Friday, October 24, 2008

Crisis Permanent! Forever! It's My Fault!

The first round of attempts by the USG to kick start the housing market and "backstop" the credit markets - buying out F'nF and AIG - failed. After more banks failed WW, funding dried up and the CDS bombs went off. The feds realized they needed to take more drastic initiatives. The second round of misguided efforts included expanding the guarantee of US bank deposits and creating a bad asset buyout fund, the Tarp.

Watching the moves of Gordon Brown, the feds realized the extent of the problems for the first time: the banking system is insolvent. Yea, I am surprised too. I knew it was bad, but insolvent? Wow. This all happened in a matter of a days, and the only silver lining is that now we can officially blame Greenspan after his startling mea culpa to the US senate.

Is Anything Working?

In my last note, I predicted a beginning to the recovery in the US housing market after the F'nF takeover. Of course, following the LEH failure and the resulting CDS/counter party problems, credit markets froze and banks effectively shut loan windows. The funding system for housing - the mortgage originators, warehousers, securitizers and investors - has shut down and the banks are not willing to re-enter their old business. In fact, even if the loans start flowing again, it appears that much more serious intervention in tax policy and loan workouts would be needed to create a bottom in the housing market.

I also called for strength in the dollar, a good call, but I have been surprised by the strength of the move and did not understand the factors at play. Along with interest rate differentials and current account deficits, the carry trade has been at the core of dollar weakness for the last few years. The unwind of this trade from both the retail and institutional markets has driven remarkable moves in currencies. The baton, though, appears to have passed on to much larger global imbalances. With the massive emerging market debt exposure in Europe, capital flight in the Euro zone looks to accelerate.

The strength of this move has been compounded by the flight to safety and away from short term funding strapped sovereigns. Hedge funds are preparing for redemptions, and US investors are selling EM funds and buying T's. With the shortage of short term funding availability, some sovereign treasuries who became dependent on these flows for their own credit bubbles (UK, AUS) are in their own funding crisis. Even more dramatic is the unwind of speculative trades by corporations in currency derivatives, betting on the continued decline in the dollar versus their own currency to pad their bottom line.

How far this move goes, who knows. The positives for the dollar have been building: euro, UK and Aussie rates falling faster than US rates, an expected dramatic shrinking of the current account deficit with the economic slowdown and the drop in oil, and expectations of the US coming out of the global slowdown with better growth prospects than others. These factors plus the powerful technical moves described above support the dollar over the short term.

Longer term, with $1T deficits in the next year or two, national debt/GDP at 100% and a very uncertain tax revenue outlook, the world will be looking for higher long rates from US investments. This, of course, compounds problems as the US budget gets sucked dry by interest payments (the crazy far right ideology of killing government through debt seems to be working). Interest expense will grow from 15% of the federal budget budget to 25%, as both total debt and interest rates increase. The dollar will start trending back down in the longer term as the international markets look for better returns.

In fact, motivated dollar buyers like China will be less motivated as the US becomes a smaller trading partner and China's current account surplus shrinks. Even more worrying, all of Asia will need to raise local liquidity from their long term US securities holdings to provide fiscal stimulus for their economies as well to support their currencies. The dollar decline will demand a higher set of long rates.

The dollar will also face significant headwinds from use of the only tool left in the federal reserve's tool kit: huge monetary growth. There really is no way to generate the ongoing liquidity and inflation needed to support the economy and avoid a nasty bout of debt deflation. This is a longer term risk but one that supports the ongoing holdings of gold.

Our short call on RIMM and ANF worked but my thankfully small position in POT continues fester into a larger carbuncle. Calls on specific stocks, at this point, seem meaningless. I am buying the leveraged long equity index ETF's on major sell off days for the bounce. But not with much conviction. The various sectors hold little interest: oil crushed on an uncertain price, metals down on a crashing China, everyone impacted by a shortage of credit and a WW economic slowdown.

Maybe fertilizer can work as there is little overcapacity/stockpiles, but it is still dependent on credit to farmers and grain prices are still in free fall. The "go to" names like GE are now big question marks with their finance/leverage exposure, despite the moves of Buffet, and with a likely round of future dividend cuts it is difficult to play income stocks.

