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.

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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.

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".

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.

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.

The Dow(n) Homes Index

Fact: A house is no longer a home; it has become a financial asset with windows.

Through the ceaseless efforts of financial engineers houses have been transformed into assets - financial assets. In this blog I have written numerous times how a simple mortgage spawned a series of related financial instruments, from simple CMOs all the way to synthetic CDOs, CDO cubed, or even CPDOs. One single mortgage could insinuate itself into literally dozens of such financial constructs, particularly through the widespread use of CDSs. What's more, homeowners frequently used their house as security for home equity loans, which are nothing more than speculative home margin loans. In other words, we have turned the previously conservative housing market into a volatile financial market. Thus the title of this post, a la Dow Jones.

PIMCO's Bill Gross is now frightened of the possibility that house prices will decline by as much as 10%, if the government doesn't step in to bail out homeowners (and bondholders, of course).

But now that we have turned housing into finance, complete with securities, derivatives, leveraged plays and rampant speculation, is there a realistic way to stop the Dow(n) Homes Index from heading...down? In my opinion, no. The process of assetizing, financializing and margining houses is so far advanced that the decline will only stop when housing once again reflects its fundamental value, i.e. when homes are valued as secure places to live and raise families for a long time, as opposed to volatile trading and collateral "sardines". This means that a buyer has to have something like 20% down and obtain long-term predictable financing that requires a reasonable portion of his/her disposable income.

Houses ARE assets; but they are long-term, non-fungible physical assets belonging to one or two individuals that need them to fulfill their most basic human need of shelter. They cannot realistically be used as collateral backing super-complicated, volatile market instruments that go up and down with "the market". Square pegs don't fit inside round holes, no matter how fine you slice and dice them - they are always square.

Meanwhile, despite all the hubbub about the Discount window, accepting ABCP as collateral, providing $25 billion loan exceptions for banks with brokerage subs, etc., it has all had zero effect on the ABS market. As one can see from the ABX and CDX charts below, CDS spreads (i.e. measures of credit risk) are still very high. Given the stockmarket's furious bounce up (another supposed measure of risk) we are currently getting curiously mixed signals. (Arbi, anyone?).

ABX HE BBB- 2007-1

CDX Investment Grade

Can anyone provide an explanation why stocks are signaling "all clear" while CDSs keep yelling "duck and cover"? Is it perhaps because the Dow Jones is followed by 300 million Americans who are suddenly clutching their pocketbooks closer to their chests, while CDS's are followed and traded by only a few thousand professionals?


And something else... I have started following weekly jobless claims as a gauge of what is happening to the "real" economy. The latest figure was announced a couple of days ago and it was significantly higher than expectations (334.000 vs. 320.000) but no one spoke about it. Notice how the latest data from BLS show 5 weeks in a row with higher claims.

Weekly Jobless Claims (from BLS)

FHA To The Rescue?

The White House has officially leaked some elements of what President Bush will announce later today about providing relief to delinquent mortgage borrowers. According to the NYT the FHA will provide its guarantee for an additional 80.000 low-income borrowers, beyond the 160.000 normally expected to use its insurance this year. If I understand it correctly, the plan will allow low-income borrowers who are 90 days past due on their payments to use the FHA's guarantee to obtain better financing terms. They would normally be precluded from doing so, because of their delinquency. However, I note that there are limits to the mortgage amount the FHA will accept: right now the basic standard limit for one family homes is $200.160 and $362.790 for high cost areas.

Secondly, the President plans to "jawbone" lenders into not foreclosing. Given the securitized nature of many, if not most, mortgage loans this will be a challenge. It is one thing to pressure a single banker into granting relief, quite another to get tens of thousands of bondholders dispersed all over the world to agree. If the administration attempts to squeeze the trustees of the various CDO's, CMO's, etc. it will run into the wall of their fiduciary obligations to their bondholders, i.e. if they agree to provide relief without the bondholders' consent they will be legally liable for damages.

This is my first impression, we have to wait for the official announcement.

East For Income, West For Wealth (and Dow 100.000)

Fed Chairman Bernanke just re-iterated that the Fed is "prepared to act" and urged Fannie Mae and Freddie Mac to step in and help resolve the mortgage difficulties "if able". All these stern words of market succor while S&P 500 is a mere 6% off its all time highs and after being up an almost uninterrupted 100% in the past 5 years. Why? Is the Federal Reserve now a Guardian of The Dow, as well as the sleepless watchdog of US commercial banking?

