Sunday, November 30, 2008

What I Want to See Next...

Jim O'Neill from Goldman wrote a great piece in the FT about the impact of the US consumer on the WW economy. To summarize, US consumer spending represented about 72% of the US GDP and about 20% of WW GDP as of 2007. Over the next few years the US consumer will save more, spend less and maybe only represent 65% of US GDP.

Mind the Gap: that's a big hole for the rest of the world to fill. The less they fill the harder the whole world's economies fall and the longer it takes them to get back up. O'Neill suggests that between China, India, Germany and maybe Japan, the gap can easily be filled. But this will take some major policy changes to mobilize consumer spending in those countries.

China made the first move, and given how big an impact the US slowdown is having on their economy, expect more heavy lifting from the Chinese government to push consumer spending. Now we need to see something big out of Germany; euro rates are coming down fast and that's a start, but we want to hear about legislation that somehow promotes consumer spending. These are some of the road signs we will look for to begin building a longer term case for a market recovery.

And on a Shorter Term Basis...

Bond issuance looks like it is making a comeback. Another great road sign to an equity market rally, as well as longer term recovery. There is a huge backlog of financings that need to be dealt with and with the capital markets in lock down over the past two months, insolvency for a lot of companies has begun to look more and more likely. CDS spreads for US and Euro companies has either widened or remained massive.

There are now early reports that suggest the higher spreads over T's offered in the market are beginning to pull investors out of their bunker. This from Bloomberg: "The extra yield on investment-grade debt over government bonds in the U.S. rose by 0.33 percentage point to an average 6.39 percentage points, the highest since Merrill started collecting the data in 1996. Spreads on European bonds rose 0.21 percentage point to a record 4.14 percentage points...

"Investors bought $127.5 billion of bonds in the U.S. and Europe this month after governments guaranteed banks’ debt sales to kick-start lending, according to data compiled by Bloomberg. Credit markets froze this year following almost $1 trillion of losses and writedowns by the world’s biggest financial companies since the start of 2007.

"U.S. companies issued $49.7 billion of debt in November, almost twice the sales last month and the most since June, when they sold $74.3 billion, Bloomberg data show...

"JPMorgan Chase & Co., Morgan Stanley and Goldman Sachs Group Inc. sold $17.25 billion of bonds under the Federal Deposit Insurance Corp. guarantee started this week. Credit-default swaps on Goldman fell after the sale, indicating an improvement in the perception of credit quality, according to CMA Datavision prices for the contracts.

"Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company’s ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

"JPMorgan also sold 1.5 billion euros and 600 million pounds ($923 million) of bonds due 2011 this week.

“I think next week you’ll see quite a bit of issuance, and you’ll see that right through Christmas,” said Paul Spivack, global co-head of the investment-grade syndicate at Morgan Stanley in New York. “You’re going to see more and more investors participating in this,” he said, commenting on bank- bond sales under the FDIC program."


We will get buffeted by lots of news reports going in opposite directions. Get ready for positive retail comps for the holidays, but incredibly bad margins for the retailers. Later this week the November sales reports will be out; expect a lot of commentary on sales numbers and not much talk on profitability. But hey, if that lifts stocks, so much the better.

Commodity prices are expected to keep falling, as the WW slowdown makes its way through the supply chain and inventory piles up. But how much of the price declines are businesses driven and how much are investor driven? Delevering is forcing all of the commodity funds back to zero leverage or to close their funds. When that ends, and it may be close, then we'll have a real picture of where commodity prices are based on business alone. Yea, it's bad, but is it as bad as prices suggest?

The bellwether name is copper, and after a monster run the metal is trading down 60% from it's peak. Oil is down 67% from its peak, and the CRB is down almost 50% - all in five months. I am a believer in the bubble and the impact of declining marginal demand, and I recognize the peak prices were not a real reflection of business, but the word 'oversold' is starting to come to mind.

More Rally Thoughts... Faber's on Board

His thoughts on a rally: "If governments around the world throw money at the system, a relief rally is the most likely scenario although, as in the case of Japan post 1990, it may only be temporary and not lead to an improvement in economic conditions (Japan has hardly grown since 1990 and the stock market made recently a 26-years low – see Figure 9). A relief rally from deeply oversold conditions would in my opinion lift assets that were battered the most: emerging markets, commodities and in particular gold mining companies.

"Now, let us combine these findings with the totally different investment conditions we had between 2002 and 2007, and with the ones we had in 2008 as well as with the oversold stock market condition amidst a rapidly deteriorating global economy, which is inevitably going to depress corporate profits for a long time to come. First, the oversold condition of the stock market: At their recent lows, US equities were as oversold as in November 1929 (before they rallied by almost 50% into the summer of 1930), as in October 1987 and as in the fall of 2002 (see Figure 12). So, purely statistically it would seem that the path of least resistance would be a rebound (same applies to commodities).

In my life I experienced two major trading markets (1968 – 1982) and Japan post 1992 (see Figure 9). I can assure my readers that during these trading market conditions (no net gain for the indices and in the case of Japan new lows) hardly anyone except very smart (lucky) traders made any money.

His thoughts on the longer term outlook:"In the next few years I expect asset markets to favor aggressive traders and not long term investors. I therefore still think that for the average investor precious metals such as silver and gold will be the preferred investment."

Of course, his major caveat to trading is that few actually make money doing it; so for the bulk of assets he recommends physical gold. But if you wanna gamble, he suggests long GLD, EEM, and any commodity index, and frankly any major equity index. Reverse for the short side. Keep in mind, he thinks the Fed should be abolished and that we are headed towards a new monetary system in the long term. From a source he uses: "The recent bursting of the credit bubble in the US and Europe is quickly spreading economic disruption throughout all global economies. At its core, the credit bubble was the result of an unsustainable currency bubble. Credit is simply claims on future money that must be earned or created in the future. The unlikelihood of being able to earn or create about $75 trillion in new dollars to satisfy outstanding future public and private claims was the nexus – and justification - for the credit unwinding we are now experiencing."

