not willing to do the necessary "switches", so phone calls were made, arms were twisted and...presto, the tuxes were rented. But $2 billion is a drop in the bucket, so we shall see what ensues.

More interesting as a move was BofA's decision yesterday to buy $2 billion worth of Countrywide convertible preferred shares with a yield of 7.25%, potentially giving them a 16% interest in the company, if/when they exercise the conversion. To accept such a lopsided deal, Countrywide must have been on the verge of drowning and desperate for a life preserver. The conversion price is set at $18/share, much below yesterday's closing level ($21.80). BofA said, with a straight face I presume, that the transaction would be immediately additive to earnings (no kidding, really?). Talk about shotgun weddings...

Wednesday, August 22, 2007

A Crisis Of Confidence, Or A, B, C ?

Some analysts think that the current credit crisis is not much more than a tempest in a teapot - a large teapot, to be sure, but a teapot nonetheless. They call it a "crisis of confidence", as if all that is missing to make things right is the belief that it will be all right, i.e. the financial engineer's version of "all you have to fear is fear itself". This type of crisis may be a step up in urgency from "a simple re-pricing of risk", as Mr. Secretary Paulson so cleverly undersates it, but the warning light is supposedly still a pale yellow.

Overlooking for a moment the simple fact that our credit and asset economy is by definition based on confidence and that such a crisis is therefore nothing to sneeze at, let's observe some other hard facts to dispel the notion of "just a confidence crisis", a wording that implies that all is taking place inside the cerebellums of panicky speculators and can thus be promptly cured by swallowing a Blue Pill of Confidence, also known as Ben & Hankie's Market Virility Enhancer.

Fact A - Record Total Debt

The total amount of debt in the US has reached $46 trillion dollars, or 338% of GDP - an all time record. Choosing 10% as a semi-arbitrary percentage for annual debt service (interest and principal), we see that it translates into 34% of GDP. This huge amount clearly cannot be met from the "income statement" side of the economy and goes straight to the "balance sheet". This means that debt has reached an exponential growth phase connected with pyramiding, or servicing debt by issuing more debt. Some call this a Ponzi scheme and as with all cons, confidence is, indeed, crucial.

Fact B - Record Debt in The Financial Sector

One third of that total debt, or 110% of GDP, is now debt of the financial sector, up from just 60% 10 years ago. Regular corporate debt has remained steady at ~40% for decades (see previous post of August 18), implying the rapid leveraging of the US economy is channeled towards the purchase of "assets" and the consumption of "services" and imported goods. To put it simply, America has borrowed to its eyes to buy suburban homes and all kinds of financial assets, watch movies and buy imported goods. (A book on the current US economy could be titled "We Also Make Planes").

Fact C - The Fall of Assets

Asset prices are dropping because irrational over-valuation is evaporating, not because some fund manager is lacking the proper levels of testosterone to buy them. For example, real estate prices got way out of hand when speculators jumped in and created the well-known bubble. We can observe the results in the Census data relating to vacant non-seasonal houses that are for-sale-only: in 2Q2007 such vacancies rose to a record 15.6% (see chart below, click to enlarge). Naturally, mortgages packaged into CDO's and other financially engineered permutations are also getting into trouble - not because of some nebulous lack of confidence, but because borrowers can't service the debt and can't sell the houses, either. RealtyTrac just announced that foreclosures jumped 93% from last year.

Data: US Census Bureau

However, there is an instance where "lack of confidence" is the appropriate term to use, if somewhat mild for what is actually happening: today, Standard and Poor's downgraded the ratings of two mortgage-related funds from AAA to CCC and may cut them further, as they said. If you count the downgrade steps, those are 17 degrees of separation between prince and pauper and they happened in one go. Yes, I would call that a lack of confidence. In spades.

Tuesday, August 21, 2007

Bank Runs - 21st Century Style

Forget the images of anxious depositors toting well-worn passbooks, thronging outside Local Savings and Loan to withdraw their hard-earned savings. Today's bank runs happen "upstairs" and in a very different way - but they are runs, nevertheless. Keep in mind what I had stressed in previous posts, namely that banking is no longer what it used to be: loans are packaged and securitized, then sold to speculators and investors who are the ultimate lenders, i.e. those hapless depositors have been replaced by hapless investors/speculators.

Here is what is happening, right now: a bank/broker/fund had the bright idea of setting up a special investment vehicle (SIV) to own CDO's, CLO's, etc., securities that had been created by putting together a bunch of mortgages, commercial loans, or hybrids thereoff. To further enhance the yield (and fees) they leveraged those holdings by borrowing short term money from the money market via commercial paper, for which they pledged those CDO, CLO, etc. assets as collateral, creating what is known as asset-backed commercial paper (ABCP). Many of those SIV's took the form of special purpose hedge funds and were sold to pension funds, individual investors - and other banks. An incredible $1.1 trillion, or 50% of all commercial paper now in circulation, is ABCP and about half of it ($550 billion) is coming due within the next 90 days.

The problem is that ABCP buyers have now gone on a strike, refusing to roll over purchases of anything that is tinged with "asset backed" - even if the mortgages and loans backing it are still performing well. Despite ABCP yields rising to 6.03%, short term investors are shunning them and turning to the safety of T-bills instead, driving 3m bill yields down to 3.20%! This leaves all those SIV's with two choices: temporarily find alternative sources of funding, or immediately sell large portions of their CDO's, CLO's and other assets. Alternative funding, if available, will likely come from vulture funds: it will be small in size, very short-term and very expensive, i.e. nothing more than a band-aid. The SIV's can't afford negative carry for long, i.e. they can't pay more for funding than the return on their portfolio. So, unless the underlying market for their assets and their ABCP's quickly normalizes, the SIV's will have to sell and do so very soon.

