Gasoline, Disposable Income and The Economy

With oil prices on the rise once again, analysts wonder why higher gasoline prices have not yet crimped demand. They frequently cite inflation-adjusted prices, which are near all-time highs reached back in the 1980's.

However, gasoline and oil expense as a percentage of disposable income is still 25% lower than the high reached in 1981. All other things equal, it means that average retail gasoline prices would have to rise towards $3.50/gal before they create the same "pain" experienced in the 1980's.

Data: US Dept. Of Commerce

Of course, this is a static comparison - the economy is completely different today. For example, household debt is now 130% of income vs. 65% in 1980 and financial obligation payments take up 19.5% of income vs. 15.5% in 1981. The saving rate was 11% then vs. -1.2% today, meaning there was much more earned income left over in 1981 to cushion the impact of higher prices. Today, surplus income has disappeared and additional spending for gasoline has to be met by more borrowing, selling assets or curtailing spending on other items.

There are two reasons why more borrowing is difficult: (a) credit conditions are finally tightening and (b) more debt means more interest expense; since spending already exceeds income, any additional borrowing will be of the Ponzi type (borrowing to pay interest).

This leaves households with two choices: selling assets and cutting spending. I believe both are in the cards. For example, households have been net sellers of equities four years in a row and retail sales are slowing down, although spending on services is still quite healthy.

Bottom line? Though the percentage of income going towards fuel expense is still below the record highs reached in 1981, the overall economy is more vulnerable right now to a rise in oil prices than ever before.

One Simple Question

Markets go up and down. The Fed hems and haws and million-dollar economists tear its statements apart to see if a comma was moved one word over. The BLS, Census, Commerce, U. of Michigan, etc. etc. etc. all issue data and reports which are slashed, underlined and marginalized until grosses of Mont Blanc pens run out of ink.

Then, after all is said and done, all of the analysts appear on TV, Internet or newspapers saying exactly the same things as before: the data, whatever it is, does not change their prior expectations and beliefs one iota. Highly scientific, eh?

My experience has taught me that 80% of all you need to know about the economy is contained within the answer to a simple question, such answer being immediately and correctly available to all reasonably informed persons. You need not travel to Delphi to offer bags of gold to Apollo's priests; in any case, Pythia was one sharp lady who just uttered things like "Haagrfstry Allastyrbg Junoklser" and let the priests "translate" according to the weight of the gold offered and the current geopolitical conditions. You know.... just like Alan Greenspan.

Here is the question:

Is it getting easier or harder to borrow money?

As anyone who has seen "Cabaret" knows, Money Makes The World Go Round. This being so, it is perfectly clear why it would also affect such comparatively trivial things like mortgages, corporate loans, stocks, commodity prices, et cetera.

Now, I must freely admit that in recent years it has gotten somewhat harder to obtain the answer. It used to be that almost all you had to do is follow the real Fed Funds rate, but no longer. As even Alan "The Oracle" himself freely admitted, there are now "conundrums" to be dealt with. To wit, how come longer rates remained stubbornly low and credit flooded everywhere even after a dozen and a half Fed rate hikes?

Ha! you may cry...: "I have been reading a certain blog and I know my credit alphabet soup: CDOs, CDSs, ABX, CMBX...I realize that banks no longer lend but simply pool, securitize and sell loans to speculators, thus are not constrained by liquidity regulator valves like reserve requirements and Fed rates."

Not only that, but you found out that, for an additional risk, borrowers could completely snub the mighty dollar and import ultra cheap loans from Japan and Switzerland in yen or francs - the finance equivalent of buying cheap-o Chinese sneakers from MartMart.

"Financial innovation" and "globalization" are now just as important as the Fed - probably even more so. Darn, can't just figure out liquidity conditions while sipping your morning java, flipping to the business section and looking at Fed funds rates.

But it doesn't take much more effort... one glance at the Foreign Exchange section will reveal the USD/JPY and USD/SFR rates. As for derivatives, you will need to go to the Internet or the WSJ and peruse the movement of credit spreads for a few indexes like ABX, CDX and iTraxx.

That's not such a chore, if we are to ascertain that the world keeps going round or if we are in for a re-release of "The Day The World Stood Still".

Dirty Pictures

I have put some charts together to connect consumer behavior, credit expansion and banking conditions (click on the images to enlarge).

• Negative Personal Saving Ratio: Americans are spending more than they are making. I bet the ratio is much worse if we exclude the top 1% of the population that makes 22% of all reported income in the US, the highest ratio since the 1920's (NYT article).
  

Honey, I've Shrunk Our Money

• Record Debt: For the past fifteen years households had gone on a long, uninterrupted borrowing spree.
  

Me Lend You Long Time, Honey

Looking at house sales, the correlation between housing activity and household debt growth is very apparent. Housing and mortgage debt went hand in hand on a super-long cycle between 1990-2005, now finally come to an end.

Hey Mister, Wanna Buy My House?

.... but the accumulated debt means a record high share of income must still go to pay the piper.

If It's The Bank Calling, I've Gone To Baghdad

• Retail sales are stalling: Real sales are not growing at all. It is supposedly smart to perpetually bet on the voracious appetite of Consumer Americanus, but this view was formed during the quarter century of constantly dropping saving rate (see above). Now that the rate is negative, such a bet would be imprudent. Keep in mind that consumer spending makes up 70% of GDP.
  

No Money, No Honey

• Banks are not prepared: Although household financial conditions are stretched, US banks are not prepared for a deterioration in loan performance. Their loan loss reserves are at the lowest levels since 1985.
  

What You Mean, No Have Dolla?

Yes, seriously past due loans (90+ days) are at very low levels. But if anyone wants to bet the credit cycle is dead and buried, this is definitely not a good time.

Relax, This Won't Hurt...Much

Correlation Risk and Rube Goldberg

In this era of financial globalization, derivativization, carry trades and cross-margining, markets are more correlated than ever before.

• A British hedge fund manager may be providing margin collateral for his long positions in Shanghai copper futures by writing credit default swaps on CDOs constructed from sub-prime mortgages backed by houses in Newark, New Jersey.
  

• A Dutch pension fund manager may be investing the fund's assets in a structured finance product that bets on a steepening of the euro yield curve, issued by a US investment bank by utilizing a sovereign bond from Greece and an interest rate swap with a Japanese trading house.
  

