Death By Leverage

I'm still on a trip, so posts are brief.

Carlyle Capital Corp. (CCC), an offshoot of the vaunted Carlyle Group, is in the news today about failing to meet margin calls. It is a recently listed (Amsterdam) investment company that bought AAA-rated GSE paper (FannieMae's, etc.) on margin. The idea was quite simple: capture the yield spread between margin loans (via ABCP, repos, etc) and the GSE securities.

Just like all such "gather pennies in front of steamrollers" rate arbitrage operations, the size had to be huge to make it worthwhile. From the 2007 annual report:

Total Equity: $669.5 Million
Total Assets: $21.8 Billion (mostly GSE's)

Divide and ...(drumroll)... leverage: 32.5 times.

No further comments.
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Update: The Fed, getting increasingly panicked of losing the credit crunch "game" in a very big way, announced an increase in its TAF facility from $30 billion per pop to $50 billion. It will also do more term repos. Both TAF and repos, the Fed said, could be increased in size as needed.

Translation: Ben keeps shouting "come seven" even as the dice keep coming snake eyes (see yesterday's post). Oh well... one of these days he will either (a) figure it out, (b) be replaced, (c) resign, or (d) be taken away by guys in white suits screaming and foaming at the mouth. All the while, Moe will be happily fishing in Bermuda - as in: "sometimes you go long, sometimes you go short and sometimes you go fishin'.."

Snake Eyes, You Lose

Imagine you run this little test, adapted from Nicholas Taleb's The Black Swan (see book recommendation on the right):

On one side is Ben, a wing-tipped bearded ex-professor of economics who now works at the Fed. He became famous because of his precise econometric modeling of the Great Depression.

On the other is Moe, a wizened veteran of Wall Street who has been bloodied in many a battle with sharpies, conmen, penny stock pushers and assorted manipulators. He is not famous and doesn't want to be. But he is quite rich.

You hold up a pair of dice and assure Ben and Moe that they are not loaded. You then start throwing the dice and after twenty consecutive throws of snake-eyes you ask both of them what's the most probable outcome of the next throw. Ben, being who he is, naturally says "seven". Moe laughs and says "snake-eyes". Ben protests that he was assured the dice were not loaded. Hearing this, Moe laughs even harder and calls Ben a schmuck. Who do you want as an investment adviser?

The moral of the story is, if you expect the economy to respond strongly to deep interest rate cuts - like it did so many times before - you better check beforehand that this time the game hasn't been "loaded".

Two Notable Events

A blog entry in the original sense: a personal journal of notable events.

• My jaw dropped when I saw that Mr. Bernanke asked lenders to forgive part of mortgage loan debt. His reasoning is that home equity would thus be bolstered and homeowners would have less reason to walk away from their upside-down homes (jingle mail). I don't think a central banker has ever done this before and it shows how deeply he is worried. As I have repeatedly said, his biggest fear is a "liquidity trap" and his suggestion shows we are getting dangerously close to it.

===> Quick calculation: there are $10.5 trillion in home mortgages outstanding; 3.1% of the mortgages held by commercial banks only, were already delinquent in 4Q2007. Assuming the delinquency rate is the same for all mortgages - a very big if, given that securitization moved many low quality loans off the banks' books - and that delinquency will peak at 5%, the total delinquencies will come to ~$500 billion. What percentage of that amount should the banks forgive to make it worthwhile for the borrowers to keep paying? I don't think anything less than 20% will do the trick in the most heavily affected areas. That's $100 billion right there - can the banks sustain such a hit, on top of the hits they've already taken to their balance sheets? And will such forgiveness push other, borderline borrowers to default, hoping to get their mortgages reduced, too?

• Municipal auction rate bond failures are at 70%. Translation: the credit crunch is spreading out to envelop the "official" sector of the credit market, i.e. these are government bonds we are talking about. The cause is quite simple, in my opinion: debt destruction - current and upcoming - has removed a lot of so-called liquidity from the financial system, i.e. there is less money to go around. Add the ongoing zero/negative personal saving rate for Americans and we are left with yet another financing hole. I wonder if foreigners will keep filling it, or eventually throw in the towel and look for better things to do with their savings.

Free Markets vs. Cronyism

I will be on a short trip, so posting will be sporadic for the next few days. Before I go, I want to clear something up, concerning my views on extremism in free markets and their zealot acolytes.