Naturally, the question is, why are ABCP buyers refusing to roll over their purchases? Is it just a case of temporary panic which will soon blow over, or are their concerns well founded? The buyers are amongst the largest and most sophisticated institutional investors (money funds, insurance companies, other banks), so they must have made their determination based mostly on facts rather than sentiment. And the facts are that most of this ABCP is just another form of margin debt, used to leverage the purchases of structured finance assets by the SIV's. Once the bull market for those assets is over (as it is clearly the case now), it is only natural that margin lenders will immediately pull their lines. This is not panic - it is a rational business decision.

So, this is what part of a modern "run" looks like in the 21st Century: not a demand for deposited cash, but a refusal to roll over ABCP's as they expire. But the net effect is the same as a "regular" bank run, except there is no George Bailey to rally the people.

P.S. Is it a coincidence that so much sub-prime and structured finance trouble seems to be concentrated at smallish European banks, particularly semi-state controlled ones? No coincidence, oh no, not at all. I could write a whole post on this subject but...I won't. Suffice it to say that many such out of the way banks bought huge amts. of US structured finance products (relative to their size), not out of deeply held convictions about their investment merits. There were other, much more..ah, how should I put this in an elegant way... mundane reasons. Like yachts, vacation homes, brown envelopes, offshore accounts...

Oh .. and government controlled pension funds, too. Just wait.

Sunday, August 19, 2007

Discount Rate Cut - So What?

The Fed cut its discount rate last week by 50 basis points (0.50%). Excuse my French, but... whoop-de-doo. For years now the Fed has been averaging around $200 million (that's "m" not "b") in very short term loans to banks, mostly O/N liquidity (see chart below, click to enlarge). The spike you see came right after 9/11 and was completely justified.

Discount Window Lending

The amounts involved are clearly insignificant and thus the rate cut was entirely symbolic. Unless, of course, we see a rush to the Discount Window to borrow in the billions, in which case we should all become highly concerned. No, scratch that, extremely concerned. Because it will mean that major banks are in deep trouble and can't borrow on their own.

Here is what the Fed itself has to say about the Discount Window:

"The Federal Reserve expects that, given the pricing of primary credit, institutions will not rely on the Discount Window as a regular source of funding. Though institutions are not required to seek funding elsewhere before requesting primary credit, primary credit is intended to be used mainly on a very short-term basis, usually overnight, as a backup source of funding. Primary credit is available for a period of up to approximately one month to generally sound depository institutions that cannot obtain funding in the market on reasonable terms. Ordinarily, this will be relevant only for very small institutions."
(Bold added)

So, keep an eye on this amount - you can get it weekly from the St. Louis Fed FRED program here.

Another item to watch is what kind of collateral is used to borrow from the Fed's Discount Window and at what prices. In recent years the Fed has accepted bank loans as collateral, plus the usual assortment of Treasurys, corporate bonds, GSE's and other ABS's. The collateral is supposed to be marked to market and the Fed will then lend anything from 60% to 98% of that value. Here's the catch: who determines the current market value for a CDO-cubed that no one wants to make a market in, or has a ridiculous two way price, like 40-90? How about a package of sub-prime loans?

Ahhh, but aren't we ever so clever? The Fed allows Discount Window borrowers to use collateral even if there is no market price available, using a uniform haircut of face value (par) depending on the asset class. For example, AAA CDO's and CLO's are assumed to be worth 85% of face. Individual mortgages...91% of face value. Home equity loans...89% of face value.

Stop laughing now...this is serious business. Because at these prices, I would tender as much as I could to the Fed, borrow up to my eyeballs and then keep their money and let them seize the collateral. You think...? Naaaahhh....

Saturday, August 18, 2007

The Rabelaisian Growth of Financial Debt

The growth of financial sector debt in the US economy has been spectacular. The percentage of such debt to GDP has been growing exponentially while non-financial corporate debt has been steady for decades, as can be seen from the chart below (click to enlarge). Financial sector debt is that which is assumed by banks, S&L's, GSE's, insurance cos., brokers, funding companies, ABS special purpose companies related to mortgage pools, etc. In just 10 years this debt went from 60% to 110% of GDP, clearly showing how leveraged such borrowers have become relative to the US economy. It is also an indication of what I call the "financialization and assetification" of the economy.

Data: Federal Reserve

Of course, debt is not necessarily bad - it all depends on what you do with it. If it is invested in long term infrastructure, plant and equipment and other such economic and productivity enhancements, then debt can be very beneficial. But if debt is created to leverage the "manufacture" of even more debt and speculation in other assets (e.g. margin and LBO debt, debt to fund stock buy-backs, CDO-squared and -cubed, hybrid CDO's, CLO's, CPDO's and ABCP's), then this type of borrowing can be extremely dangerous to the underlying "real" economy. We are currently getting a taste of this: essentially what is happening right now is the inability of the "real" economy to service all this debt piled on it, out of "real economy" earnings.

In many ways, the US has become an economy that manufactures, packages, ships, exports, markets, trades, services and promotes one product: financial sector debt - in all of its permutations and variations. The related products are hedge funds, LBO companies and private equity concerns, all of which create the demand for and depend on the consumption of an uninterrupted supply of fresh debt, grossly mis-labeled as "liquidity".