• An individual investor in India may be buying a warrant, issued by a French bank, that tracks an index of agricultural prices established by a US investment bank, leveraging his purchase up to 50 times through a loan in Swiss francs.

• A Japanese mama-san may be investing her family's savings in a local bank's product whose ultimate return depends on interest rates and currency fluctuations in Iceland.

Through highly complex derivatives, risk is now cross-correlated between all the previously unconnected apexes of financial n-polygons. There are those that say that such a construct is less risky, that it is more pliable and resilient. I say, it has spread risk where none is wanted, needed or even understood as being undertaken.

Before we proclaim all this to-and-fro as miraculous "financial innovation", I recommend we wait for the next full business cycle. It may turn out that all that jazz was in reality nothing more than an elaborate Rube Goldberg contraption, primarily designed to conceal a very simple process: The creation and concentration of huge fees.

A Look Inside Another Mortgage Sector

While everyone's attention is fixated on sub-prime home mortgages, another sector of the real estate lending market is weakening, with credit spreads rising daily. I am talking about commercial real estate loans. But first, where are home mortgage credit spreads today?

Everyone has heard by now of Markit's ABX indexes that follow credit default swaps on CDOs containing home mortgages. After plunging sharply, they bounced and are now going sideways. Below is a chart for A rated tranches, theoretically a strong investment grade mark. It is certainly indicating a risk much higher than A, but this is not today's subject - so let's move on.

ABX-HE A 06-2

Today I want to look at commercial mortgage loans, those used to build and buy malls, office buildings, hotels, etc. What's happening there? For the answer I once again turn to Markit and their series of CMBX indexes tracking credit spreads in the commercial market (unlike ABX, these are shown as spreads in basis points, so a rise signifies increasing risk and tightening credit conditions).

Below is a chart for credit spreads in A rated CDO tranches containing commercial mortgages. No bounce here: credit spreads have gone from 12.5 bp to 41 bp in one month. For a commercial real estate developer this is very bad news, indeed.

CMBX NA-A 2

However, conditions are much worse for riskier, marginal commercial borrowers. The BB rated index has zoomed from ~190 bp to 373 bp.

CMBX NA-BB 2

Why is this important? Because, until recently at least, building activity in the commercial sector was quite strong, helping to offset somewhat the weakness in housing construction. Commercial builders, however, are more sensitive to financing costs and credit conditions than home builders because their customers, the businesses that buy or rent their properties, are driven strictly by cash flow and earnings calculations, not emotional home-buying impulses.

It seems logical to me that deteriorating credit conditions in this sector will very quickly translate into a slowdown in commercial building activity, adding another negative nudge down for the overall economy.

Credit Crunch Coming in the US?

The American economy has always been driven by debt, but in recent years it has become even more dependent on credit to stimulate economic growth. Debt intensity of GDP growth, i.e. how much more debt is needed to produce an extra dollar of GDP is now 4.5x, against averaging just 2x between 1965-95.

Source: FRB Flow of Funds Accounts of the US

There is no mystery why: the economy has been transformed from one growing through production and earned income, to one where consumers spend money borrowed against inflated assets. Access to cheap debt is now as important to America as access to cheap oil and it is "burned away" just as recklessly.

Source: FRB Flow of Funds Accounts of the US

Total debt increased by $3.55 trillion in 2006 alone, or 27% of that year's GDP. "Unsustainable" is too mild a word.

Source: FRB Flow of Funds Accounts of the US

Debt generation is the supreme driver of the US economy. The financial services industry is a red-hot growth sector, eerily reminiscent of the dotcom mania of 1998-2000. Financial companies now make up almost a quarter of the capitalization of S&P 500, with information technology coming in a distant second at 15%.

S&P 500 Sector Breakdown as of 12/31/2006

Source: Standard and Poor's

Between 2001-05 the real estate bubble was the prime driver of the debt flood, finding its way into consumer spending through mortgage equity withdrawals (MEW). For the whole of 2005 such MEW's extracted $414 billion, i.e. 56% of that year's GDP growth . Since then the trend has reversed sharply, with MEW's dropping to just $24 billion annualized in 4Q 2006.

Source: FRB Flow of Funds Accounts of the US

The economy is already feeling the first effects of a credit slowdown (MEW's included), with GDP growth slowing significantly to around 2.0-2.2% for three consecutive quarters.

From all of the above, it is clear that economic growth has come in large part through the assumption of debt - more than ever before. What will happen to the economy if the debt torrent slows down or even stops entirely, i.e. if we experience a credit crunch?

Given the high debt intensity of GDP growth (4.5x) and with inflation around 2.5%, real GDP growth is highly sensitive to credit expansion. The following chart plots the theoretical effect of a credit slowdown to GDP. The calculation is based on static assumptions, but it's not totally useless as a starting point.

As of 3Q and 4Q 2006 debt was growing at an average 7%, producing GDP growth of 2-2.2%. Given the information we have so far on housing, mortgages, etc. it is likely that credit expansion has slowed in 1Q2007.

The following is from the Fed's January 2007 Senior Loan Officer Opinion Survey on Bank Lending Practices.

"On balance, about 15 percent of domestic banks reported that they had tightened credit standards on residential mortgage loans over the past three months, the highest net fraction posted since the early 1990s. Almost 40 percent of domestic institutions—a somewhat smaller net fraction than in the October survey—indicated that demand for such loans had weakened over the previous three months."

Following are some relevant charts from the survey.

Tightening Lending Standards for Mortgages

Conditions are tightening for commercial and industrial loans, too.

Tightening Lending Standards for C&I loans

In summary, credit conditions are tightening and loan demand is dropping. The survey was conducted in January and conditions have probably worsened further since (sub-prime mortgage crisis).

The conclusion is that credit expansion is slowing, likely leading to significantly lower economic growth ahead.

Take My House, Please!

"My wife will buy anything marked down. Last year she bought an escalator." Henny Youngman

Yesterday the National Association of REALTORS ® released its data for existing home sales for February. [Credibility warning: The NAR has actually gone to the trouble of REGISTERING the word "REALTOR ®" - with all capitals if you please. How serious can such people be?]

Anyway, here's what the data showed:

February 2006
402.000 homes sold, 2.985.000 homes for sale.

