Saturday, September 29, 2007

Housing, Jobs and Interest rates

I am truly fed up with "analysts" who claim that the economy is "fine" - "just a spot of trouble in the housing sector"... "job creation is strong"... "personal spending is holding up"... yack, yack, yack. Well, you be the judge.

Here is a chart (click to enlarge) showing the correlation between new housing completions (red line) and job creation (blue line). Notice the extremely tight relationship, right up to 2001. What happened then? In response to the dotcom collapse and the 9/11 events, the Fed panicked and cut rates to near zero (real rates went way negative), thus creating the artificial real estate super-bubble which "goosed" the economy (Fed Funds rates are shown in green - no scale).

The housing market has now fallen off the cliff, employment growth is rolling over and this time the Fed has painted itself in a corner. Rates are lower than at any previous cycle peak (i.e. it does not have as much room to cut), household debt is enormous and Americans are spending more than they earn; borrowing even more is simply not possible, even if it were desirable. Furthermore, 2.3 billion Chinese and Indian consumers with newly found money in their wallets means that cost inflation is already a very serious threat. And last, but certainly not least, the dollar as global reserve currency has credible competition for the first time since WWII - the euro.

Friday, September 28, 2007

Being Ben - And a Bit of Ancient Wisdom

What goes inside Mr. Bernanke's mind? Inquiring minds want to know so, after a brief preamble, we shall today attempt to delve into the (professional) soul of our current Chairman. First, a little bit of background.

Alan Greenspan was credited with engineering several economic and market "bailouts", real and imagined, thus acquiring the title of "Maestro" and further creating the term "Greenspan Put". He probably does not relish this legacy - deserved or not - particularly now that the real estate/credit recession is clearly ante portas and which traces its origins to the ultra-low interest rates of the 2001-04 period.

With each successful bout with financial market adversity, the reputation of the Fed was gradually enhanced, to the point where it is currently viewed as a Protector of The (Wall Street) People - akin to ancient Rome's emperors who assumed this title to rule without fear for their lives (the Protector's person was inviolate for as long as he held the position). The Senate and People of Wall (SPQW) have almost to a man/woman spent their entire careers under Greenspan and Bernanke - mostly Greenspan - and have come to naturally view this near deification of a government bureaucracy as status quo.

Let's now examine Mr. Bernanke.

The professor has made an entire career out of persistently proclaiming the demi-godly monetary powers of the Fed. For example, in the very first page of his "Inflation Targeting Lessons From The International Experience" (Princeton U. Press, 2001) he proclaims that ".. of all the government's tools for influencing the economy, monetary policy has proven to be the most flexible instrument for achieving medium-term stabilization objectives". In the very next paragraph he says "..central bankers are striving to develop strategies for conducting monetary policy that will "lock in" the gains of recent years and contribute to continued stability and growth in the future". In his other book "Essays on the Great Depression" the main conclusion is that the Depression could have been averted, had the Fed just cut interest rates more drastically.

Do we all understand what this is? It takes us all the way back to the great tragedians of Athens: it is pure, unalloyed hubris (exaggerated self-pride or self-confidence, thinking oneself to be as powerful as the Gods - and we all know what happens next, don't we? Nemesis, the punishment for being so prideful). In sum, pride goeth before the fall.

So here we are today: the SPQW know that our current Chairman is a firm believer in - nay, he is the Pontifex Maximus of - monetary policy as THE instrument to avert financial crises, by the application of drastically lower interest rates. And since the same SPQW grew up under Greenspan, they blindly believe in its absolute efficacy, too. They are the devoted followers of the cult of the Fed Saviour, now in full flower. Instances of economic troubles in real estate, mortgage banking, retail sales, credit and manufacturing are to be dealt with by the liberal application of low interest rate salves and constant incantations of "Cut More, Cut Faster - Cut Until You Cannot Any More, Oh Master".

Let me put it in another, seemingly more rational and academic, way.
  1. Prof. Bernanke was the Chairman of the Economics Dept. at Princeton, where he "proved" that the Great Depression could have been averted by cutting interest rates.
  2. He became Chairman of the Fed, where he can apply his "proof" in practice.
  3. He is now faced with the prospect of a recession.
  4. What is he going to do?
  5. What will the SPQW believe?
  6. What will the SPQW do?
What remains to be seen, of course, is if Professor Bernanke's theory is, in fact, correct or if he merely opened Pandora's Box. In which case, I can picture Aristophanes watching from his perch in Elysian Fields furiously scribbling notes for a sequel to Plutus (Wealth).

P.S. LIBOR for O/N dollars just widened out again today. As Bloomberg reports:

"Sept. 28 (Bloomberg) -- The cost of borrowing pounds, dollars, and euros rose as banks sought funding over the quarter- end amid a credit squeeze that shows no signs of abating.

The London interbank offered rate that banks charge each other for overnight loans in pounds rose 20 basis points to 6 percent today, according to the British Bankers' Association. The corresponding rate for dollars rose 21 basis points to 5.30 percent, and the euro rate climbed 6 basis points to 4.23 percent."

Two points, which I have emphasized above in bold:

a) The reporter is using the term "credit squeeze" instead of "liquidity squeeze" - a telling differentiation from past terminology.

b) The spread between O/N dollars in the actual interbank market (i.e. LIBOR at 5.30%) and the Fed's target for O/N money (i.e. Fed Funds at 4.75%) is a very , very wide 55 b.p. Many readers may not realize that the Fed Funds rate as set by the FRB is not the actual rate at which transactions take place, but an expression of the central bank's desire. The market sets its own rates, based on supply and demand.

You want to know when was the last time that O/N LIBOR, the actual cost of money, was as high as 5.30%? September 18, right before the cut was announced.

If you are wondering what got me into such a Graeco-Roman mood, I confess that I have been reading Robert Grave's "I, Claudius" and "Claudius The God" for the second or third time.

Thursday, September 27, 2007

Global Reserve Currency

You are the Finance Minister of Agoraphobia, a country with a relatively well-off population of 25 million people. Your country is not a member of the EU, or any other currency bloc and your President just asked you to give him a report on the Treasury's holdings, with particular emphasis on which reserve currency Agoraphobia should hold, since its own is not a major one.

You start and at some point your report will include something like this...

Desired Attributes of Our Global Reserve Currency.
  1. Holds its value quite well against other currencies, particularly major ones that account for large shares of our country's global trade.
  2. Holds its value very well against things we need to buy from the rest of the world (e.g. oil, food, machinery, consumer goods).
  3. The state that issues it must produce or provide quality goods and services we may need or wish to buy, so that even if it loses value against other currencies we can still use it directly.
  4. The state that issues and backs it must exhibit political and economic stability and behave rationally towards the rest of the world.
  5. The state that issues it must be firmly committed to the free movement of capital between borders, with relatively few - if any - regulatory hassles.
  6. The state that issues it must exhibit relatively low levels of foreign debt vs. its GDP, to minimize the chance that it will be tempted to inflate away its obligations or default selectively on its foreign debt.
For the above reasons, Mr. President, our Ministry has recently chosen the Eutopian Romeo as our major global reserve currency. As you also know, we used to hold mostly Usorian Dinkies, but it gradually came to be that it satisfied only 1 (one) of the above 6 (six) major requirements, so we switched. A smart decision, if I may say so myself, Sir.