If Rabelais was alive today he might have included a chapter about the feeding habits of such institutions in Gargantua.

Gargantua Feeding On Hedge Fund Liquidity

Friday, August 17, 2007

A 50 bp Gift From The Fed

The official Fed Funds target rate is 5.25%, but the effective rate is currently around 4.79% - this is the average at which Fed Fund transactions between banks have actually been taking place during the past 7-8 days. The Federal Reserve is supposed to intervene in the interbank money market to maintain its target rate, but it has not been doing so.

Since a variety of adjustable rate loans use the official Fed Funds rate as a benchmark, the Fed's lack of action is a direct gift to lenders who continue to pocket the 5.25%+spread rate on their loans, while their cost of funds has gone down almost 50 b.p. - at least for the portion that is related to the interbank market. A fifty basis point gift may not sound like much, but in banking it is huge. It is also conclusive evidence of unofficial easing which, if it goes on past this week, should start raising some awkward questions. For example, why is the Fed penalizing household borrowers for the benefit of the banks?

....and after those lines were written, the Fed gave another gift: it cut the Discount rate 50 bp. This is the rate at which banks borrow from the Fed against security collateral, including MBS. But they left the Fed Funds rate unchanged. This is Prof. Bernanke's first test and he seems to like muddy solutions.

Thursday, August 16, 2007

As The Yen Strengthens..

The yen is a weathervane for global funding costs, particularly for market-related speculative leverage, i.e. securities margin. Its ultra-low interest rates have attracted borrowing demand from hedge funds, funds-of-funds and private equity funds from all over the world. At the same time, local Japanese investors have moved out of their own currency in exchange for higher yielding investments abroad. This pushme-pullyou affair that has kept the value of the yen abnormally low vs. the dollar and the euro is, in my opinion, coming to an end.

No one really knows how much money is involved in this strategy, known collectively by the term "yen carry trade". Some put it at a few hundred billion dollars, others think it may involve as much as a trillion or more. Without becoming too esoteric, I think the best picture is provided by the BIS data on yen foreign exchange forward swaps (see chart below, click to enlarge). Bank FX and money market dealers structure their trading books around such swaps and - very importantly - they are considered off-balance sheet items for banks' regulatory and other capital requirements.

Data: Bank for Int'l Settlements

This is not to imply that the yen carry trade involves 4 trillion dollars. There are major non-speculative uses for such swaps, namely funding and hedging commercial transactions like imports/exports, project finance, etc. However, notice the sharp jump from $3 trillion to nearly $4 trillion after 2005, precisely when global markets turned frothy and credit for speculative purposes became very abundant. I don't think this is a coincidence and thus, in my opinion, $1 trillion is a fair estimate for the yen carry trade.

Leveraged finance is now unraveling before our very eyes and cheap yen funding is perhaps the very last straw still poking out of the liquidity pond, providing some low-cost breathing air to those speculators now deeply under water. As the yen strengthens vs. the dollar and euro the carry will produce its own margin calls, further pressuring stretched speculative positions - and that will indeed be "the last straw".

P.S. Several hours after I wrote the above dollar-yen went from 116 to 112. Margin calls must be going unmet and the banks are selling out customer positions. This is going to ricochet throughout all markets for quite a while. Cheap funding no more... there goes the straw.

Wednesday, August 15, 2007

Busy, But A Quickie

S&P 500 is now trading at 17 times earnings, a level some consider cheap. But a P/E ratio has not only a numerator, but also a divisor. What about those earnings, eh?

About 20% of S&P 500 by capitalization and 30% of earnings are made up by financial shares. Add the finance arms of industrial cos. like GE, GM and Ford and some 35-40% of all S&P 500 earnings are made up of purely financial activities. Not exactly happy times there, right now.

Now, do the math and calculate various forward P/E scenaria for the whole of S&P 500 if financial sector earnings drop by 25%, 50% and 100%. Then observe how far away we are from the 50 year P/E average of 16x. Hint: it ain't pretty.

Tuesday, August 14, 2007

Is That What We Call Them Now?

Some odds and ends from the newswires that caught my attention:

  1. Did you know that nearly 50% of all commercial paper (CP) outstanding, the short term debt issued by corporations to fund day-to-day operations, are asset-backed? They are commonly issued by funding corporations to make loans, purchase mortgages, etc. Why does it matter? Because such money market instruments are heavily bought by money market funds (MMF's), those supposedly ultra-safe repositories of peoples' savings. Most Americans may not be aware of this, but several european "enhanced" MMF's (they go by names like "LIBOR Plus") have already experienced heavy losses due to asset-backed CP investments going sour. We're not talking 1-2% losses here, but double digit hits. One insurance company had to bail out its own fund.
  2. KKR said yesterday that its funding costs have increased significantly and that this may "adversely impact the returns of (their) LBO transactions". Citigroup estimates that $330 billion of bonds and loans for announced deals remain unsold. This is more than chicken feed and it certainly takes much more than a "snap of his fingers" to get $20 billion now, as a private equity honcho bragged just a few months ago.
  3. Goldman arranged an infusion of $3 billion into one of its quant hedge funds, after it was down 28% just this month alone. They hope that such a show of confidence will avert other investors from cashing out. My opinion? In for a penny, out of a pound. Oh, and on the use of "investor" as a term to describe those that partake of the hedge fund joys, I am reminded of what Alan Greenspan had to say of the dotcom "investors" back in 1999-2000: "Is that what we call them now?"