February 2007
387.000 homes sold (-3.73%), 3.748.000 homes for sale (+25.6%).

For further comparison:

2.240.000 homes were for sale at year-end 2004
2.846.000 homes were for sale at year-end 2005

That's quite a spicy meatball of inventory, no? Particularly for this early in the year - look at the full data set for a better picture. All kinds of possible reasons: people rushing to sell early to get out of looming mortgage trouble, builders listing their unsold new homes with REALTORS® (this is getting annoying), owners listing early to beat the "spring rush" - who really knows...

Hmmm...sales down, inventory up. Merchandising 101: time for the "SALE !!" sign to go out.

Maybe Henny Youngman's wife will show up.

The Thirty Trillion Dollar Question

Do Credit Default Swaps and CDOs increase or decrease stability and systemic credit market risks?

This is not an easy question to answer, partly because we have no relevant prior experience to go by. It is such a new market and it has grown so fast that it hasn't gone through even a single full credit cycle.

Global CDS are probably around $30-35 Trillion now

I will state my conclusion right away:

Today's market arrangement intensifies existing trends. It pushes credit spreads lower than usual on the virtuous side of the credit cycle and will likely boost them higher when the trend turns vicious.

OK, I've stated my case - now I have to provide evidence. First, let's look at the current "virtuous" credit cycle.

There is no question that, until recently, credit spreads and debt defaults were at record low levels. Credit demand soared and loans were made easily and cheaply available to even the riskiest of borrowers, from sub-prime mortgages to junk loans and bonds used for LBOs. Such credit became available through the CDO's ability to pool lower quality debt, mix it with default assumptions and then slice it into large tranches rated much higher than the original debt.

Even if individual borrowers faced trouble, the rising tide of easy credit made it possible to escape default by assuming even more debt, available in the form of re-financings and equity extractions. When default assumptions are optimistic, the cascade structure of CDOs allows for a higher percentage of risky debt to be turned into immediately marketable AAA securities. Standing common sense on its head, this results in even more credit ultimately becoming available to troubled borrowers, thus avoiding default temporarily and extending the duration and reach of the virtuous credit cycle - even as it is turning into the cardinal sin of over-borrowing.

As the AAA tranches increase in size relative to the total issue, the less easily marketable pieces shrink, making their disposal easier. But they must still be sold, otherwise the whole CDO structure collapses: someone must fund and accept the risk of holding the mid-level and "toxic waste" tranches. The arranging investment banks could hold them, but this is not their function: they are best as fee-paid intermediaries, not investors. Enter the hedge funds: risk loving and performance hungry, their managers' bonuses hang on each little bit of extra return. And as they buy more of the risky tranches, once again more credit is made available to the least creditworthy borrowers and defaults are pushed down - for a while longer.

Another major type of borrower in this market is the private equity fund, raising tens of billions in loans and bonds to take over listed companies. Unlike takeovers in the 1980's that depended on direct buyers for their junk bonds arranged by Drexel Burnham, today's risky loans and bonds can be placed inside CDO's and be turned into investment grade to a great extent. During 2006, 33% of all new CDO's were backed by such risky debt (see detailed data in previous post).

There are supposed to be safety catches, of course. Rating agencies are the titular bulwarks against too much unwarranted optimism from CDO issuers. However, such agencies are paid to rate the securities by the issuer, posing huge conflicts of interest. Given the explosion of CDO deals in the past three years, rating them has become an extremely lucrative growth business and it would be going too much against human nature to be ultra conservative in granting ratings.

What about the role of CDSs? Why did such credit insurance get cheaper, creating lower spreads and making borrowing easier and less expensive? Because like any business, competition brought down price, perhaps to unreasonable levels. There is the parallel of the regular property and casualty insurance business, which often goes through pricing cycles depending on the frequency of catastrophic events. In the case of CDSs, hundreds of institutions unrelated to the insurance industry jumped into the business, eager to collect premiums. Many are hedge funds attracted by the high structural leverage inherent in CDSs and the immediate income. Synthetic and hybrid CDOs are also major sellers of CDSs, thus combining both aspects of the credit derivative and cascade elements to produce lower interest rates to borrowers.

Therefore, the current structure of credit markets lowers both interest rates and lending standards. But in no way does this mean that the ultimate, underlying borrowers become more able to properly service their debt: their credit ratings don't go up. On the contrary, by assuming even more debt they lower their creditworthiness.

Within the very CDO/CDS structure that pushed the credit pendulum from "loose" to "loosest", lies the impetus to swing it back hard and fast to "tightest".

Let's think of the process going into reverse: as more borrowers initially become delinquent, default assumptions rise and constructing new CDOs involves constructing fewer and smaller AAA tranches plus more and bigger mid- to "toxic" tranches that are difficult to sell. Credit spreads go up, CDSs become more expensive and "liquidity" dries up.

We can think of the "old" credit market structure as a lake: as water flowed in and out its level changed slowly, just inches. The current "innovative" market is a series of buckets placed one atop the other. When conditions are loose, the "toxic waste" bucket at the very top can be very small, allowing more water to spill over to the bottom AAA bucket and, being small, it is easy to hold on to it. But when more defaults occur, the size of the top, "toxic" bucket must be increased to hold the increasing "waste". Less water spills over to the AAA bucket and the "toxic" bucket becomes heavier and more difficult to hold. Since we diverted the flow to several different buckets instead of one big lake, the levels inside each bucket rise and fall much faster.

Given that no one really wants to get too wet, which system provides more stability? In the lake, many people may end up with their ankles wet as its level rises somewhat. But with the bucket scheme, those holding the top and middle ones may suddenly find themselves getting soaked head to toe. They will very quickly either ask for a wet suit (higher rates) or stop holding the buckets altogether (tighter standards).

There are some other thoughts that arise out of the nature of the CDS market as it stands today.

For example, what happens in a down market if prior CDS issuance against a single risky name greatly exceeds its total debt outstanding (keeping in mind that physical delivery of the referenced obligations is required to collect on the CDS insurance)?

