Post Hoc New Year Predictions

Year-end brings to the financial community the obligatory round of New Year predictions. The prophet camp is usually split in two: "play it safe and give'em what they want to hear" types and those that "go for broke" and try to foretell multi-sigma events. Both can be fun to read, if rarely accurate, and they are forgotten faster than cheap bubbly goes flat. Before proceeding with 2008, however, let's first look at some otherwise timeless wisdom and how it could have been applied post hoc (after the fact) during 2007.

Delphic pronouncements like J.P. Morgan's "It will fluctuate" survive the test of time best. Seemingly useless, it should be dusted off occasionally, for example when VIX (volatility) was scraping the low 10's for months on end. I dedicate it to all correlation traders. Another favourite comes from the collective wisdom of the Street: "Don't confuse brains with a bull market"; I dedicate it to the financier who bragged earlier this year of being so successful he could raise tens of billions at the snap of his fingers. For him, and other hombres at Rancho Liquid Leverage, I will throw in a slight modification of my own: "Don't confuse credit with liquidity".

"Caveat emptor" (buyer beware) is thoughtfully offered to buyers of credit insurance, particularly CDS. For further elaboration please apply to Mr. Buffet and his brand-new credit insurance monoline. To sub-prime borrowers and lenders alike, a quote from Hamlet: "Neither a borrower nor a lender be; for loan oft loses both itself and friend".

For the embattled rating agencies, also from Hamlet: "To B, or not to B, that is the question". To the ex-heads of Citi and Merrill, from Benjamin Franklin: "Drive thy business or it will drive thee".

To the financial engineers who dreamt up all sorts of statistically-driven structured finance products like CDOs, CPDOs, CLOs, etc: "There are three kinds of lies: lies, damn lies and statistics", by Benjamin Disraeli. To their clients, from Bob Sarnoff: "Finance is the art of passing money from hand to hand until it finally disappears".

All right, then, how about 2008? As the Italians say, make me a prophet and I will make you rich. I am neither Italian nor Prophet, but this dictum comes from Cicero who is a sort of Italian and his sayings have lasted far longer than any portfolio prophet: "Endless money forms the sinews of war". Obviously, to Mr. Bernanke.

Finally, since this is, after all, a public version of a daily journal, to myself: "It is not advisable to venture unsolicited opinions. You should spare yourself the embarrassing discovery of their exact value to your listener" (Ayn Rand). Come to think of it, given the provenance, it is quite apropos for Mr. Greenspan as well.

A Happy New Year to all, filled with love from your family and friends.

Creative Destruction vs. Interest Rates

On the back of yesterday's post and spirited comments on the change of the recession cycle, some more ideas along the same lines.
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We are all familiar with Joseph Schumpeter's creative destruction principle, about the ups and downs of the economic cycle forcing businesses to adapt and evolve. I think of it as Darwinism for business (see book on the right).

Here's a question, then, that ties monetary policy with creative destruction: Did the massive interest rate cuts of the Greenspan Fed - and those in the works by Bernanke - prevent the creative transformation of the US economy?

During the last recession rates went to near zero, a level not seen since the 1960's. The response should have been a strong flow of investment in new industries (creation) to replace those damaged by the downturn (destruction). This clearly did not happen and low rates produced instead a capital misallocation of historic proportions. Massive debt pumped up a housing bubble, maintained consumer spending and financed portfolio transactions such as LBOs and share buy-backs.

Observing employment patterns, i.e. the number and type of jobs lost and created during the business cycle, provides excellent insight. Manufacturing jobs, in particular, are key because they add high value at many levels. Modern manufacturing is capital, knowledge and skills intensive.

In the chart below (click to enlarge) we observe that every time the Fed dropped rates in response to a recession (blue line), employment in manufacturing rebounded (red line) - except now. During the last cycle the economy shed 3.3 million manufacturing jobs - one in five - but did not get them back when the economy rebounded, despite record-low interest rates. Losing 20% of manufacturing jobs so fast certainly qualifies as "destruction". But what sort of "creation" occurred as the economy came back?

Fed Funds and Manufacturing Jobs Chart: St. Louis Fed

The rebound did create new jobs to replace industrial workers, but of a very different sort than before. Since the end of 2000, the US private sector created a net 4.5 million new jobs but nearly all (4.4 million) are in leisure, hospitality, health care and social services, i.e. low-skill, low value-added jobs located in the periphery of the service economy. And what replaced the 3.3 million factory jobs lost? Mostly construction, financial services and business services. The table below sets out the numbers.

Data: BLS

Even if we assume that these replacement jobs add as much value as manufacturing (a very big if), we see that on a net basis the latest expansion generated nothing but low-pay employment. This point is further corroborated by a study from the Ecomic Policy Institute which shows that despite the recovery real family median incomes are lower now than in 2000. As the NY Times puts it:

A new study by the Economic Policy Institute uses Census data to trace the dismal trajectory. Economic growth during the Clinton administration peaked in 2000, followed by a brief recession. Growth resumed at the end of 2001, the beginning of the Bush-era expansion, but real family income continued to fall through 2004. It has turned up since then, but as of the end of 2006, it was still about $1,000 below its peak in 2000. Even if that difference is made up this year (and it’s still too early to tell if that will happen) Americans would be merely breaking even. That would be a pathetic outcome after six years of strong labor productivity.

For the United States, therefore, the creative destruction process ran in reverse: it destroyed high-value manufacturing and replaced it with specifically low-value services. The loss of earned income implied by this shift should have been unacceptable to society, but as we know living standards were artificially maintained by increasing debt and by the illusory rise of purchasing power from cheap imports. Instead of going through the painful, but ultimately beneficial process of creative destruction, America took the easiest way out.

Data: FRB St. Louis

Simply put, Greenspan threw a monkey wrench into Schumpeter's creative destruction process and now Bernanke is repeating the mistake. What's worse, we have been led to believe that the Fed can keep the economy going indefinitely by mere adjustments of interest rates and injections of liquidity. However, wealth is not created by monetary policy but by constant innovation and judicious investment. We are clearly not investing as we should and innovation will soon depart, following industry abroad. No one has a lock on knowledge, after all.

We can make one more observation linking the cost of money with the creative destruction process. When capital costs are unusually low, businesses can be less choosy about their investments. For example, if a businessman can borrow at 4% he may be happy with starting a hair salon returning 8%. But if rates are at 10% he has to invest in something that adds more value and is potentially more profitable.

The conclusion is that for a developed economy, at least, unusually low cost of capital - debt and equity - ultimately works against the creative destruction process and leads to a loss of competitiveness. Let me put it another way: artificially low interest rates and high share prices over a prolonged period make America complacent and "dumb", particularly if it has to compete with a dynamic bloc like Asia.

The Slow Recession

Post-WWII recessions in the US occurred because of excess inventory accumulation by manufacturers. They came fast and went away pretty fast, too, as plants laid-off and re-hired industrial workers. However, the nature of the business cycle has changed: manufacturing now makes up a much smaller percentage of the economy and employment. Manufacturing jobs in absolute numbers are back to 1949 levels, when the country had half today's population. The process of de-industrialization accelerated sharply after 2000 as China became producer to the world and the US lost an astonishing 3.3 million manufacturing jobs. (see chart below).

