A Different Kind of Credit Crunch

It is quite obvious that we are in the initial phases of a major credit crunch. However, this is not a "regular" credit contraction, where the Fed tightens in order to prevent or lower inflationary pressures. No, it's truly different this time.

As I have often laid out in previous posts, banking is not what it used to be. Credit institutions no longer loan money; rather, they act as salesmen of loans they have previously packaged and securitized as CDO's, CLO's, CPDO's, etc. The real lenders are the buyers of such securities. This process, combined with the waterfall tranche structure of asset-backed securities, allowed for credit conditions to become ultra loose, irresponsible even. Bankers did not care about loan quality, since they could turn even junk into 80% AAA-AA bonds, with the remainder off-loaded to the dozens of new yield-hungry hedge funds that were cropping up daily.

But just because there were buyers for such products (for a while), it did not mean that borrowers could service their debt. Quite the contrary, in fact. As the weakest individuals and companies were offered more and more debt without their incomes rising commensurately, it was only a matter of time before they would get into deeper trouble, faster. When this became obvious, the bond buyers suddenly disappeared; after all, they were just portfolio investors and unlike experienced bank credit officers they did not want, or have the ability, to gauge each borrower's creditworthiness inside those pools of thousands of loans.

In this crunch, the entire credit process is shutting down fast. It is not the cost for the use of money that is rising, but the cost of risk, i.e. the bond buyers are questioning the safety of their principal and this is the most potent deterrent to lending. The signs are everywhere: for example, if KKR and Cerberus can't get funding, then 99% of all other buy-out funds won't get any, either and the trillion-dollar-a-year LBO business is out of business - at least for now.

Let's look at the price of risk across all asset classes, as measured by their credit default swaps:

1. Home mortgages, as measured by the ABX indexes, are now trading at spreads at least 2-3 letters below stated, i.e. AAA is trading like BBB, AA like BB, etc. The BBB and BBB- tranches are effectively trading as if already in default.
2. Likewise for commercial real estate mortgages, as measured by the CMBX indexes. In fact, such mortgages appear even more distressed than residential ones.
3. High yield bond spreads (CDX HY) have widened from 250 bp to 525 bp literally in days.
4. Investment grade bond spreads (CDX IG) have widened from 35 bp to 77 bp, also within days.
5. Syndicated leveraged loan spreads (LCDX) have gone from 90 bp to 370 bp, again in days.

And this is not just in the US - it is happening all over the world. The iTraxx indexes following European, Asian and Australian credit risks are showing similar patterns.

In a recent Bloomberg interview, US Treasury Secretary Hank Paulson acknowledged this fact, but at the same time he underplayed it: "All that is happening is that risk is being re-priced", he said. Well, yes, of course... but risk is being re-priced so fast and by so much that the effective cost of borrowing is gapping up, not rising gradually as in prior tightening events .

• Look at LCDX - corporate leveraged loans, used for LBO's:

Index charts from Markit

A move of 280 basis points in one month is not a mere "re-pricing of risk" - it is a bona fide crisis. In the past couple of weeks at least 40 deals have been delayed - and will likely be canceled, simply because such huge increases in financing costs in such a short period of time completely destroy their cash flow projections, i.e. the whole purpose for doing LBO's in the first place.

• Here's another example, the "A" rated tranche of CMBX (commercial mortgages):

I intentionally chose a highly rated tranche to show that tightening is happening everywhere, not just the low end of the quality spectrum. The low end (BB) is a disaster - it has gone from 500 bp to 920 bp. Developing commercial real estate is completely governed by financing costs and there is no way such strong headwinds can be overcome.

To compare what is happening today with "regular" credit contractions of the past, it would be the equivalent of the Fed raising rates by at least 150 b.p. in one move. Looking at Treasurys to gauge medium to long borrowing costs is useless.


As Greenspan would have put it if he was still at the helm of the Fed..."Markets are currently reversing the prior tendency of lenders to accept lower than normative risk premia and are adjusting towards a higher plateau of effective credit pricing and a lower plateau of credit availability, further adjusting of course for perceived creditworthiness. The Federal Reserve is keenly observing this process and as always may adjust its monetary aggregate targets to reflect this fact, though it cannot intervene directly into what is a self-correcting mechanism regulated by the free market". Translation: "I told you so, clean up your own mess".

Bernanke's likely reaction (privately): "Revv the helo".