The recession is now coming into full bloom, a recession driven by the collapse of a thirty year credit bubble, built on the foundations of a seventy year decline in the regulatory base, and the demographics of the boomers. How can it be a moderate recession? Housing hasn't even bottomed yet! Expect significant earnings and dividend revisions in the coming quarters. Our capital productivity will hit new lows through this cycle, and that is a tough environment for US equities. As long rates back up, institutional investors managing pension obligations will begin shifting more of their assets into fixed income.

They will do this in some cases because they manage defined benefit programs and in some cases because of the massive demographic shift of the coming boomer retirement. This gives us the longer term picture for how the US equity market will bottom: not from selling due to earnings or even the bigger issue of balance sheet/solvency risk, but from capital flows out of stocks into bonds.

It has always been difficult to envision how the equity markets get to the kind of valuations the old timers use for market bottoms - high dividends and low adjusted PE's. A massive change in allocation is about the only way. The recent muni funding in California shows the way as the institutional investors ignored the offering but in-state individuals bought the issue up - with money that might have been going to equities in normal times or in earlier years. Add in the 10 yr double top in every western equity market with similar boomer populations and you have an ugly picture.

So how do we pick triggers for the short and long term positions? Well, for the sustainable short term trades, I think you have to look for positive bounces in consumer data - maybe from confidence or spending related to the benefits of oil prices dropping or fiscal stimulus packages. For the longer term, pros like Grantham and Buffet believe that an 8500 Dow says values are buyable for the well managed companies.

I am paying close attention to bond default rates to find a comfortable long term entry point. We are at 2.5% for the total bond market, and past recessions have produced numbers like 10% and 12%. It is fair to say that this cycle will produce even bigger default numbers, so we don't need to do too much until we see 10% type number. With the complete lack of short term funding available for companies not allowed to access the federal credit supports, expect a lot of very liquidity stressed balance sheets.

It appears that in the short term, the inventory of stocks to sell is massive; I'd like to know how much equity ownership is currently supported by leverage. I have the feeling that we will need a cathartic moment of selling that gives us the capitulation that we are looking for. We want capitulation in the equity market in order to care long term. Capitulation has a number of distinguishing psychological characteristics, such as investor disgust and exhaustion. Having been burned by the market for so long, investors capitulate by resolving never, ever, to trust the market again. In the wake of capitulation, therefore, interest in the market declines. Apathy rules.

More generally, I think fixed income is in the drivers seat. Distressed bond funds should have the opportunity to pick up great values at the top end of the capital structure while we go through an extended period of bankruptcy for individuals, companies and countries. Short term munis, meanwhile, will continue to pay solid real risk measured returns while we wait for better buys.

Oil - Prisoners Dilemma Revisited

The demand destruction mentioned in past blogs has come to the fore, as has the impact of the economic slowdown. Combined with what has been discovered to be enormous speculative buying power (yea, that really was a big part of the problem) now reversing, oil is in free fall. Opec has had little historical success in holding prices on the way down; sticking to quotas in the short term will mean domestic spending programs will have to stop in countries like Venezuela, Russia and Iraq, with the risk of political instability to follow. Why stop pumping? Opec is adding 3mbpd in capacity over next three years. In fact, pump more! We got bills to pay! It's the traditional prisoners dilemma.

Saudi Arabia needs oil prices of less than $30 a barrel to balance its government budget, according to Merrill. The United Arab Emirates requires $40 a barrel and Qatar $55. Iran, with double the population of Saudi Arabia, has a break even point of about $100 a barrel. In Venezuela, the figure is about $120. The Saudis are OK with lower oil, as it limits Iran's local power and helps the Saudis with their US Friends against the Russians and Vens. So even if OPEC gets organized, it is likely the Saudis will set the price - in the $50's.

Global Deleveraging Update - The Recession Has Arrived

Total US credit market debt to GDP is over 350% today, versus 260% at the '29 crash and 240% in 95. The deleveraging of the global economy triggered by the Minsky moment of "peak excesses" has miles to go. Individual, corporate and even sovereign insolvencies will rise substantially. The banking survival battle continues; the banks are simply getting the capital they need for the next round of write-offs.