Manufacturing Jobs (Chart:BLS)

It is instructive to examine the kinds of jobs lost and created during the full business cycle from 2000 to 2007 (see table below). Almost all net new jobs were in health care, social services, leisure and hospitality, i.e. at the fringes of the service sector. The jobs that replaced manufacturing came in construction, financial and business services.

Data: BLS

The nature of this employment restructuring suggests an increase of economic inertia at the cost of less value-added. I think that such peripheral jobs are slower to be lost during the initial phases of a slowdown, but once gone they will be slow in coming back, too. They don't cost as much to maintain, but they also don't produce as much immediate profit when the cycle turns up.

Therefore, the business cycle may now become more grinding and drawn-out, instead of painful and short. This explains why the current slowdown is like watching paint dry, with limited job losses so far (noting, however, the effects of the controversial BLS birth/death model on job creation since 2003) and mediocre retail sales, ex-fuel and food.

Opera Buffa: From AAA to CCC

The Wall Street Journal has an excellent graphic on how mezzanine CDOs like Norma, originally rated AAA-A when issued in March 2007, went from 100 to nearly worthless within months. When the WSJ page appears click (launch content) and the graphic will start.

For opera lovers, Norma by Vincenzo Bellini is probably the most demanding role for any soprano. It was the signature role of the incomparable Maria Callas who performed it 89 times in a career spanning 300+ appearances.

You can imagine what she would have thought of naming a slapstick CDO after it...opera buffa, perhaps?

P.S. In the opera, Norma almost murders her children and eventually commits suicide by throwing herself on the funeral fire consuming her lover. Hmmm... I think there must be a few opera lovers in the financial engineering field. Perhaps the CDO name was a warning? Notice the dagger...

Maria Callas as Norma (Teatro alla Scala, 1955)

Holiday Sales and The Aftermath

Retail sales muddled through during the holidays, apparently rising at the slowest level in four or five years (3.6%). After inflation, the rise is essentially zero and has come at the expense of profit margins, at least for large department stores where the weakness was pronounced. Shoppers moved their spending downscale towards WalMart and Costco, leaving stores like Macy's scrambling and doing things like staying open round the clock to squeeze every available consumer penny. Not a healthy picture, and one that will likely have repercussions going forward, as exhausted consumers pause to regroup. Let me put it this way: if it took aggressive promotions to achieve decidedly lackluster results at Christmastime, the next couple of quarters look tough, indeed. The saving rate had already dipped into negative territory once again in November, signaling another reason for a pullback after the obligatory gift-giving season.

Poor retail performance is blamed on stretched budgets from a combination of (a) rising costs for fuel and food, (b) vanishing home equity piggy banks and (c) limited wage increases.

Let's examine gasoline first. Looking at price alone provides limited information, because a variety of factors have changed over the years: inflation, incomes, fuel efficiency, number of cars per person. To account for these I produced a chart tracking the number of hours a person needs to work to buy a year's supply of gasoline for the car(s) he owns, currently around 540 gallons per car. Though fuel efficiency has improved significantly from 700 gallons/car in 1967, the number of cars owned per person has grown quite dramatically, going from 0.50 in 1967 to 0.78 currently. All of these factors are combined in the chart below (click to enlarge).

Data: EIA, DOT, FRB St. Louis

For those on minimum wage (currently ~$12.000/yr) driving has has quite clearly become a luxury. But even for average wage earners (currently ~$37.000/yr) real gasoline costs are back to the bad old days of the early 1980s. At current prices of $3.10/gal, they have to work for nearly a month just to pay for gas. No wonder, then, that even middle-class people are scaling down and looking for bargains.

Food expenses haven't become as burdensome, yet. The hour-cost of purchasing one unit of the Consumer Price Index for Food, as published by the Bureau of Labor Statistics, has risen for low-income workers but remained flat for average earners (chart below).

Data: BLS, FRB St. Louis

However, this situation may change quite rapidly if fuel costs remain elevated. Energy is a very important cost factor in food production because of the heavy mechanization and high usage of fertilizer and pesticides in US farming. During the past 12 months crude foodstuff and feed prices are up 20%, a jump that is only gradually now being passed through to consumers, as the crop cycle hits food processors. The chart below shows that there is a potentially large "pent-up" move in retail food prices relative to fuel.

Data: BLS, EIA

"Extracting" home wealth had up to recently boosted spending at the cost of increased monthly financial obligation payments. Such payments are now almost one-fifth of disposable income - a record high despite low interest rates. Of course, home loans don't actually "extract" anything; for this to happen homeowners must sell or refinance at a lower rate and save the monthly difference. According to studies done by the Fed only a minority of homeowners did this - the rest just spent the money.

Financial Obligations Ratio Chart: FRB St. Louis

According to a recent (2007) paper co-authored by Alan Greenspan and published by the Fed, net home equity extraction (i.e. after fees, taxes and points) had been running as high as 10% of disposable income in 2004 and again in 2005 but then declined to 4.5% in the third quarter of 2006 (click chart to enlarge). Given developments in the real estate and mortgage markets since then, it is certain that the extraction has dropped further, perhaps towards 2% of disposable income.

Chart: FRB, Sudden Debt

The difference between 4.5% and 2% translates to $230 billion less per year, or 5% of current annual spending at retail and restaurant establishments.

A Christmas Tale

One Christmas morning Americans woke up to find their swords beaten into ploughshares. The mighty nuclear carriers and submarines had been transformed into power stations, bombers and fighters into windmills and the vast armada of tanks and troop carriers into hydrogen-fueled trucks and buses. The huge Army barracks stood as sparkling universities and the Pentagon shone as a state-of-the-art solar array. The dumps of shells, bullets and grenades had become fertilizer. The menacing silos of intercontinental missiles were gone, replaced with plants producing ethanol from the grasslands of the Plains.

The people were frightened at first. How could they protect themselves from all they dreaded? What stood between their homes and the enemies that menaced their land? A cry went up to quickly convert everything back into weapons and munitions, and many an opportunist asserted they would do it, if only the pay was right. "Security requires sacrifice", they proclaimed. "Why, look at all our wealth! - if we do not protect it, surely it will be plundered by those evil and greedy, waiting just outside our shores. Nay! - they may already be inside, working to weaken and destroy our mighty fighting spirit. To arms, to arms!!"

Yet, even as these ugly words arose, the people looked around carefully and found the land more prosperous than ever; and though they searched diligently, they could not discover foes within or without. Everyone was busy learning how to put the new machines to better use, how to transform their lives to better fit the new era. Foreigners did come, but instead of menacing with arms they proffered goods to trade in exchange, for all this technology was new to them and valuable.

And the people soon realized that the only enemies were those few of their own who called them to fear and battle. So they did what all sensible people do with such ilk: they scorned and laughed at them, and made them perform their ludicrous tirades at every school and theater in town. Oh, how the children giggled! The ridicule was so great that soon no one thought of swords again without guffaws and hoots.

And the land became happy.