There is further reason why this credit crunch is very dangerous: total US debt (federal, state and private) as a percentage of GDP is now at the highest level ever. It takes more total debt to create a unit of economic activity than ever before and its sudden constriction is simply going to have a bigger negative effect on the economy.

Data: Federal Reserve

At the same time, there is less available income to back up the debt. The ratio of household debt to disposable income is also at the highest level ever.

Data: Federal Reserve

One final point of opinion: I think this process of credit spread adjustment and tightening is in itself the initial stage of a wider move away from portfolio investments that will take many years. To draw a parallel, just as we have had a long-lasting bull market for such assets that started around 1982 with the inception of trickle down economics, major tax cuts, wealth and income divergences and so many other societal changes, I believe the process will shift to something else. My most likely candidate is a steadier-state economic model based on ecological concerns and depletion realities.

Get Off The Bong Bus

I started this blog eight months ago when it became glaringly obvious that the global economy was becoming hooked on the high-potency drug of debt-financed asset appreciation. It was like dozens of dope bubbles were emanating from bongs all over the world to create one huge hallucinogenic balloon passed around tens of thousands of speculators who rolled their eyes ecstatically with each "hit" and maniacally kept pushing the BUY button over and over again.

It was a throwback to a Miami Beach college spring break, a lifetime ago. Pinching pennies, I had chosen to travel from NYC by charter bus, packed with other college students. The trip was to last a full 24 hours. The moment the wheels got rolling everyone lit up joints, bongs and paraphernalia such as I had never seen before. What can I say, I had a sheltered childhood and besides, grass smelled to me like dried cabbage leaves on fire - ugh.

Before the bus was out of Holland Tunnel it was so hazy inside you could hardly see two rows back - and it stayed that way as we all floated down South on I-95. It was freezing cold and opening a window was out of the question - until North Carolina, anyway. I was the only one on the bus that did not smoke - but boy, was I forced to inhale... When I pleaded with my seat-mate to at least not fire up his monstrous Cheech & Chong special, he gave me such a dirty look that I shut up for the rest of the trip. I suffered in silence and a week later I took the plane back.

Likewise, for months now it felt like I was inside the Bong Bus all over again, forced to inhale clouds of second-hand dope about "huge liquidity", "innovative finance", "risk and volatility attenuation", "paradigm shift", etc. The window was opened a couple of times and a bit of THC was let out, but it was quickly shut again and the party got even heartier. Everyone was stoned out of their mind and I think I even spotted the driver passing nickel bags around.

But the party is now most definitely over - zooming CDS spreads are evidence the hash bag is nearly empty and that everyone had better sober up before the cops raid the joint. All who are caught with their pupils (and portfolios) dilated will have to spend a few years in speculator slammer, where exposed assets get severely violated.

P.S. I was going to write a "serious" post today, recapping what happened this week and connecting to my original posts several months ago - early warnings about CDS's, CDO's, etc. Then I figured...what's the use? I can pat myself in the back all I want and feel vindicated, but that is of (dubious) value to myself only. So, being the weekend, I thought a bit of levity was in order. The bong bus story is absolutely true, by the way. Isn't it amazing how even the looniest experience eventually becomes useful?

You Call This Lower Inflation?

The 2Q2007 GDP numbers just came out (+3.4%), just as expected. Analysts also rushed to hail the PCE price index rise of "only" +1.4% - minus food and fuel, of course.

I have had enough of this absolute "minus food and fuel" baloney. So here is a chart of the full PCE inflation, along with the measure minus food+fuel. Reach your own conclusions, but keep in mind that according to the same release, a full 21.2% of all personal consumption expenditures are made for food, fuel and transportation services. Try minusing those from your real life....

Oh, and something else: Market-based PCE inflation, i.e. excluding items that the government says you get for "free" (like getting money out of an ATM without incurring a charge) rose by 4.6%, the highest in at least 15 quarters.

Swallowing The Hog Whole

Sometimes just one or two sentences are enough. Consider this paragraph, from a Bloomberg story.

The ``golden era'' for leveraged buyouts proclaimed by Henry Kravis two months ago is losing its luster.

Kravis, co-founder of New York-based Kohlberg Kravis Roberts & Co., said on May 29 that there was ``plenty of capital'' to finance acquisitions. Yesterday, Chrysler and Alliance Boots Plc failed to find buyers for $20 billion of loans to pay for their buyouts. Ten banks, including Deutsche Bank AG and JPMorgan Chase & Co., were stuck holding the debt. (bold added)

The last sentence, read in context, literally screams about how far we have come from traditional banking. Imagine... the banks "are stuck holding the loans"! As if banks are not supposed to make loans, in the first place.

