Wednesday, December 26, 2007

Consumer Co-dependency

It appears that the abused average American has finally had enough. Target reported that Christmas sales were very weak and lowered their revenue growth numbers for December quite a bit. Add in the margin pressure from discounting and earnings in that sector should be a mess. The problems seem to be widespread and for once, stocks actually seem to be reacting to obvious fundamental problems. This should really be no surprise at all but sadly, equities have ignored fundamentals for so long that it's a shock when reality intrudes on the feeding frenzy.

Here at Financial Jenga, we've been documenting the many pressures facing consumers for some time now. Housing and mortgage debt were covered in Where to Start? We wrote about the deteriorating employment situation and failure of government statistics to reflect it in Behind the Numbers. The collapse of personal savings and explosion of total household debt was the theme of First Principles. Why is anyone surprised that a consumer sector with no savings, huge debts and fewer jobs would decide that reducing spending the the right course? "When you're in a hole, quit digging" is just common sense.

Of course, common sense has been in short supply for years. Americans have been able to get away with all sorts of foolishness and the banks and other lenders have been their enablers. It is simply human nature to slip into wishful thinking that there really IS a free lunch out there somewhere. Mark Twain once described a banker as "a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain." Former uber-banker and CEO of Citigroup, Chuck Prince pretty much confirmed Twain's characterization back in July when he said:
When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.

Apparently, Chuck has stopped dancing and wants his umbrella back - except that he's no longer CEO. The reason he's not CEO now is because he waited too long to grab the umbrella and it looks as if he was right that "things will be complicated."

Banks are always willing to lend when they think there's little risk. That doesn't mean they are right in their risk assessment. Consumers have proven willing to borrow as long as they think they can make the payments. They are often overconfident on that front. The confidence of both is being pressured by the weak job market. Banker's willingness to lend is also falling with the value of the loan collateral - especially housing. Consumer confidence faces additional challenges due to higher food and energy prices. They were both wrong to be confident because they confused cyclical and secular economic forces. They also failed to recognize that their own behavior was the cause of the spike in asset prices. They borrowed and lent money used to buy the assets and prices quite naturally rose. Then they all congratulated each other on how smart they all were to "get in on a rising market." Now the prices are falling and the debt will still be the same size.

Consumers have a co-dependent relationship with their bankers - who have enabled destructive behavior for years. It appears that both sides are ready to walk away now that the relationship serves the needs of neither side.

Friday, November 23, 2007

Tactical Nukes

The fundamental case for a bull market died a long time ago and has not terribly sound in a long, given the combination of high valuations, slowing growth and a significant portion of earnings that were an outright illusion. Strategically speaking, the last time the bull case made any sense was in early 2006. That has not prevented tactical factors from pushing an overvalued market still higher in the interim. The primary tactical focus has been "liquidity" which readers of this blog will recognize as simply a synonym for growing debt.

The UDB threw off a tremendous amount of this "liquidity" as debt expanded rapidly. The serial collapse of mortgage finance, CDOs, MBS, asset-backed CP and other debt markets has reversed the flow as outstanding debt/credit shrinks. But how is this affecting stocks, you might ask? Well, there is the obvious collapse of profits in the building and financial sector as well as similar impending action in the consumer sector. But these are indirect effects and failed to knock down the indexes for long until recently.

There is now a much more direct impact on supply and demand for stocks and the financial pressures are affecting both sides of the equation. On the supply side, many distressed financial firms will be forced to issue new equity to bolster their crumbling capital base. Two major sources of "greater fool" demand for stocks have essentially disappeared - leveraged buyouts and corporate buybacks financed with debt. Lenders are no longer willing to finance such foolishness now that it has been exposed as such. The WSJ has this to say:

Driven by billions of dollars in share buybacks, record-setting buyouts and a wave of mergers, the amount of stock in the market shrank by hundreds of billions of dollars in the past four years.

With the supply of stock down and demand strong, the market rallied. Now, as the economy slows and credit markets buckle, high-profile companies are cutting back on buybacks, and some wish they held on to the cash they gave back to shareholders.

The reversal of the trend exposes a flaw in the buyback strategy -- many companies bought high and are selling low.

Big Buybacks Begin to Haunt Firms

"Liquidity" has been removed. LBOs of any real size are dead. Instead of buying back shares to reduce the supply, corporations are starting to issue more stock and increase supply just as demand is falling. It looks to me as if the even the tactical bull case has been nuked at this point. The strategic case is long-dead. What is the reason to still own stocks today?

Saturday, November 17, 2007

Sea Change on the Street

Guys, there was a huge change of tone over the last two weeks and especially this week. The denial that has ruled Wall Street for so long is beginning to show major cracks. We're finally seeing grudging admissions that this is a much bigger problem than they were willing to admit. What used to be just a "subprime" crisis is now a "mortgage" crisis.