Spreads, Credit Fears and Principal Conservation

The following chart tracks the yield of 3-month US Treasury bills; recessions are marked in gray (click to enlarge). With the exception of 1984-86 when inflation came down rapidly due to plunging oil prices, every time T-bill yields dropped significantly the US economy entered a recession, or was already in one. The reason is that investors facing recessions get out of riskier assets such as stocks and corporate bonds and park their cash in T-bills, instead.

Three Month T-Bill Yield Chart:FRB St. Louis

The same thing is happening today, but with an important twist. The current credit crisis is targeting specifically the short end of the yield curve. The failure of the SIV - ABCP and other structured finance markets has increased demand for the safest possible short-term instruments, i.e. T-bills. While 3-month bills are now at 2.85%, bank certificates of deposit (CDs) with the same maturity are at 5.00%, 3-month LIBOR (the rate at which banks lend to one another) at 4.86% and commercial paper issued by financial institutions at 4.90%.

The spread between T-bills and such rates is the main credit fear indicator for money markets. The next chart shows the spread between 3-month bank CDs and T-bills (click to enlarge). It is at 2.15%, the highest in over 20 years.

Data: FRB St. Louis

However, even this big spread understates the magnitude of the current crisis because it is in absolute terms, not relative to current interest rates. It is one thing for spreads to be at 2.15% when market rates are at 10% and very much another when they are at 3%. For proper perspective, the next chart tracks the spread as a percentage of T-bill rates (click to enlarge).

Data: FRB St. Louis

The ratio is now at the highest point in at least 43 years (75%), meaning that investors are so concerned about getting their money back after three months that they are willing to forgo a record 75% more income available through CDs than from T-Bills (2.15%/2.85%). This is not mere credit fear, but full-out principal conservation mode.

Effectively, the money market has ceased functioning normally. Banks rely instead on borrowing unprecedented amounts from central banks and this explains the ECB's decision last week to provide "unlimited" liquidity and the Fed's announcement that it will continue its TAF operations for as long as it takes. The central banks have drawn a line in the sand, betting that they can ultimately win the battle against fear.

This is a very fragile state of affairs. Despite the rhetoric, even central banks do not posses enough resources to fund the entire system and one more wave of major credit-related news could easily wipe out the line.

Yes, Virginia

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The next few days are devoted to the Holidays. May I wish you all the warmest and most joyful of times. Sudden Debt will likely return, as Mae West used to say, "in between the holidays".
But in the meantime...
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The following epistolary communication was recently intercepted by our homemade Echelon system. The first letter was addressed to a Mr. Jack Bonus, Managing Director of Bonus Bonus and Bail, a reputable investment bank. His response follows, beautifully calligraphed upon heavy cream stock and engraved in copperplate with the firm's "BBB" logo.

Dear Mr. Director, I am 26 years old and some of my friends say there is no invisible hand. My boss says, "If you see it in your paycheck, it's so". Please tell me the truth, is there an invisible hand?

Virginia Smith

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Dear Virginia,

Your little friends are wrong. They are affected by what they earn, instead of what they ought to yearn. Skeptics, liberals, socialists, Keynesians and terrorists, all. They want their little selves to be more than mere insects in the great marketplace of ours - to be given by it, instead of giving to it. They do not grasp the ultimate truth contained in such a boundless enterprise: wealth is created by the invisible hand.

Yes, Virginia, there is an invisible hand. It exists as certainly as malls and car dealerships and restaurants do, even if you may rarely afford to visit them. How dreary life would be for the rest of us if such commerce did not exist! It would be as dreary as not having Armani and Hermes and Bentley, no trinkets to make our lives more tolerable. We should have no enjoyment except for polyester and frozen fries, then! And imagine what yours and your friends' lives would be like if you could not dream of such gifts, too. How could you tolerate meatloaf and plonk if you could not peek through our windows to see us quaffing Cristal and munching venison? Why, the very thought would extinguish the light that fires your eternal hopes.

Not believe in the invisible hand! You might as well not believe in the stock market. You may lose your entire pension in some misbegotten investment made in your name by a fund manager in Florida, but what would that prove? Nobody sees the invisible hand, but that does not mean it does not exist. The most tangible things available to us are created by it, but did you ever see capital gains dancing in the Street? Of course not, because they dance in our accounts, unseen and unseeable by you and yours.

You try to take away a bone from a mongrel and see what today's economy is like for most, but there is a veil covering the workings of the invisible hand that not the strongest analyst could tear apart. Only greed of a higher order than known to most permits entrance past the veil, to grasp that which the hand has wrought.

No invisible hand! Thank Mammon! it lives and lives forever. A thousand points from now, Virginia, nay 10 times 10.000 points from now, it will continue to bulge the purse of those that steer it.

Very truly yours,

Jack Bonus
Managing Director and Head
Secret Handshake Dept.

The Stock Market Conundrum

The housing market is in deep trouble, corporate profits are dropping and credit is tightening. Prices for food and energy are rising fast and the consumer is limiting discretionary spending. The chances of recession are increasing. And yet the stock market, or at least the popular indices, is stuck near record high levels stubbornly refusing to crash and burn as so many predict. What gives?

First there are the conspiracy theories: the market is being manipulated by a cabal of insiders who do not wish to see it drop for fear of economic and political consequences. Members supposedly include brokers, Treasury officials, hedge funds, etc. This is not a bad theory, as such go: the popularity of derivatives and the absence of individual investors has made equity markets much narrower and theoretically easier to influence.

The signs are there: sudden upward spikes with no news developments, just as the market appears most vulnerable to a plunge. It has been notable that this action typically takes place around 2.30-3.00 p.m., i.e. in time to artificially boost the market right before the 4.00 p.m. close. But is the market actually being heavily manipulated, or is there something else going on, potentially more dangerous?

There has always been an element of manipulation in markets. Big players routinely use dominant positions to move markets in their favor and today is no exception. The current market is characterized by a few really big houses all singing from the same "long equities" - "long risk" book and who, in addition, are all using the same black box quant programs devised by their similarly-schooled financial engineers. In other words, there is an institutionalized resemblance to the strategies and methods employed by the majority of the big participants, resulting in their moving as a herd. This bias is in turn recognized by many smaller speculators who try to anticipate and benefit from such moves, further strengthening and amplifying the moves into a self-fulfilling prophecy.

Second, program trades now account for a very large portion of the volume, as do trades that originate from hedge funds. The day-to-day importance of more traditional buy and hold investors such as mutual funds, pension and endowment funds has greatly diminished. Further, even they have allocated some portion of their funds to alternative investments, i.e. to hedge and private equity funds employing black-box tactics.

This, however, does not explain the behavior of traditional investors who still use fundamental value, top down analysis, etc. How come they are not selling? The facts suggest the answer: they are selling. Look at the sectors being hardest hit: banks, builders, retailers, automakers - they are all down very substantially from their highs, exactly following their poor fundamentals. So, the entire market is not on black-box auto-pilot mode.