It is obvious that in recent years major banks became so hubristically spoiled by making fat origination and securitization fees, that the very idea of loaning their "own" money shocks them. They had turned themselves into sausage factories: in came loans of the worst possible quality - "pigs" - and out came mouth-watering AAA link sausages to suit every taste: CLO's, CDO's, CPDO's, hybrid CDO's, CDO squared and cubed... the variety was captivating.

As any sausage maker knows, the trick is to take the cheapest possible meats, mix in a ton of extenders, flavorings, colorings, preservatives and water and turn them into "charcuterie" at ten times the price. Much better looking and smelling than the fat, dirty hog that originally came in. But, just like cheap bacon, all of the above bank products shrink to 1/3 their original size when things get too hot.

Well, the customers are finally realizing that bank sausages are not as healthy and nutritious as advertised and are passing on their latest offerings. The banks are now stuck with a roomful of smelly loans they don't know what to do with. Guess they'll have to swallow the hog whole - hairy ears and all...

With yesterday's drop in global stockmarkets came fresh upward pressure on credit spreads. The spreads for the CDX indexes calculated by Markit are rising very steeply, significantly including the one that follows investment grade bonds.

CDX Investment Grade Index

CDX High Yield Index

The importance of these moves is very high, given the leveraged nature of markets world-wide and the prevalence of debt-financed LBO's. In other words, first the takeover premiums are going to deflate to zero (no way to finance a deal right now) and then the leverage multiple is going to start working in reverse.

Liquidity In Emerging Markets: An Illusion

In addition to the ready availability of money (or loans, which is the same thing), liquidity also has another meaning: the ability to readily buy or sell in sizable amounts with little price impact.

Until 2-3 years ago this was certainly not the case for emerging markets: just a few issues (perhaps 10%) traded in decent size on a daily basis and the rest traded "by appointment", more or less. While these markets are still illiquid by US standards, they have progressed. The question is, why? Have local investors jumped in, converting their bank savings into portfolio investments? This is the case in China - and definitely too much so. But in other countries something altogether different is happening.

In many emerging markets locals are passive and the most influential investors/speculators are foreign institutions (usually hedge funds), who are dealing back and forth amongst themselves, ramping up share prices almost at will. Their activity creates volume and the illusion of market liquidity, when in fact there is hardly any underneath. The locals are not active - and why should they be? They are on the sidelines enjoying the gains with whatever participation they already have.

The major question is this: when the foreigners wish to depart, who are they going to sell to? Since there aren't any really sizable domestic investors they will have to sell to one another, like in a game of musical chairs but with Ravel's Rondo played at 10x the normal speed.

It's like this: a wealthy investor identifies a small illiquid stock he thinks is underpriced and starts buying heavily. Naturally, the price goes up and he keeps calling his broker with fresh buy orders every day - after all his mark-to-market profits are bigger every day. He even starts using margin, to boost his returns. His broker, being a broker, front-runs him when he can get away with it (which is all too often) and this adds to the illusion of liquidity. "See", thinks the investor, "there are other smart guys who realize XYZ is such a good investment."

Finally, the price reaches his target point and he calls his broker with the glad news: "Bob, I'm satisfied with my big gains. Sell everything". To which the broker replies: "Happy to hear that, Charlie - but who am I gonna sell to? You are the only buyer".

Don't even think this is a hypothetical story. It happens all too often.

Cerberus

(Special Intra-Day Post)

In case you have forgotten your Greek mythology, Cerberus was the three-headed hound, keeper of the gates of Hades. Apt name for a private equity fund, eh? The Dog From Hell? (What were they thinking of when they picked that name?)

Well, they just delayed the Chrysler takeover loan deal - there is simply no demand. In other words, they couldn't find anyone that would stick the loans inside a CDO or CLO and sell them to the public at anything approaching reasonable interest rates.

Just a few days ago I was writing... "Seriously, though: failed offerings are always signs of a top and with good reason. Markets are all about the balance between supply and demand and such failed issues are the best proof of lack of demand."

This is a failed offering and it seems like the bank(s) and Cerberus itself are "eating" the paper.