He argues that we have spent the last 30 years in a liquidity driven market (by the banks and securtization markets); we will now be in a liquidity supported market (by the government) until the deleveraging is finally finished. That means massive increases in the money supply WW and ZIRP. This should lead to extended periods of negative real 3 month T-Bill rates, which historically have lead to sustained inflation and solid outperformance from gold.

For long term equity investors, I think the growing consensus is that this correction will be so severe and long lasting that investor sentiment and psychology will experience a sea change. Growth managers will lose out to value/dividend managers; equity markets will have to offer a superior valuation to attract capital. So what happens to the massive amount of money still in the hands of aggressive managers in hedge funds, private equity shops and growth funds?

It will take less time time than you can imagine to drain these managers of their fire power - ongoing redemptions and changes in fund charters. At that stage we will move into a more fundamentally driven market, with lower multiples and higher premiums/dividends. It means bonds and dividend paying stocks for long term investors - to get paid for the risk.

Friday, November 28, 2008

Sovereign Default - A Study

From the FT, a quick summary of the status of the UK financial position and why its CDS spreads keep expanding by the day:

The horrific numbers for fiscal deficits contained in the PBR might give pause. The government’s net borrowing is now forecast at 8 per cent of gross domestic product in fiscal year 2009-10, 6.8 per cent in 2010-11, 5.3 per cent in 2011-12, 4.1 per cent in 2012-13 and 2.9 per cent in 2013-14. Public sector net debt, supposed to remain below 40 per cent of GDP, is forecast to reach 57 per cent four years hence. If one paid attention to the requirements of the Maastricht treaty, which laid the way for the eurozone, the debt ratio would reach 68.6 per cent of GDP in 2012-13, while the deficit, supposed to be below 3 per cent, is forecast to hit 8.1 per cent next year and would be 3.3 per cent in 2013-14.

So how did the public sector’s net borrowing jump from 2.6 per cent last financial year to 8 per cent next year? Why has the forecast deficit for next year jumped by £80bn (5.4 per cent of GDP) since the Budget delivered just last March? And why, not least, should one believe the Treasury now?

Part of the explanation is the decision to apply a temporary fiscal boost of £16.5bn (1.1 per cent of GDP) next year. But this counts for only a fifth of the slippage. The rest is due to “revisions and forecasting changes”. Virtually all of this – 5 percentage points – is, argues the Treasury, due to deterioration in the “cyclically adjusted”, or structural, borrowing requirement, now forecast to reach 7.2 per cent of GDP next financial year. In short, the Treasury is telling the world that the view of the structural fiscal position of the UK it held last March was nonsense.

What changed so drastically? As a share of (a smaller) GDP, current receipts are now forecast to be 3 percentage points lower in 2009-10, current spending 1.9 percentage points higher and investment 0.6 percentage points higher than was forecast in the Budget. These changes are overwhelmingly due to revisions in the fiscal capacity and level of GDP: a permanent reduction in taxes on financial sector profits and housing transactions; and, more strikingly, a lasting loss of GDP. In 2010, the economy is now expected to be some 5.5 per cent smaller than forecast in the Budget. Worse, this loss is not going to be made up in the near future. In 2015, GDP might be 4.5 per cent smaller than hoped last March.

What implications do these drastic revisions have?

First, the Treasury’s view that the last cycle ended in 2006 seems quite ridiculous. The correct view is that the UK has been caught in an unsustainable supercycle, with a once-in-a-lifetime bubble in global finance and domestic housing. It is only now in the downswing. The cyclically adjusted fiscal deficit, properly measured, was far larger than believed for at least a decade. So fiscal policy should have been much tighter. If it had been, the UK would be in far better shape today.

Second, the UK cannot afford the spending it once hoped for. The government recognises this: current spending is forecast to grow at only 1.2 per cent in real terms from 2011-12 and net investment to fall by 0.9 per cent of GDP. As a result, spending is forecast to fall from 44.2 per cent of GDP next year to 41.5 per cent in 2013-14. Even so, tax shares must also rise: the PBR forecasts a rise of 2.4 percentage points between 2009-10 and 2013-14. Misery lies ahead for years.

Third, even so, the Treasury surely remains too optimistic: despite the scale of the shock to the world economy and the financial system, it assumes an annual peak to trough decline in GDP of a mere 1 per cent; an economic recovery in the second half of next year; and then a return to trend growth at 2¾ per cent a year, despite the need to shift output into capital-intensive, export-oriented manufactures. This is not plausible.

Finally, assume, instead, that GDP shrinks by 2 per cent in 2010 and 2011, before expanding by 1.75 per cent in 2012. It would then be 11 per cent lower in 2012 than forecast in the Budget. The fiscal accounts would be drowning in red ink.

Everything depends on avoiding a deep and prolonged recession. In that event, markets might even reject the explosive increase in government debt. Letting bank lending stay frozen is not an option. The government surely knows that. Do the bankers?

I don't think they are intentionally letting bank lending stay frozen. The only thing they could do now is to take over the bank in full nationalization. Oh, Right.

. Now.

Thursday, November 27, 2008

A Couple Thoughts on Liquidity, Lehman and Sovereign Risk

On the after-effects of Lehman’s collapse:

…money fund investors responded to the “breaking of the buck” issue at the Reserve Fund by withdrawing funds from “Prime” funds and placing most of those proceeds in Treasury or Government-only money market funds. That’s the 21st century equivalent of a “bank run,” and its consequences contributed to the severe freezing up of interbank lending in September and October.

From a random trader;

The volumes are dire, a lot of this is on-screen pricing, its not being moved. But to be honest, if you believe there are people with deep pockets out there who believe sovereign CDS trades offer good value then why aren’t they selling protection and compressing spreads? On the UK there are 100 basis points you can pick up, then you should be writing contracts, offering protection and compressing spreads down on UK CDS.

No one can arbitrage this (expensive CDS's on sovereign debt) at the moment. Those days seem to be gone. We seem instead to be entering this forbidding sort of environment where governments are having to do everything in their power to stabilise the system, to the point of risking (their) own funding. If you are in that situation you can’t expect sovereign spreads to come in.