This brings up another observation - the popular indices may be near all time highs, but market breadth is deteriorating. Advance-declines and new high-new lows peaked around July and are heading down; the generals with heavy influence on the indices may be marching on, but the soldiers are not. This observation is consistent with the first point, i.e. the narrowing of the market with heavy derivatives-based strategies that depend on index trading.

NYSE Advance - Decline Issues

NYSE New Highs - New Lows

NASDAQ New Highs - New Lows

What's holding up the indices? The index-heavy big caps - they are the traditional core holdings of the big, real money buy and hold institutions: Apple, GE, Microsoft, IBM, 3M, Alcoa, Exxon, Boeing, etc. The current conventional economic wisdom is that the global economy will remain strong, even if the US goes into a mild recession - and these are exactly the multinationals that will fare best. If there are conventional money managers with contrary views, it does not pay for them to act contrary to groupthink. Contrarian mistakes are punished, but conventional ones are OK.

Since real money investors are not selling core positions, black-box types and their second-tier followers can dance with derivatives to shape day-to-day index performance. The conclusion is that there is no heavy-duty, large scale government/PPT manipulation going on. But what is going on is potentially more dangerous.

What if the above conventional macroeconomic view is wrong, as is increasingly more probable? In that case the real-money institutions will start liquidating core blue chips, pressuring the indices down. No black-box can come up with the buying power needed to mop up 30.000.000 Exxon shares at once - none. In fact, if these types of orders start to pop up frequently at trading desks the black boxes themselves will go to "short equities" - "short risk" mode and push derivatives in the other direction, precipitating sharp downdrafts instead of ups. We may see a nasty replay of 1987's interaction between cash stocks and their multiple derivatives, even if the process is more drawn out than a single day or two.

Finally let's not forget the link between credit and equity markets that exists today in the form of Credit Default Swaps (CDS). Picture this: an equity trader looking over his shoulder to the CDS market and a CDS trader looking over his shoulder to the equity market, each taking cues from the other and each trying to "draw" faster. It worked very well on the way up during the virtuous cycle, so there is no reason to believe the link will be severed during a vicious cycle.

Crossing The Line - Cutting "The Line"

The ECB yesterday had to provide 348 billion euro ($500 billion) at 4.21% to cover its unprecedented promise to supply the market with unlimited funds in the two week period, which included the turn of the year. The bank had never before committed to satisfy all requests in any of its liquidity operations. This action crosses the line between "lender of last resort" and "major lender to the market". That it would do so reveals the increased pressure building inside the global financial system, ever since the credit problems surfaced in the interbank money market last summer.

At that time most analysts expected the troubles to quickly go away after central banks injected liquidity, in a repeat of the LTCM bailout of 1998. When that did not work, all manner of schemes were announced: MLEC to save SIVs, ARM freezes and TAF operations from a group of five central banks working in concert (FRB, ECB, BoC, BoE and SNB). None have so far succeeded in reversing the freeze gripping the interbank money market, the single most important financial market for the day-to-day workings of the economy.

Banks are presently unwilling to lend to one another. This has resulted in central banks having to raise the scope, size and frequency of their liquidity operations, increasingly assuming responsibility for the entire money market - not only as setters of interest rates, but as ultimate arbiters of who gets how much liquidity. This is an extraordinarily uncomfortable, unsuitable and unfamiliar position for central bank bureaucrats to find themselves in.

Some people are hoping that things will change for the better after the New Year, but I fail to see it. Given current conditions, banks' credit departments are surely already working at revising trading limits ("lines") to other banks and many of their trading customers. Such lines are usually reviewed annually and cuts are uncommon, at least amongst the major institutions. They are considered a slap in the face and are most commonly answered by retaliatory cuts. While this may sound childish, it is in fact very serious business reserved for the grown-ups in the banks' credit committees.

A bank faced with decreased lines from other banks cannot maintain its own lines to them at high levels. If it keeps providing more liquidity than it has access to, it simply won't have enough to run its own business - i.e. to fund its customers. Multiply this across the system and you have a shrinking of the overall credit available in the interbank market. This will immediately migrate to the customer side, first affecting the large speculators who depend on prompt access to margin funds (e.g. hedge funds). No need to spell out what this reduction in available credit means for securities markets.

The process of reducing risk in professional investment portfolios has already begun, judging from the sudden plunge in the State Street Investor Confidence Index, "a quantitative measure of the actual and changing levels of risk contained in investment portfolios representing about 15% of the world's tradable assets." State Street is one of the world's largest custodians ($15 trillion in custody), so they have a pretty clear picture of what is going on inside institutional accounts.

Data: State Street

Where does this leave the central banks vs. the money markets? Obviously, their relative importance will rise temporarily, tempting some participants to expect them to become perennial providers of massive liquidity. This is impossible, for two reasons:

• They do not have the necessary monetary resources and suasion is powerless when everyone is scrambling for hard cash. Notice how it took the ECB "unlimited" amounts to finally bring rates down, instead of a simple round of calls to dealing rooms (known as "checking rates").
  

• Their acts cannot overcome the commercial and investment banks' own credit committee decisions to cut credit lines to other banks and customers.
  

The one thing that will eventually restore order to the interbank market is its gradual deflation to a more manageable size. I believe this process is already in the works.

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In a separate development dealing with the herein oft-discussed issue of Credit Default Swap (CDS) counter-party risk, the NY Times has a revealing article about ACA Capital Holdings. Notice, in particular, the booking of basis trade profits. Well worth a read.

Ding, Dong...It's Been Tried Already

Messrs. Bernanke, Paulson and the less eponymous Eurobankers are throwing liquidity at anything that moves, in hopes of averting a recession - why? What troubles them so deeply about the global financial system that they are willing to do unprecedented things, like provide unlimited liquidity at below market rates? From the Financial Times:

Emergency help for financial markets entered new territory on Monday as the European Central Bank announced it would on Tuesday offer unlimited funds at below market interest rates in a special operation to head off a year-end liquidity crisis.

**** Flash Update: The ECB pumped in a whopping 348 billion euro, i.e. half a trillion dollars. Baby, bathwater, the sink, the attendant, even the bath house were thrown in. Reach your own conclusions - my own will appear in tomorrow's post.****

Regular readers know the answer: in our fiat system, all debt is money and all money is debt, therefore the authorities are panicking at the prospect of a sudden economic implosion caused by credit destruction, i.e. the evaporation of large amounts of money. In other words, Depression. (The title of this blog, Sudden Debt, was chosen a year ago because such a terminal outcome was becoming obvious to yours truly. Permit me, then, this small bit of self-accolade: things are unfortunately developing as I thought.)

The natural response of central bankers, when faced with the prospect of monetary implosion, is to use the sole weapon at their disposal: offering cheap money. Nevertheless, people can't be forced to borrow, even if rates go to zero. This condition is known as a liquidity trap, and Mr. Bernanke is infamous for suggesting - tongue firmly in cheek - the extreme cure for it: raining down cash from a helicopter (the idea came from Milton Friedman).

We know that a massive liquidity cure has already been employed in the United States under Mr. Greenspan, "the original" depression fighter. He took rates to near zero following the implosion of the NASDAQ bubble, thus creating the pernicious real estate bubble. The result was more debt, i.e. more money upon which the global economy floated these past 5-6 years. The Chinese economic "miracle" is largely a product of more dollars, created not only in the US but also in China, masquerading as yuan.