The terrible reports from major retailers like Pennys, Macys, Kohls and the spectrum of apparel shops along with restaurants like Starbucks, PF Chang, Chipotle, Brinker and Panera are causing the Street to question the "resilient consumer" thesis. They should since it is based on the ability of the consumer to dig themselves into an every deeper hole of debt. But McDonalds and Target did well and Walmart OK. What does it tell you when spending is switching from department stores to discounters and from premium or sit down restaurants to the golden arches?

We don't hear the word "contained" much anymore do we?

Smacking Fannie
Fannie Mae is messing with their accounting to hide rapidly rising losses. They snuck in the accounting change that cut reported losses by almost half. This sort of game has been very common at financial companies in the last few years. They usually get away with it but this time investors noticed and slammed the stock down 20% in just a few sessions. The executives at Fannie must feel like Mike Leach when one of his OLinemen gets called for holding. We're going to see a LOT more of this simply because there is so much out there to find.
More doubts about Fannie Mae's disclosures

Commercial Divers
Next, we get the first real world confirmation that commercial real estate pricing is now falling. Synthetic indexes like the CMBX and credit indicators have been indicating decline for many months. The MIT index covers CRE owned by large pension funds and showed a decline of 2.5% for Q3. That would imply that prices rolled over either during Q2 or early in Q3. Commercial joins residential and commercial construction spending should follow shortly.
MIT index shows first drop in commercial property value since '03

Just incidentally, the subtitle "Indicates housing woes, credit crunch 'may be spreading' " trips one of my pet peeves. There is not a housing crisis spreading to other sectors like a contagious disease. This is more like a genetic heart defect inherited by a group of brothers from the Credit family. One, let's call him "Bob Residential" has a near-fatal heart attack. Another, named "Joe Consumer" is in the hospital for major symptoms but nothing life-threatening yet. "Jim Commercial" and "John Corporate" are having chest pains. The media wants to blame Bob for everybody's problems but the reality is they were all flawed from birth (of the current crop of loans).

Goldman Shocker
Goldman Sachs, which had previously been very bullish, is now calling for $400 billion in direct losses from the crisis in mortgages, plus $2 trillion in withdrawn credit as bank reserves shrink. Well, at least they've got the right number of zeros now but they still fail to account for anything beyond residential real estate.
U.S. could face $2 trillion lending shock
"The macroeconomic consequences could be quite dramatic," Hatzius said in the note to clients. "If leveraged investors see $200 billion of the $400 billion aggregate credit loss, they might need to scale back their lending by $2 trillion."

Hatzius said such a shock could produce a "substantial recession" if it occurred over one year, or a long period of sluggish growth if it occurred over two-to-four years.

The related article in Forbes made me roll my eyes and mumble "nice job Goldman, what took you so long?" This was obvious to anyone who bothered to do elementary analysis even a year ago. It's also why the Ben Stein's of the world have always been full of it. His "analysis" failed to account for how much the losses would push down the price of everyone else's houses or how the damaged financial system would be forced to cut lending. Duh!
Cost Of The Crunch? $2 Trillion, Says Goldman
In July, for example, Fed Chairman Ben Bernanke put subprime-related losses at $50 billion to $100 billion. "Even at the time, these numbers seemed quite optimistic," wrote Goldman economist Jan Hatzius, in a note Friday. "Now it is clear to most observers that they are far too low."

So it looks as if the new bull case is huge losses and probable deep recession. Goldman has been a constant cheerleader since they have a lot to lose from this scenario. IMO, they have simply calculated that the loss of credibility from continuing to spew slanted nonsense now outweighs the loss of business if the economy and market fall a little sooner. Make no mistake, they would be extremely unlikely to make such a change unless they felt the events were already on the doorstep.

The Bleeding Edge
Of course, Hatzius at Goldman is just catching up to David Rosenberg at Merrill, who turned quite bearish 6 months. The guys who had this right from the beginning are Paul Kasriel at Northern Trust and a pair of academics - Nouriel Roubini at NYU and Robert Shiller at Yale. Notice that none of them work for investment or money center banks. Earlier, I linked the Bloomberg interview with Morgan Stanley's head of credit strategy, calling for a greater than 50% chance of the credit markets coming to a "grinding halt." The scary thing is that Roubini is now going further and saying the "risks of such a generalized systemic financial meltdown are now rising."
Nouriel Roubini's Global EconoMonitor

This is obviously not something I've foreseen. My expectation has been for severe and widespread losses, with a few major firms failing. Roubini has not yet published his full analysis but I pray that his conclusions are wrong though I will consider them with an open mind. Just as I've prayed that my own conclusions were wrong despite believing in them wholeheartedly. The problems seem inescapable. Hope for the best, prepare for the worst.