It could be that, if a troubled company gets closer to default the CDS issuers (the insurers) prefer that it goes into default instead of prolonging its existence as a high-spread borrower that creates large mark-to-market losses for them. What if there is 50 times as much in CDS's outstanding than underlying debt? If the CDS's were issued evenly amongst 50 issuers, then perhaps 2% of a very bad thing (bankruptcy and default) is preferable to 100% of a bad one (very high spreads) and constant margin calls. Furthermore, won't such CDS issuers gamble that the CDS owners won't be able to obtain the bonds to put to them in order to collect on the CDS insurance? Won't that increase the market's pressure to the risky company to go into bankruptcy?

Taking the example further, say that this 50-to-1 CDS issuance is not evenly spread out, but concentrated amongst a very few issuers. In that case, those few issuers will be certain that the CDS owners won't be able collect on most of their insurance. Won't it make sense for them to write as much insurance as possible, driving this recovery percentage even lower? And doesn't that mean that the insurer will then prefer the underlying company goes bankrupt, making most CDS issued worthless? How perverse can it then be that the insured party (underlying co.) is worth more dead and bankrupt to the insurer than sick but alive? How would you like it if your medical insurance company - to whom you have been faithfully paying annual premiums - wants to pull the plug from your expensive life-support system?

Another thought; more and more CDSs are being issued, driving credit spreads lower but not, of course, raising the debt-carrying capacity of the underlying borrower. At the same time, as the CDS-to-debt ratio rises and greatly exceeds 1-to-1, the ultimate worth of those CDSs in a default event diminishes. Possible lose-lose situation: the apparent credit-worthiness of the company is increasing (lower credit spreads) allowing it to borrow more than it should - but the ultimate value of the self-same CDS's in a default event is decreased. In the end, CDS buyers paying "dirt-cheap" prices for credit insurance may be getting exactly what they paid for: dirt.

In closing, this is a complicated subject for which I am 100% sure of only this: there are many implications and possibilities that we may not see until the credit cycle turns negative.

Please provide your own thoughts and comments.

CDOs By The Numbers
...and Where Does The Yen "Carry" Fit In?

I have been discussing Collateralized Debt Obligations (CDOs) and associated credit derivatives recently (March 15 post: "Well, what do you want it to be?"). Today I present some numbers to go with the story. Data are from SIFMA, the Securities Industry and Financial Markets Association. The link page also provides a concise explanation of the collateral, structure, purpose and other features of CDOs.

First, global CDO issuance has expanded at a furious pace - up six times in just three years. The chart below tracks the new issues of CDOs every quarter since 2004.

Of the total $489 billion issued in 2006, almost 80% were issued in US dollars, 18% in euro and the remaining 2% in yen, sterling and other currencies. Given the size of US debt markets, such a concentration is expected.

The next chart breaks out the CDOs issued in 2006 by collateral type. Structured finance collateral (60% of all issues) includes residential and commercial mortgages, asset-backed securities, credit default swaps, other CDOs (resulting in CDO-squared or -cubed) and other securitized and structured products. Another 34% is backed by high yield loans made to borrowers rated Baa3/BBB- or lower. Investment grade bonds make up a minor 5% and all other account for the rest (rounding error).


It is apparent that CDOs are used mostly to pool and securitize low-rated obligations. Using the cascade structure, CDOs can transform a very high percentage of risky debt into securities rated AAA to A because they currently use optimistic (in my opinion) default and recovery assumptions in structuring the tranches. The vast majority of CDOs issued during 2006 were designed to capture exactly that difference between the high yield of the underlying collateral versus the lower yield of the CDO tranches. According to SIFMA, such "arbitrage" issues amounted to 86% of all CDOs issued in 2006 (the rest were "balance sheet" transactions done to remove assets from balance sheets, used to maintain regulatory capital ratios).

Another way to categorize CDOs is by issuance type. Cash flow CDOs are designed to pay investors by passing through to them interest and principal payment cash flows from the underlying debt collateral. Synthetic CDOs sell credit default swaps (CDS) to create a replicate cash flow. By doing so they also assume the liability of paying out on the CDSs in case of defaults, so buyers have to deposit funds in a special purpose vehicle entity (SPV) as security, or margin. Naturally, they do not deposit the entire or even a large portion of the potential liability - that would defeat the whole purpose of the CDS and the related CDOs - but only a very small portion. How small depends on default and recovery assumptions and, once again, I believe these assumptions are too optimistic. Hybrid CDOs combine those two structures: they collect and pass through both "real" cash flows from debt collateral and "replicated" cash flows from a synthetic structure. Finally, market value CDOs are designed to provide payments from both cash flow plus selling off part of the collateral, so the market value of the collateral greatly impacts the payout and performance of the CDO. The break down by type is shown below.

Unfortunately, SIFMA does not break down the dominant category of "cash flow plus hybrid" into its two components, so we do not have a clearer picture of the systemic risks involved in the CDO market. It is quite obvious that synthetic and hybrid issues contain significantly higher risk, based on the leverage imbedded in their structure (CDS and margin).

Finally, a reader asked how the yen carry is involved in the CDO market - apart from the simple strategy of borrowing cheap yen to buy higher-yielding CDOs on margin, of course.

The more "creative" use of yen loans comes in the initial funding of synthetic and hybrid CDO's. As we saw above, cash must be deposited into an SPV to collateralize the potential CDS liabilities in case of defaults. A speculator may simply provide hard cash for this purpose, but in this age of leverage and maximum return competition, it is much more likely that he simply gives his prime bank a security from his portfolio as collateral to obtain margin money through as cheap a source as possible. Enter the yen (or the swiss franc)...

I close by stressing, yet again, that all this talk of "ample liquidity" can be very distracting and even deceiving. Despite what many believe, liquidity is not some absolute, measurable quantity of cash sitting somewhere as a stagnant pool, just waiting for the nimble speculator to suck it up and put it to use.

Liquidity is the accessibility to and the pricing of credit, i.e. lending standards and interest rates. The former are cyclical, running the gamut from "fog the mirror" to "indenture your children as collateral". Until very recently we were as close to the former as we have ever been (CDO issuance is certainly a clue), but now the pendulum is clearly starting to swing in the other direction. As for interest rates...what can I say, but the obvious: they are going up everywhere, including Japan and China.

Like the rest of finance these days, liquidity is best described as a derivative: the mathematical first derivative of debt. Which begs the question, of course, first derivative against what? Time, GDP, income, gold, crude oil...? That's a question to ponder for another posting..