The bottom line is that Mr. Bernanke's monetary thunder has already been stolen by the previous Fed and the Chinese monetary authorities, who created massive amounts of liquidity. We now face a condition where consumers are loath to borrow more, because they have already borrowed too much. Offering more credit, even at low rates, does not alleviate their plight.

The one way out is also likely to be the most painful: a long period of downward adjustment in debt/asset and price levels, so that obligations can once more be adequately serviced from economic "rents", i.e. earned income from employment and corporate operating profits. The era of capital gains as constant booster shots is clearly over.

Smart college administrators in Harvard (Yale is jumping in, too) are fast adjusting to reality: they slashed tuition for students whose families earn up to $180.000 by 30% to 50% and expect that no student will need to take out college loans. In addition, and very tellingly, Harvard will "no longer consider home equity in determining a family’s ability to pay for college". It is well worth reading Harvard's release in the link above.

If it were a public announcement, it would go like this:

Ding, dong... Harvard is proud to announce that deflation has now commenced, starting at the very top. Essential service prices for the vast majority of Americans making less than $180.000 per year are 30%-50% too high and taking out more debt won't help. In addition, we would like to point out that regular capital gains are a thing of the past, at least in housing. Our opinion, which we are backing with our hard cash, is that low interest rates and capital gains as drivers for the economy, are finished. This concludes our announcement...Ding, Dong.

Debt Is A Zero Sum Game

Are bonds an asset class? I bet that if I ran a poll amongst financial professionals, 99% of them would instantly answer yes. They would be wrong, however, because the correct answer is concurrently yes and no, meaning that the question itself is incorrect. Blame it all on the double-entry accounting system, so ingrained in peoples' minds ever since it was invented by Luca Pacioli, in 1494. More on that later.

Debt is a zero sum game: one person's liability is another's asset - it all depends on your circumstance, your point of view. If you own debt you consider it an asset, whereas if you owe it you consider it a liability. On an overall net basis, debt cancels out - it cannot exist by itself. The only "real" assets are real estate and ownership of means of production, i.e. equities. Thus, ultimately debt is based on consensual fiduciary trust, backed by ownership of land, stocks and human capital.

What's the use of debt, then? Because it is not equally spread amongst people, debt can be used to selectively leverage ownership and thus the temporary monetary value of real assets. Debt can never exceed the value of real assets, of course, but the rate at which it expands or contracts vs. the value of assets, can. When we expand debt faster than the value of assets we create temporary credit bubbles, which ultimately pop to restore balance.

For the past 15 years, total debt in the United States has been rising significantly faster than the value of stocks or real estate, pointing to the creation of incipient bubble conditions, at least on a localized basis. Globalization has spread out the boundaries of asset ownership and thus the effects of debt, but I for one am not ready to view the global financial system as homogeneously efficient and impartial. There is no global society as of yet, despite pronouncements that The World is Flat.

Data: World Federation of Exchanges, FRB

To close, let's go back to Luca Pacioli, the "father of modern accounting". Why did it take human beings so long to come up with the double-entry system? After all, it was nothing more than a simple logical arithmetic process, and people had been trading goods and keeping accounts for thousands of years before him. Why didn't the Greeks with their superb mathematical skills come up with double-entry - or at least the Romans, with their meticulous bureaucracy?

The answer is simple: they didn't need it - but the Venetians, Milanese, Genovese and Sienese did. By the 15th century the city-states of Italy had become trading giants whose merchants' debts (mostly bills of trade) could be traded as "money" - asset and liability at once. Not surpisingly, then, the oldest bank in the world is Banca Monte dei Paschi di Siena, founded in 1472. We've been wondering about "what is money" ever since, but I think the Sienese bankers had it all figured out a long time ago. They became rich enough to make their city one of the most beautiful in the world.

Santa Maria dei Servi, Siena

Santa, Baby...It's Ben, Again

Santa, Baby you're unfair. Where's the rally? And what's with all these coals you stuffed down my woolly credit stockings, even before I had a chance to hang 'em, proper like, in front of the marketplace? ... C'mon baby, where's you holiday spirit? Ho, ho, ho?

Allright, I admit I haven't been a good boy. I have plagiarized... Cut and Paste, Cut and Paste. But Alan did it, too, and you brought him gifts... Stocks 'n' bonds 'n' houses, all shiny and bright... Maybe I'm a bit Goofy, maybe I haven't thought things out all the way. But please, Santa, just this year? Please, please, please?

All I want for Christmas is for two big banks, my two big banks, my own two banks... to stay sooooool-vent!

Here There Be Monsters

The phrase “here there be monsters” was used by early European mapmakers to warn of dangerous beasts awaiting in unexplored locations of the Seas.

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The manufacture of CDOs and other such highly engineered financial products was similar to any other industrial process: raw material (loans) came in and were processed into an array of products (CDO tranches). After inspection by the quality assurance department (rating agencies), the merchandise was shipped out and sold to different customers, each according to his needs. The AAA tranches went to pension funds, insurance companies, mutual funds and other end-users, while the mezzanine tranches were bought by higher-risk entities such as hedge funds.

But what happened to the left-overs, the non-rated equity tranches that are first to absorb losses, known as "toxic waste"? These contain 100% concentrated risk, extracted from the raw-material loans when they were packaged into the more marketable tranches. Unlike industrial waste, this paper could not be dumped into the environment but had to be sold to speculators willing to bear the highly elevated risk, or be kept by the "manufacturer" bank which then retained the risk itself.

How much of this toxic paper was produced? According to SIFMA the global issuance of CDOs in 2004 - 1Q2007 totaled $1.17 trillion (click image to enlarge). The percentage of equity tranches varied between 2%-15% of face amount, depending on the assets, the structure, etc. Assuming an average 8.5%, it comes to $100 billion and in this credit-crunch environment it is pretty certain it has been totally wiped out.

CDO Issuance Data (SIFMA)

Next question is, who bought them and who is stuck with the losses? As we saw, only two major classes of holders existed for this toxic waste: issuing banks and speculators with a highly elevated appetite for risk. There is no way to know what the split is, so let's assume the holdings were equally split between banks and hedge funds, leaving each with $50 billion of losses.

Here comes the interesting part: so far, banks worldwide have written down slightly over $50 billion for their entire exposure linked to US mortgages and structured finance which is, of course, far greater than just the equity tranches. The conclusion is that there are significantly greater losses coming up for the financial sector in the very near future, since $50 billion covers only their estimated exposure to the equity tranches. Hedge funds are also on the hook for at least an equal amount of losses.

Trying to navigate through the terra incognita of structured finance holdings at banks (and hedge funds) is a near impossibility. They are so heavily annotated with Class II and Class III markings - plus unknown off-balance sheet exposures - as to be the equivalent of "Here There Be Monsters" in old maps. It is little wonder that the credit market has seized: mariners are unwilling to steer by such maps; the few that do, ask for pay commensurate to the risk. Yields on asset-backed commercial paper have moved back to the highs reached before the Fed cut rates for the first time, and risk spreads are the highest in at least seven years.

