The Inflated Asset Economy

They say a picture is worth a thousand words and I agree, so here is a post of a few thousand. The focus is on how the US economy was transformed over the decades from an industrial economy to virtual reality one, based on assets and debt. Sadly, it doesn't require too many "pictures".

• The Demise of The Industrial Economy

The demise of manufacturing has been spectacular, both as a percentage of GDP and jobs.. This is what we really mean when we say "globalization".


What about the service economy? Great, as long as we also keep the industrial base intact, not out of some sentimental reasons but because it is the creator of technology upon which we all depend.

• The Rise of Assets and Debt
  

Making things as a way of adding value to the economy has been replaced by pumping up financial and real estate assets and borrowing against them, in order to replace income that has been lost from de-industrialization. Look at the way household debt has zoomed versus income - a double in 15 years.

*Total financial assets minus deposits and un-incorporated business equity

It does not take a rocket scientist to figure out that what is happening is dangerous. How is all this debt going to be serviced? So far we are doing it by issuing even more debt, purchased essentially by China, Russia and the Oil Cartel. I don't think they will keep the pyramid scheme going for too much longer and a global superpower cannot and should not depend on the lending practices of others.

"Get 'Em While You Can"

I spoke to a dealer who is on the front lines of equity derivatives trading yesterday and the very first thing he told me was that everyone now thinks markets are going to rush to new all-time highs, so the battle cry is "buy before it's too late". Pundits are already suggesting that smart money should get right back into the yen carry game, embrace risk, etc. Oh my, how quickly panic is transformed into greed... This vertiginous emotional roller-coaster is well known to yours truly, having observed it amongst speculators many a time.

Managing the rebound after a plunge like the recent one takes significant skill in market-making, particularly in dealing with the real money sell orders that come in mixed with the hot money buys. The skill consists of downplaying the importance of the sell orders in relation to the buys when arriving at the prices that cross the tape. It is not easy, but market makers are helped by the fact that real money investors usually place "limit" orders, whereas hot money always goes for "at market". The trick is to slowly work the "limit" sell orders, executing them against carefully controlled bids, while causing the "market" orders to be executed at once - as requested - but at ask prices that are immediately widened out. In this way prices jump more than the balance of buy-sell orders would suggest and specialists and market makers can usually recoup what they lost on the way down. Everyone is satisfied, except for the "market" buyers who see their fills come in higher than they expected. But they are usually so hot under the collar, they are still happy. (There always has to be a "sucker" in a "sucker rally", no?)

I vividly remember my first encounter with a NYSE specialist (the important members on the floor posts who make markets in stocks). The firm I worked for at the time had brought him in for one of our formal training sessions. He was impeccably dressed and groomed and while the head of training introduced him and explained his function on the floor as part antagonistic, part helpful to our customers' and firm's interests, he stood with his hands clasped and calmly scanned the audience. When the introduction was over he cracked a wide smile and let four Dracula teeth show through his grin - everyone burst out laughing and the point was well made: his function was to make a profit for himself, first and foremost.

He proceeded to hold a short simulation of how order execution takes place on the NYSE floor, with our hapless selves as floor brokers for our firm instructed to execute various market, limit, stop, etc. orders and himself in his usual role of specialist. We got.. whomped, to put it mildly. It was a very worthwhile initial lesson in how markets really work. There have been many more lessons since - I taught some of them myself.

Anyhow, what I am trying to say is be extra careful of wide price swings. "Real money" pros don't crash headlong through an ice cream parlor window, if all they want is a second scoop of vanilla. When the store is being trashed by a bunch of hungry yahoos, they are perfectly content to step out and wait until they all go away. The result of real money pulling sharply back can be best observed in the primary market, i.e. the issuance of new securities, which has now slowed down dramatically. Various announced but unfunded LBO deals can't sell bonds and plans from private equity funds to go public are being "delayed".

Finally, how about a top Swiss banker as commentator? Jean-Pierre Roth, the head of the Swiss National Bank (the country's central bank) had this to say: "We're certainly not at the end of the story. There are question marks surrounding the development of the American economy. Something unbelievable happened. People who had neither income nor capital got credit with very attractive conditions. Now reality is striking back".