Oh, and KKR just joined the party. The Boots loans are not selling, either. And you know what's funny? Those alchemists have finally done the unthinkable: they managed to turn gold into lead.Bbefore the LBO announcement Boots CDS's were trading at 27 bp and now they trade at 450 bp. Quick, someone tell me: where exactly is the added value in LBO's?

Default Rates

A reader asked if there is proof about expectations of default rates reverting to the mean. Such expectations are a direct function of default rates themselves, but with a time lag (expectations precede the fact). The creation of the CDS market, however, has provided us with a powerful tool to measure expectations directly. Unfortunately, it is a very new market so we cannot exactly assess its correlation vs. actual default rates. Still, given the sheer size of this market ($35 trillion outstanding), we can be quite sure that its significance is high. With CDS spreads now rising steeply across all asset classes (home and commercial mortgages, junk and investment grade bonds), examining default rates more closely is very important.

The following chart was produced by data from a study by NUY Professor Edward Altman, long considered a leading authority in high yield ("junk") bonds ("About Corporate Default Rates", 2007).

Junk Bond Default Rates

I have added the arithmetic average, weighted average (by amount), and a band of +/- 1 standard deviation (σ) around the arithmetic average. Even a cursory glance at the chart shows that 2006 defaults were near the bottom of the band. Coupling that with the recent poor performance of the CDS market, I have a high degree of confidence that default rates will rise significantly in the near to medium future.

Who Needs PPT's When We Have LBO's?

Sometimes I hit upon a chart so powerful that it literally makes me gasp. This is the case with the following one, taken from the Bank of International Settlements 2007 Annual Report (click to enlarge). The amounts are in trillion dollars and are adjusted for inflation (constant 2005 dollars).

Value of announced LBO's in trillion $US (constant 2005 dollars)

In 2007 thus far, global LBO's are running at a rate 33% higher than 2006. So, it looks as if we may easily surpass $1 trillion in LBO activity this year - assuming the current rate is maintained. Total global market capitalization was $55 trillion as of May 2007; withdrawing almost 2% of market value in one year does wonders for stock prices.

However, there is an absurdity lurking here: private equity and LBO firms are taking dozens of listed companies private, but they are going public themselves. The whole process does not make any sense at all: we are being asked to pay a premium over and above what the LBO firms paid themselves in order to end up owning the same assets. It is little wonder that their IPO's are not faring well, so far.

Add the recent widening of credit spreads which is raising borrowing costs (e.g. the CDX High Yield index has jumped from 275 bp to 455 bp in the past 45 days) and we may already have seen the peak of the LBO activity, which translated into high takeover premiums being placed on stockmarkets.

Sigma Happens

Are you comfortable with probability and risk mathematics? I don't mean a passing acquaintance with the principles of throwing dice and winning at Monopoly, or figuring out the odds at a roulette table. I'm talking about a PhD in financial engineering, or at least a Master's in Mathematics with a Thesis in Probability Theory. No? Then you do not belong to the brave new world of finance and are herewith relegated to the status of dinosaur. Don't worry, you have plenty of company, Warren Buffett included.

At least that's what the new crop of frightfully (I choose my words carefully) bright kids populating the halls of finance would have us believe. I know, because sometimes they make me feel like a brontosaurus: big size, small brain.

This whole string of thought started when a reader (thanks "Kicker") asked me if I had any insights into CPDO's, or Constant Proportion Debt Obligations, a highly leveraged bet on default risk that sells Credit Default Swaps (CDS) on CDX and iTraxx indexes to generate income and capital gains to pay coupons of Libor+200 to 300 bp. It also has this rather unique feature: if the CDS premiums and capital gains don't generate enough cash flow to pay the stated coupon, this instrument is designed to automatically sell even more CDS's to make up for the difference. In gambling they call it "doubling down" after a loss. Polite society calls it "throwing good money after bad". Modern finance calls it "innovative".

The whole concept is based on the notion that if default risk rises too much above the level designed into the CPDO structure (itself calculated from historical default data), then it just has to revert back to the norm. Thus, selling even more CDS is the proper way to recoup the losses and eventually make a profit, too. In math terms, 3-sigma events are considered so rare as to be comfortably ignored - so comfortably, in fact, that rating agencies give this type of structure a AAA rating, despite leverage of up to 20 times (Oh, Brave New World!).