Wednesday, October 24, 2007

Tech Wreck

We've had ongoing weakness in profits for much of the technology sector so far this reporting season. But the sound of all the earnings misses has been drowned out by a handful of rapidly-growing companies with high multiples and even higher expectations. Jim Cramer of CNBC infamy has dubbed them the Four Horsemen. GOOG, RIMM and AAPL produced big numbers to feed the Nasdaq frenzy but the 4th horseman stumbled badly after the close today.

AMZN delivered strong revenue growth and beat profit expectations slightly - which was fine. Then they dropped a bombshell with their guidance.

Operating income is expected to be between $221 million and $291 million, or grow between 12% and 48% compared with fourth quarter 2006.
First problem is the range is wide enough to drive a truck through. That tells you they have no real idea what is going to happen - rarely a good sign. Second problem is that expected EPS growth for 4Q is 100% year over year. At the top of their guidance, they only fall short by half. At the bottom of the range, their profit growth will be one-eighth of expectations. That kind of miss is really bad and potentially disastrous for a high-flyer like AMZN.

What is important here is that the miss by Amazon will force people to look at what is actually happenning to earnings in technology and not just a few hyped up names. When they do look, they will see a rather ugly picture behind the hype. Almost every major technology company to report so far has had serious problems - either revenue shortfalls or forward-looking weakness as reflected in guidance. Many of them are big, even dominant players in their sector. Here's a partial list:

Texas Instruments - analog semis and digital signal processors
Broadcom - WiFi and other communications chips
Altera - PLDs (key components in telecom and networking gear)
Linear Tech - analog and mixed-signal semis
Microchip - microcontrollers for consumer and industrial applications

Ericsson - cellphones and cellular network gear
Alcatel/Lucent - communications equipment
IBM - weak hardware demand

Many of the semiconductor companies are telling us that 4th quarter revenues will be weaker than last quarter. That is the opposite of the normal seasonal pattern, suggesting a significant weakening of underlying demand. These chipmakers' customers are a very broad cross-section of the global technology sector and encompass tech's A-list, so the weakness is broad-based as well.

For months, the question has been "if a tech company falls in the forest, will it make a sound?" The answer has been a resounding NO. Now we're about to find out what happens when one falls in the front yard and crushes the house.

Monday, October 22, 2007

Reserves, Profits and Multiples

One of the key problems with valuation in the stock market today is the difficulty of determining actual profits are trying to compare the numbers that are reported to previous years where different standards were used. Many bulls have tried to tell me that I should buy because the S&P 500 is selling at a P/E of only 16x 2008 earnings. Well, there are a ton of problems with that statement so let's just cover the fatal flaws.

First, I don't know what 2008 earnings are going to be and neither do they. They are using a guess as the denominator to get that multiple. The number we do have is the historical reported numbers and based on that the multiple is 18x, significantly higher.

Second, 18x is very expensive and even 16x is far from cheap. 16x would be a normal peak multiple over the business cycle. 18x would be extreme territory normally. During the 20th century, the P/E for the S&P 500 has exceeded 18x on a sustained basis 3 times: the late 1920s, the mid 1960s and the late 1990s. Each of them was followed by epic bear markets. Not a good set of precedents.

Each of those periods also featured prolonged (multi-year) periods of high earnings growth. We had the same thing this time in 2004-05 but EPS growth has fallen from 18% to 0% while equity indexes make new highs. Dangerous? You bet! In the past stocks rolled over shortly after earnings growth started to slow down. This time they refuse to roll over even when the slowdown is about to go to negative growth.

Then there is the quality of the profits themselves. The financial sector and banks in particular are quite problematic. The NY Times has done excellent coverage on the severe depletion of loss reserves at the big banks.

Some investors seem to think that banks’ current share prices reflect whatever grim earnings news remains ahead for the sector. But anyone who thinks that we have hit bottom in the increasingly scary lending world is paying little mind to the remarkably low levels of reserves that the big banks have set aside for loan losses. Indeed, loss provisions as a percentage of total loans held for investment plummeted to a historic low in the second quarter of 2007, the most recent period for which comprehensive figures are available.

Yep, we're heading into a major default crisis and banks have the lowest reserves ever. That's not a problem or anything that the Fed and Treasury want us to worry about. But the weak reserves have allowed financials to over-report profits for the last several years. Time to correct that and the price will be weak profits and for some, losses instead for the forseeable future. And I'm supposed to be interested in paying extreme peak multiples for inflated financial sector profits? No thanks.