If This Is Tightening, I'm J.Pierpont Morgan

Countrywide Financial, the largest mortgage lender in the US, is finally tightening lending standards. Starting last week, they no longer accept applications for no-money down mortgages from sub-prime borrowers without proof of income.

My jaw is open - how about yours? I really am speechless. You shouldn't even be able to rent a mobile home in a tornado zone under such loose credit conditions, never mind buy a house in California.

Were they REALLY making such loans? I guess so...

Anyway, this "tightening" is so small, it indicates we are still in the very, very early stages of the downward part of the credit cycle.

Also, to follow up on comments I made about Spanish housing a couple of days ago, Bloomberg has an article out about the subject, titled: Vacation Homes Boom in Spain May Bust as Banks Recoil

I was in the area mentioned in the article a few months ago and I can confirm that the whole Costa del Sol, from Gibraltar to Almeria (about 500+ km), is one giant vacation construction site, with El Cheapest attached condominium projects machine-gunned from the water's edge up to the hills. We are talking, up one hill and down the other. I saw the saddest excess at Carboneras, at the far end of Almeria province, a grungy but laid-back factory town still undeveloped by comparison to, say, Estepona. Just around the corner (and down-wind?) from the huge, smoke-belching cement factory they are building this enormous "luxury" vacation-condo complex, having hollowed out an entire hill. It's still too new to see it on Google Earth, but the factory is very visible. Here's a picture - the development was being built slightly south of the factory.

Carboneras Cement Plant, Spain (Google Earth)
Click to enlarge

"This Is The End of The Liquidity Party"

The title is by Jim Rogers, the legendary investor/speculator (and bike world-traveler), taken from a recent interview he gave to Reuters.

Let's do some dissection:

1. What is liquidity?
2. Where does it come from?
3. Where does it go?
4. And how does its party come to an end?
   

1. Liquidity is created by debt. If it is easy and cheap to borrow, more and more people do so and money supply rises fast.

2. Where does liquidity (debt) come from? The chart shows debt/GDP for the four main sectors of the US economy. Households and financial corporations went on a borrowing frenzy in recent years, made possible by record-low interest rates in the US, EU, Japan and China. The explosion of credit derivatives boosted this process even further, by creating the illusion of lower credit risk.

Source: US Federal Reserve (Flow of Funds Accounts - Z.1)

3. Where does liquidity go? When the extra money chases...

(a) ...a limited supply of consumer goods ---> we get high consumer inflation.
(b) ...assets ---> we get bubbles.

Because of globalization and ultra-cheap Chinese goods, (a) was not an issue. So, we ended up with (b): asset bubbles everywhere.

4. The party ends when people can't and/or won't borrow any more.

• People can't borrow when their incomes are no longer sufficient to service the debt.
• People won't borrow when returns on assets become too small vs. the financing costs.
  

The first condition is obvious for the US just by looking at the negative personal saving ratio. Households are already spending everything they make so they can't make additional debt payments. If, nevertheless, they do somehow manage to borrow more, then it all turns into a giant Ponzi scheme of debt piled on debt, just to service even more debt. Party over, right there - and remember that 70% of US GDP is based on consumer spending.

The second condition is always more difficult to establish conclusively, because feverish, irrational capital gain expectations always overule rational rate of return calculations - until it's too late. That office party you thought would be over by 10.00 PM? It can go on until 02.00 AM if the librarian puts the lamp shade on her head and goes down to the corner store for more booze.

As far as US housing is concerned, the rent-price ratio, calculated and charted by the Philadelphia Fed (below), tells the whole rate of return story. Rents don't even come near to covering the costs of owning a house anymore.

Are there any signs that debt appetite is now slowing down? Yes. The following chart shows that debt growth for households and the financial sector finally started coming down in 2006, particularly after the second quarter. The recent sub-prime mortgage implosion must have slowed down household borrowing even further during 1Q07.

Source: US Federal Reserve (Flow of Funds Accounts - Z.1)

Is the liquidity party over like Jim Rogers claims? Yes - particularly as the cheap yen and swiss franc "carries" become more expensive. In fact, I believe the liquidity party is about to become a prolonged credit crunch: a condition where debt is both expensive and difficult to obtain and existing debt burdens become so onerous that the only way out is to continuously sell assets, driving down their price.

We will then have gone through the full cycle, from "liquidity party" to "liquidity crisis".

What A Credit Derivative Looks Like - In Color

If you have been reading my postings for a while, you are familiar with my views on mortgage debt, RMBS, CDO, CDS, CPDO, ABCD and all such derivative and structured finance acronymia. It's all coming to a boil right now, but for the most part it's really, really dry stuff - except for the hardcore types who get heart palpitations just thinking about variations in GNMA experience ratios.

I usually include a graph or two in order to be more, ahem...graphically explicit, but inherently the process of presenting derivative finance is tortuous. Humor helps, but I have been told - in no uncertain terms - that my version tends heavily to sarcasm instead of wit.

So, today being the weekend and all, I will take it easy and let a picture do the blogging - about 1.000 words' worth as the Chinese say.

For your viewing pleasure and thoughtful consideration you will find below a picture of several thousand tightly packed units used in the issuance of all those MBS, CDOs, CDSs, etc.

Housing Developments in Perris, CA (Gooble Earth, alt. 10.481 ft)

Perris, California is the "zip code" with most mortgage default notices in the state, according to the LA Times. If you have to commute to L.A. it's one hour to go, two to come back. According to the story, a typical house in one of those "developments" goes for around $330.000 right now, though some hopeful sellers still ask over $370.000. Seems pricey to me from this altitude...

Sadly, this type of sardine-can real estate exploitation is not unique to California or even just the US. If you have visited the south of Spain you know what I mean.

Help Wanted

Today's subject will be jobs and help-wanted ad spending.

But before that, just a short comment to follow up on something I brought up a few days ago: political awareness of the mortgage debacle is rising fast. I just saw an interview with Mrs. Clinton on Bloomberg TV yesterday and the very first thing mentioned was mortgages and who is to blame - this issue is just now hitting the major politicians' radar screens and I am certain that they will quickly zoom in. Homes are at the very heart of the American way of life and this presidential race has started early, thirsty for major issues beyond just Iraq.