Always At Your Service,

Dagny Taggart

Minister of State for Finance

Wednesday, September 26, 2007

Houses As Places To Live In

What a shocking idea, eh? Imagine that... Houses simply being structures that house families, instead of assets that may be sold for immediate gains, or cash cows that can be milked indefinitely. There is a logically simple way to estimate the fundamental demand for housing: all other things equal, the more people that are around the more housing is needed. let's examine this correlation...

First a chart of annual new housing completions (click to enlarge), i.e. how many new houses were actually being built per year. This is probably the most striking housing "bubble" chart that I have seen: since 1970, previous housing booms lasted just 4 years, trough to peak. However, the last one started in 1992 and went on for a full 14 years.

This means that there have been a heck of a lot of new houses built in this 14-year uninterrupted boom phase, many times more than any other cycle. Comparing the number of new houses with the increase in population is revealing. Following is a chart for the 1992-2006 period comparing how many houses were built every year to the annual increase in population. More and more new houses were being built, even as fewer people were added to the population.

For the 14 year period, there were a total 23.1 million housing units built, while population increased by 46.4 million people - one new housing unit built for every 2 additional people. The chart below shows the progression of this ratio during the boom phase. At the end of the bubble, there was an incredible one new house being completed for every 1.5 new persons! And remember, this was not something that happened over a short 4-year boom, but went on for a full 14 years.

Bottom line? There were A LOT of houses built, outstripping by far the "natural" demand that arose from population increases. The current glut in housing was a long time in the making and will take a long time to go away, certainly more than 2-3 years. This is quite simply just the beginning of the bust cycle: assuming it bottoms out at the previous ratio of 3 new people per 1 new house, it would result in 960.000 housing completions per year. To give you an idea of where we are right now, last month (August) completions were running at 1,523,000 per year and starts at 1,331,000 per year.

I think we have a very long way to go. I wouldn't want to be near a mortgage-related investment, no matter if it is prime, AAA, backed by an agency or Mammon himself.

Monday, September 24, 2007

For My Next Trick, I Will Fall Into This Here Trap...

I noticed that recently there has been a "surge" in the readership of this blog and some readers were even kind enough to provide encouragement and valuable criticism in the comments section. Thank you.

Please note that in the interest of brevity I may sometimes quickly pass over whole sections of knowledge in the presumption that readers are familiar with the subject. I recognize that this is not always so, but it would be cumbersome for most to constantly repeat material, particularly if I have already dealt with them in previous posts. I encourage new readers, if they have the time and inclination, to read some older posts. Alternatively, if some financial terms are unfamiliar there are tremendous encyclopedic resources in the Internet these days, e.g. Investopedia is a fine tool for basic information.

Back to our regularly scheduled program..

Apart from combating inflation, the Fed's mandate includes maintaining economic stability, which is officialese for "avoid recessions - but if you can't, make damn sure we get out of 'em ASAP". The main instrument at its disposal is setting the cost of short-term money via targeting the Fed Funds rate, i.e. what banks charge each other for overnight money. It is a weapon with one critical built-in defect, as the Bank of Japan can readily testify: Once interest rates go to zero the central bank is out of conventional ammunition for stimulating the economy. This is known as the "liquidity trap": once you are in it... good luck getting out. You can't set nominal interest rates below zero because no one will pay interest to have his/her fiat money on deposit with a bank - not for very long, anyway*.

(If you want to experience first hand the thrills and chills of running your own central bank, visit the Swiss National Bank's site, where they have an excellent monetary policy simulation program - a sort of internet game for money geeks. All I can tell you without spoiling the fun is that you will walk away with a much greater appreciation for the challenges of a central banker's job. Lots and lots of humble pie for us backseat monetary policy amateurs.)

Because of the trap, a careful central banker tries to stay as far away from the "hole" as he/she possibly can. Mr. Bernanke's now infamous speech about raining money from a helicopter, a joke originated by his mentor Milton Friedman, refers to just such a "liquidity trap" and how to get out of it - at least theoretically.

How is the Fed doing on this "stay as far away from the hole as possible" front? Not too well, I'm afraid. As you can see in the chart below, during the past 35 years, before every recession (indicated in grey) Fed Fund rates were anywhere from a low of ~7% to a high of ~18%, i.e. there was plenty of room to cut substantially in order to stimulate the economy.

Where are we now? Because in this cycle the Fed started raising rates from such a record-low level, it only managed to get to a high of 5.25% - the lowest post-recession peak since 1960 - before stimulation in the form of rate cuts was necessary once again (indicating, also, how shallow the recovery really was). The Fed is starting with significantly less ammunition in its monetary policy gun than ever before, while at the same time faced with runaway debt, a massive current account deficit and a tumbling dollar.

There is another very powerful monetary policy tool: the statutory ratio of bank reserves to deposits. It sets how much of the depositors' money can be lent out and is the way to control credit growth directly. For example, a 10% reserve ratio can ultimately create $1000 credit out of $100 of deposits, as the money lent out is re-deposited from one bank to the next. The Fed's ratio for non-transaction deposits (e.g. savings accts. that limit the number of withdrawals, CD's, time deposits, etc.) is now 0% - can't get any lower than that. For checking and other such transaction deposits the ratio is 10%.

From the above it is obvious that the Fed doesn't have much wiggle room before hitting the bottom of the trap at 0% interest rates, implying that very soon policy makers must look elsewhere for economic stimulation: financial/asset bubbles are exhausted as levers for growth.

Where should they/we look? Call me a romantic, but I believe widespread economic prosperity is not a matter of finance, but of industry. In the past several years we have put the cart (finance, assets, consumption) before the horse (R&D, innovation, production) and we are now caught in a bind. In my opinion it is time to correct this and have finance once again follow and serve the interests of industry. Our world is faced with immense challenges from resource depletion to climate change that cannot be dealt with by finance alone - or the consumerist technology of games and cell phones. We need to reclaim our global technical and political leadership position in "harder" industries, from alternative energy to environmental protection.

We now, sadly, lag - and that's is no place for America.


(*) There has been a notable exception: Switzerland in the late '70s had negative rates for a short period because foreigners kept piling into the Swiss franc, expecting FX gains.

Rocks, Hard Places and Pricing Models

Abbreviation Key

ABCP: Asset-backed commercial paper
BIS: Bank for International Settlements
CDO: Collateralized debt obligations
CDS: Credit default swaps
CLO: Collateralized loan obligations
GFM: Global financial meltdown
ISDA: International Swaps and Derivatives Association
LBO: Leveraged buy-out
SIFMA: Securities Industry and Financial Markets Association
SIV: Structured Investment Vehicle

American monetary policy and financial markets have been caught between a rock (huge debt) and a hard place (fundamental economic dislocations) for a considerable time; the effects have been visible since at least 2000, when the burst of the dotcom bubble necessitated sharp interest rate cuts and the strong dollar policy was abandoned by the Bush administration. The events of 9/11 further accelerated the rate cuts, to protect the US economy from the potential threats of a deflationary spiral.

Many blame Alan Greenspan for the current credit/asset bubble, unjustly in my opinion. The Fed was not responsible for the gutting of the American industrial base and the resulting explosion of the current account deficit, nor the deep neo-conservative tax cuts that ballooned debt. Finally, the Fed was certainly not responsible for the ruinous Iraq war. All the Fed could do was to combat the effects of these deeply misguided political choices with the blunt instrument of short-term interest rates. What was even worse, even this instrument became increasingly ineffective because the explosive rise of credit derivatives (CDSs), short-circuited monetary policy and kept driving long rates lower, even as the Fed was trying to push them higher (this "conundrum" was frequently mentioned by Greenspan). But this post is not an apologia for the past Fed Chairman. He can defend his own record while making a fortune as a best-selling author.