Discount rates on 30-day commercial paper (Charts:FRB)

Spread between A2/P2 and AA non-financial CP

In the era when ships sail loaded with GPS, radar and SATNAV why does anyone expect investors to jump into a ship captained by a bearded one-eyed pirate gulping rum and yelling: "C'mon ye stinkin' cowards!! Are ye afraid to die?"

Then and Now

On the back of yesterday's discussion about energy regimes and the need to change from fossil to alternatives, I will make a special book recommendation prior to the main post.

A commenter (thks. Anon.) reminded me of one of the most important books I have ever read: Daniel Yergin's The Prize:The Epic Quest for Oil Money and Power, winner of the 1992 Pulitzer Prize for non-fiction. The title says it all and despite its size and subject matter it reads like a novel. The author has since become a red flag for peak oil proponents, but if you wish to understand what has been shaping world events for the past 100 years you really should read this book.
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Yesterday the Fed announced a Treasury Auction Facility (TAF - notice the allusion to "tough") and an arrangement with other central banks to form a united front, "designed to address elevated pressures in short-term funding markets". Nice trick, I first thought, and then started laughing. I mean, what is one to make of this confederacy of dunces? They first underscore there is a serious global problem, but then proffer a BandAid?

If desperate times call for desperate action, why bother with droplets of credit? If you are going to go down that route (as opposed to coming up with credible solutions), you might as well start warming up the printing presses, because the Sea of Debt will require an Ocean of Cash to service. Thus, in the spirit of tragicomedy, today I am attempting comedy. I will leave the tragedy to others, obviously better equipped to provide it.

What a difference a year makes.
That was then.
This is now.

Snap of the fingers
$10 billion dollars for your LBO fund.
"Hey, you! Waiter! Where's my damn soup?"

Bonus time
Choice of Ferrari colors.
Extra playing time at the video arcade.

Hedge fund
2/20% , VIX stuck at 10, lush green.
What you must scrape together to pay for lawn service.

Risk
Smaller than the chances of winning LOTTO.
We have a winner!!

Vacation
Mustique island villa, $30.000/wk.
Gilligan's Island on cable. Cheez Doodles, $1.29/bag.

Working Environment
Master of The Universe.
Yes, master.

2006 Vintage
The MBS schlock you turned into CDOs.
The only schlock you can afford. Twist-off bottle.

Financial engineer
Genius.
Moron.

Repo Man
The house man you called daily to run your bond positions.
The man that calls at your house daily.

Bail bonds
Get out of bonds.
Vinny.

WalMart
Who?
Welcome to our store, how may I help you?... Welcome to our store, how may I...

AAA rated CDO
Safe as houses.
Safe as houses.

The Fed Is Not The Issue

Every day, I get spam that promises to make my life so much happier and fulfilling, if only I would get larger breasts. It's the same with the Fed: pumping up debt through cheap money is now as beneficial to the economy as giving D cups to the entire male population. Brassiere sales would jump, but the benefit would not last.

The main concern today is fiduciary adequacy and not liquidity. We have already borrowed so much (total debt is near 350% of GDP) that our ability to service existing debt is more relevant than access to additional debt. The importance of the Fed to the economy is thus limited, and our fixation with what it does, or does not do, is a distraction from dealing with the real issues.

Data: FRB

What are the issues?

1. Forget the Fed; there can be no monetary solutions to fiduciary problems.
   
2. Re-establish the relevance of fiscal policy as more than just discussion about tax cuts.
3. Raise earned income, instead of relying on capital gains and portfolio income; create permanent high value-added jobs, targeted to exports.
4. De-leverage.
   
5. Emphasize industry over finance and production over consumption.
   

As a trained engineer with 25 years of finance experience, I believe the way to achieve the above - at least partially - is to move with all possible urgency towards a new energy regime. Jimmy Carter was absolutely correct about at least one thing: we must engage in energy independence as in the moral equivalent of war. If nothing else, consider this: Alan Greenspan admitted that the Iraq war was about oil.

I do not pay attention to the loud, but ignorant Cassandras of doom and gloom - switching to other energy sources can be done and, what's most important, must be done. We humans are already choking on our own effluent, and that's with 2.5 billion Chinese and Indians consuming energy at a fraction of Western levels.

Data: IEA

The real obstacle to change is not technology, but powerful fossil-fuel vested interests: oil, gas and coal companies, "authoritarian" oil regimes (polite term for friendly dictators) and the military industry. Just like tobacco companies, they are cash-cow giants who fight very hard to retain the status quo. At current prices, the crude oil business alone is worth $2.5 trillion per year. So it's a very big and very profitable status quo.

The lineup fighting change is completed with the Russians who, from Peter the Great onward (1672-1725), never lost their desire for geopolitical domination. As the world's largest oil and gas exporters, they once again have the financial and strategic capital to send Navy carrier groups into the Mediterranean and bomber planes over the Atlantic.

Fossil fuel dependence transfers vast wealth from billions of consumers to a few potentates, destroys our habitat and requires huge military expense. Crucially, it also wastes our "seed corn" concentrated energy, which we should instead be sowing to harvest sustainable energy in the future. The benefits accruing to us from our oil-based dollar hegemony are increasingly being overtaken by the costs, and to keep the scheme going is bordering on criminal neglect.

How do we accomplish change? The moral equivalent of war requires that we forfeit some comfort today for the certainty of a better tomorrow. If done properly and urgently (always a challenge to do both), the "discomfort" period could be quite short - certainly less than a generation.

Here are some concrete proposals:

1. Impose a tax for all carbon-based fuels (yes, corn ethanol too) at the equivalent of $1/gal, increasing by 10c every three months.
2. Recycle the tax money into the economy as: engineering and science scholarships, R&D projects and direct subsidies to alternate energy projects.
3. Promote distributed energy systems over central power stations, e.g. solar/wind/geothermal mini-stations for the production of hydrogen through electrolysis. The model is the Internet Web vs. the large computer centers of the past.
   

The carbon tax would immediately raise approx. $500 billion per year, or 3.8% of GDP. While certainly not small, this sum is well within the ability of the US economy to absorb and recycle efficiently. Our foreign oil dependence is so high, that our oil import bill now runs nearly a trillion dollars per year, or 6.5% of GDP - approaching the percentage during the "bad old days" of 1980.

Data: British Petroleum

Some will say that this is nothing but a grand "tax and spend" scheme. Well, yes - that's exactly what it is. Real wars cannot be fought and won based solely on voluntary donations. Likewise, fundamental paradigm shifts require the enlistment of the entire society, not just that portion which is affected on the margin of supply and demand.

In closing, I would also like to point out that there will likely be significant social benefits from switching to a looser, more distributed energy regime. This could be the topic of an entire book, let alone some notes at the end of a blog, but the main thrust is that distributed energy empowers and necessitates locally participative democracy, instead of the centrally passive democracy we have now.

The Hand-To-Mouth Factor

A reader calling him/her-self "ignorance" asked:

What's the point of critical mass? When do consumers finally realize the direness of the situation and everything starts unwinding?