Monday, August 13, 2007

Injections of Futility or, Bail and Fail

The big central banks are injecting temporary liquidity into the system, at around $150 billion a pop, most of it as O/N loans to banks (i.e. here today, gone tomorrow). This amount is large when compared to normal CB money market operations, but it is less than a drop in the bucket when compared to the size of the credit market, currently in turmoil. For the US alone, total credit market debt outstanding is $46 trillion, an amount so unfathomable that it defies comprehension (it translates into $400,000 of debt for every single US household).

The global liquidity injections thus amount to 0.32% of this debt alone and given the size of the still developing credit crunch, they are but mere exercises in futility. Of course, they must be undertaken if only because that's what central banks are obliged to do under their role as lenders of last resort (Prof. Bernanke has written two books on the subject), but I do not for an instant believe they are going to make any real difference. In the end, they act mostly to underscore the extent of the problem and the Fed's predicament.

This is not a repeat of the 1998 LTCM situation, where a single large player made a wrong bet and was quickly bailed out to avoid more serious consequences to an otherwise sound financial system. Rather, today it is the whole system that is in deep trouble: it relies on too much debt piled on top of overinflated assets, further complicated by monstrous amounts of derivatives. The most apt analogy I can think of is a runaway nuclear reaction, with central banks in the role of small lead rods - too small to contain it once it gets going.

There is nothing within the sole purview of the Fed, or any other central bank, that it can do to transform and rectify the system; its relative size is too small in comparison to the modern financial behemoths. Goldman Sachs alone has balance sheet assets of $943 billion, an amount larger that the GDP of every country in the world except for the top 10. But, tellingly, their equity is a mere $38 billion, so their leverage is a troubling 25x and this is before the off-balance sheet items, like various swaps. Nevertheless, the days when a large private financial house could act as de facto central bank (e.g. Morgan in the 1890's) are gone forever, even if some fervid neo-conservatives would like to see the government drowned in a bathtub.

There is a glaring paradox here: those same free market enthusiasts that ardently proclaim the supreme efficiency of modern finance in allocating capital where it's best utilized, go begging to the government to save them when their capital evaporates due to their own folly. It is actually not a paradox at all, of course - since time immemorial such behavior has been known simply as childish, or wanting to have your pie and eat it, too. Actually, since central banks are owned and financed by governments (i.e. taxes), they want to have their pie and eat everyone else's, too. Laissez faire when it suits, sauve mon derriere when it doesn't. That's called virulent capitalism, not free market economics.

There is certainly a strong ethical dimension in the divisive question that has come up in recent days: should the CB's bail out the big financiers and their rich customers with public money, or should they let them learn a sharp lesson about risk vs. reward? There are firm proponents of both opinions, but there is also a third one: Even if they bail, they are still going to fail. The reason was made clear above, i.e. it is the whole asset-credit system that is in trouble, not just a few players within it.

We need a Plan B to deal with this situation and we need it ASAP, but...

(a) I am certain there is currently no Plan B. Ideologues with blinders are running the show right now and they can't even fathom that Plan A could be wrong. Witness the extremes to which Plan A could theoretically be taken, if all else fails (helicopter cash). This is not novel thinking, just much more of the old.

(b) Any Plan B would by necessity seriously damage the vested interests that reign within Plan A and would immediately be painted as dangerous, radical and unpatriotic.

(c) Individual human thought may leap, but society's habits change only gradually and then only after the proof hits them hard over the head. Witness global climate change, for example.

Attempting to close on a more humorous note, maybe the central banks could start by changing how they name their money market operations. For example, the ECB calls the injection of an unprecedented 95 billion euro "a fine tuning operation". The whole orchestra sounds like a dozen buzz saws ripping through rusted sheet metal and they worry about A sounding flat?

So, in this hot summer season, here's my own suggestion, inspired by a film by Lina Wertmuller:

Travolti da un insolito destino nell'azzurro mare d'Agosto

or, in English,

Swept away by an unusual destiny in the blue sea of August.

P.S. For the reader comment section: If you have seen the film, who do you think should play the market-equivalent parts of Gennarino the sailor and signiora Raffaella?

Friday, August 10, 2007


With the so-called subprime credit crunch spilling over into Europe and then the rest of the world, I think we need to take one step back to gain some perspective.

First, let's dispense with two common misconceptions - or outright lies, if you prefer:
  1. It is not a "US subprime credit crunch", but a credit crunch, period. The trouble surfaced first at low-quality mortgage loans because that was the weakest in a long series of weak links. The problem, taken as a whole, is too much debt assumed by too many borrowers who cannot hope to service it without relying on constantly higher asset prices. In other words, it is a classic asset-credit bubble, only this time it is not contained within one country but it spans nearly the entire globe.
  2. Liquidity is not a stash of cash sitting in an account, looking for assets to buy. Liquidity is (a) access to reasonably cheap credit and (b) the ability to sell assets at reasonable prices, quickly and in size.
The corollary from (1) above is that the current credit crunch is not a "spreading out" from sub-prime to other sectors, but the initial phase of what is likely to be a long, drawn-out process of declining debt and asset prices. It could happen in one fell swoop (aka Crash), but that's what central banks are for, as we saw yesterday. They cannot stop the process, but they can act as lenders of last resort to slow it down. However, even if there is a "sudden event", I expect it will be followed by many more years of aversion to debt and risk. There is simply too much reliance on debt and asset appreciation in the global economy for it to go away in one step, however severe.