Sunday, October 7, 2007

Global Reversal

It's been a few weeks and there's been a bit of excitement surrounding the Fed. But from an economic and credit standpoint, it's largely "sound and fury, signifying nothing." Risk spreads are still wide, lots of high-grade and few low-grade bonds are being issued, market rates (all but the shortest maturities) are higher not lower. Sure, stock markets are rallying on the promise of inflation but the Fed may not be able to deliver, especially since only the Bank of Japan is using the same playbook.

If you look closely, the recent past is very similar to the 1970s. We have rising inflation everywhere, though masked this time using statistical manipulation in the First World. Inflationary credit excess driving unsustainable demand for all kinds of stuff. This benefits rising industrial exporters (Japan then, China now) and commodities producers (OPEC, Chile, Brazil, Canada, Australia, Texas, Alberta and various African nations). We experienced a co-ordinated global boom then, just as now and for the same reasons. In fact, we are currently experiencing the highest sustained rate of global GDP growth since the early 1970s - not a terribly auspicious precedent.

Even with cuts in the Fed funds target rates, the US economy seems to be well along the road to a severe recession. Housing can only be described as collapsing. To those who argue that prices haven't come down much, you are correct - that comes later. Prices are sticky in housing since the average market participant is poorly informed. Price declines often continue well after a bottom in sales and construction. Just given what's happened already, we can look forward to 18-24 months of falling prices.

Predictably, lending against depreciating collateral isn't terribly popular and the initial effects of less EZ credit are being seen in the first small drops for consumer spending and retail sales. The declines would have been worse without rapid growth of credit card balances.

The Federal Reserve reported that consumer credit rose at an annual rate of 5.9 percent in August, the biggest increase since a 7.9 percent jump in May.

The increase was led by an 8.1 percent leap in revolving credit, the category that includes credit card loans.

This will get much worse for at least a year. With consumer spending now accounting for an unprecedented 72% of the economy, the vulnerability to a consumer spending slowdown is obvious. Of course American consumers have been spending money they don't have for the last 5 years and the engine for excess spending - the housing bubble has been sputtering and has now shut down.

What's fascinating is that similar dynamics are now being seen overseas. Many nations have experienced simultaneous housing bubbles and their associated wealth effects. A number of them are now rolling over in credible imitations of the US housing market of 2006. What ties them all together is credit. Live by the (credit) sword, die by the sword. It hasn't hit the inflation boom economies yet but it very likely will.

UK Builders
UK Lenders
New Zealand

There's evidence of housing rolling over in such diverse locations as Sri Lanka, the Baltic States and Thailand. Once again, the only common thread is a deflating global credit bubble.

Monday, September 10, 2007

Australia Leads the Way

The race to the bottom in financial responsibility reached a new milestone today. The Reserve Bank of Australia - their equivalent to the Fed agreed to take asset-backed debt paper as collateral for repo loans to commercial banks. The Wall Street Journal reports this morning:

Banks that may be forced to assume assets from the conduits that have financing coming due could themselves face shortages of capital.

To head off such a problem, Australia's central bank, the Reserve Bank of Australia, has relaxed rules on collateral it will accept for short-term funding. This would enable banks to take more time to evaluate which portions of the asset-backed commercial-paper market are most affected by ailing subprime mortgages.

In doing so the Australians went beyond the Federal Reserve, which doesn't accept such paper as collateral in repo operations but did recently clarify it was willing to accept a wide variety of such paper for its lesser-used, and costlier, "discount window" loans to banks.

Basically, the RBA is willing to accept asset backed paper as collateral for loans now. The Fed will apparently do the same but only at the discount window where distressed banks come to borrow, hat in hand.

Conduits and structured investment vehicles (SIV) enabled banks to move assets off the balance sheet, where they would no longer count against their required capital. By providing these entities with a guaranteed line of credit, the bank was on the hook if investors who normally provide funding got cold feet. Of course, it was assumed that the high times would last forever so such a thing could never happen but naturally it did.

In hindsight, it can be seen that the conduits and SIVs were an attempt to evade the reserve requirements and banking regulations. These things traded on the credit and the good name of the bank but never appeared anywhere in the financial statements. Simply another clever, legalized fraud. Taxpayers should not be on the hook for this sort of gamesmanship.

Friday, September 7, 2007

Behind the Numbers

Today we hear that 4,000 fewer people had jobs in the USA in August than in July. Don't believe that - the losses are much worse than just 4k.

The numbers of losses have just gotten too big for the statistical "adjustments" to hide. The actual employer survey data showed job losses throughout the second quarter and minimal gains in the first quarter. The Birth/Death Model added 120k jobs in August. That is the assumed net addition from startup businesses, less the losses from existing firms folding. Does anybody actually believe that number should be positive instead of negative given the number of small business failures? The actual employer survey showed 124k losses. The reality is likely to be worse than that once the actual net jobs from business startups and failures is measured.