This is actually a very intriguing question, so I will attempt an answer below.
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Betting against the propensity of the US consumer to shop, come hell or high water, has been a bad wager for decades. Consumer spending now accounts for 70% of US GDP, the highest proportion ever (see chart below).

Data: FRB St. Louis

Two questions arise:

a) What allows the US consumer to keep spending?
b) Can it change suddenly (critically)?

The mechanism that kept consumer spending high and rising over the years, was quite simple: less saving and more borrowing. Starting in the mid-1980's the saving rate (the portion of disposable income not spent) moved lower, eventually reaching zero, and household debt rose sharply from 65% to 135% of disposable income. Not to mince words, Americans live hand-to-mouth and are in debt up to their eyeballs. Under these circumstances, it is little wonder that consumer spending is kept aloft. But what's lurking down below?

Data: FRB St. Louis

The expense for basic, non-discretionary items like food, fuel and debt service is rising once more (see chart below, current to end 2006). Coupled with zero saving, this potentially spells trouble for spending on discretionary items, where demand is more elastic.

Hand-to-mouth, high debt and rising bills for necessities... doesn't sound too promising. What could tip the whole thing over?

Expenses for food, utilities, heating fuel, gasoline and financial obligations (2006)

Americans now live paycheck to paycheck. If they lose their jobs they will immediately cut down spending, not because they choose to but because they have to. Thus, now more than ever, the important numbers to watch are those related to employment.

The Labor Department releases payroll numbers monthly (jobs that were added or lost in the previous month) and initial claims for unemployment benefits every Thursday (known as jobless claims) . Let's look at each more closely.

The monthly payroll number is watched very closely, by politicians in particular. This is the number you will hear most about in any campaign: "During my Presidency/ Governorship/Mayoralty, I added X million new jobs". When Clinton said "It's the economy, stupid", this is what he meant and that's people reacted to. In addition, it is the Holy Grail of all macro-based econometric models. Predict the employment number and the rest is dot connection. Wall Street is particularly keen on it because it affects expectations for inflation, interest rates and, of course, consumer demand. In other words, everyone watches and everyone cares. So how accurate is this number?

In a word... it depends. The Bureau of Labor Statistics (BLS) has to deal with intense seasonality, as well as the ebb and flow of businesses opening and closing - the so-called business Birth/Death factor. Seasonality is well understood and follows repeated patterns. However, the Birth/Death factor is very different - this is what the BLS itself has to say about it:

"The most significant potential drawback to this or any model-based approach is that time series modeling assumes a predictable continuation of historical patterns and relationships and therefore is likely to have some difficulty producing reliable estimates at economic turning points or during periods when there are sudden changes in trend. BLS will continue researching alternative model-based techniques for the net birth/death component; it is likely to remain as the most problematic part of the estimation process." (bold added).

In other words, the accuracy of the monthly payroll number is highly dependent on a "problematic estimation process" - not exactly comforting. The following chart shows the number of new jobs reported by the BLS and how many of them were due to the Birth/Death Model. In 200-06 the model "created" 34-42% of the reported numbers. In the first 11 months of 2007 the model accounted for a very high 82% of all reported new jobs.

To wit, even as the actual BLS survey showed many fewer jobs being created, their Birth/Death model tacked on and reported an additional 1.1 million jobs, because it is still stuck on "expansion" mode, extrapolating a trend that simply isn't there.

Data: BLS

Anyone even slightly familiar with mathematics can see that the discrepancy is so high that the reported numbers are entirely unrealistic and will eventually be revised down. For the same reason, however, we can reach a highly reliable conclusion: that we are indeed undergoing an economic turning point, from expansion to slow-down or perhaps contraction. The Birth/Death Model is valuable, after all...

The other employment number the BLS reports is weekly jobless claims. They have been trending higher, as expected in a slowdown, but not spiking up as during a recession. To further adjust for the larger labor force over the years, I charted the ratio of claims to people employed (see below). The chart tells a story quite consistent with an employment holding pattern: new jobs are scarce, but there are no massive layoffs, either. Notice, however, that we are near historical lows.


Let's put it all together and attempt to answer the original question - when will the mighty US consumer shut off spending? The truthful answer is, I don't know. But I know where to look for very credible signs preceding the spending cuts: weekly jobless claims.

I also know something even more important: given the hand-to-mouth existence, high debt and rising inelastic expenses, significant job losses will lead to deeper and faster spending cuts than ever before. That will be the critical point, not only for the consumer, but for the entire US economy. I'll be watching...

The False Prophets of Wealth

A Sunday Sermon

Watch out for false prophets. They come to you in sheep's clothing, but inwardly they are ferocious wolves. By their fruit you will recognize them. (Matthew 7:15-23)

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In a world where debt expands much faster than our ability to put it into productive use generating income, are we cursed to lurch from one asset bubble to the next?

In the late 1990's we experienced one of the most powerful popular delusions in financial history: that the average person could sit in front of a screen and get rich by day-trading shares of companies with little intrinsic value, other than a dot.name and a Hail Mary business plan. Popular Capitalism, we called it, blissfully ignorant of the inherent oxymoron. The end came swiftly and painfully. Within just two years in 2000-2002, $7.1 trillion of stock market wealth evaporated, representing an astonishing 73% of GDP.

The shock to the economy was expected to be so severe that the Fed, perennially terrorized by its institutional memory of the Great Depression, went into panic mode, slashing interest rates to fifty-year lows. The objective was to prevent the stock crash from turning into something far more menacing - and it succeeded, at least temporarily.

Data: FRB and World Fed. of Exchanges

The sector chosen to produce America's urgently needed rebound was real estate. Mr. Greenspan made no bones about it: he constantly emphasized that average Americans had much more wealth locked up in housing than in stocks and that low interest rates would release this "frozen" capital, letting it loose upon the economy as debt-driven consumption. Moreover, the low cost of borrowing would increase new housing demand, create jobs in construction and finance, and raise existing real estate prices. When the follow-up effects of new housing were added (furniture, appliances, services), the economy was expected to enter another virtuous cycle.


It all went according to plan, until greed once more overcame common sense and yet another pernicious bubble formed. As the nation had already become accustomed to viewing capital gains as a birthright, people predictably jumped from flipping stocks to flipping houses. Stock margin was replaced with no-money-down liar loans and house prices were off to the races. The asset class that was supposed to act as the golden anchor of family savings was pulled up, melted into coin and spent like so much pirate loot. By the time the real estate market peaked in 2006, all it took to go from one bubble pop to the next was a breathtakingly short six years.


The mess is only now starting to hit home. Structured finance vehicles like CDOs, SIVs and ABCP allowed mark-to-market losses to be obscured by opaque pricing. For as long as end-user investors did not need the money, it mattered little; dealers could claim that prices were whatever came out of mark-to-model black boxes. But when the money was needed - for example, to pay schoolteachers in Florida - the trouble surfaced to the "real" economy. Investment bankers now blame it all on unpredictable 20-sigma events, but this is like Casablanca's Capt. Renault professing to be "shocked, shocked to find that gambling is going on here", while a croupier hands him a pile of money, saying: "Your winnings, sir".