Mrs. Clinton made clear that she does not favor a government bail-out of borrowers and called instead on the lenders to "work with the borrowers"; experienced observers can read between the lines and come to their own conclusions about issuers, investment banks and investors/speculators in the mortgage and credit derivatives arena.

On to jobs.

One of the less-frequently followed concurrent economic indicators is spending for help-wanted classified ads in newspapers.

The chart below is produced with data from the Newspaper Association of America
showing the year-over-year change in such ad spending (no data available for 1992-94). The latest eight quarters are broken out separately for greater detail (hatched bars).

Three points: a) Periods of economic weakness/recession coincide with negative ad spending, b) compared with previous rebounds, want-ad spending was quite anaemic following the 2001-02 plunge and c) the last three quarters have been progressively more negative.

These observations tie in quite well with my previous post (March 11, below) about the current slow job creation.

Source: Newspaper Assn. of America

"Well, What Do You Want It To Be?"

Today I will follow a debt trail, from loan origination all the way to its ultimate existence as part of a credit derivative product. I will use a sup-prime mortgage loan as an example, but any debt obligation will do. Keep the question of the title in mind, it will make sense in the end.

Let's start two years ago with Ron and Ronda White, a couple in their early 30's with a combined income of $60.000 who have their eyes set on a $300.000 house to call home. They have saved only $5.000 to put down, which barely covers the closing costs. Their mortgage broker talks them into a $250.000 first mortgage ARM with an initial 2-year teaser rate of 2% rising to prime+1% thereafter and a $50.000 second, 30-year fixed at a whopping 10.5%. Despite the obvious problems apparent right from the start, such loans were made to hundreds of thousands of people. But no matter...

The two loans were immediately sold to investment bank XYZ who pooled them with other loans (creating Residential Mortgage Backed Security, or RMBS) and placed them inside a CDO. Using recent default data, the financial engineer employed by XYZ took 90% of the White's outstanding mortgage amount and placed it in CDO Tranch A, the supposedly safest portion rated AAA and paying 0.10% more than other AAA straight corporate bonds. The rest was apportioned 7% to Tranch B rated BBB, paying 1.5% more than equivalent bonds and the remaining 3% to Tranche C, also known as the "equity" tranche, which was unrated and paying 10% above Treasury bonds. In case of default, Tranche C gets hit first until it is exhausted, then Tranche B and, finally, Tranche A. This is a "cascade" or "waterfall" pattern, common to all such collateralized products.

Notice how 100% of a loan package that could be described as CCC has been turned into 90% AAA, 7% BBB and 3% NR. In plain terms, the "engineer" is betting that no more than ~3% of the total principal and interest will be lost, including recoveries from selling foreclosed real estate.

Call this the First Derivative - depending on conditions, the market prices of the CDO Tranches will vary significantly more than straight corporate or government bonds.

Those CDO Tranches are then sold as follows, typically:

• Tranche A to a pension fund attracted by the slight yield premium on a AAA bond.
• Tranche B to a fixed income mutual fund.
• Tranche C to a hedge fund attracted by the high yield - or is retained by XYZ.

So far this has been a plain vanilla process, the only question mark being how high or low the "engineer" places the assumptions for defaults and recoveries.

The next step in debt "derivativization" is the issuance and trading of Credit Default Swaps on the first two Tranches of the CDO. It can be done by XYZ, another bank, a hedge fund or all of them - there is no limit. These swaps guarantee payment in case of default events by the CDO, itself a conduit for Mr. and Mrs. Smith's mortgages. These CDS's require an up front payment and subsequent semi-annual ones, usually for up to five years. One can think of them as tradeable insurance policies. Naturally, Tranche A carries a much smaller insurance premium than Tranche B, given the respective AAA and BBB ratings.

Call this the Second Derivative - the prices of CDS's will certainly vary more than the prices of the underlying Tranches and much more than straight bonds.

These CDS's generate income to the seller, who assumes the risk of making the buyer whole if the CDO Tranches experiences payment shortages. Who sells this insurance?

• CDS on Tranche A may generate 0.15% annually and is typically sold by a bank or a pension fund attracted by the income generated by insuring a AAA credit.
• CDS on Tranche B may generate 1.30% annually, commonly sold by hedge funds.

Who buys the stuff? It would seem pointless for the CDO owner to buy protection for the bonds he already owns, but it does happen for portfolio hedging purposes or even as a way to "trade" the underlying CDO's without actually selling or buying the actual bonds.

But there are more buyers than just hedgers, as we shall see below.

Another investment bank, it could even be XYZ itself, buys a bunch of such CDS's and creates another CDO, also with tranches, ratings, etc. Remember, all you need for a CDO is a stream of regular payments to slice and dice into tranches.

We have now reached the Third Derivative stage: the potential volatility of such a product can be orders of magnitude greater than a simple bond. This is a CDO made up of CDS on another CDO made up of RMBS's - the alphabet soup is thickening fast. The credit leverage, i.e. what happens to the price of this type of product for a given rise in loan defaults in the, by now very distant, mortgage is very, very high.

Should an "investor" actually provide cash to purchase the above Third Derivative CDO we have what is known as a "funded" CDO. But this is becoming increasingly uncommon, because there is yet another derivation that can be performed on Mr. and Mrs. White's nortgage.

Another investment bank (or the original XYZ) can construct an "unfunded" CDO from the CDS's in step three, an instrument that just pays out or demands payment from its owners on a quarterly basis, depending on the shrinking or widening of the CDS spreads. This "synthetic" CDO owns nothing - not even the CDS; it just uses them to mark to market the said CDS spreads and to thus calculate the quarterly payments.

We are up to the Fourth Derivative. Sorry, but I have run out of superlatives to describe the leverage, volatility and credit risk sensitivity of these constructs. And yet, les apprentices sorciers who cook them up think it "innovative financial engineering". Like any fourth derivation, the price of such instruments is completely unrecognizable versus the original mortgage.

Thus the title of today's post, explained best by an anecdote:

Bank XYZ is looking for a dealer for its derivatives desk. Candidate A walks in the door and the desk manager asks, "What is 2 and 2?" --- "Four, sir" answers the job candidate. "Next", says the manager.

Candidate B is asked the same question: "Depends on if you mean 2 plus 2, or 2 minus 2", answers B ..."Next"...