In a word, yes. This what the once proud institution has succumbed to: being a carnival barker for the hedge fund and private equity interests that now dominate markets, not only in the US but the whole world. But, once again, why? Because asset prices, shares in particular, are now the "be all" and "end all" of the global economy. Income generation as a way to prosperity has been savaged in the West by the pittance wages of the 1.2 billion Chinese ex-peasants, not to mention the mere hundreds of millions of other assorted Asians and near Asians. And let's not forget another 1 billion Indians...

The die has been cast: The Economy of The East is based on labor income and The Economy of The West is asset wealth. And just as it was unthinkable in years past for incomes to go down in any given year, it is now absolute anathema for asset prices to drop. It is not only a reason of national importance, but of global balance: we in the West buy lots of their cheap goods, they buy our expensive assets. This is a balance resting on the knife edge of market performance, a global financial accord that is rapidly overtaking entrenched perceptions established decades ago in Bretton Woods.

How is it maintained? By a series of algorithms that are pushed, stretched and if need be kicked into constantly spewing out buy orders for all manner of securities, regardless of fundamentals and it all boils down to one simple parameter: momentum. Buy because the market is up and going higher, period. All the rest is fancy footwork pour epater les bourgeois. Roughly eighty percent of all transactions in US equities are now done by hedge funds, 15 percent by other institutions and a minute 5% by individuals. The name "hedge fund" has long become an oxymoron because they no longer "hedge" anything and they merely follow the latest fashion in trading, which right now is "quantitative strategies". There are exceptions, of course, but the great majority just follow the exact same fake rabbit around the dog track.

It all became exceedingly clear in the recent market drop, when hedge funds reported incredible losses (some lost 30% in one month), from a mere correction, however sudden. Everyone was on the same side: long risk, short volatility, short yen and all leveraged to the maximum.

So the Fed promptly pushed the "panic" button, though it did not wish to appear doing so. First it cut the Discount Rate to show resolve and then (very, very quietly) permitted the large banks with brokerage subs (Citi, JP Morgan, et al) to lend an astonishing $25 billion each of what is clearly depositor money to their said subsidiaries, so that they could in turn provide it to their customers in trouble (i.e. hedge funds). Not only that, but as we have already seen, those "customers" were often nothing more than in-house hedge funds and SIV's.

Does anyone recall that this is exactly how large banks got into the deepest possible trouble in 1929? They kept lending depositor funds to the broker call loan market (i.e. margin), which then simply evaporated within two days. Just like today's margin loans, ABCP's, the yen carry and all other types of financial leverage bets, they did it because the rates were higher than regular loans and could be demanded back within a day or two. Safe until proven poisonous.

Mr. Bernanke surely knows all this - he is, after all, a professor who has written two books on the subject of Fed operations during that period. He is apparently resolved that unlike 1929 no "liquidity need" shall go unmet on his watch to cause anything approaching a significant correction, no matter what the eventual consequences. And what may those consequences be?

Well, if Ben's Balloon Emporium keeps pumping more and more helium into the market it will certainly levitate. And there will be no ill effects, save perhaps a shrilly voice from gulping too much He, because...let's see... if each Chinee were to buy just $10.000 worth of US stocks...(gulp, gulp) by golly mate, that's twelvvve treeeellion dzollarz worth! And why stop there? The oil sheikhdoms are good for another 10 trillion, at least, and then you have the Indians and the Russians (gulp, gulp) - holy cow, Dow 100.000 heeeere vve come!

Inflate Incomes, Deflate Assets

Ever since the Great Depression the worst nightmare of all Fed and Treasury officials has been the prospect of deflation gripping the US economy. This fear was the driving force behind Mr. Greenspan's decision to lower rates post the dotcom crash and with even greater urgency after 9/11. The system was flooded with cheap dollars and the ghost of deflation past was exorcised - at least for a while.

The consequence of this largesse was the greatest leap in debt creation and credit-related derivative finance ever seen in history. Real estate and financial assets immediately benefited and leaped to all time highs, not only in the United States but all over the world. Bubbles were created in London, Marbella, Shanghai, Las Vegas, Moscow, Dubai, Mumbai - and all points between. I believe I am not exaggerating when I say that the credit-asset bubble is now much bigger and has greater global reach than the dotcom one.