The household survey has been flashing danger even longer. No jobs created since November of last year. August household survey shows 316k jobs lost. The unemployment number stayed flat because they just took nearly 600k people out of the workforce for no apparent reason. The household survey captures people not considered employees - sole proprietors and independent contractors mostly. That would describe a lot of building subcontractors, realtors, mortgage brokers, etc. With what's happening in the housing sector, you should expect large discrepencies for a while as many such people lose their jobs.

August Employment Report

BLS Birth/Death Model

Friday, August 31, 2007

Ongoing Credit Implosion

The rate of implosion in the credit markets continues to accelerate. In fact, the process seems to be proceeding very rapidly and the only element missing is mass bond defaults. According to Bloomberg, the asset-backed commercial paper (ABCP) market has shrunk by 20% in a mere three weeks and the total CP market is 11% smaller over that period. This type of credit has contracted by $244 billion in a very short time. For those who think the Fed can simply "print money" to revive asset inflation, $244 billion is roughly 4x the $68 billion total of all US currency in circulation today. And of course, the CP market is just one of many credit markets undergoing a buyers' strike.

Private label MBS of any kind is very hard to sell right now, which is why even Countrywide is doing almost nothing but conforming loans.

[Countrywide] says that soon about 90% of its originations will conform to either bank loan or such so-called "Government Sponsored Enterprises" standards.

The corporate junk market is nearly frozen right now. As far as I can tell only one junk deal of any size has been done in eight weeks. Other than debt issued or guaranteed by governments, very little is being sold in the bond markets anywhere right now. Unless you are a "natural" AAA or AA-rated entity, you can only issue debt at punitively high interest rates.

There is complete distrust of credit ratings for any sort of structured debt. Of course that's what happens when BBB-rated "investment grade" structured bonds lose over half their value. More confirmation of just how bogus the ratings were and how badly standards had slipped came recently. S&P cut their rating on some structured investment vehicles (SIVs) from the gold standard AAA to near-default CCC in one fell swoop. As we previously mentioned in Fed Actions and Terrorist Attacks, the ratings agencies got paid three times as much on structured bonds but I'm sure that had nothing to do with the generous ratings. Surely, they are only correcting an inadvertent previous oversight.

Of course, when the ratings are that badly wrong, no one cares what about motives or excuses. All such ratings become suspect. Nothing the Fed can do will restore trust in the ratings agencies. Only the agencies themselves can do that and only with time and hard work. Similarly, much of the credit that was extended should never have happened. Since the creditors have been burned by dumb mistakes, those won't be repeated - regardless of how many unsustainable investment structures depend on the them.

The Fed cannot recreate the naivete, the wild optimism and the frenzy that drove much of structured finance over the last several years. The illusion of permanently lower risk has been broken and cannot be recreated. Much of the recent "financial innovation" was utterly dependent upon this illusion and so those products must simply disappear. The UDB has burst and the Fed just needs to get over it. Efforts by the CBs to halt this process will meet with the same success as King Canute's command to halt the tides.

Saturday, August 25, 2007

First Principles

Well, it's been one heck of a week. With all of the insanity going on around us, sometimes it's best to take a step back and return to first principles. One of those is the Business Cycle - you know that thing that the Fed has supposedly abolished? The two questions that come to mind immediately are "why did the cycle exist?" and "how did the Fed get rid of it?"

The first one is easy. Economic cycles have existed throughout our history and always will exist as long as emotional humans are making economic decisions. The National Bureau of Economic Research has tracked US economic cycles going back to the mid-19th century. In the immediate postwar period, the cycles became more predictable as the Fed began to regulate them and induce the occasional recession to purge excesses before the market did it for them. During this period, it was discovered that the cycle could be manipulated though not controlled. The typical pattern was roughly three years of expansion, followed by a 12 month recession. The only major exception was the long expansion which lasted through most of the 1960s. The excesses from that one contributed to the really ugly decade that followed - and I'm not just talking about disco and afros for white guys either.

Unfortunately, other than Paul Volcker the Fed seemingly learned little from that experience. After Saint Paul imposed a painful but effective remedy for inflation, his successor Alan Greenspan embarked on a policy of continuous credit expansion. This has "worked" in the sense that economic growth was sustained over a long period, few setbacks were encountered and those were short and shallow. But the price was a crumbling economic foundation. Consumption became the dominant basis of the economy. Consumption growth was funded first with falling savings, then with growing debt. The major collapses in the savings rate came during the 1990s as it fell from 7% to 2% and again after 2002 when it went from 2% to negative.