The process of inflating the credit/asset economy started in 2001-02, accelerated in 2004-06, and the final blow-off stage was experienced in late 2006 - early 2007. Massive amounts of structured finance securities were issued (CDOs, CLOs and a dizzying array of hybrids) and the pace of LBOs reached astounding heights.

The two charts below speak volumes about the process of ramping up asset prices and borrowing against them. This was by no means solely a US phenomenon - it happened globally.


Chart: BIS

The issuance of such enormous amounts of structured debt to finance ever-riskier mortgages and LBOs and thus pump asset prices higher would have been impossible without the massive expansion of the CDS market, which kept marking the price of risk lower and lower. The two charts below show outstanding notional amounts for CDSs and risk spreads. Clearly, it was the lowest-rated entities that benefited the most, both in the US and the emerging markets.

Data: ISDA

Note: This is an older chart that shows pre-crisis CDS spreads Chart: BIS

All of these elements resulted in a sort of malignant "virtuous cycle". Less risk signaled by the CDS market meant that more and more risky loans could be pooled together and securitized into bigger tranches of nominally AAA-A CDOs. At some point during 2004-06 the driving forces even reversed: instead of loan demand driving CDO issuance, it was the CDO issuers' demand for "product" to package that drove loan origination. The low interest rate environment created enormous speculative demand for anything that paid a spread over Treasurys or LIBOR (i.e. CDOs, etc.) and the high fees involved in securitizations made the whole business extremely lucrative. Predictably, loans of dubious provenance were originated by a vast network of fly-by-night mortgage boiler rooms. Again, this did not happen in the US only.

The exact same process occurred in the more rarefied (in image only) world of LBOs, where ghosts of junk past were suddenly alive once more. Absurd prices were bid for second tier companies not because the takeover entities could run them more efficiently (which would at least produce some economic productivity benefits), but because they could get them done with cheap money and thus earn large transaction fees. The number of private equity funds multiplied fast, including some in impossibly unlikely places, run by newly-minted "financiers" with zero experience in operating real economy businesses. As soon as cheap financing disappeared the deals immediately started falling apart - because there were no fundamental reasons to undertake them, in the first place.

Which finally brings us to the subject of the pricing models used to issue and mark-to-model all those structured finance securities. It is quite obvious that the primary variable in all pricing models is their sensitivity to credit risk, i.e. the risk of default. During the "virtuous" cycle, when credit risk goes down, such models indicated higher prices, which were used to issue structured finance securities at higher prices and with higher proportions of readily salable AAA-A merchandise. But as the cycle turned "vicious" those models started throwing out lower prices - and when the credit risks signaled by the CDSs jumped suddenly and substantially, as happened in August, those model-calculated prices moved radically down, causing havoc in the balance sheets of existing CDO holders such as banks, SIVs and hedge funds. The trouble was further enhanced by the fact that many holders were highly leveraged, i.e. they had borrowed heavily through ABCPs and prime-bank margin to buy those securities. Judging by market action quite a lot of margin came from the yen carry tactic. Live by the sword, die by the sword...

But why did participants choose to mark-to-model instead of mark-to-market? Two reasons:

(a) Because of the fragmentation in the structured finance business there were thousands of "made to order" issues that had next to zero secondary market liquidity. Usually the issuers pledged they would maintain a secondary market, but for practical purposes this was an empty promise. Even in good times the spreads between quoted bid-offer prices routinely exceeded 5 points ($50 per $1000 face) and in tiny amounts (eg $500k). We call this "trading by appointment only". Therefore, they couldn't truly mark-to-market because there simply was no active market.

(b) During the "virtuous" cycle marking-to-model served to hide the enormous embedded fees paid by real money buyers in the new issue market. For example, pension funds bought large amounts ($50 million and more) of such securities at par, a price that routinely included 5-8% underwriting fees - an atrocious percentage for AAA-A bonds when bought in size. I know of several instances where fees even exceeded 10%. By comparison, highly rated agencies and straight corporates are issued with fees of 0.5-1%.

Which brings us to what could be the "next shoe to drop". As defaults in the mortgage and junk loan sectors rise, as they are already, the models will calculate significantly lower prices, particularly for those issues that were put together with overly optimistic default assumptions. I won't be surprised to see some issues eventually model-priced at 10-20 cents on the dollar, even if their prospects for partial recoveries mean that their true values are double that. In other words, just as the models produced "garbage" prices on the upside, they have the potential to come up with "garbage" prices on the way down.

This mark-to-model snafu must have also been a factor in the Fed's decision to cut more than expected last week. Imagine a banker tearing his hair out as he saw his model inputting junk CDS spreads of 400+ bp and spewing out CLO prices in the 60s-70s, i.e. mark-to-model losses of 30-40% - and the same thing happening to his SIVs and his numerous leveraged hedge fund customers. Those CDS spreads had to come down immediately or else ... GFM was a real possibility.

As we know CDS spreads are most immediately correlated with equity prices, so the best way to have them drop fast and a lot was to engineer a stock market rally, even if artificially. Ergo, the Bernanke Fed "surprised" markets on cue, as needed.

But this is clearly a very short-term band-aid. The reality is that overextended debtors don't have the ability to service their debts and their assets are no longer worth what they once were, from real estate all the way out to LBOs, which are starting to drop like flies. The Fed may have staved off disaster for the time being*, but unfortunately nothing has changed on the ground.

* I can't really blame Mr. Bernanke too much. I know intimately what monetary/financial crises feel like and as a central banker you can't let them turn into immediate disasters. So you do what you have to do now, hoping to resolve the longer-term issues later.

Saturday, September 22, 2007

Will Falsettos Become Castratos?

Before I get to today's post, I would like to thank all readers who said such nice things about my writing in the comment section yesterday.

Following the Fed's rate cut, the talk on the Street is now "full speed ahead, we're going to bust right through the old highs and then.. The Moon". With the exception of some greyhairs, the rest of the chorus is simultaneously hitting those forced, falsetto high-C's that can pop eardrums. If you aren't familiar with musical terms, falsetto may also be described as "shrill". More on that later, opera fans...

To use Mr. Secretary Paulson's jargon, risk is being repriced, alright - down. Spreads for the CDX, LCDX and other such credit risk indexes are sharply lower and volatility as measured by the VIX index is also plunging. Bullish percentage on various stock indexes is fast retracing to pre-crisis levels: for example BPSPX, a bullishness measure for the S&P 500 index is nearing 65% after hitting 31% in August (it was 75% in mid-July).

The reason, sing the falsettos, is the kindest cut of all (those 50 bp's) that revealed the existence of the Bernanke Put to go with the existing Paulson Put. Two puts naturally provide an order of magnitude more juju magic against loss. It's like a sub-prime CDO tranche structure: if the Paulson Put fails, the Bernanke put takes over. "They won't ever let the market ever go down, tra-la-laaaaaaa-eeeiiii." I have a Monty Python-esque image of a bunch of Vikings chanting "Spam, Spam, Spammity-Spaaaam... "

Does anyone really believe this operetta? Oh, yes... There are plenty of newly-minted, cash-rich but naive speculators out there, all thumping their chests at the high-roller tables. Look no further than the Chinese, the Indians and all of the Petroleans. Plenty of fast bucks, little market experience and a whole army of western "advisors". Spam, indeed.