It is also much more dangerous, because it involves the very core of the world's financial system: credit and asset instruments denominated in US dollars, the de facto global reserve and transaction instruments. US Treasurys are the most widely circulated debt and dollars are used to price everything from crude oil and natural gas to copper, scrap iron and sugar - plus the shipping rates to transport them. "Dollar Hegemony" is not a rhetorical expression but a fact that translates into matchless global power. If the dollar were to be debased, or otherwise overthrown from its position of dominance, it would carry with it the larger part of America's power and supremacy.

With this introduction, we now turn to the present, i.e. the credit contraction and asset deflation currently in progress. The debate as to what is likely to occur as a consequence in the near to medium future is delimited by two extreme positions: "super-inflationism" and "super-deflationism". The former is closely related to devotees of gold as a storehouse of value (a.k.a. gold bugs) and the latter is often associated with survivalists, autonomists, Die-Off theorists and the like. There are many positions in between, the two most common being stagflationism and navel-gazing market Nirvanism (all will be well if we just let Mother Market take care of things).

My opinion (which will buy you nothing, unless you also have a one euro coin, in which case you can knock down an espresso in Rome) is that hyperinflation is out of the question, at least to the very considerable degree that monetary and fiscal policy can influence matters. I am certain that no President, Treasury Secretary or Fed Chairman will knowingly and willingly sacrifice the dollar's standing as global reserve currency in order to gain temporary relief for highly leveraged speculators. Officials will certainly provide assistance so that the transition to lower asset valuations is accomplished in as orderly a manner as possible, but there will be no massive monetary bailout. The Fed, at least, has already signaled its intentions along these lines and - significantly - so have the ECB, BOJ and PBoC.

Instead, I believe, we have already entered a period of drawn-out asset deflation which will last as long as it takes to reduce the massive debt accumulated over the past decade and repair the damaged balance sheets and income statements of households. The personal saving rate (the percentage of income that remains after expenditures) will need to rise substantially above zero, by a combination of lower consumption plus higher wage and salary income. This will pressure corporate profits, which, however, are at record levels as a percentage of GDP and can be reduced with little damage to the overall economy. Overstretched speculators will suffer, but that is part of the de-leveraging process.


The bottom line is that we should follow a process that gradually repairs middle America's finances, with the objective of achieving a three-way stability between incomes, debt and asset valuations. If we do not we may end up at one of the extremes described before, which will be a real disaster.

Home Depot Goes To The Movies

When the credit squeeze started to become obvious several weeks ago, one of the first things I said was that pending LBO deals would be canceled, delayed or re-negotiated. One of the largest was the sale of Home Depot's construction supply unit to a private equity consortium; it originally carried a price tag of $10.3 billion.

This deal has now been re-negotiated down 18% to $8.5 billion, plus Home Depot itself is participating in the financing of the deal with $1 billion. Therefore, on a net cash basis, the price is really $7.5 billion, or 27% lower than what was originally agreed upon on June 19, just two months ago. There are approx. $400 billion of similar deals in the pipeline and as the NYT commented in a very interesting article:

The stock prices of companies involved in other pending buyouts are near their deal prices, suggesting that investors expect them to be completed as originally agreed upon. However, when one participant in the Home Depot battle was asked what would happen to the next series of deals, he said: “Study what just happened here. You’ll see this movie again soon.” (bold added)

This is a "real economy" development in the credit market with pretty obvious consequences for asset valuations - in this case stocks and LBO debt, which is no longer available "at the snap of my fingers". And keep in mind that the people involved were the creme de la creme of the PE/LBO business: Carlyle, Bain and Clayton Dubilier. If the banks had to strong-armed them, what are they going to do to the B-team?


P.S. The effective Fed Funds rate is currently much lower than the target set by the Fed (5.25%), as can be seen from the chart below (click to enlarge). This is the rate at which large banks lend one another O/N money in the interbank market.


One observation: The drop in effective Fed Funds below target does not mean that everyone's borrowing costs are now lower - far from it. It actually signals that credit is getting much tighter, or even completely unavailable, for those borrowers that are suddenly being re-classified as risky. This results in large money center banks finding themselves with excess cash that was previously loaned out to the now riskier credits - and nothing to do with it. Therefore, rates go down. Not a good sign...