Of Parties and Shotgun Weddings

The top four US banks tapped the Fed's Discount window yesterday for $500 million each (what a coincidence, each wanted exactly the same amount!). In fact, the banks had absolutely no desire to borrow, so Citi, BofA, JPMorgan and Wachovia were frog marched to the window and told in no uncertain terms by Bernanke and Dodd to borrow on behalf of their customers facing insolvency, or else. The banks did the absolute minimum they could get away with and took their leave, saying the will come back...soon.

The Discount Window is open to banks, but the credit and liquidity problems currently reside mostly with their leveraged customers (mortgage originators, hedge funds, etc). The banks are supposed to take their customers' collateral (loans, ABS, CDO's, etc.) and back-to-back it with the Fed, thus becoming a "liquidity intermediary", since the Fed cannot deal directly with such riff-raff. In money broking this is called a "switch".

Problem is, the customers could decide (or be forced) to default on the bank loans, sticking them with the obligation to repay the Fed and to keep the collateral in exchange. But who wants that collateral...

The whole show was intended to exhibit the smooth co-operation between government, banks and the liquidity-challenged, but ended up looking like throwing a party where one showed up, forcing the organizers to rustle up four gents in rented tuxes to pose for the society photographers and make comments, like: "We are ever so pleased to be here, at such a wonderful bash. Oh, quick everyone, look over there - is that Clint Eastwood I spot over by the exit? Let me go and see..."

When I first commented on the Discount rate cut a few days ago, I pointed out that only around $200 million were outstanding on average, thus the rate cut was meaningless unless the amounts started going much higher, allowing the money to reach those that needed it. A couple of days passed and the big banks were not willing to do the necessary "switches", so phone calls were made, arms were twisted and...presto, the tuxes were rented. But $2 billion is a drop in the bucket, so we shall see what ensues.

More interesting as a move was BofA's decision yesterday to buy $2 billion worth of Countrywide convertible preferred shares with a yield of 7.25%, potentially giving them a 16% interest in the company, if/when they exercise the conversion. To accept such a lopsided deal, Countrywide must have been on the verge of drowning and desperate for a life preserver. The conversion price is set at $18/share, much below yesterday's closing level ($21.80). BofA said, with a straight face I presume, that the transaction would be immediately additive to earnings (no kidding, really?). Talk about shotgun weddings...

A Crisis Of Confidence, Or A, B, C ?

Some analysts think that the current credit crisis is not much more than a tempest in a teapot - a large teapot, to be sure, but a teapot nonetheless. They call it a "crisis of confidence", as if all that is missing to make things right is the belief that it will be all right, i.e. the financial engineer's version of "all you have to fear is fear itself". This type of crisis may be a step up in urgency from "a simple re-pricing of risk", as Mr. Secretary Paulson so cleverly undersates it, but the warning light is supposedly still a pale yellow.

Overlooking for a moment the simple fact that our credit and asset economy is by definition based on confidence and that such a crisis is therefore nothing to sneeze at, let's observe some other hard facts to dispel the notion of "just a confidence crisis", a wording that implies that all is taking place inside the cerebellums of panicky speculators and can thus be promptly cured by swallowing a Blue Pill of Confidence, also known as Ben & Hankie's Market Virility Enhancer.

Fact A - Record Total Debt

The total amount of debt in the US has reached $46 trillion dollars, or 338% of GDP - an all time record. Choosing 10% as a semi-arbitrary percentage for annual debt service (interest and principal), we see that it translates into 34% of GDP. This huge amount clearly cannot be met from the "income statement" side of the economy and goes straight to the "balance sheet". This means that debt has reached an exponential growth phase connected with pyramiding, or servicing debt by issuing more debt. Some call this a Ponzi scheme and as with all cons, confidence is, indeed, crucial.

Fact B - Record Debt in The Financial Sector

One third of that total debt, or 110% of GDP, is now debt of the financial sector, up from just 60% 10 years ago. Regular corporate debt has remained steady at ~40% for decades (see previous post of August 18), implying the rapid leveraging of the US economy is channeled towards the purchase of "assets" and the consumption of "services" and imported goods. To put it simply, America has borrowed to its eyes to buy suburban homes and all kinds of financial assets, watch movies and buy imported goods. (A book on the current US economy could be titled "We Also Make Planes").