The proof to (2) above has been brewing for weeks, but finally made headlines yesterday as the ECB, Fed and BOJ had to intervene to provide... liquidity (if there was so much to begin with, where did it all go?). Liquidity is directly connected to credit because if everyone demanded cash in exchange for all goods and services the economy would immediately collapse into Medieval mode. Credit is a function of trust, i.e. the expectation of repayment, and thus liquidity is a function of trust - or confidence, if you like.

Bubbles of all sorts are phenomena of excessive confidence vs. the cash generating capacity of the underlying assets that are being inflated and they pop when excess confidence evaporates. We are now in the first stages of a credit - liquidity - confidence crunch, brought upon by the final realization that asset prices have moved so high that they cannot satisfy their debt loads out of cash flow.

And thus, Fed's Fearsome Phantasm (I couldn't resist) is raising its ugly head: persistent deflation that cannot be cured by lower interest rates. A liquidity trap, as is known to central bankers. Most scoff at the idea that we could actually experience falling prices in the US, but they are clearly mistaken and the evidence is all around us, though usually misinterpreted by the casual observer. Just a couple of examples because I have to catch a boat (ah, summertime...):

(a) House prices are now dropping in absolute terms, the first time since the Great Depression. A quarter of US GDP is related to housing activity.

(b) Because of China's huge manufacturing overcapacity, most consumer goods are cheaper today than years ago. If final demand fails to keep up with production (already happening, look at retail sales) we will see even lower prices and business failures.

(c) Negative saving rates and no access to credit means purchases must be curtailed and/or assets sold. That's deflationary.

(d) ..and finally, if anyone still believes that modern-era fiat currencies can be inflated to kingdom come to avoid the trap, think of Japan.

Have an interesting weekend...though the Chinese would consider this a curse.

Thursday, August 9, 2007

"The Complete Evaporation of Liquidity"

As I usually do, I wrote this today for posting tomorrow. Events are running ahead fast, however, and I think it is more timely to post it today.

On March 15 I posted what has turned out to be a prophetic entry titled "Well, What Do You Want It To Be?" , which followed the various stages in securitizing and derivativizing a simple home mortgage up to the fourth degree (CDO, CDS, hybrids, funded vs. unfunded, etc). By that stage the resulting structured instrument is completely unrecognizable vs. the original mortgage and is impossible to price without a long list of assumptions about future default rates, the shape of the yield curve, volatilities, etc. The various institutional owners, mutual funds among them, relied on daily, weekly or monthly indicative valuations from their broker-dealers who were more than happy to oblige by concocting essentially fictitious quotes, since no one was selling, anyway. But the real price is always revealed when you finally have to sell and then the firm quote you may get could be... -95, i.e. no bid - 95 offered. A completely worthless quote that cannot be used to price anything, let alone sell.

BNP-Paribas, the largest bank in France and one of the largest in the world, took the highly unusual and severe step of stopping the calculation of NAV's and suspending redemptions for three of its mutual funds that held such mortgage-related instruments because, and I quote: ``The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating''.

Let's translate, though it is quite straightforward for an official release:

a)The complete evaporation of liquidity = No one wants to buy, there are no bids.

b) Impossible to value = Brokers/dealers aren't even giving us official indications - too scared of their implied legal obligations.

c) Regardless of their quality or credit rating = Those AA or AAA ratings are on paper only. God knows what they really are.

There are also several highly disturbing facts:
  1. These are plain vanilla mutual funds from a highly reputable bank, not some high-roller leveraged hedge fund. Supposedly ho-hum, safe and with daily pricing and redemption privileges. They are designed for the conservative middle-class investing public who are putting money away pour les enfants, or towards a house down-payment.
  2. The amounts involved are quite large: as of July 27 the three portfolios together amounted to $2.8 billion.
  3. The structured bonds in question are rated AA or better.
The myth of "containment" is now completely and utterly destroyed. If vanilla mutual funds are in such trouble, can you imagine what is happening to the balance sheets of hedge funds? For example, those that bought mezzanine CDO's on margin which now have NO BID? Or, how about those that wrote naked CDS's on those same CDO's?

Here's a question to ask the SEC, NASD and, of course, the OCC (Comptroller of the Currency: Ensuring a Safe and Sound National Banking System For All Americans): Do you have any idea whatsoever what the real exposure is to the hedge funds of the institutions you are charged with overseeing? Especially those large deposit-taking institutions (aka banks) that also act as prime brokers (soup to nuts package deal to hedge funds, from transaction services all the way to margin lending). Because if liquidity has evaporated, what's the collateral ultimately backing those savings and checking accounts worth?


...and as I finished writing this the ECB had to intervene in the interbank euro money market to provide 90 billion euro at 4% (normal amts. are around 5 billion) because banks started to deny lending to one another, pushing O/N rates to 4.7% - if they could get any, that is. This being an area I know very well, I cannot emphasize enough how concerning this is. The ECB became the lender of last resort, a role that central banks hope to never have to play because it means the financial system has seized up. Likewise, dollar O/N LIBOR rates shot up to 6% from 5.37% yesterday and this is for the biggest, strongest banks like BofA and Barclays. The Fed just did a 14 day repo to add liquidity at 5.25% - no news on the amt. yet. (just in $15 billion).

If the banks are nervous about lending money O/N (just one day) to one another, what do you think they are doing with their hedge fund customers? Calling in margin loans (yen included)? Bigger haircuts on the collateral? Higher interest rates? Pressuring them to reduce debit balances by selling positions? All of the above?