We essentially outsourced the necessary but burdensome job of saving to Asia. Few economists seem to have drawn any connection between the outsourcing of manufacturing and of savings. Manufacturing requires investment and investment requires savings. It would seem reasonable that the nations which save and invest in the real economy (not just financial paper) would increase their manufacturing and that seems to be the case. The US is left with little savings, heavy debt, bad loans and a weakened manufacturing base. The cycle has not been abolished. It has simply been stretched and distorted beyond all recognition.

Tuesday, August 21, 2007

Fed Actions and Terrorist Attacks

We are beginning to see severe impairment of credit functions - the fruits of massive and long standing frauds that have recently come to light. By now, many of you are familiar with the 'mark to model' fraud, where the imaginary prices generated by a computer model are preferred over the actual prices which are being paid by actual people - especially when using the former allows firms to report gains rather than the losses they have suffered in reality. With some 'investment grade' paper trading at huge discounts to par, the rating services have a lot of explaining to do. The fee structures for structured finance create serious conflicts of interest.

"S&P, Moody's and Fitch have made more money from evaluating structured finance--which includes CDOs and asset-backed securities--than from rating anything else, including corporate and municipal bonds, according to their financial reports. The companies charge as much as three times more to rate CDOs than to analyze bonds, published cost listings show."

Then there are the garden-variety frauds that occur in every credit cycle and are endorsed or at least accepted by the accountants. Low losses in good times are assumed to be permanent and provisions for losses are small - inflating reported bank profits. This is often compounded by banks which drain their pre-existing reserves to inflate profits further. When combined with loose credit standards, nastiness is practically guaranteed to ensue since the low losses will be followed by very large losses once the weaker borrowers come under pressure. Financial 'innovation' simply adds to the problems since it is nearly always used to take on more risk, not reduce risk.

At the end of a massive credit cycle like the one we have just experienced, financial earnings are wildly overstated, assets are significantly overstated, credit quality is very bad and it is very difficult to distinguish the banks with some troubled assets from those that are insolvent. Under these conditions, it only makes sense to be very cautious when making loans.

Uber cautious lending is exactly what is happening today. Spreads on risky bonds have widened dramatically as investors demand to be compensated for risk again. New issuance of junk bonds has been virtually nil for eight weeks. More ominously, about half of the commercial paper (CP) market seems to be in the process of going away. There is almost no interest in asset-backed CP except at punitively high interest rates. In fact, this market judged the Fed's discount rate cut to be about as useful as a terrorist attack.

"Even the Fed's decision to cut the discount rate that it charges banks failed to revive demand. The rate for overnight borrowing in the asset-backed commercial paper market soared 0.39 percentage points to that price on Aug. 17, the biggest rise since the Sept. 11 terrorist attacks."

The bizarre rally in stocks is especially puzzling in light of the continued deterioration in credit quality and availability. This is way beyond 'whistling past the graveyard' by the equity markets; it's more like cramming fingers in their ears, kicking and screaming "lalalalalala I can't hear you!"

Saturday, August 11, 2007

Humpty Dumpty Repair

It appears that the CBs have managed to stave of an immediate disaster in the financial markets - at least for the moment. Yet any hope of a material turnaround in market conditions seems distant indeed. The entire system was built on an ever-rising tide of debt and confidence. Debt served to expand the money supply and confidence ensured that the larger pool of money would move through the economy at accelerating velocity.

Now, fears of default have undermined the willingness to lend and borrow - undermining the psychological conditions necessary to sustain debt growth. At the same time, confidence has been crushed, slowing the headlong rush of money around the globe. The sale of CDOs has fallen dramatically - 35% from June to July. These instruments epitomize both trends; they serve to direct capital into new debt deals quickly while simultaneously taking out loans themselves to leverage the profits from those deals.

Confidence has not merely broken, it is shattered. The Fed and other CBs can do nothing to restore this confidence but that hasn't kept them from trying to put Humpty Dumpty back together again. The massive and fully justified loss of confidence has nothing to do with the Fed; it is in the credibility of Wall Street, housing collateral, ratings agencies, credit derivatives and complex financial structures generally. During the boom, the opaque, complex vehicles didn't matter as everything was going up. As things got shaky, the lack of transparency served as a smokescreen to hide the losses and keep the public in the dark.

As the scale of the problem has come to light, trust and confidence in everyone involved has tanked as it should. They have sustained or abetted a fraud against investors and should not be trusted. Given the reluctance to lend, it's clear that many financial institutions don't trust each other. The Fed can flood the markets with credit to temporarily stabilize the system but they can't undo the series of frauds and resulting rational distrust that has spread through the financial world like a virus.

The alphabet soup of complex and opaque credit derivatives helped to hide the damage for a long time. They continue to mask the full extent of the losses and the identity of the losers. But belated recognition by investors has changed the default setting. Previously, they assumed everything was fine unless specific problems were identified. Now, the problems are known if not truly understood, so the assumption is that risk portfolios are in trouble unless proven otherwise. The lack of transparency that was previously helpful is now a gigantic ball and chain.