Fact C - The Fall of Assets

Asset prices are dropping because irrational over-valuation is evaporating, not because some fund manager is lacking the proper levels of testosterone to buy them. For example, real estate prices got way out of hand when speculators jumped in and created the well-known bubble. We can observe the results in the Census data relating to vacant non-seasonal houses that are for-sale-only: in 2Q2007 such vacancies rose to a record 15.6% (see chart below, click to enlarge). Naturally, mortgages packaged into CDO's and other financially engineered permutations are also getting into trouble - not because of some nebulous lack of confidence, but because borrowers can't service the debt and can't sell the houses, either. RealtyTrac just announced that foreclosures jumped 93% from last year.

Data: US Census Bureau

However, there is an instance where "lack of confidence" is the appropriate term to use, if somewhat mild for what is actually happening: today, Standard and Poor's downgraded the ratings of two mortgage-related funds from AAA to CCC and may cut them further, as they said. If you count the downgrade steps, those are 17 degrees of separation between prince and pauper and they happened in one go. Yes, I would call that a lack of confidence. In spades.

Bank Runs - 21st Century Style

Forget the images of anxious depositors toting well-worn passbooks, thronging outside Local Savings and Loan to withdraw their hard-earned savings. Today's bank runs happen "upstairs" and in a very different way - but they are runs, nevertheless. Keep in mind what I had stressed in previous posts, namely that banking is no longer what it used to be: loans are packaged and securitized, then sold to speculators and investors who are the ultimate lenders, i.e. those hapless depositors have been replaced by hapless investors/speculators.

Here is what is happening, right now: a bank/broker/fund had the bright idea of setting up a special investment vehicle (SIV) to own CDO's, CLO's, etc., securities that had been created by putting together a bunch of mortgages, commercial loans, or hybrids thereoff. To further enhance the yield (and fees) they leveraged those holdings by borrowing short term money from the money market via commercial paper, for which they pledged those CDO, CLO, etc. assets as collateral, creating what is known as asset-backed commercial paper (ABCP). Many of those SIV's took the form of special purpose hedge funds and were sold to pension funds, individual investors - and other banks. An incredible $1.1 trillion, or 50% of all commercial paper now in circulation, is ABCP and about half of it ($550 billion) is coming due within the next 90 days.

The problem is that ABCP buyers have now gone on a strike, refusing to roll over purchases of anything that is tinged with "asset backed" - even if the mortgages and loans backing it are still performing well. Despite ABCP yields rising to 6.03%, short term investors are shunning them and turning to the safety of T-bills instead, driving 3m bill yields down to 3.20%! This leaves all those SIV's with two choices: temporarily find alternative sources of funding, or immediately sell large portions of their CDO's, CLO's and other assets. Alternative funding, if available, will likely come from vulture funds: it will be small in size, very short-term and very expensive, i.e. nothing more than a band-aid. The SIV's can't afford negative carry for long, i.e. they can't pay more for funding than the return on their portfolio. So, unless the underlying market for their assets and their ABCP's quickly normalizes, the SIV's will have to sell and do so very soon.

Naturally, the question is, why are ABCP buyers refusing to roll over their purchases? Is it just a case of temporary panic which will soon blow over, or are their concerns well founded? The buyers are amongst the largest and most sophisticated institutional investors (money funds, insurance companies, other banks), so they must have made their determination based mostly on facts rather than sentiment. And the facts are that most of this ABCP is just another form of margin debt, used to leverage the purchases of structured finance assets by the SIV's. Once the bull market for those assets is over (as it is clearly the case now), it is only natural that margin lenders will immediately pull their lines. This is not panic - it is a rational business decision.

So, this is what part of a modern "run" looks like in the 21st Century: not a demand for deposited cash, but a refusal to roll over ABCP's as they expire. But the net effect is the same as a "regular" bank run, except there is no George Bailey to rally the people.