Plan A: The Con. What's For Plan B?

The word "con" comes from confidence, as in a con man first gains your confidence and then proceeds to rob you blind. That first step is crucial, because peoples' natural suspicion prevents them from doing truly stupid things until someone gains their trust. The Fed under Bernanke is no different. Their inaction on interest rates Tuesday is a simple confidence trick, a head game: "See", they said, "the economy is just fine. No need to worry about credit risk at all - in fact we are worried about inflation. Trust us". Now, the Fed is not intent on robbing anyone directly, so I have to believe their intentions are good, even if their choices are limited by current circumstances. Ever since the Great Depression the Federal Reserve's biggest nightmare has been a deflationary spiral - hence the cash helicopter that Mr. Bernanke is so famous for.

Given what is happening out there in the economy and financial markets, a bit of confidence trickery is all they could do. Imagine if they had come out and said this, instead: "We are very worried about the zooming cost of credit risk and what it is doing to the economy, so we are lowering interest rates starting immediately". The damage this would have done to the market's morale would have been much greater than any benefit from a 25 or 50 bp cut in rates. So, the party line is now firmly set from Wall Street, to the Treasury Dept., the Fed and on up to the White House: "The US and global economy are sound, all that's happening is some very risky debt and related assets are being re-priced. The situation is well contained and poses no threat whatsoever to the rest of us. Now, go shopping."

I honestly hope they don't believe their own b.s. and that they have a Plan B all worked out and waiting, just in case the con game approach doesn't pan out. Because in the Great Depression the Hoover administration (1929-1933) kept thinking it would all be sorted out quickly - just as soon as the bad debts and their associated assets could be dealt with. Andrew Mellon, the Treasury Secretary at the time, wanted to "liquidate everything" and believed that a panic was not altogether a bad thing, because "it would purge the rottenness out of the system". Easy for him to proclaim "leissez faire": being one of the richest people in the world, he didn't have to sell apples, eat in soup kitchens or sleep in flop houses, like the millions of unemployed who were let go in the liquidation process.

Therefore, I hope that Plan B isn't of the dogmatic "do nothing and the free economy will sort things out" type, because 98% of the US population has not participated meaningfully in the prior asset price rally and is just going to get anihilated, crushed between high debt and job losses. Keep in mind that the kind of economy we are running these days can shed jobs at the blink of an eye. All it takes is to throw the desks in a van, turn off the lights and tell the landlord to find another tenant. No factories, no heavy machinery, no unions, no long-term capital to recoup and no stake in the community, either.

I think we need way out-of-the-box thinking for Plan B, because the same old, same old (and this includes Keynes) is just not going to cut it in a planet of nearly 7 billion souls running out of cheap food, fuel and usable water, but full of WMD's mostly owned and operated by the 5% of the population that consumes 25% of those resources and on the hook for 80% of all debt outstanding in the entire world (and that's before counting the immense unfunded liabilities to Medicare and Social Security).

P.S. Isn't it curious how in the past few days markets rally in the last half hour before the close? Pure coincidence, of course... must be all those traders coming back to the office after a long, lazy summer lunch at Fraunce's and suddenly realizing they had forgotten to buy all day long. So they panic and rush to place huge buy orders in the time remaining - "at market", of course. Or even higher, if at all possible, please :) Just look at yesterday's hilarious intraday chart for GS. From 190 to 197 in 3 minutes. Those must have been really good oysters...

Wednesday, August 8, 2007

Sticker Shock At The Risk Emporium

As Mr. Treasury Secretary Hank Paulson so elegantly understated it, risk is being "re-priced".

The blinds are down, the "Grand Sale" sign is gone and shopkeepers are hastily re-arranging their window displays. Suppliers are calling daily, even hourly, with higher quotes and they can hardly keep up with changing all the price tags. Customers, used to rock bottom prices, walk away shaking their heads in disgust vowing to look for cheaper merchandise elsewhere, only to discover that the same thing is happening everywhere. What's more, several previously abundant products have been pulled from the shelves completely and dozens of smaller stores have closed for good, having gone from riches to rags literally within days.

The big stores are still in business, but their owners are not feeling too chipper, either. They know that when prices go up so fast and so much, customers simply can't adjust. Sticker shock is bad news for business and it does not matter if your are selling pizzas or mezzanine loans.

Back to the financial community.. As risk gets re-priced banks and brokers (particularly) have to mark their own portfolios to market and that hurts, though there are dozens of tricks to mask and ease the pain. But their real risk exposure is elsewhere: it resides in their major customers' balance sheets, those hedge and private equity funds that borrowed so heavily to speculate in overvalued, risky assets from stocks and CDO's to real estate in Romania. (Are you familiar with the term "prime broker"? If not, you should be.) The risk connection is direct, even if a few domino drops away.

The game could be sustained for as long as no one wanted their money back. But everyone now knows that risk is being re-priced at the Risk Emporium - and who wants to get stuck inside? Get the money out first, ask questions later, because there is an infinite amount of time but a finite amount of money, despite all the nonsense about liquidity. This is where and when things get nasty: withdrawal requests combined with margin calls can bring down leveraged funds within days, even hours. Funds can stop redemptions, but all this means is that customers will most definitely get wiped out, because margin calls have priority.