We are only half way through the housing write-offs and more recession related credit write-offs are coming - much more. So don’t expect a serious resurgence in lending. The attempt too recapitalize the banks to avoid general insolvency through liquidity simply prolongs the inevitable. The current recap of banks allows bad banks to appear like good ones leaving counter party issues unresolved, and lines up the capital for the next series of write-offs coming over the next few months; full nationalization is around the corner.

The failure of LEH uncovered the dirty secret of CDS counter-party problems that have brought the lending markets to a complete halt. The CDS risks are significant; while the LEH unwind seems to have been orderly, we don't know what concentrations are out there and expect more finance company CDS write-offs. Some have suggested that the derivative system is self correcting: no investor would want a concentration of exposure... and of course, that's rubbish. Greed is greed. If one makes you money do ten, do 100. The apologists for derivatives are now having to explain the currency derivative mess; what asset class is next?

With massive spreads in the interbank lending market and a general unwillingness to assume counter party risk, short term funding has left the building. That means simple products like LoC's are not issued, trade comes to a halt. More importantly, companies that have funding mismatches continue to face insolvency - companies like investment banks, and again even some countries. Finally, with the Federal guarantees now offered on high grade commercial paper, the A2/P2 gets massively squeezed at spreads over A1/P1 approaching 500 bps.

The recession related asset write downs start now: credit card and consumer loans, corporate loans, commercial real estate loans. We've not seen any significant losses from the core loan books at banks. The corporate loan numbers are scary: $1T out of $7T in total corporate debt is junk. In '02 we saw a total of 12% in total corporate defaults. S&P expects 23% in defaults by 2010. So, that's $1T of corporate debt default over the next 2 years (some absorbed by PE cos). Add in higher overall financing costs and the outlook for corporate loan portfolios could not be worse. Now imagine the CDS exposure related to these defaults - maybe $2T+; who's holding it? What are those write offs?

"It may be that, looking backwards, just as too many AAA structured finance bonds were thought too safe (and thus paid too little) so investment-grade corporates were “overrated” and are now being proved to be actually much riskier. The investment grade iTraxx Europe, which has never existed through a recession, is thus adjusting to a more historically accurate correlation between it and the junk-grade crossover.The modeling and pricing assumptions around CDS and CDS indices - both iTraxx Europe and Crossover - are totally inadequate in the current crisis. Default modelling has relied on historical data going back, typically, over the past twenty years. The last banking crisis like this that we faced was in 1930. Is the pricing of credit broken?"

The list of possible deteriorating assets on bank balance sheets is a long one, but we should note the exposure to emerging markets. According to the BIS there appears to be over $4.7T in cross border bank loans to E Europe, LA and Asia. This number is eye popping - a cyclone bigger that the mortgage problem? And it has yet to hit. The good news for US banks is their exposure is less than 4% of that total. The rest is on the balance sheets of European banks.

Finally, the debt bomb that is the US government has to raise lots of additional money in 2009, backed by itself, of course. The total is expected to be around $3.5T, versus $1T in 2008 and compared to a past high of $500b in 2004. While about $2.5T of this record '09 issuance is for US bailout program, much of which is expected to be recouped (!), it will test the very stressed debt issuance machine.

Aspirational Lifestyle Economies are not Inherently Sustainable

Moving on, the US consumer capitulation is still ahead. This is the event that causes a wholesale change in consumer behaviour and expectations - ultimately value systems adjust. Wages have declined for the past decade, job loses are mounting, credit is unavailable, and savings don't exist. Have banks also underestimated credit card problems as well as corporate loans? They are likely using old models again that don't reflect current credit-card usage patterns. These patterns have changed dramatically since the last downturn.

"A broader range of consumers now carry cards, and many run consistent credit balances to fund their lifestyles. This has led to successively higher peaks over the years in credit card charge-off rates.The danger is that the current financial downturn results in a new, far-higher peak charge-off rate that leads to unexpectedly large losses at banks and other card issuers. During the 1980s, charge-off rates averaged about 2.6%, In the early 1990s recession, those rates peaked at 4.98%. Charge-offs rose to 5.39% in the late 1990s and then hit their most recent peak of 7.69% in the first quarter of 2002. At the end of June, net charge-offs had risen to 5.52%. Third-quarter data have yet to be released, but will undoubtedly be worse based on numbers already being reported by banks and card firms."

