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.