Who do you think has been buying most of those structured finance products leveraged 20x, eh? Who has been shoveling fresh money to the hedge funds and private equity funds? It wasn't Americans or Germans, I can tell you that much. I know one guy from the above national group, whose name you have NEVER heard and isn't even a household name in his own country, who walked into a private equity fund and plunked down $200 million. Leveraged at a minimum 5x the fund created a cool $1 billion buying power. The gentleman is not a fool - he is a legitimate, successful businessman who simply knows very little about financial markets, i.e. how the serious unloading takes place precisely after a major break, when the chorus sings "buying opportunity" all the loudest.

My hair - whatever is left of it, anyway - is greying nicely, in a rather attractive and distinguished way (end of advertisement), so I am one of the very few left singing in the lower register. No longer only on fundamental grounds, but also because of the old saying: "The bull climbs a wall of worry". If that worry disappears, as it is rapidly doing now, that's the time to start worrying. And if it gets replaced with certainty, particularly amongst those youngish operatic Wall Street falsettos striving to extend their natural singing range, their customers may very well accommodate them by turning them into castratos - if their predictions turn out wrong.

Have a lovely week-end.

Thursday, September 20, 2007

The Real Reason For The Fed's 50 bp Cut

Occam's Rule: Sometimes the truth is so simple that even as it stares us in the face we are blind to it.
The Federal Reserve cut its Fed Funds benchmark rate by 50 bp to 4.75%, more than most analysts' expectations. Already there have been trillions of pixels written to explain why, but none that I have seen follow the time-honored Occam or KISS principle (Keep It Simple, Stupid).

Here is a chart that explains the FRB's move; for the non-professional there is an explanation after it.

The chart above shows the interbank money market yield curve for US dollars, from overnight (O/N) out to 12 months. These are the rates that banks charge each other to borrow for the period specified. When you hear LIBOR mentioned (London InterBank Offered Rate), these are the rates they refer to.

The money market is by far the most important in the world, the very foundation upon which banking and finance rest, because it provides the day-to-day financing that keeps the wheels of finance and commerce spinning. It is normally a very mundane and boring market, a sort of meat and potatoes process that just works day in and day out. Think of it as finance's equivalent of the electrical power plant, i.e. it is taken for granted - until something goes wrong. Any trouble in the money market is immediately transmitted via the banks to the bond and stock markets and then quickly out to the "real" economy.

So what does the above chart tell us? On September 12 the money market was truly ugly, with a big "hump" in the cost of money from 1 month out to 6 months. The spread in interest rates between 3 months and O/N was almost exactly 50 bp. The reason was that Asset Backed Commercial Paper (ABCP) that typically came due in 30-90 days was not being rolled over and everyone was scrambling for money to replace it. This is also why the ECB was constantly pumping huge amounts of money into the system: it was bailing out the banks' SIVs that could not find any money to replace their ABCPs (I wrote elsewhere that the ECB was doing the Fed's laundry - this is the reason).

At a borrowing cost of 5.70-5.80% against assets that yielded maybe 5.50% and leveraged 10-20x, various SIVs and other borrow short - lend long players were bleeding money like crazy. The situation was indeed critical and the cost of money had to be brought down sharply or the banks would have to sell collateral (CDOs, CLOs, etc.) in a depressed market and write huge losses in their books - If they could find a buyer, that is.

So the cost of money was brought down. Clearly 25 bp would not have done the trick - just look at the chart - and so the Fed cut 50 bp. It's as simple as that. Nothing to do with the economy, jobs, retail sales or the cost of peanut butter in Peoria. Ain't the truth fun?

So now what? As you can see from the blue line, the "hump" is still there but it is much smaller. The banks have been given some breathing room and can keep those CDOs, CLOs, etc on their books more comfortably. But - there is always a but - the mass of ABCP and ABCP-type financing has now shifted to the O/N market, i.e. it rolls daily because lenders do not trust them and want to be able to pull their money out ASAP. This type of financing from one day to the next is very dangerous: if there is another credit crisis like we saw two weeks ago, such lenders will demand their money all at once, in the same day. To draw a parallel, say everyone has to drive to work every day but gas stations only provide each customer with enough gas for just one round trip. It is easy to imagine what will happen if gas runs short...

Let me say one final thing: most people are not fools. If bankers and politicians try to instill a false sense of confidence by claiming things are different than what everyone knows, they lose credibility. Do it too much and people get really worried and think: defense (i.e. I want my money NOW). Most people know houses are too expensive, most people know there is way too much debt and just about everyone knows that financier pay at a billion dollars a year isn't sustainable.

As a Republican once said: "You can fool some of the people all of the time, and all of the people some of the time, but you can not fool all of the people all of the time".

Wednesday, September 19, 2007

The Dollar, The Fed, PBoC and BOJ

The Fed cut a larger than expected 50 bp, almost entirely to delay or forestall the most serious effects of the asset/credit crunch. In plain language, lines of bank customers outside British banks waiting to withdraw their money must have scared the dickens out of Mr. Bernanke, who has made a whole career out of constantly repeating Milton Friedman's "the Fed should have cut more in 1929".

The immediate positive effect on the economy (the real one, not Wall Street) will come through the reduction in existing ARM payments, easing the pressure on household debt service and hopefully slowing the wave of foreclosures now upon us. (Yesterday RealtyTrac announced that monthly foreclosures in August jumped an astonishing 115% from last year. ) So the Fed giveth some debt relief with one hand - but what has it taketh away with the other? The value of the dollar is dropping, causing new highs in the prices of just about every significant commodity, oil in particular. Isn't a jump in inflation closely behind?

There is a seemingly logical counter argument: the two most significant foreign currencies for the US economy are the Chinese yuan (cheap imports) and the Japanese yen (cheap loans). The yuan is essentially pegged to the dollar, so Chinese imports are not going to get more expensive. The yen is perennially weak and its interest rates are not very likely to rise much. In other words, where it matters the dollar is stable and does not create imported inflation.

This, however, is a static and simplistic approach. China is already experiencing high domestic CPI inflation (6.5% in August, the highest in 11 years) and the PBoC has had to raise official rates and reserve requirements repeatedly, to little avail so far. One of the next measures may involve an upward revaluation of the yuan to cool the economy somewhat and prevent higher wage demands and to guard against imported inflation. This will immediately result in higher import prices in the US, i.e. inflation.

Japan is also at risk of experiencing cost-push inflation: it is completely dependent on oil and other commodity imports and cannot forever pay for them with a weak yen. At some point, the positive effects of the weak yen on exports are going to be out-weighted by expensive imports and that's when we may see the yen move higher, too.

The US cannot ignore the inflationary effects of a cheaper dollar just because its two most important counterparties are currently "pegging" their currencies at advantageous rates. They are doing so because it is (or was) in their own best interests and not out of consideration for the US. Once their domestic interests change those "pegs" are going to go away.

In the case of China the need to revalue is pressing and the PBoC is setting the stage by rapidly narrowing the gap between US and Chinese interest rates. After yesterday's Fed cut and last Saturday's PBoC rate hike the spread between Fed Funds (4.75%) and the PBoC benchmark 12 month depo (3.87%) has narrowed to 88 bp, down from 300 bp a year ago. But despite hiking seven times since last year, real interest rates in China are still very negative at -263 bp (The Economist chart below is 6 months old, but serves for perspective.) This means that China needs to urgently loosen its foreign exchange-rate regime so that it can fight inflation more efficiently.