Free markets (in this case financial markets, since they are my area of expertise) without tight regulation to even out the playing field as much as possible, rapidly deteriorate towards crony capitalism, i.e. a particularly virulent form of junglenomics. US financial markets were the envy of the world because a whole array of professional regulators (SEC, NASD, NYSE, FRB, etc) stood ready to send in the feds and bodily carry out manacled perps, in full view of their co-workers and the cameras.

No, it didn't always work out as it should have and many a big fish swam away leaving the minnows to fry in the pan. But mostly it worked, and the markets were the better for it. This is no longer the case and dominant positions now exist (or existed) unchecked in most markets and crony capitalism makes itself evident in many aspects of the US economy (Enron, for example).

Some people sadly still confuse freedom with total lack of regulation, thinking oversight interferes with a "natural" right to do as they please. In that case, their proper place is up in the mountains with the rest of the wild animals (Aristotle had something to say about them, people who do not wish to participate in a cohesive society and be bound by its rules). Others place absolute faith in the invisible hand, thinking it will even out everything all by itself. To my mind, they belong to the Flat Earth Society.

No doubt, they in turn will paint me a "commie", showing a complete lack of understanding about what communism is all about. Well, both communism and absolute laissez-faire don't work - in practice - because they both disregard human nature: man is no saint. He will no more gladly share everything he has with his fellow than he won't fall prey to unfettered greed for individual gain.

Free market capitalism is not antithetical to the common good - quite the contrary; it is just that human nature will always be governed by extremes of fear and greed and behavior must be governed by checks and balances, for everyone's benefit. Likewise for democracy, which can all too easily deteriorate towards mob rule or fascism, a fact understood very well by the writers of the Constitution. It is extremism that I rail against, not freedom.

Bottom line: excellence in market regulation leads to better and freer markets. And please... do not confuse quality with quantity, from either perspective: more is not better, but neither is less. Smarter, more effective, more efficient... that's better.

See you all soon.

A Lifetime Of Leverage

The period 2001-07 saw the fastest ever rise in US household debt versus disposable income (see chart below). People were urged to spend more now against their future income because "modern finance" had - supposedly - created the tools allowing them to do so easily and safely. A whole slew of structured and derivative debt instruments thus flooded the market, financing the consumer demand that followed. (Note: In many ways the Chinese "economic miracle" is just a manifestation of easy credit.)

Data: FRB St. Louis

Well... it was fun while it lasted. The spring has been sprung and those lured by the bait are now stuck inside the debt servitude mousetrap. Like Kafka's Josephine the Singer of the Mouse Folk, they must sing the tune demanded or face starvation.

Interestingly, many sensible people that vehemently dismissed as speculative leverage for the purchase of securities or commodities (i.e. margin), borrowed heavily to buy consumer goods. They thus accepted a lifetime of leverage for the immediate satisfaction of their desires, regardless of their means. Pushing this line of thought a bit further, they fashioned their lives into a speculative marketable instrument which must constantly go "up" in price, or face ruination.

This may be the ultimate victory for free market extremists, but it is a cruel one and may yet prove very hollow. The credit crisis which is already rendering some classes of debt worthless (e.g. sub-prime mortgage write-offs) is still in its very early stages and, in my opinion, has a lot more to go before it is finished.

I won't be at all surprised to see a debtors' revolt at some point; warning signs can already be spotted: newspapers are increasingly giving front page status to "human interest" stories about debt and a cottage industry is springing-up around "walking away" from debt. Also, watch the politicians: debt is becoming a prime issue and I bet it will get to center stage for the general elections in November.

Financial Palmistry

This just in from our "cocktail party tricks" department:

Amaze your friends by demonstrating that all they need to know about market excesses during 2004-07, and their future course, can be seen in the palm of their hand.

Here's how...

Hold your hand up as if you were to perform a military salute. Think of your fingers as bars in a bar chart with your palm being the X axis and your fingers rising along the Y axis. See picture below.

Point out that the four fingers are rising smartly above zero and that the thumb is "holding up" the X axis. You'll come to the thumb in a minute; first, identify the other fingers as "stocks", "bonds", "real estate" and "commodities", in no particular order. This was an unprecedented, "Everything Up" situation. As the economy and markets go through cycles, one or two of the "fingers" should be negative, e.g. stocks should rise and bonds drop during an expansion and vice versa, etc.

But not this time. Before the bottom dropped out of the credit market in mid to late 2007, every single "finger" was doing extremely well.

Lets' look at the "fingers" between January 2004 and August 2007 (all numbers approximate).

• S&P 500: +40%.

• US High Yield Corporate Bond Credit Spreads: Down from 360 bp to 250 bp (i.e. credit-worthiness way up).
  