As with stocks in 2000-02, real estate wealth is wasting away. The drop isn't as fast or as severe, but it affects a far greater number of Americans. What Greenspan saw as the main advantage of a housing boom, i.e. wide participation, is its greatest shortcoming, as it turns into a bust. When stocks drop $100 the loss to 80% of Americans is just $9. But in the case of housing they lose $35 - four times as much. The impact on the mood of the consumer, the so-called "wealth effect", is likewise severe - though with a significant delay, because house prices are not tied to a daily Dow Jones-type ticker. People have difficulty accepting that their own house is now worth significantly less. They too, are marking to model or, more accurately, marking to dream.

This is not lost on the Fed and the administration, both of whom are once more in thinly-veiled panic mode. They keep throwing up all kinds of misbegotten plans to save the day: the super-SIV, lifting lending restrictions to bank subs, encouraging Discount window borrowing, freezing ARM rates - BandAids, all. Perhaps they will try another tax cut soon?

The false prophets of wealth are finally seen for what they really are: pushers of debt and needless consumption. They preach that if debt is made cheaper, if the liquidity taps are opened wider, if we just borrow more, we us all shall be wealthy. But in a global financial system that is already awash in liquidity, what need have we of more? What is there left to speculate on margin, that is not already levered to the hilt? Nothing.

Enough with the sermonizing. The practical question is: what should be done? If lower interest rates and the various government plans are not the solution, what is? I shall revert with concrete proposals, but in the meantime please read what someone had to say about this very subject over two thousand years ago. It is to be found underneath the blog title at the very top. Some things never change.

CDS Factors In Equity Valuation - Part D

This is the fourth in a series. Parts A, B and C were posted on Sep. 10 - 12 and Dec. 3, respectively.

I wish to express my appreciation for all comments and suggestions made by readers of the first three parts; they were invaluable.
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Part D: The Equity Risk Premium as Insurance Premium

It was shown previously that Credit Default Swaps are in fact insurance contracts and not bona fide swaps. Taking this insurance characteristic further, let's view the entire CDS market as a large insurance company (CDS Inc.) underwriting credit default insurance on the following entities:

• Global Governments
  
• Global Structured Finance
  
• Global Corporations
  

We need to dispense with the first two, since we are examining the effects of such insurance on equities, i.e. the corporate sector. Before we can do so, we must estimate what portion of the total CDS business is attributed solely to the corporate sector. (If you don't care for the gory details, I estimate it as 80% - now go to Step 3).

Step 1

We can safely assume that central government credit represents only a small portion of the default insurance business. The largest government debt issuers in the world (US, UK, Germany, France, etc.) are themselves rated AAA and serve as risk-free benchmarks. The sole exception is Japan, which carries a AA- rating; it is highly unlikely, however, that hedgers and speculators are much interested in underwriting or purchasing CDS on Japanese government bonds (JGBs), given the extremely low nominal interest rates (e.g. the 10-year JGB is currently at 1.56%). The rest of the world's governments simply do not issue so much debt as to make a difference. In sum, I estimate that no more than 5% of CDS notional outstanding is against central government credits.

This leaves regional/municipal debt. In the US, by far the largest issuer of such bonds, this market is estimated at $1.7 trillion, spread among 50.000 separate entities that issue bonds (SIFMA). This is a market where credit insurance has been dominated by the monoline insurers (MBIA, AMBAC, FGIC, etc.), long before the advent of CDS. It is pretty much an end-user investor market, meaning that there isn't all that much speculation going on. With the exception of a few large issuers such as the States of NY, NJ, California and Florida the market is highly fragmented. This, in effect, limits the use of CDS to mostly hedging purposes and it is unlikely that notional CDS outstanding exceeds the face value of muni bonds, or approx. $2 trillion - if that much. This represents less than 5% of global CDS, bringing the total for all government-related credits to ~10%.

Step 2

Next is structured finance, i.e. credit insurance written against CDOs, CLOs, etc. The total size of the asset-backed market is ~$2.6 trillion, with new bond issuance particularly heavy during the last 2-3 years. For credit insurance, this was also a hedging-related activity until rather recently, when speculation on the sub-prime MBS market created significant short selling interest, particularly against the ABX and CMBX indices. There is no way of knowing with any degree of certainty what multiple of face value is covered by CDS - but we do know that banks have been taking large, multi-billion losses on their portfolios of such paper, so it cannot be very large. Goldman is apparently an exception and so are some hedge funds who called this market right and benefited accordingly. I will go ahead and guesstimate the amount at ~$5 trillion, or another 10% of notional CDS.

Step 3

This brings the total for the first two sectors to 20% of CDS notional, or $9.1 trillion, leaving 80%, or over $35 trillion, as CDSs written against global corporate names. The US Office of the Comptroller of the Currency in its latest survey found that US banks' positions in credit derivatives ($12 trillion) were broken down as follows: 73% investment grade - 27% sub-investment grade (chart below). It can safely be assumed that this split is pretty much the same across the entire CDS market.

Chart: US Comptroller of the Currency

Let's revert now to the original premise, that CDS Inc. is one very large insurance company writing all this coverage, 80% of which is insuring the credit, or business risk, of Global Corporations, Inc. We know that current credit spreads for investment grade corporations are approx. 80 bp (CDX IG) and for sub-investment grade approx. 450 bp (CDX HY). The weighted average for the market is thus 170 bp, or 1.70%. However, this is likely too high because we must subtract the far less risky government credits and GSEs included in the 73/27 split given by OCC. With all the estimating going on everywhere, I will reduce this rather arbitrarily to 150 bp, as representative of the entire "book" of corporate CDSs.

If you are still with me...bravo. There isn't much more left to go.

Step 4

So, the annual GROSS insurance premiums changing hands for the entire corporate CDS market is 1.50% of $35 trillion, or $437.5 billion per year. Think of this as the annual premium paid on a contract to cover the risk of holding Global Corporations Inc. securities. The present value of such a contract for 5 years, discounted at 4.40% (the 30-year Treasury rate) is $2.3 trillion. If we view the CDS market as perpetual, then the present value rises to $10.5 trillion.

It is thus possible to argue that these sums represent the amount of risk that has been shifted from the global cash equity market onto the CDS market, thus making stocks appear less risky, or cheaper. Equivalently, we could say that total capitalization and P/Es for global markets are being understated by the equivalent amount. At the end of June, the total market cap of all major stock markets (i.e. stocks of corporations that are most likely to be covered by CDS) was approx. $47 trillion, therefore CDSs created an over-valuation of anywhere between 5% and 22% for stocks. While theoretically we could choose the 5% that represents the expiration of CDS insurance within 5 years, in practical terms it's more proper to view CDS as a perpetual market, adjusting instead for amounts outstanding.

The bottom line is that global shares may now be approx. 22% overvalued, due to the effects of the CDS market alone.

Again I will close by saying, please do take as many shots at this as you see fit. Comments can only help.
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P.S. Correlation between S&P 500 and US credit spreads