A Prayer

Let us not forget that we have been deep in a debt ponzi scheme for nigh the last decade plus. Peter borrows to buy Paul's company, then the company borrows to buy overpriced assets. Neither is well covered by the underlying cash flows and both can't get refinancing (illiquidity) and therefore can't repay loans (insolvency). Wash, rinse, repeat.

Wednesday, November 26, 2008

The Market Likes TARP2

So, the market's moving, the technical internals are improving and it seems as though the bear rally may be gathering steam. What is the market responding to, and will we get more of it? Or to quote the R-Man, "
Classically, based on over 70 years of Lowry's data, a series of 90% down-days followed by a 90% up-day signals the end of a bear market and the beginning of a new bull trend. Is that what happened this week?" He thinks yes.

It look as though the market likes the fiscal stimulus package out of the UK, the one coming from Europe, the new TARP, the Citi saver plan and the massive stimulus/easing out of china. The fiscal packages are easy to understand: it's the trigger we thought would cause a rally as it feeds directly into the economy and boosts demand, thus picking the velocity of money up from a stand still. It makes investors hope/think that the recession we are all in will be shorter and more shallow than Roubini has been saying.

If, please, if we get a fiscal package in the next 2-3 weeks from the US, then we have a real chance to get back to the Dow 10's. The bear market rallies from the past range anywhere from 30-50%; up 50% from 7500 gives us 11,000. We are up about 15% so far. For perspective, until Nov 20, 2008 was shaping up to be the worst year in the history of US stock markets, down 48%. That's worse than anytime since James Madison was President. There's gotta be some value in there...

We have made it through a reporting season so EPS numbers are likely to remain, while deeply at risk, largely unchanged until late January. So for now, PE's are cheap, measures against book value are cheap, analysts are going positive and it appears that over half of the equity delevering by hedge funds is over (we may have another week or so of redemption risk). Best of all, the percent of equity analysts bearish on stocks is at an all time low - the perfect time to get positive.

The new TARP is the real story, however. It immediately puts a stop to the two week balance sheet deterioration of the banks caused by TARP1 turning into TERP. The market likes the attempted recapitalization of banks, but doesn't see how it helps housing in the near term and isn't really sure that buying preferred shares is the way to go.

But backstopping $600b in crappy assets on the bank balance sheets and buying F'nF securities does give confidence to investors and begins the process of putting a floor in housing related securities - the key, I think, to investor confidence. In fact, 30 year mortgage rates have plunged in the last two days in response to the TARP2, which will spur loads of latent refinancing interest and maybe housing demand. The normal spread between 30 M rates and the 10yrT is about 1.30%; a week ago it was 2.35% and it's now 1.70%.

The further $200b of consumer lending support of TARP2 acts as a psuedo fiscal stimulus; it's money that supports financing companies buying the consumer debt, in theory adding to the availability of capital for consumers. Add in the brobdignanian backstop of Citi - $340b of pure government inflationary muscle - and confidence grows further. Collectively, these Fed efforts are flattening the yield curve, a first sign
in months that their efforts are making a difference. I think the pro investors have been waiting to see this.

So, next week we get the Eurozone fiscal stimulus, followed by news of the car rescue - which looks to be passed on to the next administration, and a hopeful US stimulus package. Maybe we do get a nice December rally. I'm back in a small SSO position at $23 with stops; I don't really know what bottoms up names to pick, so I'll look to add to this position.

The only group that has shown strength is the construction/remediation group - GVA, ACM, URS. But they're all up 50-100% off the bottom. Oil will move on any rally, in the hope that economic recovery is sooner rather than later, but that will be a trap. The TBT look s very oversold. We are looking for a further move down in long bond yields, but the moves of the last week have been too big. In this world just described, EEM would also be a good place for upside - lots of commodity exposure.

If there is a sustained rally, look for the Dow to move above the 50 day MA, or 9287, for some metric of confirmation. The Dow has been amazingly faithful to simple technical levels. The next stop is the Nov 4 peak of 9625. The 50 week MA has just crossed down on the 200 at Dow 11500; that's obviously bad for the longer term but may provide a market top for the hopeful rally.

Tuesday, November 25, 2008

From QE and ZIRP to Bulldozer Paulson and Supranationalization

An FT Update... Painfull but Necessary

First, this short summary from the FT: "The world economy is suffering from a Keynesian shortage of demand. Worse, it is trapped in a dangerous downward spiral of falling asset prices, rising bankruptcies, foreclosures and unemployment feeding into more of the same, along with falling commodity and now goods prices. Since no country is exempt, international co-ordination is needed and made easier because of the obvious common interest. The rapidity of the current contraction also means that fiscal solutions, though helpful, are not timely enough and create obvious free rider problems.

That is why monetary policy should be the first line of action. But conventional monetary policy has gone almost as far as it can in the US and Japan. The failure of the European Central Bank and the Bank of England decisively to respond in October was very damaging, but that is now history*. Policy rates will fall further in December, but may make only a modest contribution to stabilising demand, given the further decline in bank balance sheets and rising levels of fear. It is therefore time for unorthodox policy, but one that is far better than Milton Friedman’s helicopter drops of money, because it is reversible."

Monetary Thoughts...More Pain

This is the call the US Fed is now making: Quantitative Easing. This is a new term that comes by way of the Japanese slow down of the 1990's. It means pumping money into the economy any way you can. In the case of Japan's use, it simply lead to a massive growth in the money supply. The Fed is trying to argue that in our case we are attempting to narrow credit spreads by providing liquidity in various asset markets (the Fed buying commercial paper, corporate loans, MBS', etc) and make investing a possibility again.

The Fed rate cuts are having little impact in creating new lending and investment, and the yield curve has become very steep as short rates are cut but long rates hold high. 30 year mortgages have been unchanged for the past year until Monday. The Fed thinks that by buying financial assets - providing liquidity and closing the bid/ask - they can have a real impact further out on the yield curve. The evidence of that plan's success is found in the immediate drop of 30 year mortgage rates due to the new TARP2, and the overall flattening of the yield curve.