Spending patterns are changing; this unwind will continue to move inexorably forward, slowed only by the benefits of a decline in the oil price, a strengthening dollar and fiscal stimulus. These are important supports and could alone generate a 2.5%+ nominal gain in GDP in 2009. But this deleveraging event is so big and powerful, that it will take years to reset balance sheets and asset values, requiring more than one time supports to the US consumer to help them muddle through. Given enough time the oil and dollar benefits could easily reverse.

At the peak of the recession, the more bearish pundits looking for 10-12% unemployment, a 4-5% GDP drop, and a 70% equity decline. The world has lost 50% of its wealth since October '07 (not the best measure - back to 04 levels), generating a significant reverse wealth effect. The current total of untapped bank credit lines is $6T and not on the bank balance sheets. That's six times total bank equity. We are but one year into the mother of all credit crunches and two years into a housing decline. Don’t be seduced by anyone telling you that “all will be fine” anytime soon.

Sovereign Insolvency - Psst, Wanna Buy Iceland? Cheap! Ver-ry Cheap!

There is a permanent change coming in bank based lending: no more three months unsecured lending bank to bank at low spreads. This is having a damaging impact on not just companies, but also countries. The global capital system needs new forms of capital inflows or much bigger domestic savings. Argentina has taken over their private pension system (to protect investors!) to access incoming contributions to cover government short term debts over next few years.

This highlights the issues facing many countries: even those with large foreign currency reserves face liquidity problems and in fact solvency risks. Pakistan is almost out of their reserves - in less than a year. They have less than six weeks of money to pay bills. Mexico has seen its reserves drop by 13% in the last month attempting to support the peso. Many EM's are long dollar assets with short term dollar funds which they cannot now access. Plus, the local export earners have levered up on one-way bets on the falling dollar (Brazil, Korea).

We now have a severe short squeeze in Asia, Latin America, the FSU and the Euro zone. Its like a slow burn version of 1998 plus the new credit problems (although the EM’s are starting from a much better reserve position). There is no central bank help for them, and they are very reliant on commodity earnings. This created massive liquidity on the way up and the reverse on the way down. Russia has $500B in reserves, but its private sector has to repay $120B alone in the next five quarters, as capital inflows end and commodity prices nosedive.

The IMF is likely bailing out Ukraine, Turkey, Hungary and Serbia. Even the UK has been dependent on short term international wholesale funding. With capital flight, the pound gets…pounded. And then there's the US: running an empire and financing two wars, and deeply in debt already; will it work?

China - Cracks in the Porcelain?

With the massive delveraging comes a decline in consumer spending in the US and Europe and a resulting negative impact on China's export earnings. Growth in China is slowing and this begs two questions: one, will growth drop below that important threshold that porvides scocial stability, and two, if so, can the government manage that threat. The size of the global slowdown is becoming more clear and China will be dipping deeply into the reserves account for heaps of infrastructure spending. But will it be enough? Will the Chinese consumer need to wake up?

From Mr. Grantham: "But the real story of the last five years has been the investment binge at home, most notably in heavy industry. A couple of years ago, China’s steel industry association decided to investigate the output of the hundreds of small, new plants that had sprung up but which were not included in the official statistics: it discovered extra capacity equivalent to more than the entire US steel industry.

Officials have admitted that China should place less emphasis on investment and low-cost exports and more on consumption, services and innovation. Now that transition can no longer be delayed. Are these changes compatible with the system of governance?" Can China spur enough consumer spending to displace the declinein investment spending? Not without the consumer becoming a much more powerful force.


While there may be a sizable near term rally in the US equity markets, the medium and loner term outlook continues to be dire. A US recession of considerable size and duration is ahead. With the globalized nature of the economy, all other countries are facing similar conditions. There may be calls from widely revered market mavens that the current prices are good, but patience seems to be the order of the day. Deleveraging thirty years of debt - globally - will be painful and slow, and very politically destabilizing .

We are well into the process, but we are now cutting into the muscle and flesh of our economies. Well known institutions are failing, previously deep and liquid markets are disappearing, and the governments are stepping into their long forgotten role of patron saint of capitalism. In the meantime, focus on the low duration fixed income payouts that will continue to improve.


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