It can't be undone now. It will take months to find who is holding all of the toxic waste and how much they are holding. Until then, all financial institutions are guilty until proven innocent. Lending will continue to be frozen by the high risk of losses. Humpty Dumpty can't be repaired even by "all the king's horses and all the king's men."

Friday, August 10, 2007

Legions of the Damned

In Leverage and Its Uses, we discussed the large and growing cohort of companies with shaky credit and bond ratings in the CCC to C range. Many of these firms are effectively bankrupt already, borrowing just to pay the interest on existing debt. Such a practice was only possible in the loose money conditions of the UDB (Universal Debt Bubble), which is now bursting with shocking speed. These companies form one one cohort within the Legions of the Damned.

Today's actions by the European Central Bank and the Federal Reserve cofirm that the real threat is DEFLATION - not inflation. Central Banks don't pump $150 billion dollars into the banking system because they are afraid of creating too much money.
Central banks move to counter liquidity crunch

Central banks no longer expand the money supply by literally printing currency. They create new money by expanding credit through the financial system - mostly the banks but with other financial institutions playing an increasingly important role. Quasi-banks like hedge funds and CDOs take in money (investments instead of deposits) and use it to fund the purchase of assets, while introducing additional credit in the form of leverage as part of the process. These hedge fund and CDO positions have been used as collateral for further loans, increasing total debt in the system to absurd levels.

Over the last several weeks, there has been a collective recognition of the inherent riskiness of using illiquid, volatile and hard to value paper as collateral for lending. The lenders are requiring either much more (paper) or better (cash) collateral to secure the loans. The result is the global "Dash for Cash" that we've seen recently. Cash is King again and the scramble to come up with it resulted in huge spikes in overnight lending rates. The injection of $150 billion into the system was designed to bring the rates back down to the ECB and Fed targets of 5.25% and 4.0% respectively.

Had the CBs not acted, there would have been massive forced selling of the illiquid paper, demonstrating it to be nearly worthless. Now that would only formally recognize a situation that already exists in reality but as long as the banks can pretend that it's worth face value, they can continue to make loans and prop up consumption. This is a classic example of Gresham's Law - to oversimplify "Bad money drives out good money." When dodgy paper assets are treated nearly the same as cash, nobody is going to put up cash.

We are reverting from this state to more normal relative valuation. As part of that process, the value of cash - as measured by interest rates is rising. The CB action is intended to suppress this normal market mechanism and keep cheap credit flowing. Unfortunately for their plan, market participants have correctly diagnosed this as a last-ditch effort born of panic. The price of money (the interest rate) has risen dramatically in commercial paper, where the free market still largely determines prices.
Commercial Paper Yields Soar to Highest Since 2001

Which brings us back to the Legions of the Damned. The commercial paper market which is tightening up is part of the same bond market that has kept these companies on life support for several years. The same bond market that is refusing to fund risky mortgages and risky leveraged buyouts. The plug has been pulled and the life support is shutting down. Is anyone listening?

Sunday, August 5, 2007

Leverage and Its Uses

During the Universal Debt Bubble (UDB), corporations borrowed a lot of money, so where did it go? Quite a bit of it went into buying other companies as worldwide buyouts reached a record $4.06 trillion in 2006, with about 40% of that in the USA. That was well above the previous record $3.3 trillion in 2000. The difference was that the M&A boom in 2000 was done largely with stock; this one is funded with debt. When things went bad in 2000, the equity didn't have to be paid back, but the debt from the current frenzy will.

While a lot of money went to buy other companies' stock, another big chunk funded companies who bought back their own stock. Naturally, all of this debt-funded stock buying has served to prop up equity prices. Many shareholders came to believe that they were in a no-lose position because of continuous demand from buybacks. And if anything went wrong, someone else would swoop in and buy the whole company as part of the M&A wave. That sort of overconfidence is usually a setup for a big fall - which looks to be starting now.

Until very recently, we were on pace for takeovers to be even higher in 2007 than last year. Then someone apparently had a blow to the head that restored rational thought processes. The interest payments on many of these deals could barely be supported in the current good times. What might happen in bad times is something I don't like to think about. Apparently, many market participants agreed and collectively decided not to think about it - until forced to as buyout deals started to go sour. There are apparently some $300 billion worth of deals that still need funding and can't get it.
"Investment banks including JPMorgan Chase & Co. and Citigroup Inc. have promised to sell about $300 billion in bonds and loans to fund takeovers of companies including TXU Corp. and First Data Corp. Investors have balked at buying much of the debt offered so far"

The banks have stuck their necks way out there and are not anxious to increase their exposure further. In fact, they are trying hard to get out of the deals they've already committed to doing. There will be little M&A activity for the foreseeable future. To a significant extent, company stock buybacks are also dependent on debt. The clearest case of this was Expedia, which was forced to cancel 80% of its buyback when their borrowing fell through.