Candidate C comes in and before he answers the question he looks at the manager and asks: "I just want to be absolutely sure - the job is for the credit derivatives desk, right?"

"Certainly", answers the desk manager.

"In that case, 2 and 2 is whatever YOU want it to be", says C.

"Hired, when can you start?"

P.S. Now, let's say that Mr. and Mrs. White default on their loan and, along with them, another 6% of the mortgages default, too - way above what the "engineer" had assumed. What will happen to the prices of the above RMBS, CDO, CDS, Synthetic CDO's? Aren't we lucky we have trader C to tell us - or aren't we?

P.P.S. If it was not made clear, unlimited CDS's can be written on a particular debt obligation, including the CDO in step one. Say a "first derivative" CDO has $100 million outstanding. The CDS's issued against, however, may amount to many times that - as I said, there is no limit. Therefore, there is no limit to the third or fourth derivative CDO's that may be issued, themselves backed by those multiple CDS's. This situation can easily create a viral contagion negative effect, as one "sick" original CDO can infect many others through the CDS market. Ouch.

Of CDO's, LBO's and Stocks

As I was saying yesterday, Collateralized Debt Obligations (CDOs) were constructed from a variety of debt instruments, thus providing unusually cheap financing to less credit-worthy borrowers. For better or worse, they facilitated transactions that otherwise would have been impossible to accomplish. One example is sub-prime mortgages which helped create further vaporous impetus to the presently imploding housing bubble - but it is not the only one.

Another sector that benefited from CDO's is the debt used to finance leveraged and management buy-outs (LBOs and MBOs). Such cheap debt provided private equity funds with tremendous liquidity resources and financial reach. Nine out of the ten largest ever LBO's were made during 2006 (pls. see posting from Feb. 27 below).

The chart, from fixed-income asset manager PIMCO, shows how volume of such transactions soared in just the past four years.

Private equity firms could borrow cheaply because there was high demand for their LBO debt from CDO issuers. Once again we observe the transmutation of CCC risk into AAA through "financial engineering", based on the extrapolated assumption that defaults on risky bonds will remain at historic lows. Defaults on bonds rated below investment grade reached an all-time low of 1.57% during 2006 vs. an average of 4.90%. But, as the chart below shows, even the average is not indicative of true risk because such bond defaults can reach much higher levels during economic slowdowns - as high as 10-11%.

Source: Moody's via ProFund Advisors

I believe that credit risk is currently being re-assessed and marked higher in all sectors, not just real estate and sub-prime mortgages. The easy-money liquidity sources that drove LBO bids up and helped boost equity markets world-wide are going to start dwindling in the immediate future. After all, to a very large extent the ultimate providers of this liquidity were the buyers of CDOs: pension funds that have to answer to political/regulatory overseers and hedge funds that are subject to sudden investor withdrawals.

Prudent-man rules still apply to all investment activities, particularly when it comes to providing pensions for millions of working people. It will be very challenging for a pension fund manager and his investment councelor to coherently and honestly justify investing in financial instruments that ultimately finance highly leveraged, risky takeovers of listed companies at high multiples of book value. Imagine, even, if they have to do so in front of a Congressional sub-committee hell-bent to discover malfeasance and apportion blame - sometimes unjustly.

Hedge funds could face a much quicker and final judgment from their speculator-investors: a simple request for their money back, i.e. liquidations. As risk appetite is reduced everywhere, hedge funds - being the riskiest in the investment spectrum - will likely feel it first. Unless of course they can demonstrate that they are positioned on the opposite side and can benefit from rising risk aversion through short sales, etc. In that case their actions will simply exacerbate the problem for the others - after all, hedge funds are mostly trend followers and amplifiers. For some of them, pushing the "down" button in the elevator comes as naturally as riding it to the penthouse.

"Because We Had An Unfunded Liability To Pay Off"


Let's talk CDO's: Collateralized Debt Obligations.

Take a bunch of loans such as no-money down mortgages to people with horrible credit ratings and slice them into pieces and re-package them as CDO tranches rated from NR (not rated) all the way to AAA.

How do you turn a C credit into a AAA? In the traditional sense, you can't. But this isn't your daddy's bond world, this here is modern "financial engineering". The way you construct these faux ratings is by dedicating interest and principal payments from all of the loans first to the top rated tranche, then the second, and so on down to the "equity" tranche. Each tranche's rating, therefore, does not represent the average ratings of the obligations held by them, but depends on the expected cash flow, based on the way the tranches are built. The expectations themselves are based on historical data, i.e. if similar loan pools have shown a 5% historical default rate, then the CDO "engineer" will base his tranches on this assumption, plus a bit more as a safety factor, and the ratings agencies will do the same.

As default rates came down in the past few years, engineers could produce a greater proportion of the AAA to BBB rated tranches and less of the "toxic" equity tranche remainders, which acted as rubber bands stretching and shrinking to accommodate the higher or fewer defaults vs. the expectations.

Pause for a visit to engineering class (the "real" one, not the financial kind):

In sophomore year Statics I had a superb professor, Dr. Chang, a dour Chinese gentleman educated in Berlin who managed to combine harsh German authoritarianism with thinly disguised Chinese contempt for us "lesser" cultures. His "real life" problems went something like this: "Meeester Schmidt (he meant Smith), let'z assume vee HANG you worthless body from a noose attached to a cantilever I-beam and then vee slice your scrawny throat..vat is ze bending moment of ze beam?" Yet, this abusive Nazi had more teaching awards than he could hang in his office...I guess because his lectures were memorable, to say the least. One of the first things he taught us was:

"You may interpolate from a set of data with reasonable safety, but you will never, ever extrapolate - under penalty of death. Not the death of your own miserable selves, but of the hundreds of innocents you will kill when the bridges you design collapse. Eees that per-fe-ctly CLEAR or should I bring my dog to class next time to convince you?"

...Yawhol, Herr Doktor, wherever you may be.

You DO understand how extrapolating default experience from the recent past into the future is extremely dangerous, YESSS?? If not, you need private tutoring - probably by the prof's dog.