The Fed balance sheet has expanded by over 100% to $1t in the past year. Resolving the credit spread problem and rebuilding investor confidence is key as the total amount of corporate financing required in the coming quarters is massive, from corporate loans to commercial real estate. And right now the only thing foreign investors want are US T's.

But the Fed has expanded their balance sheet mainly by printing money. Normally, they would need to raise money from the dent markets to sterilize, or offset, the money they are creating to support all of the programs. Through September and October they ran their supplemental financing program, raising $550b at the peak. That's compared to an expansion of the Fed balance sheet of $800b through the same period.

In theory this is good - we do want to fight deflation and we welcome inflation as a heavily indebted nation. But the Fed needs the money multiplier to stay high for that plan to work. And it has crashed as banks have shut down lending. While money supply is up, it's not having any impact without a strong multiplier. QE may offset some current deflationary risk, but longer term these measures could create other problems associated with growth in money supply - inflation and dollar devaluation, risks highlighted by the recent pull back in the dollar and big bounce in gold.

In tandem with a large fiscal stimulus, the argument is that through QE you can keep aggregate demand from falling further off a cliff and restore confidence through a narrowing of credit spreads and the resumption of investing. Any way you slice it, it still means a massive growth in money supply. It also will be a policy followed by the UK and Eurozone as they take their rates to zero.

The move to zero interest rate policy, or ZIRP, is the second to last tool in the monetarists tool kit. It is an attempt to stimulate an economy through borrowing; of course, if all the other countries do the same, then we don't get the same bang for the buck. But with zero percent rates and a massive growth in the money supply, the government offsets the deflationary impact of delevering. That, I think, is the current thinking at the Fed in the strategy to address the credit crisis.

Fiscal Thoughts... A bit More

At the Treasury, I don't think Paulson has a clear idea of what to do. He and congress are tied in political knots to avoid fiscal solutions that smack of favoritism, socialism, etc. Fist he made the TARP, a $700B fund for buying ailing MBS. Then he turned it into the TERP for buying preferred shares in banks and "bank like companies" to recapitalize the banking system. In reality these efforts of the Treasury are really quantitative easing efforts directed by the Fed.

The market for asset backed paper hated this idea, and the value of residential and commercial mortgage backed paper on bank balance sheets plummeted, pointing to a new round of ugly write offs.Then he created TALF out of the TERF to help investors raise money to invest in the asset backed market - a market that accounted for a huge amount of past financing (cars, boats, general consumer finance, etc). And now, back to TARP, The Return: a new program for the ailing credit markets, that now includes the TALF idea.

TARP2, directly funded by the Fed includes $600b for buying MBS, like the original TARP plan had intended, plus another $200b to finance consumer and small business lending - a sort of fiscla stimulus package. The resurrection of the TARP looks like a good idea - along with TALF, it's the only program that really addresses the housing finance/price problems.

30 year mortgage rates dropped and CMBS/RMBS paper rallied on the news of TARP 2. Refinancings are on the way. This addresses the needs of those who are still solvent but getting hurt - those with good credit records and not too deep in debt, the ones we're all going to count on to keep the ship steady until the rest of us can get back in.

But back to TERP, puting capital into banks in the form of preferred shares is completely chicken shit. The write downs still-a-coming, and they are huge, come out of tangible common equity. Some estimates suggest we will need another $1t in capital to get the leverage in the US financial system back to manageable levels - that is leverage measured by the equity that takes a hit on write downs.

I thought for sure that we would have a fiscal stimulus policy by now, but it looks as though Bush will go out with the same oblivious nature of denial that he came in with. It may be that we get no major plan until February. That means an ugly 2-3 months in the US and UK/Euro economies. In the playbook of the Great Delevering, we have only made it half way through delevering the financials. We still need to delever the corporates and then the consumers. This is a 3-4 year process, with one year down. This fiscal spending is the only way to cushion the economy and lessen the impact of the process. The US is one year ahead of the UK and the Eurozone. Just keeping score.

(the official bailout tally: Troubled Asset Relief Program, or TARP, which became T Equity RP in Sept - $700b; Temporary Liquidity
Guarantee Program in Oct - $350b; other random and unspecified government guarantees for asset backed paper, commercial paper and FDIC - sky's the limit, but at least $5t; Commercial Paper Funding Facility in Oct - $1,300b; Money Market Investor Funding Facility in Oct - $540b; Term Asset-backed Securities Loan Facility, or TALF, in Nov - $200b; Government Sponsored Entities Purchase Program in Nov, or TARP2 - $600b. Bloomberg says the implicit total is now $9t; 1991 S&L Crisis - $230b)

Housing, Commercial RE, Gold, Cars, Citi, Goldman Schadenfreude, China Lies and Sovereign Nationalization

In the meantime, the housing market continues to deflate, with prices dropping in September and Q3 at accelerating rates. The various policies and plans mentioned above should begin to have an impact on housing, but I suspect we will need to have an even broader policy response: new tax support for homeowners, more efforts to write down and work out mortgages to keep people in their homes. In fact, if the Treasury just came out and formally admitted it will guarantee GSE's, I think the Dow would be up 800 points on that alone. Just make it clear, would ya?

Among the other balance sheet bombs we have been waiting to see detonate, Commercial RE is, if not the biggest, one of the more concentrated. With a slew of specialist funds and a lot of commercial bank backing, this bomb started detonating last week. Two CMBR programs were on the verge of default causing CDS's for the whole group to scream. I think it's fair to expect banks to start dealing with this problem in Q4/Q1 through more write offs.

The auto companies were thankfully denied their bailout for now and the board of GM has formally announced that bankruptcy is an option. I understand not wanting the big banks to go ch11, because the collateral damage will be huge. But if we don't force GM to reorg, then we really should be shot. It will say that the political process is still driving the boat and we are making a mess of our attempts to allow the economy to delever and recover. Ch11 is as big a part of capitalism as stock options.