P.S. Is it a coincidence that so much sub-prime and structured finance trouble seems to be concentrated at smallish European banks, particularly semi-state controlled ones? No coincidence, oh no, not at all. I could write a whole post on this subject but...I won't. Suffice it to say that many such out of the way banks bought huge amts. of US structured finance products (relative to their size), not out of deeply held convictions about their investment merits. There were other, much more..ah, how should I put this in an elegant way... mundane reasons. Like yachts, vacation homes, brown envelopes, offshore accounts...

Oh .. and government controlled pension funds, too. Just wait.

Discount Rate Cut - So What?

The Fed cut its discount rate last week by 50 basis points (0.50%). Excuse my French, but... whoop-de-doo. For years now the Fed has been averaging around $200 million (that's "m" not "b") in very short term loans to banks, mostly O/N liquidity (see chart below, click to enlarge). The spike you see came right after 9/11 and was completely justified.

Discount Window Lending

The amounts involved are clearly insignificant and thus the rate cut was entirely symbolic. Unless, of course, we see a rush to the Discount Window to borrow in the billions, in which case we should all become highly concerned. No, scratch that, extremely concerned. Because it will mean that major banks are in deep trouble and can't borrow on their own.

Here is what the Fed itself has to say about the Discount Window:

"The Federal Reserve expects that, given the pricing of primary credit, institutions will not rely on the Discount Window as a regular source of funding. Though institutions are not required to seek funding elsewhere before requesting primary credit, primary credit is intended to be used mainly on a very short-term basis, usually overnight, as a backup source of funding. Primary credit is available for a period of up to approximately one month to generally sound depository institutions that cannot obtain funding in the market on reasonable terms. Ordinarily, this will be relevant only for very small institutions."
(Bold added)

So, keep an eye on this amount - you can get it weekly from the St. Louis Fed FRED program here.

Another item to watch is what kind of collateral is used to borrow from the Fed's Discount Window and at what prices. In recent years the Fed has accepted bank loans as collateral, plus the usual assortment of Treasurys, corporate bonds, GSE's and other ABS's. The collateral is supposed to be marked to market and the Fed will then lend anything from 60% to 98% of that value. Here's the catch: who determines the current market value for a CDO-cubed that no one wants to make a market in, or has a ridiculous two way price, like 40-90? How about a package of sub-prime loans?

Ahhh, but aren't we ever so clever? The Fed allows Discount Window borrowers to use collateral even if there is no market price available, using a uniform haircut of face value (par) depending on the asset class. For example, AAA CDO's and CLO's are assumed to be worth 85% of face. Individual mortgages...91% of face value. Home equity loans...89% of face value.

Stop laughing now...this is serious business. Because at these prices, I would tender as much as I could to the Fed, borrow up to my eyeballs and then keep their money and let them seize the collateral. You think...? Naaaahhh....

The Rabelaisian Growth of Financial Debt

The growth of financial sector debt in the US economy has been spectacular. The percentage of such debt to GDP has been growing exponentially while non-financial corporate debt has been steady for decades, as can be seen from the chart below (click to enlarge). Financial sector debt is that which is assumed by banks, S&L's, GSE's, insurance cos., brokers, funding companies, ABS special purpose companies related to mortgage pools, etc. In just 10 years this debt went from 60% to 110% of GDP, clearly showing how leveraged such borrowers have become relative to the US economy. It is also an indication of what I call the "financialization and assetification" of the economy.

Data: Federal Reserve

Of course, debt is not necessarily bad - it all depends on what you do with it. If it is invested in long term infrastructure, plant and equipment and other such economic and productivity enhancements, then debt can be very beneficial. But if debt is created to leverage the "manufacture" of even more debt and speculation in other assets (e.g. margin and LBO debt, debt to fund stock buy-backs, CDO-squared and -cubed, hybrid CDO's, CLO's, CPDO's and ABCP's), then this type of borrowing can be extremely dangerous to the underlying "real" economy. We are currently getting a taste of this: essentially what is happening right now is the inability of the "real" economy to service all this debt piled on it, out of "real economy" earnings.