Chart from The Economist

The conclusion is that the Fed did what it had to do to avoid the phantasm of Depression from haunting Mr. Bernanke. Fine - now it must pay attention to the value of the dollar because it cannot long depend on the good graces of the PBoC and BOJ. They have other fish to fry.


P.S. Fact vs. Virtual Reality

The following news item is presented in the interest of separating virtual reality (created chiefly at the intersection of Wall & Broad) from hard fact.

British Airways is suspending its London to Detroit flights. Demand is lacking due to auto slump.

This little snippet has a reality quotient 10x bigger than any FOMC meeting note.

Tuesday, September 18, 2007

Central Bailout Banks

The Fed's FOMC is meeting today to decide on its interest rate policy. Setting the benchmark cost of money is always an important decision, but recent events have fundamentally altered the main role of the Fed, ECB and BOE (and the BOJ, though indirectly). Currently, they are acting mostly as lenders of last resort and less as arbiters of monetary policy.

The injection of hundreds of billions of dollars into the interbank market, the permission to 3-4 major US banks to lend $25 billion each to their brokerage subs, the acceptance of highly questionable ABCP as collateral and the latest bailout of Northern Rock, all point towards a role that was once reserved only for dealing with extreme crises. And if the BOJ is not participating directly in the bailouts (at least not yet), it is doing so indirectly through being the largest global lender of last resort of them all: keeping yen interest rates at absurdly low rates they pump hundreds of billions of cash into the system, through the so-called yen-carry trade.

In those rare instances in the past when central banks had to step in and play this "bailout bank" role, they did it quickly and immediately reverted to their monetary policy duties. There was no reason for them to "linger" on the stage, simply because there was no overall threat of systemic risk. Clearly, this is no longer the case and anyone can see that the trouble is spreading, not receding. Late yesterday the British government had to step in alongside the BOE to guarantee all deposits at Northern Rock, plus those at Alliance and Leicester - another lender that got into trouble.

Viewed from that perspective, today's FOMC decision on interest rates is mostly symbolic for financial markets, but it is highly important for Prof. Bernanke's image and reputation going forward as Chairman. It will be his first test under pressure and everyone will be watching to see how he does. If he listens too much to the siren songs of the various politicos and bond daddies and proclaims the Fed as Bailout Central his credibility will be worth less than the equity tranche of a leveraged SIV.

If I may be so bold as to make a suggestion, he should probably be calling on Paul Volcker for advice and support.


Ben's Bail Bonds cuts 50 bp:

(a) stocks rally 3%,
(b) the dollar makes a new low vs. the euro (1.3980),
(c) gold goes to a 28 year high ($735) and
(d) oil rises to an all time high ($82.10).

Ben's economic prescription for survival based on the above:

(a) Since the vast majority of Americans do not own any stock, skip (a).
(b) Buy only cheap Chinese goods.
(c) Sell your wedding bands, bracelets and gold teeth and with the proceeds...
(d) Immediately buy some heating oil futures to prevent freezing this winter.

As Jim Rogers said today before the FOMC announcement, Bernanke spent his entire academic career studying the monetary printing press - and he just got his hands on them.

Monday, September 17, 2007

Collateral Damage

The first bank run of the 2007 Credit Crisis is now in full swing, as hundreds line outside Britain's Northern Rock branches to withdraw their savings. Some had to wait for as long as 4-5 hours and the BBC reports that around $4 billion was withdrawn Friday and Saturday. The run continues today (Monday), despite BoE's offer of an unlimited line of credit.

If anyone had any remaining illusions as to the nature of the problem facing markets, these are now surely being swept away. The bank in question apparently had a very small exposure to sub-prime loans (though I understand it frequently made loans for up to 125% of house market value), yet it is facing a crisis because it relied on the interbank market for 70%+ of its funding, instead of traditional retail deposits. As the interbank market dried up, Northern Rock simply could not obtain the day to day funds needed to run its business.

And why did the interbank market dry up? Two reasons: (a) Lack of trust and (b) banks needed to keep the extra cash to plug their own holes, which opened up as SIV's imploded and hedge funds needed money for margin calls.

I spoke to a long-time associate in the interbank market in London and asked him for his gut feeling. His take was that we are currently in the eye of the storm - calm, but with more trouble to come. Interestingly, he was the second professional who described the situation in exactly the same way. Another thing he mentioned was that he never expected to see a bank run taking place on London's high street - Podunk, USA maybe... but not London. Ah, the deleterious effects of globalization....

I close with an observation of my own: some think that China and other emerging markets are immune from the Credit Crisis. I, however, view them as another domino which just happens to be standing a few places further down. Their turn will come, too.
Scary Update: The UK government promised to guarantee all Northern Rock deposits. To the depositors this may seem like a good idea. The scary part is that it may seem like a good idea to several less savory characters, too. Like, for instance, other bankers. Moral hazard, anyone?

Friday, September 14, 2007

Let's Cut Through The Baloney

Just a liquidity crisis? If you believe that, you probably also believe that baloney is made from meat.

Definition of a liquidity crisis: a bank, or anyone else for that matter, has a portfolio of fine, productive assets but for whatever reason is short of quick cash - for a very limited amount of time. The crisis is very quickly resolved by providing the assets to a lender as collateral and getting a quickie loan. Crisis over. In fact, the whole thing never even reaches the condition of "crisis".

Definition of credit crisis: the same as above, but now the lender takes one look at the collateral proffered and instead of "fine and productive" deems them baloney, i.e. it looks like "meat" but is mostly starch, water, salt and preservatives. He tells the potential borrower "no can do" and to kindly take his collateral elsewhere, e.g. some Lender Of Last resort (LOLr) that is not very particular about the difference between proteins and carbs.

Definition of an asset crisis: The same as a credit crisis, but the LOLr can no longer accept any more baloney as collateral without becoming a luncheon meat merchant. At that point the LOLr runs to the politicians and lays it all on their lap and asks them to make the decision: Print or sink?

Definition of an economic crisis: The politicians form a committee to study the matter of the asset crisis.

Have a nice weekend.

Thursday, September 13, 2007

ImploSIVe Structures

I had a long conversation with a bank treasurer recently and among other things we discussed ABCP's and SIV's. His bank had just lost a small amount of money (for banks small is relative - it was in the low seven figures) in one of the SIV's that went belly up. The very first thing he mentioned was that the financial engineers' excuses about rare 5 or even 25 sigma events being the cause, was absolute nonsense. We both agreed that these instruments, even the tranches rated AAA, were bound to fail catastrophically if market values for the underlying collateral dropped by even as little as 10%.

The reason was the combination of tranche structure and 10x leverage. For example, an SIV typically issued a bottom "equity" tranche, then a consecutive "middle range" series of tranches rated BBB, A, AA and AAA, plus a top "super-senior" tranche. The middle range that was sold to investors carried the 10x leverage through issuance of ABCP in order to produce the extra yield, or LIBOR "plus" that everyone wanted. With a mere 10% correction in the assets backing the SIV the value of all tranches it issued, from equity to AAA, immediately goes to ZERO. The super senior tranche still retains value, but it is necessarily a very small portion of the original SIV. This is exactly why ABCP investors won't roll their paper and demand their money back, instead.

The combination of leverage plus tranche structures makes a mockery of credit ratings, at least as we used to understand them in the past. In this "innovative finance" context, AAA apparently meant that "the market price for the collateral won't ever go down by more than x%" - which is plainly nonsense. If anyone insists in calling a 10% correction in MBS prices a 5 or 25 sigma event, they really need to stop reading financial comic books and concentrate on studying the history of credit default effects of the business cycle. Then they can go back playing with their Lego(R) blocks.