The nationalization of US banks continues apace with a further TERP investment in Citi. The bank is insolvent but has so much counterparty exposure that its failure would be another LEH x 2. This is a reminder that the banking system is still levered to the tune of 30x tangible equity, on its way to 12x. Both BAC and WFC have similar ratios of tangible equity to assets as Citi. That means $1t in new capital and 2-3 more years of processing the write downs. I think it really does mean the full nationalization of the US banking system.

In fact, it is difficult to see a long term end to the deleveraging spiral we are in if banks don't change behaviour. They need to move away from the originate and sell business and back into the originate and hold business of decades past. The days of outsourcing the core credit analysis skills of banking to the ratings firms are over. Sack up boys, it's time to put the eye shades and suspenders back on and get to know your customers.

Meanwhile the BSD's at Goldman have been leveled. The top five guys have collectively lost $840mm in paper profits. In an interesting, quick and dirty analysis, the stock topped at $225, leverage had to be cut by 2/3, financing costs will be much higher and deal volume much lower in the future, while their hedge fund/PE business will likely rebound. So the stock goes to $75 on the leverage cut (2/3), while the other issues cancel each other out.

Talking about yesterday's BSD's, the Chinese economy looks to be falling apart. If the speculation is right about the level of decline in the US/UK/Eurozone in Q4, then factory utilization in China must be getting crushed. Margins were already thin due to the mass level of competition in Chinese factories, so mass layoffs must not be far behind.

The just announced China rate cuts and easing of bank reserve limits, plus the recently announced fiscal stimulus package attest to the government's concern. The Chinese government has also confirmed they will push consumer spending hard. Together, these changes put China's investment in US fixed income assets to test. In pursuit of big budget bailout projects, China reverses its stance from buyer of US$ assets to seller. That reverses the dollar flow cycle that has supported the US debt machine and the dollar itself.

The issues about a China slowdown, the need for a new consumer spending program and the social threats that leads to have been mentioned before. But how big does the correction need to be to force this kind of secular change? Once in a generation? Once in a century? Don't you think we're there? China has never been where it is now; they have no idea how to navigate major social change in the age of the internet and mobile phone, despite Cisco's help. The country is divided into urban and country, people own stocks and houses, and the country is part of the global economy. God help 'em if the west ever gets religion about the social and ecological damage done buying China made good. More melamine, sir?

The impact of the WW slowdown on Asia will be felt severely in Q4/Q1, with declining currencies and markets. The slowdown has had the expected impact on FX reserves of EM countries, especially commodity dependent ones: Russian reserves have dropped from $550b to $450b in the past three months. This is great for the US foreign policy efforts: less concern for the rogue states of 2007 - vens, Russians, Iranians - and Chinese influence.

Deflation is certainly in force and will be for the coming few quarters; the economy is in a massive slowdown, commodity prices are tumbling, consumer spending is crashing, housing prices/rent are in full retreat and global delevering is crushing asset prices across the board. The TIPS have been hammered and might be a good place to look; the policies described above are as inflationary as they can be in the long run and will ultimately lead to a recovery and the return of inflation.
In fact, the first stage of the great delevering is simply transfering the debt from the financial sector to the public sector; step two is rebuilding economic strength and allowing the consumer and corporations delever more slowly. So when we do recover, it will mean slow, debt burdened growth ahead.

But the size of the loses at this point are so huge, and the size of the federal guarantees and funding - approaching $9t (that's in addition to the $10t US debt) - are so massive, that you wonder how much more the system can handle before we ask questions about this fiat money system. At what level of M3 growth (which is hard to estimate these days) does gold get moving again? When does the dollar resume is decline? At what level of CDS spread for US debt? The announcement of the new TARP hit the dollar by 2% and jammed gold up by $75.

Through this correction and going all the way back to 2001, gold has been the best investment. Even in the last few weeks as it has corrected from $1000 to $800, it has outperformed equities and much of the bond market, and in non $ assets is has actually been a positive return. The outlook for gold is still positive, first as a hedge against the $, and second as the ultimate hedge against sovereign risk and fiat currency concerns. We may be at the end of the $ rally as the Eurozone and the UK have made clear their move towards ZIRP; what other surprises come out of those economies to cause more dollar strength?

This concern about absolute sovereign debt levels is a real concern for Iceland. They have now taken out loans of $10b, or the size of their entire GDP. GDP will drop by 10% in '09, and the economy will now have $19b in total debt to recap banks and deposits. Pensions are gone, taxes are going up and everyone will be fishing again. The country faces mass emigration and the obvious risk that they cant repay the debt.

How does this end? I would say, the Netherlands or the UK just absorb the country. Supranationalization. Switzerland is not far behind when you consider the leverage of their banks relative to the size of their economy. Who saves them? The US? The situation is so bad that these issues have to be considered. The CDS for UK bonds are trading at a higher premium than the CDS' of 10 UK companies. The UK has foreign bank liabilities of 3x its GDP, and a 380b pound currency mismatch between assets and liabilities and FX reserves of 1/10 that. Hence the pound weakness.

Guidance... Rally Continues?

The banks are finally getting some religion about the US outlook: Goldman says GDP will be down 5% annualized in Q4, the 10yr T will hit 2.75% in Q1'09, US earnings estimates are still way too high and unemployment will hit 9% in Q4'09. Their outlook for 2010 is for continued expansion of unemployment and tepid GDP growth into 2011-12. Does that foot with a Dow 8000? Not sure.

The outlook for a major spike in corporate high yield defaults hasn't changed, but prices suggest a 20%+ default rate and that would be even higher than the 1930's - and twice the level of the early 1990's and the early 2000's. High quality bond funds are beginning to look interesting; spreads are huge, the prices might reflect the coming carnage and the liquidity should recover first.

The latest notes on UST's call for a flattening of the the yield curve, with short rates at zero and long rates at 2.50-3%. This process lasts through Q1'09 as mortgage refinancings increase on lower rates and mortgage investors have to buy long dated T's to manage this early repayment. It's a process being supported heavily by the Fed and we should get closer to the normal spread of 150bps on the 3mo and 10yr notes; maybe not all the way, but maybe 250bps.