If this sounds alarmist, it is. Because in talking yesterday with a long-time friend in the business he said: "Those guys at Goldman and Morgan, they are smart, they'll figure it out - it will be OK". How does it go? Denial, hope, anger, capitulation, apathy... I am alarmed because we are now clearly past the "denial" stage and in full "hope" mode. Even Mr. Paulson acknowledges the problem, but "we have a strong economy", etc. We can see this in the way markets are acting: the "hopefuls" are looking for bottoms, just 5% off the top.

In speaking with a broker whose observations I highly respect, she had this to say: "This time around it won't be the little guy who gets stuck. It will be the supposedly "smart" money, the hedge funds and the big-time individual speculators... unless of course the little guy is somehow convinced to jump back in, right now". Now, that would be a shame, wouldn't it?

Tuesday, August 7, 2007

Don't Worry, Be Happy

Adding insult to injury, the two Bear Stearns hedge funds that went belly up recently have filed for bankruptcy in the court of...the Cayman Islands. The fact that most assets were held and managed in NYC is of little consequence to the legal state of incorporation, which was in fact the Caymans. And here's another fact: 3 out of 4 hedge funds in the whole world are incorporated there, a miniature country of three islands 100 square miles in total, with a population of 45.000 souls - there must be something in the air, eh? Their main industry is financial services, but by that they mean being the de jure corporate seat - the de facto part takes place in more properly exciting locations, like Manhattan and The City.

There comes a time, however, when the law of the land must be invoked, e.g. liquidation under bankruptcy. Creditors will have their day in court and so will management, of course. The judge, who is not going anywhere anytime soon (except perhaps to the aptly named Pirate's Den Pub down the road) will most definitely keep in mind that there are plenty of other such statelets with sun, rum and lax incorporation laws ready to pounce on the juicy fee business generated for hundreds of his legal brethren active in the incorporation and registry business in George Town. That being the case, what are the chances that the local courts will rule against management?

To make sure that the sunny courts of Cayman will be totally unhurried and unmolested in reaching their just decisions in due time, Bear Stearns has also filed in Manhattan courts a motion for protection against all lawsuits there, while the process goes on down south. Let's see if that judge grants them their wish...

Meanwhile, the stock market bounced yesterday on (unsubstantiated) hearsay that the government will somehow intervene to limit the hemorrhage in the credit market. Earth to Mars: there isn't enough money in the till to bail out every one, or even some, of the troubled "institutions". Oh, the Fed will soon enough decide that interest rates need to come down substantially to "better reflect the current business environment", but this time they will be pushing on a string. As I have said before, it is not the price for using the money that matters now (interest rates), but the fear of principal loss - and for that there is no price. When the situation reaches a certain qualitative point, the higher the interest someone is willing to pay to borrow money, the less the chances of his getting it. Lenders see that as a desperate sign of panic and stay away. Greed is suddenly replaced with "better safe than sorry". Then the specialized vultures will eventually swoop in, pay ten cents on the dollar and fly away to await the next cycle. At that price they can afford to wait a long time, sipping a rum punch by the pool of the Ritz-Carlton - in Grand Cayman, of course...

P.S. Today, we learn of another victim of margin calls: Luminent Mortgage (NYSE: LUM ...where do they come up with those names?). Things are becoming more and more sudden... I mean REALLY sudden: the stock was near $11 a month ago, with an all time high of $15ish. Five days ago it was at $8 and today it is trading at 75 cents. You want fast? This is what the word vertigo was invented for. And remember, for each unmet margin call there is a major lender who is taking the hit.

Monday, August 6, 2007

Crocodiles Wept

As the title of this blog implies, things are now moving quickly in the debt world - but in the opposite direction than was previously the case. "Liquidity" - that incredibly misapplied term used to confuse the uninformed about what is simply debt - is drying up faster than a crocodile's tear.

Witness the incredible plunge in the fortunes of American Home Mortgage, which went from near an all-time high of $35 per share in February to bankrupt and worthless today. The company specialized in Alt-A mortgages, the next step up from sub-prime and listed some of the world's largest banks as its main unsecured creditors (Deutsche, JP Morgan, Bank of America, et al), who are on the hook for unspecified amounts, out of a total of $19 billion in debt. Given the nature of the mortgage business and banking in general, there are going to be some serious impairment charges coming up soon for lots of such creditors.

The loss of some 7.000 jobs at AHM in one fell swoop is also characteristic of how suddenly things are happening in our "modern" finance era. When the stool of "high liquidity" is kicked from underneath, there is nothing to hold up the corporate structure but thin air - and gravity is a harsh mistress to the overextended. Finance job security is notoriously cyclical, despite what seemed to be the case in the last few years. "Easy come, easy go - so save for the rainy day because it always rains in the end", is how an aged friend in the business used to put it and he knew darn well what he was talking about: he had started out as lowly office boy in a brokerage office. In August 1929.

The buzz saw is being applied to other, more august companies' shares: Bear Stearns has plunged from $170 to $100, Goldman Sachs from $230 to $175, JP Morgan from $53 to $43, Merrill Lynch from $95 to $70. Yes, they are rebounding today... but is it because their prospects are suddenly much brighter, or is it because the dead crocs are bouncing?

To answer that, answer this simple question: Say you are Archie, the chairman of the investment committee of the Upper Navonia State Teacher's Pension Fund, assets under management $3 billion, of which you had previously agreed to place $300 million in "alternative" investments like hedge funds and such. Your salesman from Upper Bracket and Co. calls you and recommends you add to your positions: "Such a GREAT opportunity, Archie!!" he says, with just a trace of anxiety in his well-trained pitch. "Well, yes Bob... that may be the case, but can you please first explain WHY we're down 12% on the original $300 mio? Just a contained situation, you say? Aha, well let's wait until the situation stops bleeding cash all over the place and THEN I'll put some more in, huh? I have pensioners and employees to answer to and they read the papers, too, Bob....Yeah let's do lunch next week...I'll call you."