In the meantime - and most certainly NOT coincidentally - the ECB had to pump in 75 billion euro ($104 billion) into the market yesterday. This was 3 month money and it was a record. They might as well issue credit cards, eh? In case anyone hasn't figured it out by now, the ECB is doing the Fed's laundry...

Wednesday, September 12, 2007

CDS Factors In Equity Valuation - Part B

This is the second in a series.

Part B: The Emergence and Growing Importance of The CDS Market

The initial creation of the Credit Default Swap market goes back before 2000, when CDSs were issued mostly against riskier sovereign debt, like Latin American or Eastern European government bonds. The market has since expanded rapidly to include corporate, ABS and index issues; amounts outstanding grew exponentially at an average of 110% per year and according to the International Swaps and Derivatives Association (ISDA) stood at a notional value of $34.4 trillion at the end of 2006 (latest data available).

Data: ISDA

Notional amounts are not market value amounts; that is, they represent the face amount of the credit insurance and not the value of the premiums that changes hands. That being said, notional amounts for CDS are not merely big numbers with little significance, as some claim*. One reason is that, unlike fires in California or earthquakes in Japan, credit events are not uncorrelated: a slowdown or recession creates financial pressure across most of the corporate spectrum, not just in selected areas. Globalization has also added a potent catalyst: weakness in retail sales in the US may, for example, rapidly manifest itself as factory slowdowns in China and less demand for cargo shipping everywhere. A butterfly flying in Peoria may create a storm in Shanghai and sink a ship in the Pacific, too.

Another reason that large notional CDS amounts matter is that, unlike regulated insurance companies, many of the entities that sell CDSs (i.e. those who provide the credit insurance) are less certain to maintain reserves for the potential liabilities they underwrite. It is unrealistic to expect that a 20x leveraged hedge fund has set aside a portion of its capital against the CDSs it sold to boost its performance.

Yet another factor has to do with timing: the CDS market grew exponentially exclusively during a boom cycle, i.e. when defaults were at historic lows and credit insurance became cheap. It has not been tested during a bust cycle and we will simply not know who is swimming in the buff until ebb tide. In other words, so far CDSs are a bull market phenomenon, when everyone claims to be a genius.

Lastly, under our legal system corporations are separate entities and their shareholders can walk away from corporate debt without personal liability. In other words, shareholders hold an implied "put" option on the company's debt: in bankruptcy proceedings they can "put" the debt back to the lenders and move on. There is good reason why lawmakers provide this legal immunity: it promotes enterprise by lessening the penalty associated with business failure. But the CDS market takes this immunity away from the overall economy and even multiplies the potential penalties: by creating multiple claims against a company's outstanding liabilities, CDSs may become economic penalty amplifiers during the "bust" cycle - which in no way has been abolished, despite claims to the contrary.

Let's pause here: the original debt put option still exists, incorporated within stock ownership of any given company "X". This put option certainly has some value and it must be reflected in the price of the stock. But through CDSs we have also created parallel and multiple puts on the debt of the same company "X" which trade separately and also have value, in this case clearly indicated by the market price of the CDSs. The amount of X's debt covered does not change, no matter how much CDS is written against it - but the writer of CDS insurance assumes the business risk of X, anyway i.e. he acquires a portion of equity risk similar to going long stock, without buying stock.

In effect, the CDS writer is creating phantom equity exposure in X, but X is not getting any direct benefit: no equity capital and no increase in its share price. Since the total equity of X does not change no matter how many pieces we cut it into (shares plus CDS contracts), it follows that each piece must be worth less, shares included. In other words, to the degree that CDS issuance acts to "water" the stock of X, it makes it theoretically less valuable.

Of course, real life is not that simple. The buyer of CDS may be a market maker without prior exposure to X and who thus may have to hedge his equivalent "short" position by buying stock or other equity derivatives from the open market. Through this process CDSs apparently act as volatility attenuators for stocks during boom cycles, i.e. when least needed. This readily explains the low volatility environment we observed in recent years, with stocks rising slowly and steadily exactly in those markets where CDSs were most prevalent: the US and Western Europe.

To gauge the overall possible effect of CDSs on equity values, I added the global market capitalization of all equity markets to the above chart (see below). Market cap is not directly comparable to CDS notional amounts, but as we saw above the connection is there and it is growing.

In the next posting I will examine current pricing of CDSs and its correlation to broad equity indexes.


(*) Also note: unlike earlier CDSs most current contracts are settled for cash, i.e. without the exchange of bonds or other specified securities. This is certainly true for index CDSs, which have become very popular. Ultimately, cash settlement means that one default event may result in multiple CDS payments that far exceed the real economic loss sustained by the default. As a reader commented (Shawn H), in such cases a company may be worth more "dead" than alive, or vice versa. It all depends which interests hold the stronger hand: the CDS buyers or the sellers. This is a distortive factor that can lead to highly damaging market manipulation.

Monday, September 10, 2007

CDS Factors In Equity Valuation - Part A

As indicated in the previous post, I have started work on a share valuation model that attempts to integrate Credit Default Swap factors into the equation. This will be done as a series of postings, not only because it would otherwise result into one very long post, but also to allow for timely and helpful comments from readers, as I go along.

Professional colleagues already know that the CDS market has a very big impact on stock prices. There are plenty of models on this correlation, particularly amongst the quant and prop traders. If any of you chance upon this blog it may feel like ...coals to Newcastle. But as will become clear, particularly in later instalments, my idea is not to price stocks based on CDS or vice versa, but to look at the possibility that stocks appear relatively undervalued because a part of the equity risk has been stripped out and is trading separately OTC in the CDS market. It's a bit like creating zero coupon bonds from regular bonds by "clipping" the coupons. Likewise, the stock "corpus" trades on the regular exchange, while its risk "coupon" trades OTC as CDS. To get the proper price we must put both together. I have not personally seen this idea floated anywhere, so if anyone has, please let me know.

A note for those who shudder at mathematical equations: All that will be involved are the four basics: +/-* . Perhaps a Δ (change) and a Σ (sum) here and there but no calculus, I promise. At least not in the first installment... ;)


Part A: The Basics of Equity Valuation

In standard portfolio theory, equity prices can be calculated as the sum of (a) the present value of the series of expected dividends plus (b) the present value of the annual "extra" we expect to receive in the form of capital appreciation and dividend growth, commonly called the Risk Premium.

Price = Discounted Cash Flow + Risk Premium

=> P = DCF + RP
(Equation 1)

The DCF calculation is pretty straightforward: take the series of annual dividends for 30 years, apply a discount interest rate (usually the 30 year Treasury) and arrive at the present value. There may be slight variations depending on the number of years used (30, 40, 50?) and the discount rate, but on the whole that part of the valuation is not volatile, simply because dividends don't change very fast.

When expressed as an interest rate (the usual way) Risk Premium has an inverse relationship to equity pricing: the lower the risk premium, the higher the resulting stock price. The "classical" way to estimate RP as an interest rate (RPi) is through the P/E ratio (PE):

RPi = (Earnings/Price) - (Real 30 year Treasury yield)

=> RPi = (1/PE) - Real Yield (Equation 2)

A way to arrive at the P/E ratio and thus current equity pricing, is to solve the above equation for PE:

=> PE = 1/(RPi + Real Yield) (Equation 3)

This clearly requires that we independently provide the value for RPi, the Risk Premium rate. Keep this firmly in mind as we progress, because it is the window through which the CDS market enters into equity valuation.