It's a cycle that puts heavy buying into the long end, lowers yields and further helps the US homeowner. This beneficial cycle will do battle with the massive debt funding needs of the US government: $500b done in Q3, $500b needed in Q4 and $400 needed in Q1'09. But for now, the charts for long term T's say full breakout, as ZIRP takes hold. Again, the TIPS are looking interesting.

The 10% rally in the Euro and UK markets on the UK fiscal stimulus package gives us some insight into the potential impact of a US fiscal stimulus package. Any hint that we might be able to soften the recession, lessen its length and reboot some level of aggregate demand will move the market. Both the Dow Industrials and the Transports both broke to new lows, but then bounced right back to end last week back in the low 8000's. The VIX served as a good trading measure as it hit 80 and made the buy signal, and CDS spreads hit a similar peak giving a solid concurring oversold signal.

My tendency is to stay long with SSO, as a wicked 50% bear market rally has yet to show up, but I'm still looking for the trigger that sucks in the last hopeful players. Certainly, PE's WW have dropped into the single digits and the bond sell off has been epic. Valuation and extreme bearishness still look good for a long position, but with the current volatility, I have little short term trading confidence.

Longer term, no change in outlook. We might not get the fiscal package until February and in the meantime, EPS numbers are going down hard from here. The coming cycle of corporate bankruptcy will remind everyone of the downsides to capitalism: equity holders get killed, companies relist and business continues. Equity actually does have the highest risk on the balance sheet. This will kill growth stock premiums and lift the importance of dividends. As a sign of this, dividend yields finally overtook UST 10yr yields for the first time in 50 years.

The Credit Crisis: A Summary Courtesy of the NYT

In the fall of 2008, the credit crunch, which had emerged a little more than a year before, ballooned into Wall Street’s biggest crisis since the Great Depression. As hundreds of billions in mortgage-related investments went bad, mighty investment banks that once ruled high finance have crumbled or reinvented themselves as humdrum commercial banks. The nation’s largest insurance company and largest savings and loan both were seized by the government. The channels of credit, the arteries of the global financial system, have been constricted, cutting off crucial funds to consumers and businesses small and large.

In response, the federal government adopted a $700 billion bailout plan meant to reassure the markets and get credit flowing again. But the crisis began to spread to Europe and to emerging markets, with governments scrambling to prop up banks, broaden guarantees for deposits and agree on a coordinated response.


The roots of the credit crisis stretch back to another notable boom-and-bust: the tech bubble of the late 1990’s. When the stock market began a steep decline in 2000 and the nation slipped into recession the next year, the Federal Reserve sharply lowered interest rates to limit the economic damage.

Lower interest rates make mortgage payments cheaper, and demand for homes began to rise, sending prices up. In addition, millions of homeowners took advantage of the rate drop to refinance their existing mortgages. As the industry ramped up, the quality of the mortgages went down.

And turn sour they did, when home buyers had to leverage themselves to the hilt to make a purchase. Default and delinquency rates began to rise in 2006, but the pace of lending did not slow. Banks and other investors had devised a plethora of complex financial instruments to slice up and resell the mortgage-backed securities and to hedge against any risks — or so they thought.

The Crisis Takes Hold

The first shoe to drop was the collapse in June 2007 of two hedge funds owned by Bear Stearns that had invested heavily in the subprime market. As the year went on, more banks found that securities they thought were safe were tainted with what came to be called toxic mortgages. At the same time, the rising number of foreclosures helped speed the fall of housing prices, and the number of prime mortgages in default began to increase.

The Federal Reserve took unprecedented steps to bolster Wall Street. But still the losses mounted, and in March 2008 the Fed staved off a Bear Stearns bankruptcy by assuming $30 billion in liabilities and engineering a sale to JPMorgan Chase for a price that was less than the worth of Bear’s Manhattan skyscraper.

Sales, Failures and Seizures

In August, government officials began to become concerned as the stock prices of Fannie Mae and Freddie Mac, government-sponsored entities that were linchpins of the housing market, slid sharply. On Sept. 7, the Treasury Department announced it was taking them over.

Events began to move even faster. On Sept. 12, top government and finance officials gathered for talks to fend off bankruptcy for Lehman Brothers. The talks broke down, and the government refused to step in and salvage Lehman as it had for Bear. Lehman’s failure sent shock waves through the global banking system, as because increasingly clear in the following weeks. Merrill Lynch, which had not been previously thought to be in danger, sold itself to the Bank of America to avoid a similar fate.

On Sept. 16, American International Group, an insurance giant on the verge of failure because of its exposure to exotic securities known as credit default swaps, was bailed out by the Fed in an $85 billion deal. Stocks dropped anyway, falling nearly 500 points.

The Government’s Bailout Plan

The bleeding in the stock market stopped only after rumors trickled out about a huge bailout plan being readied by the federal government. On Sept. 18, Treasury Secretary Henry M. Paulson Jr. publicly announced a three-page, $700 billion proposal that would allow the government to buy toxic assets from the nation’s biggest banks, a move aimed at shoring up balance sheets and restoring confidence within the financial system.

Congress eventually amended the plan to add new structures for oversight, limits on executive pay and the option of the government taking a stake in the companies it bails out. Still, many Americans were angered by the idea of a proposal that provided billions of dollars in taxpayer money to Wall Street banks, which many believed had caused the crisis in the first place. Lawmakers with strong beliefs in free markets also opposed the bill, which they said amounted to socialism.

President Bush pleaded with lawmakers to pass the bill, but on Sept. 29, the House rejected the proposal, 228 to 205, with an insurgent group of Republicans leading the opposition. Stocks plunged, with the Standard & Poor’s 500-stock index losing nearly 9 percent, its worst day since Oct. 19, 1987.

Negotiations began anew on Capitol Hill. A series of tax breaks were added to the legislation, among other compromises and earmarks, and the Senate passed a revised version Oct. 1 by a large margin, 74 to 25. On Oct. 3, the House followed suit, by a vote of 263 to 171.