Let's stop it right there and use our common sense for just a minute. A AAA-rated bond that pays Libor +200? Ok then, I'll go ahead and arbitrage it against another AAA bond and just keep the spread. Being a dinosaur and all, I can think of several more such quaint and safe strategies, so when my bright banker calls recommending this CPDO I'll just throw them at him and see if he will just agree to pay me 2-3% on whatever amount I choose, without me putting up any money at all, of course. He should have no problem with that - what do the rest of you lizards think? Free lunch? Money for nothing? Chicks for free?

All right, time to get serious. This is a product that depends on two assumptions:

a) The low-default experience of the recent past will continue and,
b) If defaults rise they will quickly fall back.

But, here's the rub: the ultra low default expectation environment we are experiencing right now is ITSELF a 3-sigma event and will revert to the mean, too.

Here's a chart of the yield spread between junk bonds and Treasurys, showing exactly how far away from the mean we have moved in default expectations (i.e. the yield premium is way too small and has stayed that way for too long).

The bottom line is that the CPDO structure is a recipe for disaster.

Note: the CDX IG spread just hit 52 bp and CDX HY 430 bp. Both are new reaction highs. iTraxx is now at 35.

P.S. If you are interested in the discovery and application of probability and risk mathematics, I highly recommend Against the Gods by Peter Bernstein. It is very enjoyable and a good reference, too.

Banking: Unsafe At These Margins

Banking has always been considered a license to steal, assuming you could get a banking license to begin with. Because of the multiplier effect inherent in low regulatory deposit reserves, banks essentially create money and profits out of thin air, if they keep their operating costs low enough and their lending practices sound.

Global banking has changed radically in the past 20 years. Commercial and investment banking have once again become closely related, as corporate customers no longer wish to pay banks a spread for their traditional intermediation role (take deposit-make loan) and tap the securities markets directly for debt and equity capital. It came as no surprise that the 1933 Glass-Steagall Act separating commercial from investment banking was repealed in 1999.

Faced with rising competition, banks across the US merged in increasing numbers. There are now some 7.000 commercial banks vs. 14.000 22 years ago.

US Commercial Banks (St. Louis Fed)

But even as banks got fewer and bigger, competition for the remaining business - lending to households and small businesses - got even more competitive. Net interest margin (NIM), the most commonly followed gauge of banks' lending profitability, has come down dramatically, even as the risk profile of the borrowers has theoretically deteriorated. It is one thing to lend to solid blue chip corporate customers (however, note: are there any left?) and quite another to Mr. and Mrs. Jones, as the current mortgage mess clearly shows.

Net Interest Margin (St. Louis Fed)

Even as NIM came steadily down, return on assets (ROA) stayed high, but flat. Increased fee and trading income balanced the steady erosion in net interest margins. Remember this when you get hit with a huge fee for being even one day late with a credit card payment


Despite the steady reduction in core lending profitability and stagnation in ROA, US banks found another way to boost reported profits: they simply cut loan loss reserves to the bone.

Loan Loss Reserves/Total Loans (St. Louis Fed)

Banks weren't without justification for doing so, however. Reported net losses also came down at the same time - though not as fast, or as much, as loan reserves.

Net Loan Losses/Total Loans (St. Louis Fed)

To see how much faster banks cut down on reserves vs. actual losses, I constructed a chart of the difference between the two, i.e. (reserves minus losses)/total loans. This is the banks' cushion against further losses and it is now at the lowest level in 22 years.

Therefore, it is no wonder that Return on Equity (ROE) for banks has stayed high, though it seems to be turning down a touch recently.

Return On Equity (St. Louis Fed)

It is pretty clear from the above that bankers and their shareholders are betting that losses won't increase much from these record-low levels. Given what is already happening in the residential and commercial mortgage market, plus the stirrings of higher credit spreads in the corporate market (see yesterday's post), such a bet carries long odds, in my opinion. And there is, unfortunately, more: the largest banks have vastly increased their exposure to hedge and private equity funds, lending lots against little and low-quality collateral. One of Bear Stearns' funds that went under used 17+ times leverage; an incredibly aggressive ratio of debt to assets that unfortunately in not all that uncommon in this "high liquidity" era.

Bottom line: In their quest to produce ever higher returns for their shareholders, banks have done away with considerable safety features in their lending practices and balance sheets. Thus the title of today's post, a throwback to Ralph Nader's 1965 book (Unsafe At Any Speed) dealing with the US auto industry.