We may think of RPi as the "extra" spread above and beyond current dividend return that an investor is willing to accept in order to assume the risk of holding stocks, instead of
risk-free assets (e.g. Treasury bonds). This is partly what Alan Greenspan was referring to when he warned, right before he left the Fed, that prolonged periods of unusually low risk premia commonly end up badly*. Simply put, they indicate a high degree of risk appetite, i.e. speculation.

To put this into perspective, at the recent S&P 500 top of 1555 the present value of dividends (i.e. DCF) came to approx. 400 points, with the rest accounted for by the Risk Premium. Therefore, share buyers at that point were expecting 75% of their returns to come from capital gains and future dividend growth. Today's situation is not much different, with 425 S&P points accounted for by DCF and 1020 points by the Risk Premium, i.e. the split is now 71% - 29%. These are very high imbedded expectations for growth, particularly when one takes into account that corporate earnings as a percentage of GDP are currently at an all time high.

The question thus arises: why are investors willing to accept such low risk premia (when expressed as interest rates)? Has anything changed in the way we calculate or estimate RPi in equation (3) above, to arrive at higher P/Es? The answer is certainly yes and the reason can be found in the explosive growth of the Credit Default Swap (CDS) market, which is functioning as a mechanism for stripping out and trading separately that portion of risk associated with creditworthiness. Naturally, creditworthiness is highly correlated to corporate finances and we can readily perceive how signals from the CDS market quickly find their way to share prices.

That will be the subject of Part B, which I will post in the next few days.

(*) Unlike many in the financial blogosphere, I have great respect for Mr. Greenspan. We can certainly argue bubble creation, but under the circumstances he was probably the best Fed Chairman ever. I point out that he warned against the dotcom madness and even raised rates to contain it, despite then low inflation. The drastic rate cuts he engineered must be viewed through the events of 9/11 and were completely justified, at least up to a point. Don't forget he also had to deal with a mad-hatter fiscal policy designed by the Bush II neo-conservative administration. I also appreciated the merciless way in which he tortured English language syntax when providing congressional testimony. He could speak for hours without anyone understanding a damn thing - he was proud of it, too!

Friday, September 7, 2007

Stealthy Bubbles

A major investment bank issued a research report yesterday encouraging its clients to immediately purchase stocks, because there won't be another opportunity to buy them as cheap as right now, as they said. Market timing opinions are a dime a dozen (my own are even cheaper), so no great news there. What is interesting, however, is that one of their reasons for recommending shares is that they have not observed any telltale signs of euphoria, mania or bubbles in such markets. Ergo, contrarian investing dictates buying.

I have a couple of comments...

Firstly, not all bull markets end with manic buying. Sometimes they just roll over quietly and head lower in a slow, grinding process. In fact, clearly observable and spectacular bubbles a la dotcom are the exception, but it could be that the writer of the report is not old enough to have experienced other market modes.

Secondly, the record-breaking emergence of hedge and private equity funds in conjunction with structured/derivative finance has meant that bubbles are perhaps much better hidden than in the past. Such professional speculators do not rush headlong into markets and can use more sophisticated techniques than direct purchases of shares. For example, they may sell CDSs (credit default swaps) to create equity risk exposure, instead of buying shares directly. This has the expected effect of boosting share prices, but in a less volatile fashion. There is very strong evidence of this occurring, as CDS notional amounts literally rocketed from $8.5 trillion at the end of 2004 to $34.4 trillion at the end of 2006 (Data from ISDA). I believe this is at least part of the reason why equities kept creeping higher and higher in a reverse drip-dry process, with no correction at all - until recently.

There is another crucial implication to the emergence of CDS. To arrive at a proper price for shares, we must now include CDS to the equation. Remember, the existence of CDS means that we have stripped credit risk out and we are trading it separately. For market exposure purposes, a share's price is not just what is shown on NYSE or NASDAQ. We must add back - somehow - that part of the "price" that is now trading separately as CDS. I do not know what the size of this upward adjustment should be, but the enormous amount and super-aggressive pricing (until recently) of CDSs tells us it has to be very considerable. (This will make a great PhD thesis, by the way).

This means that conventional measurements of equity market valuations are now obsolete, at least in markets that use heavily such "innovative finance" enhancements. I think of it this way: Stocks are now made up of two "parts" - part A trades on the regular stock exchange and part B trades OTC in the CDS market. To get a proper valuation we must add A and B together; just looking at part A is misleading.

I believe there are stealthy equity bubbles out there and they are already popping, as can be observed by widening CDX and iTraxx spreads.

The more I think of this subject, the more I like it. So I will attempt to come up with an "adjusted" S&P 500, or some such broad valuation index, taking into account CDS factors. This will take some research and time - if anyone has any suggestions please use the comments section. Proper credit will be given where due, of course.

Conduit Warnings Redux

Note: I believe that in the Bloomberg story mentioned in the original post the reporter writing about "purchases" of MBS paper by Australia's CB has her terms wrong. It appears that the Reserve Bank will from now on accept such bonds as collateral for repo, which is very different from direct purchases for cash. It elevates the CB's status back to "lender of last resort" from instead of "buyer of last resort". And yet... the same reporter is back on the same subject today (Sep. 7) saying:

"The risk of owning corporate bonds in Australia fell this week after a the central bank's move to pump money into the financial system by buying debt backed by home loans restored confidence banks will lend to each other...... The Reserve Bank of Australia's planned purchases eased concern that losses related to U.S. subprime debt will further cut funding avenues and earnings at the nation's companies." (bold added)

My original post is below.


In recent years many banks set up nominally separate conduits to keep mortgages and other loans off their balance sheets, enabling them to conserve regulatory capital. Such conduits played the oldest game in banking: they borrowed short by selling and rolling ABCP's and lent long by holding CDO's, CLO's and other such asset-backed securities. The banks kept the spread and at the same time conserved regulatory capital, which allowed them to make or purchase more loans on the books and then to shift them off by securitizing them and "selling" them to their conduits. Neat, eh?

Well, yes, until the ABCP market simply stopped functioning and the conduits could not fund themselves independently. Several banks have already had to technically "bail out" their own conduits by taking their assets back onto their books. This means higher regulatory capital requirements and lower ability to make or purchase additional loans, i.e. a form of immediate credit tightening.

One such example is reported by Bloomberg today, involving National Australia Bank (the country's largest) which has already taken on $US 4.9 billion from its conduits and will likely have to take back another $US 4 billion. ANZ, Australia's third largest bank also had to take back loans and will likely take back more, for a total of about $US 3.5 billion and Westpac has a potential exposure of $US 5 billion. All this has forced Australia's central bank to intervene directly into the market, buying mortgage-backed bonds for cash - a very unusual move that underscores the extent of the trouble. Events are rapidly evolving from "lender of last resort" to "buyer of last resort" - and the buck hopefully stops right there because after that it is the printing presses.

As reported by the WSJ, Citibank has 25% of the entire SIV/conduit market with $100 billion under management. Barclay's is also heavily involved and it already had to tap BOE a couple of times claiming, however, that it was facing technical glitches in interbank market settlements.

In closing, the trouble with asset-backed credit is migrating closer and closer to the balance sheets of big global banks and this is a "conduit" for serious trouble. It is one thing for hedge funds to go down in flames; high risk eventually turns into big losses. But if banks are starting to take direct hits into their balance sheets, that is a whole different ballgame, by at least an order of magnitude.