• Case Schiller Home Price Index: +40%.

• Goldman Sachs Commodity Index: +33% (as of 1/2008 it is +66%).

How was this possible? It's all about the "thumb": look at the picture again and notice how it is holding everything up. Now let's identify it as "Debt" (though for a time it was ludicrously misnamed "liquidity"), and everything falls into place:

• Total debt: +35% (includes all sectors, i.e. government, corporate, household, financial).

Lastly, point out to your friends that the "thumb" is now getting crushed from the credit market contraction, then leave it up to them to make predictions for the rest of the "fingers".

Floral gypsy dress (for the ladies) or Johnny Carson-type Carnac The Magnificent turban (for the gentlemen) strictly optional.

Lies, Damned Lies and Bond Insurance

Credit insurance was born in the municipal bond business, to take advantage of a quirk: rating agencies apply different rules in assigning ratings to states and local governments than they do when rating corporations. In essence, they rate local governments against each other. If the State of Upper Anchovia is deemed worthy of a AAA based on its finances, then the State of Lower Anchovia with slightly lower financial strength gets a AA, even though it would be worthy of a AAA if it was judged by itself.

The demand for municipal bond insurance came entirely from individual retail investors who wanted the comfort of AAA-insured ratings, thinking them equivalent to Treasurys. Since municipal bonds rarely defaulted, monoline insurance companies made a pretty penny selling unnecessary insurance to unsophisticated investors. It was like selling snow damage insurance in the Sahara, or as P.T. Barnum said, there's a sucker born every minute.

But then the monolines got greedy and jumped on the structured finance bandwagon, insuring all manner of private, asset-backed bonds. There is nothing wrong with wanting to make extra profit, as long as you price the marginal risk/return properly. Clearly, the monolines did not, choosing instead to buy into the financial engineers' elevated assurances about the implausibility of multi-sigma events and the non-existence of black swans. Oh, and the elevated fees must have played a role, too..

So here's my suggestion: The federal government should guarantee all state and municipal bonds - at least those not tied directly to private-sector projects. It will cost next to nothing and save local governments billions in the process, in lower interest and insurance costs. This will leave the monolines with the weak structured finance part of their insurance book, and undoubtedly result in downgrades and large write-offs. But this is the private sector and it can take care of itself, one way or another. The public sector, on the other hand, must be protected from avarice.

Will there be conflicts from the constitutional separation of power between sovereign states and federal government? I imagine so, though I am not familiar with constitutional law. Nevertheless, there is no reason whatsoever to keep subsidizing private speculators through proceeds derived from duping the public in the name of government. The lucrative loophole that arose from mis-rating local government debt must be shut down, once and for all.

The nonsense of paying loan-shark rates (8%-20%) for adjustable-rate local government debt when T-bills are at 2% has gone far enough.

Update: Several readers objected to my guarantee proposal, mentioning that some local governments are badly mismanaged and thus should not have their debt back-stopped by the federal government. Here is a chart of the overall state and local debt as a percentage of GDP.

By comparison to the household and financial sectors, who have sent their debt soaring, local governments have been paragons of fiscal virtue. Cicero (see masthead) would have been proud.

Data: FRB

Dutch Boy, Finger and Dam, Inc.

What are we to make of the possibility that several banks will try to inject $3 billion into one of the ailing monoline insurers? The news involves AMBAC, which insures $524 billion of bonds, including municipal and structured finance issues. I have some observations:

The effort is all about appearances instead of reality, i.e. preserving the AAA rating for the monolines so that banks' own portfolios of insured securities can still be used at elevated prices for regulatory capital purposes. In today's virtual reality banking it's the nameplate fictitious AAA that matters, instead of the factual reality that exists in the marketplace. In other words, if a CDO has a AAA rating, a bank can still employ mark-to-model methods and calculate a very high virtual price for its balance sheet, instead of having to use a lower factual price (i.e. what someone will pay for it right now).

We can get a sense for this from the Fed's guidelines for acceptable collateral at the Discount Window, which clearly favor AAA-rated issues for CDOs, CLOs and such structured instruments. The same collateral rules also apply to the Fed's current TAF (Term Auction Facility) operations, which have become quite vital in meeting banks' liquidity needs. It is important to note that..."If the margined value of a winning Participant's available collateral were to fall below the amount of TAF Advance awarded to it in the Auction at any time before, on, or after, Settlement Date and before Maturity Date, the Participant would need to pledge additional collateral to cover the shortfall...". In other words, the Fed would issue a margin call.