In many ways, the US has become an economy that manufactures, packages, ships, exports, markets, trades, services and promotes one product: financial sector debt - in all of its permutations and variations. The related products are hedge funds, LBO companies and private equity concerns, all of which create the demand for and depend on the consumption of an uninterrupted supply of fresh debt, grossly mis-labeled as "liquidity".

If Rabelais was alive today he might have included a chapter about the feeding habits of such institutions in Gargantua.

Gargantua Feeding On Hedge Fund Liquidity

A 50 bp Gift From The Fed

The official Fed Funds target rate is 5.25%, but the effective rate is currently around 4.79% - this is the average at which Fed Fund transactions between banks have actually been taking place during the past 7-8 days. The Federal Reserve is supposed to intervene in the interbank money market to maintain its target rate, but it has not been doing so.

Since a variety of adjustable rate loans use the official Fed Funds rate as a benchmark, the Fed's lack of action is a direct gift to lenders who continue to pocket the 5.25%+spread rate on their loans, while their cost of funds has gone down almost 50 b.p. - at least for the portion that is related to the interbank market. A fifty basis point gift may not sound like much, but in banking it is huge. It is also conclusive evidence of unofficial easing which, if it goes on past this week, should start raising some awkward questions. For example, why is the Fed penalizing household borrowers for the benefit of the banks?

....and after those lines were written, the Fed gave another gift: it cut the Discount rate 50 bp. This is the rate at which banks borrow from the Fed against security collateral, including MBS. But they left the Fed Funds rate unchanged. This is Prof. Bernanke's first test and he seems to like muddy solutions.

As The Yen Strengthens..

The yen is a weathervane for global funding costs, particularly for market-related speculative leverage, i.e. securities margin. Its ultra-low interest rates have attracted borrowing demand from hedge funds, funds-of-funds and private equity funds from all over the world. At the same time, local Japanese investors have moved out of their own currency in exchange for higher yielding investments abroad. This pushme-pullyou affair that has kept the value of the yen abnormally low vs. the dollar and the euro is, in my opinion, coming to an end.

No one really knows how much money is involved in this strategy, known collectively by the term "yen carry trade". Some put it at a few hundred billion dollars, others think it may involve as much as a trillion or more. Without becoming too esoteric, I think the best picture is provided by the BIS data on yen foreign exchange forward swaps (see chart below, click to enlarge). Bank FX and money market dealers structure their trading books around such swaps and - very importantly - they are considered off-balance sheet items for banks' regulatory and other capital requirements.

Data: Bank for Int'l Settlements

This is not to imply that the yen carry trade involves 4 trillion dollars. There are major non-speculative uses for such swaps, namely funding and hedging commercial transactions like imports/exports, project finance, etc. However, notice the sharp jump from $3 trillion to nearly $4 trillion after 2005, precisely when global markets turned frothy and credit for speculative purposes became very abundant. I don't think this is a coincidence and thus, in my opinion, $1 trillion is a fair estimate for the yen carry trade.

Leveraged finance is now unraveling before our very eyes and cheap yen funding is perhaps the very last straw still poking out of the liquidity pond, providing some low-cost breathing air to those speculators now deeply under water. As the yen strengthens vs. the dollar and euro the carry will produce its own margin calls, further pressuring stretched speculative positions - and that will indeed be "the last straw".

P.S. Several hours after I wrote the above dollar-yen went from 116 to 112. Margin calls must be going unmet and the banks are selling out customer positions. This is going to ricochet throughout all markets for quite a while. Cheap funding no more... there goes the straw.

Busy, But A Quickie

S&P 500 is now trading at 17 times earnings, a level some consider cheap. But a P/E ratio has not only a numerator, but also a divisor. What about those earnings, eh?

About 20% of S&P 500 by capitalization and 30% of earnings are made up by financial shares. Add the finance arms of industrial cos. like GE, GM and Ford and some 35-40% of all S&P 500 earnings are made up of purely financial activities. Not exactly happy times there, right now.

Now, do the math and calculate various forward P/E scenaria for the whole of S&P 500 if financial sector earnings drop by 25%, 50% and 100%. Then observe how far away we are from the 50 year P/E average of 16x. Hint: it ain't pretty.