I also note that the ECB is being forced today to once again offer money to the interbank market, since the O/N rate moved to 4.68% yesterday, much higher than its 4.00% benchmark. The amount provided came to EUR 42 billion ($57 billion) - that's a lot of money and the recurrence of the need after earlier injections two weeks ago is a very bad sign, indeed.

Banks are turning into CB cash junkies.

Wednesday, September 5, 2007

Panamax-ed LBO's

I'm always on the lookout for reality-based relative value comparisons with the make-believe world of finance, so when I saw in a news blip that the cost for widening the Panama Canal is estimated at around $6-7 billion (let's call it an even $10 billion, those projects always run over budget), my interest was immediately aroused. Does this amount strike anyone as odd? I mean, by comparison to the tens and hundreds of billions of dollars casually batted about by Masters of The Universe financiers?

After all, there is hardly a project with more global economic significance than widening the Canal. International trade routes are absolutely dependent on it and it has even given its name to a class of cargo vessel (Panamax), which will presumably get reclassified once the Canal is widened.

So, how come something as vitally important to the global economy as the Canal widening costs a mere $6-7 billion (OK, $10 billion...) and the takeovers of mostly unknown mid-level US and European companies by private equity funds are (were) happening at multiples of this amount? The relative value comparison between the two is completely out of proportion and by this yardstick - "One Panama" = $10 billion - such LBO transactions appear grossly overvalued.

Let's see...

Sallie Mae: 2 1/2 Panamas
Cadbury (just the drinks unit): 1 1/2 Panamas
First Data: 2 1/2 Panamas
TXU: 4.5 Panamas

...and so on and so forth. Just for the first six months of 2007 there were LBO deals announced for a total of 61.6 Panamas, while the value of LBO's around the world for all of last year reached 75 Panamas (see chart below).

(1) Constant 2005 dollars - Chart from BIS

Thus, the question quickly springs to mind: how much greater is the economic value of those LBO's vs. the real-life economic benefit of widening the Panama Canal? Seventy five times? C'mon... I quickly note that just five years ago total annual LBO activity came to a more reasonable 10 Panamas.

Maybe I am comparing apples and oranges here but keep in mind that they are both fruit, i.e. economic enterprises run for profit. Since as investors we cannot buy the Panama Canal for a relative value play, we just have to be cognizant that LBO's are currently grossly overvalued vs. something that has a solid and tangible economic "worth".

To coin a phrase, let's say that LBO finance has "Panamax-ed out".

Tuesday, September 4, 2007

Loose Loans Sink More Than Homes

The current unraveling of the structured finance market is said to be caused by, and contained within, the sub-prime mortgage market, i.e. financing for homes purchased by people with sub-standard credit. I strongly disagree; I view global credit markets as a continuum, a series of dominoes placed to form intricate shapes and effects, like one of those championship domino events we see on TV.

The sub-prime domino was the first to fall and, tellingly, it immediately knocked down the LBO domino, one that was seemingly completely unrelated to real estate. Then the ABCP domino fell, causing the money market fund domino to drop. In the meantime, the stockmarket domino also fell, causing the yen borrowing block to drop in a loop pattern that fed back and reinforced the thrust and speed of all domino moves.

The main thread running between all those dominoes is risk. As interest rates came crashing down during 2001-2004 to protect the US economy from a deflationary spiral, they ignited a massive borrowing boom directed to all manner of assets from suburban homes to emerging market shares. When conventional finance was exhausted, financial engineers started creating "innovative" products that had absolutely no connection to the real economy. Such credit exotics as hybrid CDOs, CPDOs, yield steepeners, etc. were manufactured bets and nothing more. Their creators maintained their raison d'être was that they spread risk around and thus provided a valuable service to the overall economy, which could now assume even more risk. I submit that reasoning to the court of common sense which, though common, is in apparent scarcity amongst the particular financier class.

In the end, borrowing had no other purpose than to place highly leveraged bets on other financial bets: risk piled on more risk. A simple example: an American hedge fund borrowing in yen to buy on margin a hybrid CDO made up of European CDSs. How many degrees of risk do you count right there? It is not surprising that the market simply stopped functioning, instead of just declining: complexity created one more overwhelming level of risk and everyone just froze. It is one of those profound "And now what?" moments, when everyone involved suddenly wakes up to the mess they created and is at a loss about what to do.

In the past a quick nudge of monetary policy would eventually do the trick. The cost of borrowing would be brought at or below the economic return of assets (rents, business IRR's, etc.) and the ball would start rolling again. But this is clearly not going to work this time around because what must be reduced is exposure to total risk itself, not the cost of borrowing to assume even more risk.

The market is not dumb: it realizes the dominoes have started falling and this is precisely why lenders, investors, speculators have all gone on a strike against anything that carries even a whiff of obscure risk that cannot be rationally calculated. They simply do not wish to be sitting on top of a domino.

At this point there is only one way to reduce risk relatively quickly and that is to lower or eliminate leverage used to place pure financial bets. Again, the market has realized this and is withdrawing ABCP financing just as quickly as it comes due. This is no mere coincidence; ABCP is a near cash-equivalent product that can be liquidated by simply not rolling it over, i.e. there isn't the pain involved in selling exotic bonds at a huge discount and writing losses in the books. Putting it another way, in a crisis you first sell what you can sell.

Of course the removal of ABCP is going to force down the whole ABS market, which in turn will remove cheap financing from all assets... and the dominoes will keep falling until the pattern of The Debt Bubble runs its course and risk is once again at a level that can be covered from the excess returns of assets, i.e. where the current reward of holding a risky asset clearly and conclusively exceeds the risk.

In closing, a note on the post's title. "Loose lips sink ships" was the warning given to WWII soldiers about inadvertently disclosing sensitive information to the enemy.

My version is a bit more inclusive, unfortunately.

Saturday, September 1, 2007

That Old Style Religion

You sin. Then you sin some more. And then even more. A bit later you figure you better get some insurance and so you visit the priest. You confess and he prescribes some anodyne penance, like 30 Hail Marys and giving up chocolate fudge sundaes every other month - after which, he assures you, all will be forgiven and the Pearly Gates will remain open for your minimally sorry (as in con-trite) ass.

Lo and behold, the fullness of time soon arrives and yup, though you walk through the Valley of Death without fear of punishment because of said priest's soothing reassurances, you suddenly find yourself facing none other than Mr. Fire and Brimstone himself.

"Woa", you say, "there must be a mistake in the database. Father Ben told me all would be well and I even did an extra Our Father three nights in a row."

The Trickster smiles devilishly (how else would he smile?), as he heaves you towards the nearest fiery pit and says: "Your greatest sin was believing that you could get away with so much sinning with just a slap of the rosary".

"But, but", you manage to whimper as the infernal fire starts to singe your eyebrows, "I trusted the priest. He told me all was O.K., so why should I get the blame? Besides, if you can't trust them, then who can you trust?" The Devil pauses, looks you seriously in the eye and in a grave, yet sorrowful voice, tells you, "The Boss gave you free will, the right to make up your own mind - didn't he? Well, that freedom comes with a price - and consequences. Now move along, I see a financial engineer approaching and that section is already beyond capacity. I will have to stick him in with the rating agency guys and lately they're at each other's throats".

The above "parable" is meant to suggest what can happen if investors and speculators place too much faith in the abilities of the Fed and other branches of the government to resolve systemic financial risk with just (hot) air. If their Hail Mary measures do not work, then there will be hell to pay. Almost literally.