Thursday, August 2, 2007

Residential Construction Jobs: A Closer Look

The July jobs report is coming up Friday (we got a early look from ADP yesterday), so I thought I would do a piece on employment, particularly construction jobs.

Residential construction activity has come down sharply and yet the Bureau of Labor Statistics still reports next to zero job cuts in the sector. For a clearer picture of what is happening, I have indexed the number of jobs, the number of units currently under construction and the number of housing starts - see chart below (1985= 100, click to enlarge). Construction activity has fallen sharply, yet no significant job cuts are observed.

Data: BLS, Census Dept.

I have also produced a chart of two ratios: jobs to units under construction and jobs to housing starts. Reported jobs per unit being constructed are somewhat high, but it is the jobs per unit started that look abnormally high, i.e. by historical standards the BLS is reporting way too many such jobs still in existence for each house being started. If the jobs/starts ratio was the same as during the previous construction cycle low in 1991, it would translate into 806.000 jobs today vs. the June BLS report of 1.003.000 (seasonally adjusted). By this metric, the BLS is over-reporting residential construction jobs by nearly 200.000.

There have been several explanations offered for this discrepancy, most commonly that illegal immigrants are off the books and therefore their layoffs are not counted. While the home construction industry is a significant user of such workers, it does not explain the sudden jump in the ratios, i.e. if their numbers were increasing disproportionately vs. legal workers in recent years, this fact would have shown up in the ratios before 2005, as fewer workers per unit started.

I have another explanation: Builders have been holding on to their workers even when starts fell off rapidly, hoping for a turn-around in their business. They could afford to do so because the previous cycle was long and extremely profitable and they still had lots of unfinished work in progress. We see this from the jobs per unit under construction ratio which is still within "normal" parameters.

Nevertheless, given the deepening troubles in real estate, home builders must be getting very worried. If the current summer home sales season ends without any significant upturn, the charts above suggest we may see a much larger seasonal layoff come October-November - or sooner if builders decide to jump the gun. Those 200.000 "extra" jobs may disappear within 2-3 of months, putting a lot of additional pressure on consumer spending.

I believe we will be seeing this starting with Friday's jobs report.

Wednesday, August 1, 2007

Roach Motel Hedge Funds

As the credit crunch continues, more and more hedge funds are getting squeezed between lower asset values and margin calls. The news is everywhere and in my opinion will get much, much worse. The credit crunch is morphing into a confidence crunch, whereby previous "savvy investors" suddenly realize that they were in fact "delirious speculators" and rush to save whatever money they can by pulling it out.

This is somewhat of a throwback to bank runs and thus the suspension of redemptions is very ominous. In plain words, you can't get your money out. "What? Outrageous!", you say. "Read the fine print", they say. After obtaining a 10x magnifying glass and poring over the 300+ pages of print in the offering document that you so quickly signed when visions of sugar-plums were dancing in your head, you discover that, lo and behold, fund managers can indeed do that. It is supposedly for your protection, so as to avoid selling assets at distressed prices.

I am of the opinion that most of the hedge funds that have sprung up in the last 3-4 years are becoming financial "Roach Motels" (R). Money has checked in - but it won't be checking out and as more "investors" get news of suspensions the rush to get their money out will only intensify.

The situation will also impact private equity funds, but the process will likely take longer (at least the portion that will become public). The game there involves much bigger boys and girls (think "Carlyle") with similar-sized greed and tanker-fulls of hubris - notice the word "tanker", it is significant. It also happens that such "participations" come with very complicated strings attached, a web that reaches to the very heart of global government and corporate elites. They make stupid mistakes like everyone else (human folly is as old and common as stones), but they have far greater means to cover them up, at least until they have left center stage. Nevertheless, for some it won't be so easy.

I am referring to Sovereign Funds, that immense financial folly so fashionable with au-courant government officials and their well-fed bankers, who know better than their peon "subjects" what they should be doing with their money. More services? Oh no, no. Better health and education? Are you daft? Investment in alternative energy R&D? Please... A majority of such Sovereign Funds prefer...hedge funds and private equity funds. I repeat, this is investing money from the public purse. Is that apropos? Hell, no. (Is it lucrative? Hell, yes.)

A private investor can always choose if he will or won't check into the Roach Motel Fund - but in the case of Sovereign Funds the public at large is never consulted. If a private investor has only himself to blame for his credulity, in extremis masses have more direct and effective ways of exacting recompense for losses sustained by decisions made by corrupt or inept officials. If this plays out as I think it ultimately will, I won't be surprised to see major political upheavals in some capital cities, with some denizens checking into real roach motels, complete with barred windows and barbed-wire fences - or worse. After all, if a mild case of construction-related kickbacks merits the death sentence, what punishment is appropriate for the loss of $10 billion when vox populi is shaking the President's?Chairman's/Sheikh's windows?

If this sounds almost barbaric to western ears, it is the way the cookie crumbles in most of the rest of the world. Why does this matter to us, right here, right now? It does, because those that have previously signed-off on such sovereign investments are well versed in the principles of survival under Mosaic Law, as applied to official government scapegoats. In other words, if ANYONE expects Chinese or Oil money to save them with fresh infusions of cash, they are simply deluding themselves.