With the takeover wave in full retreat and much of the fuel for stock buybacks being choked off, the two key pillars supporting the stock market are looking very shaky. For now, that should be more than sufficient the keep stocks weak.

Once we go out a few months, the far larger fundamental problems will start to become apparent. First, is the large number of companies that should already be bankrupt but have been kept on life support by cheap debt.


"The persistently large volume of 'CCC - C' rated bonds in combination with a historically low default rate suggests that liquidity more than fundamentals kept defaults in check."

"'CCC - C' issuers are generally only able to service their significant debt burdens by tapping external funding and have no cushion to sustain them if business or borrowing conditions soften. "

Well, borrowing conditions have already softened and these companies can no longer borrow more money to pay off the interest like they've been doing. In addition, we have just over 2 months until the reports for the 3rd quarter start to come in. That will be when many financial firms are going be forced to report just how much the end of the UDB has cost them. It could get ugly, but that's another topic.

Corporate Finance

The Universal Debt Bubble (UDB) has enabled many activities that could never be sustained in anything resembling a normal environment. Perhaps nowhere is this more clear than in the field of corporate finance and the related debt and equity markets. Let's look at the borrowing side first.

Just as with housing, cheap credit was widely available in the corporate sector. Anybody could borrow and at much lower than normal interest rates too.

One of the most important effects is that it was almost impossible to default on a debt. Since there was almost always another lender lined up to make a loan, companies refinanced instead of going bankrupt. This was very similar to the way homeowners refinanced instead of facing foreclosure. The magnitude of the drop in defaults was astounding. A study by Moody's showed that over 32 years the lowest rated bonds (Caa, Ca and C) averaged 23.7% defaults each year.

With the UDB in effect, the default rates for those risky bonds has fallen to virtually nothing:
"Issuers rated CCC or lower typically default at an average annual rate of 25 percent, as measured by Fitch. In 2006, the default rate for such issuers was 4.5 percent, the lowest in 20 years."

With consequences seemingly abolished, borrowers lenders began to behave badly - just as they did in the mortgage market. More and more of the bond deals funded were in the lowest credit categories: the corporate equivalent of subprime. The structures were increasingly convoluted and risky. Toggle notes were issued, giving the debtor the right to pay interest either in cash or more bonds - reviving the disastrous pay in kind (PIK) structure from the 1980s. This also looks suspiciously like an option ARM or negative amortization loan. Covenant lite loans removed most of the traditional protections for the lender, echoing the no-doc, no verification trend in mortgages. The parallels are uncanny - just as they should be since they were caused by the same UDB forces.

Once all of this foolishness is gone, we should see things revert to their historical levels. If we see anything close to normal, junk bond losses will be substantial.
There are many other resemblances and we may deal with them at a later time. But the next topic for discussion will be what companies did with all of the money they raised in the bond market.

Where to Start?

This is such an enormous subject, it's difficult to know where to begin. I'm going to start with the prevalence and destructiveness of excessive debt. The best illustration of that so far is in the housing market. The symptoms there are more obvious and advanced than elsewhere. So let's go to the stats.

According to the Federal Reserve mortgage lending grew from $153.8 bil in 1995 to $1,051.8 bil in 2005 - a mere 584% in 10 years.

The results were amazingly predictable: housing prices rising rapidly, with a speculative frenzy at the end. It's axiomatic that bubbles can only last as long as there is more money coming in. I'll freely admit that I expected a top in housing in 2004 as the pool of qualified buyers was drained. The lenders fooled us by making further loans to unqualified buyers to keep things going for another 15-18 months. In the end, this has only made things worse naturally.

We are at the front end of the suffering now. It was easy to see it coming when new houses were adding 2% or more to the existing supply for years and the population was growing at half that rate or less. The Census Bureau confirms that the number of empty houses has never been higher. Until 1999, homeowner vacancy rates were almost never above 1.7%. That number has been 2.5% or higher for 4 straight quarters now - suggesting over 1 million empty and unneeded houses.

The consequences are popping up in the form of falling home sales and prices, rising delinquencies and foreclosures, with collapsing lenders following quickly behind them. For detailed coverage and discussion of all these trends, check

Unfortunately, the madness of the lenders was not confined to housing - far from it. There was similar Crazy Eddie lending in commercial real estate, corporate lending, foreign government bonds and the various forms of consumer credit. I'll examine each of these separately but the bottom line is that these practices have erected a house of (credit) cards that now threatens to collapse - taking much that I hold dear with it.