Let's follow through a bit..

Assume a bank has collateralized its TAF loan with a five year, 5% AAA-insured CDO. Given current rates (5-year Treasury at 2.83%), this bond would be expected to trade significantly above par - if the AAA-insured rating was, in fact, real. Since the CDO doesn't really trade in the secondary market, the mark-to-model fiction is being maintained through the AAA rating and the Fed takes it as collateral at par (minus the haircut).

Now, if the AAA rating were to be cut down to AA or A in a monoline downgrade, the game would be up. The mark-to-model algorithm would have to take into account the alternative credit insurance market (e.g. CDS prices), resulting in much lower prices for the CDO and thus margin calls from the Fed. Pretty ugly.. But this would only be the beginning of the trouble, because in such a downgrade scenario other dominoes start falling, too.

1. There are many investment pools that can only invest in AAA securities: e.g. many pension, mutual and money market funds. As soon as the AAA ratings are gone they would be forced to sell - imagine the crush at the gates as everyone tries to get out at once.
2. Bank regulatory capital would be affected, since AAA-insured securities have a much smaller reserve requirement than lower-rated ones.

Not to mince words, banks and regulators want the AAA fiction maintained at all costs. But it is fiction, so reality will ultimately catch up. The AMBAC plan (if it comes to fruition) is only a delaying tactic, meant to maintain the fiction long enough for reality to change back to positive, instead of abysmal. Think Dutch boy, finger and dam... The hope is that the credit storm will end before the whole dam collapses and drowns a large number of the financial system population.

Hope dies last, of course, and the delaying plan may yet work - so who am I to question it? It is just that my experience has shown that in matters financial it is best to deal with reality as it exists today, instead of playing Annie (The sun'll come out tomorrow, Bet your bottom dollar that tomorrow there'll be sun!).

Reality is that there is too much debt versus earned income in the US and many other western countries. There aren't any painless ways out of this fix (certainly not monetary ones), and the pain to correct it must be shared by all: investors must accept some capital losses and significantly lower real rates of return going forward, corporations must accept lower profit margins by boosting wages and salaries (i.e. increase earned income for workers), and individuals must realize that low taxes are a thing of the past.

We got into this mess as separate entities - persons, corporations, countries - each selfishly and separately looking to maximize individual gain. The way out must perforce involve commonality in understanding the problem and cohesion in finding solutions.

The Peoples' Bank of USA

As the credit crisis expands like ripples in a pond, politicians are waking up to the fact that they "must do something". Homeowners upside-down on their mortgages (i.e. they owe more than their homes are worth) are their current focus. The New York Times reports that as many as 8.8 million homeowners may be under water. As I have said in previous posts, the chief driver of mortgage defaults is exactly such a condition, leading to "jingle mail".

Panicked bankers are now all over Washington suggesting ("imploring" describes it better) that the federal government should buy and guarantee their risky mortgages, effectively turning Uncle Sam into the Peoples' Bank of The United States.

Don't you just love it? When times are good, bankers are all for invisible hands, laissez faire and Friedmanite free markets; but let Mr. Market give them a bit of the stick and they turn bolshier than Rosa and Leon (that's Luxembourg and Trotsky, for those less versed in communist hagiography).

Fine, then. The Brits have already shown the way with Northern Rock: if you want your bank rescued you must give up equity ownership proportional to the government's involvement. It's only fair and definitely within laissez faire economics: he who provides the capital gets to own the means of production, no? If the government, i.e. the people, provide the money, then the people should own the banks. And the process has started, anyway: it's the People of Dubai, Qatar, Singapore, China, Korea, et. al. who already own sizeable chunks through their SWFs. Why should Americans be left behind - in their own country, no less?

So, line 'em up boys.. Citi, BOA, Bear, Morgan and - why not - Goldman. To each according to his need and from each according to his worth.

Ain't communism grand?

Fidel, The Black Swan

When Fidel Castro threw out the corrupt Batista regime in Cuba (i.e. our bastards) President Dwight Eisenhower said that we should not worry about him much because he would be gone soon. Fifty years and ten Presidents later (six of whom are already dead), Fidel finally decided to step down. As Nicholas Taleb would say, he is a Black Swan.

Fidel: The Political Black Swan

What's the moral of the story? NEVER underestimate what looks like a "contained" situation. Like the subprime crisis.. which begat the credit crunch.. which begat the slowdown.. which begat (?) the recession.. which may beget much worse and for a much longer period of time than conventional wisdom currently expects.