When the bill passed, it was still unclear how effective the bailout plan would be in resolving the credit crisis, although many analysts and economists believed it would offer at least a temporary aid. Federal officials promised increased regulation of the financial industry, whose structure was vastly different than it had been just weeks before.

The first reactions were not positive. Banks in England and Europe had invested heavily in mortgage-backed securities offered by Wall Street, and England had gone through a housing boom and bust of its own. Losses from those investments and the effect of the same tightening credit spiral being felt on Wall Street began to put a growing number of European institutions in danger. Over the weekend that followed the bailout’s passage, the German government moved to guarantee all private savings accounts in the country, and bailouts were arranged for a large German lender and a major European financial company.

And even as the United States began to execute its bailout plan, the tactics continued to shift, with the Treasury announcing that it would spend some of the funds to buy commercial paper, a vital form of short-term borrowing for businesses, in an effort to get credit flowing again.

Continued Volatility

When stock markets in the United States, Europe and Asia continued to plunge, the world’s leading central banks on Oct. 8 took the drastic step of a coordinated cut in interest rates, with the Federal Reserve cutting its two main rates by half a point.

And after a week in which stocks declined almost 20 percent on Wall Street, European and American officials announced coordinated actions that included taking equity stakes in major banks, including $250 billion in investments in the United States. The action prompted a worldwide stock rally, with the Dow rising 936 points, or 11 percent, on Oct. 13.

But as the prospect of a severe global recession became more evident, such gains were impossible to sustain. Just two days later, after Ben S. Bernanke, the Federal Reserve chairman, said there would be no quick economic turnaround even with the government’s intervention, the Dow plunged 733 points.

The credit markets, meanwhile, were slow to ease up, as banks used the injection of government funds to strengthen their balance sheets rather than lend. By late October, the Treasury had decided to use its $250 billion investment plan not only to increase banks’ capitalization but also to steer funds to stronger banks to purchase weaker ones, as in the acquisition of National City, a troubled Ohio-based bank, by PNC Financial of Pittsburgh.

The volatility in the stock markets was matched by upheaval in currency trading as investors sought shelter in the yen and the dollar, driving down the currencies of developing countries and even the euro and the British pound. The unwinding of the so-called yen-carry trade, in which investors borrowed money cheaply in Japan and invested it overseas, made Japanese goods more expensive on world markets and precipitated a steep plunge in Tokyo stock trading.

Oil-producing countries were hit by a sudden reversal of fortune, as the record oil prices reached over the summer were cut in half by October because of the world economic outlook. Even an agreement on a production cut by the Organization of the Petroleum Exporting Countries on Oct. 24 failed to stem the price decline.

Stock markets remained in upheaval, with the general downward trend punctuated by events like an 11-percent gain in the Dow on Oct. 28. A day later, the Fed cut its key lending rate again, to a mere 1 percent. In early November, the European Central Bank and the Bank of England followed with sharp reductions of their own.

Federal officials also moved to put together a plan to aid homeowners at risk of foreclosure by shouldering some losses for banks that agree to lower monthly payments. Detroit’s automakers, meanwhile, hard hit by the credit crisis, the growing economic slump and their belated transition away from big vehicles, turned to the government for aid of their own, possibly including help in engineering a merger of General Motors and Chrysler.

The leaders of 20 major countries, meanwhile, agreed to an emergency summit meeting in Washington on Nov. 14 and 15 to discuss coordinated action to deal with the credit crisis.

The Crisis and the Campaign

The credit crisis emerged as the dominant issue of the presidential campaign in the last two months before the election. On Sept. 24, as polls showed Senator John McCain’s support dropping, he announced that he would suspend his campaign to try to help forge a deal on the bailout plan. The next day, both he and Senator Barack Obama met with Congressional leaders and President Bush at the White House, but their efforts failed to assure passage of the legislation, which went down to defeat in an initial vote on Sept. 29, a week before it ultimately passed.

The weakening stock market and growing credit crisis appeared to benefit Mr. Obama, who tied Mr. McCain to what he called the failed economic policies of President Bush and a Republican culture of deregulation of the financial markets. Polls showed that Mr. Obama’s election on Nov. 4 was partly the fruit of the economic crisis and the belief among many voters that he was more capable of handling the economy than Mr. McCain.

As president-elect, Mr. Obama made confronting the economic crisis the top priority of his transition. Just three days after his election, he convened a meeting of his top economic advisers, including the billionaire investor Warren Buffett; two former Treasury secretaries, Lawrence H. Summers and Robert E. Rubin; Paul A. Volcker, a former Federal Reserve chairman; and Eric E. Schmidt, the chief executive of Google. After their Nov. 7 meeting, he called quick passage of an economic stimulus package, saying it should be taken up by the the lame-duck Congressional session, and that if lawmakers failed to act, it would be his main economic goal after assuming office Jan. 20.

Mr. Obama also faced a host of other demands as president-elect, including calls to bail out the auto industry, particularly General Motors, which warned that it would run out of cash by mid-2009. And some economists and conservatives questioned whether, given the economic crisis, he could still meet some of his pledges from the campaign, like rapidly rolling back the Bush tax cuts, which some felt would hurt demand, and pushing ahead with his planned expansion of health care coverage, which could greatly increase a soaring deficit.

Wednesday, November 12, 2008

Win Some Lose Some

Yup, stopped out. The EEV trade would have been great, if I could have stayed awake long enough to trade. The shift from daylight savings time means the market opens up here at 1:30. We still haven't moved into our house, so that means I hang out in the lobby of the king Solomon Hotel and trade. A recipe for bad decisions.

I'll tip my hat to my friend Kenny for that idea, but I'll accept full responsibility for the bounce trade that never really happened. Or it did, but man was it brief. I'm now stopped out again, with not much to show for all the effort. It appears the deterioration in the US economy is happening so fast and so hard that hope has no time to gain purchase in the minds of investors. John Thain, late of flipping Merrill to BoA, recently remarked that we are "entering a slowdown of epic proportions." I'm short term neutral for now, long term scared. I would like to be short, but I am scared shitless of a massive bear rally. As the old timers say, sitting on you hands is the toughest thing to do.