There is more: CDO's are not only constructed from mortgages - any debt obligation will do. How about debt to finance highly leveraged buy-outs by private equity funds? Fine. Bank loans? Great. Commercial real estate loans? Super....you get the idea. It becomes pretty clear where so much money to finance ridiculously risky lending has come from - it has been borrowed under the thinnest of the false pretenses, disguised as highly rated CDO's, often from unsuspecting pension funds and other such "professionals" who buy the said CDO's based on the boiler-plate ratings.

Why? In the words of a pension fund manager: "Because we had an unfunded liability to pay off" and we needed the extra yield. But it is not all that much extra after all the fees for the "engineers" and their salespeople are taken out - about 10 basis points (0.10%) over straight AAA bonds.

Oh, it gets worse: in order for CDO's to actually produce spreads over the equivalently rated straight bonds AND generate fat fees they are leveraged, sometimes up to 13 times the original amount raised. Anyone care to guess in which currency are (were) cheap loans available? Yes, Yen. As in carry trade.

Bring ze noose and ze cantilever beam, Meester Schmidt, you vill need ze practice.

Stock Buy-Backs

So...who's been buying stocks? Looking at the Federal Reserve's latest Flow of Funds release it becomes pretty obvious: since 2003 corporations themselves have gone on a debt-financed stock buyback binge.

The chart below shows that net issuance of equities (new issues minus buybacks) by non-farm US corporations has reached a record -$602 billion, a fourteen-fold increase in net corporate buybacks since 2003, financed by a record assumption of $437 billion in new debt. Is it any wonder that S&P 500 bottomed out in 2003 and has been rising since?


Which begs the question: Is this the best use of shareholders' money? Isn't corporate capital best invested in growing the business? Such enormous buybacks signify that - on balance - US managers judge that investing in their own companies' expansion is not attractive. The corollary is that earnings growth will decline and that current P/E's are, therefore, too high.

Unless it all has to do 100% with pushing up stock option values? I'm not that cynical...

Lies, Damn Lies and Seasonal Adjustments

The monthly US employment figures came out on Friday and several people have already commented on them, e.g. how the government jobs (+39k) were a very large part of the total new jobs (+97k) and that the private sector added just +58k jobs, the lowest monthly number since July 2004. All this is true; but keep in mind that the figures are seasonally adjusted, i.e. they bear no resemblance to the real numbers. Employment in the US is very seasonal due to holiday patterns, weather conditions, etc. so gross numbers are adjusted in an attempt to cancel out those factors and allow for meaningful comparisons. Both sets of data can be obtained from the US Bureau of Labor Statistics.

For example, the government jobs mentioned above were reported by the BLS on an unadjusted and (adjusted) basis, as follows:

Dec. 2006: 22.494.000 (22.114.000)
Jan. 2007: 22.003.000* (22.129.000)
Feb. 2007: 22.484.000 (22.168.000)

(*The actual loss of government jobs between December and January is seasonally concentrated on the state and local education sector, i.e. school holidays)

What was in fact a net loss of -10.000 jobs between December and February ends up being reported as a net gain of +54.000. Don't you just love statistics?

I hasten to clarify that I am not claiming there is hanky-panky going on - just that seasonal adjustments can frequently muddy the waters. Even small temporary variations in the raw numbers that run counter to the established pattern, can skew the adjustment very sharply and result in almost meaningless "adjusted" figures.

In the above numbers, the established pattern must have expected an even bigger loss of government jobs between February and December than the -10.000, so the seasonal adjustment shows instead a "phantom gain" of +54.000.

Unless you are an actuary, aren't you bored yet? Wait, there is a point to all of this: let's compare raw, not-seasonally adjusted employment figures. Over longer time periods the seasonal variations won't matter. Shown below is a chart of the rolling 12 month net change for all private sector jobs and further below is the change in annual percentage terms. I use the private sector jobs as they better reflect the "real" economy. (The patterns are the same when govt. jobs are included, anyway).

Source: BLS, figures in thousands

The immediate, relevant observation is this: jobs are not being created in anywhere near the same number or rate as previous times of expansion. We should have been seeing around 4-5% gains in employment instead of the current 1.5% - and it looks like the line is rolling over now, heading even lower.

Bottom line: Employment growth is crucial because a negative saving rate and huge debt load are pressuring US household finances like never before, i.e. earned income growth is key to averting a crisis. So far it does not look very good.

"Hypo"-Thetical Phone Calls (as in "hypothecate")

It is becoming increasingly obvious that the real estate/mortgage story is paralleling in many ways the dotcom crisis of 2000-03. The same signs of bubble, malfeasance and excess are rapidly morphing into a virulent process of sudden asset price drops and risk readjustment.

What looked like a going concern just three months ago has now become a "sudden death" candidate heading for bankruptcy. What started as a nervous twittering of lone voices in blogs, is now literally exploding across the mass media: Bloomberg reports that Fed Governor Susan Bies says sub-prime defaults are "the beginning of the wave", New York Times in its front page declares that a "Crisis is Looming in Mortgages" and Reuters reports that CDO issues are not finding buyers - to mention but a few stories. The news cannot be ignored or swept under the carpet any longer.

If you are a hedge fund manager holding such mortgage-related paper, what would you do now that the news is breaking hard? You know that within just a few days, if not hours, your more astute customers will be calling with questions like: "What is your exposure to this stuff?" and "What are you planning to do?" or, even worse, "What's the current mark-to-market on your mortgage-related portfolio? No, Jim I don't mean the indicative price on some banker's screen, I mean what's the goddam BID for the whole thing, right now!..No, Jimbo, you can't call me back after lunch. Go ahead and call ABC and XYZ investment bank while I wait on the line and get live bids. Better yet, put me on a conference call with them."

You see, the customer is likely a pension fund manager himself, who has to answer to his bosses and they are ultimately answerable to politicians who will be looking for witches to burn and scapegoats to skin. It's true: "it" rolls downhill.

Better hit the bid right now, painful as it may be, so when the phone rings you can put on your super professional voice and say: "Yes, we had a position, but we managed to get out at a small loss - better safe than sorry, eh Howard? Tsk, tsk, yes it is snowballing...I agree with you...what? You are worried about Bob's fund, too? Well, I better let you go then - you will want to make a call to him ASAP I guess. Always a pleasure speaking with you, Howie - let's do lunch soon, OK?"

Pheeewww...dodged that bullet.

Now, are we all getting ready for the CDS bullets?