We have seen the markit CDS spreads jump quite a bit in the last three weeks, questions about Spain and Italy sovereign solvency are coming up, US corporate issuance is basically zero, credit card are getting shut off by banks, the TARP keeps changing direction and it doesn't look like the oil price decline has helped any where near enough. In the Battle between lower oil and a fiscal package, and broke consumers, the later is wining. The credit card shut down is a huge deal, as consumers have been using this credit for daily items. I suppose the possible short lived consumer bounce will have to wait until Q1, when we get out first fiscal stimulus and lower oil can begin to help.

I guess the market wasn't impressed with an Obama win, nor with the China stimulus. Easy to understand the first, and a bit of a scary reaction to the second: the real response was, "so things are that bad in the Middle Kingdom?". Mutual fund withdrawals continue and some of the big hedge funds are shutting down (Tontine), adding alot of selling pressure to a fragile market.

The long term look for worldwide equity markets continues to be ugly and getting uglier. BoE and ECB both slashed rates, banking systems in both regions are likely bankrupt. Sovereign bankruptcy is a risk for a growing number of countries, FX reserves are declining at precipitous rates in the capital account surplus countries. The US Fed no longer has any monetary tools left to manipulate the system; all they can do now is use "quantitative easing" which simply means printing money. That means there really is no Santa Clause anymore.

As we enter the holiday season, I really don't want to try and act the hero. With the Dow closing within 100 points of an intraday correction low on Wed, there may be a quick bounce trade Thurs/Fri, but you gotta stay up for it. At this stage it looks as though the indices want to test the 2002 lows and that might be another place to take a stab at a long bounce. In the meantime, I should focus on diving, surfing and learning mi pidgin.

Monday, November 03, 2008

Greed and Fear

I have avoided the political so far, but on this day of participation, let me jump in. A nice place to start the forthcoming diatribe is the unwinding of LEH. This ugly and destructive process has revealed another rotting part of the modern capitalist structure: the prime brokerage system. This system is the lifeblood of hedge funds, as it hold their securities for their various trading accounts. It also re-lends these securities; when the music stops, you end up with multiple claims on these securities and a long work out period. Is this just another institution of capitalism that doesn't really work?

This of course leads us to the ultimate question that the republican right needs to answer: do we really need a government? I believe in the cabal of anti-government republicans who have supported the loose spending/low tax ways of the Bush administration. They really do want the government budget soaked up by interest payments to choke off the social spending programs and ultimately the bureaucracy itself.

We have so lost our way. We look at government as the enemy and as a result, send only the infirm and self-infatuated to govern. We deserve Sarah Palin. Follow me: we need a government to at least deliver the services of defense and the orderly operation of society. Otherwise, we're on our way to the ugly South American model of walled enclaves, m60's, favaela's and a Chinese Hawaii (Chawaii or Hawainese; dim sum with pineapple?).

The national economy generates income for the government to provide these services, a civic structure, society's glue. In fact the economy doesn't operate without these services. To preserve the functioning of the economy, and therefore society, the government needs to regulate and provide oversight for the institutions that pump the lifeblood of the capitalist system. The last eight years should prove the case.

We have seen the very foundations of a capitalist system without regulation and oversight end in bankruptcy and failure - banks, Ibanks, ratings agency, bond insurers, insurance companies. The institutions lost credibility or were bought by the government. As has been widely said, we capitalized the profits and socialized the losses. The individual players made billions and the taxpayers will cover the institutional loses.

Even Greenspan admitted, in what will be the height of stupidity/naivety on his part: I thought the banks would self regulate in the spirit of self preservation. Yea, that's right: he thought the coke sniffing, whore chasing St. Barts crowd would act - not with scruples, but simply for survival. With not a little joy, we can all at least celebrate the return of finance to 7% of GDP, along with the resulting 700,000 job losses and $100b in wage cuts that will bring. After that moment of schadenfrued, let us wake up and accept that some government is needed, and let's support it and participate in it. From a desert island in the South Pacific...

And so the rally begins. Feeling good that the developed markets can manage a multi month rally, with some ups and downs. Draaisma at UBS just went "full house long" which is apparently a positive thing. He says we are at good valuations, we've had capitulation, the ISM is knocked out, etc. Basically, the worst is in the stocks. PE's are at 8x '08 and 14x a projected trough number of '09.

While I like to see these guys come out bullish to support my short term call, I can't buy the longer term outlook. There is alot going for the argument that this recession/debt adjustment period will be longer and deeper than anything since the 30's. Institutions like the IMF have thrown around studies saying that recessions preceded by banking crises have led to market correction of an average of 55%. And a 14 PE on trough EPS sounds good, but that still ain't cheap. In the 70's we had 6 PE's on trough earnings and 6% dividends - both produced by the painful recurrence of an economy in need of viagra.

As the options for readjusting portfolio allocations push managers away from equities, you can make a pretty good argument for a slow, long recovery from this bear market. UBS, that really well managed Ibank that should be bankrupt by now, just announced a $1.5b infrastructure fund targeting 10-13% returns.

That kind of money can buy you some high value deals in electricity generation and water treatment with the right leverage, but you need ten times that number for the serious infrastructure jobs. And the return from those super size deals will be a lot lower - roads and bridges for example. But I'm guessing the institutions will still lap up 9% return with a potential warrant kicker if they can put a shitload of dough to work. Methinks equity is going to get some competition.

On the EM front, we have had a hell of a rally already. I am still positive on Asia - a buyer of not a seller of commodities, great balance sheets, lots of FX reserves. I will buy the ETF country funds for some of these over the next few weeks on selloffs. But the other EM markets look scary - default scary. The EEV looks ripe; it's the double inverse of the EEM which holds alot of oil and resource stocks. I'm gonna look at getting in tonight in the high $80's with an $85 stop. Love the beta, good liquidity and I know my downside.