Crisis Note 2007-3: ABS East - Zombies in Disneyland? And more pontification
11/07/2007
Disclaimer: These are my opinions, not those of my employer, MF Global, nor those of my previous employer, Cantor Fitzgerald.
I'm a research geek at heart, and I feel compelled to help clients define strategy. I hope this helps.
Well, this was a weird ABS conference, as was to be expected. Barely any large dealers around ("regionals" dominated), lots of unsmiling, serious people talking in hushed tones, investors licking their wounds, surviving hedge fund managers licking their chops, CDO managers scrambling to raise money to reinvent themselves as distressed funds, and quite a few people wandering without a company name on their name tags (hint, they are now "consultants").
It appears as if the ABS community is praying for a miracle, and for the market to revert back to normal once the new year is ushered in. Many people are saying that we really need the big financials to disclose their true losses, and then liquidity will return to the ABS markets, with 2008 being a return to normalcy.
There was concern about the monolines (also mostly absent at the conference), thanks to the recent headlines, and some (private) discussions about Level 3 accounting, and the solvency of the dealers.
Except for DBRS, I did not see much rating agency representation, probably with good reason as well.
Much of the discussion was at the micro and functional level: how to mark bonds, what scenarios to use, when will the market recover, what the new ABX index will look like (air), what went wrong, etc.
However, my take, which I've been talking about all summer, and nothing I saw at the conference has made me change my mind is: the fixed income market, as a whole, is delusional, (as is the equity market), and they are missing the forest for the trees.
This message will discuss many of the issues I am seeing and thinking about. It is long.
Allergy alert: If you are bullish, this piece may break out the hives. If you have heart problems, please consult your doctor before proceeding.
First of all, a recap of the current situation, mostly from the 8/10/2007 article. Tooting my horn, but that piece is worth a read:
Everyone is coming to the realization that this crisis is a result of leverage. But the conversation also goes hand in hand with the comment that "this is a subprime problem". The US press is the main culprit here. (Hint: Everyone should be also reading the Financial Times, FT.com.) The latter consideration is WRONG. Read on.
The background:
The bull market in debt and equity has been driven by GLOBAL LEVERAGE.
In the 8/10 article, I state: Leverage has come from 3 primary sources:
- Repo & ABS CP (hedge funds, SIVs, SPVs),
- Levered Loans and bridge loans (private equity - stock markets @premium)
- Yen Carry Trade (invested in stocks and bonds, euro, USD, NZ, Aus,Iceland)
- CDOs & CLOS helped re-leverage a lot of this leverage. Blame Basel. (To understand what I mean by "Blame Basel", please see the article from the FT dated 11/7/07.)
- When you peel back the onion, global leverage has come primarily from FUNDING COUNTRIES - those with low interest rates.
- Hedge funds borrow cheap money in funding countries, for the most part don't hedge the currency risk, and invest in high yielding countries.THIS IS KNOWN AS THE CARRY TRADE, AND HAS CONSISTENTLY BEEN THE MOST PROFITABLE TRADE FOR HEDGE FUNDS SINCE THE LATE 90s. This money has resulted in asset price appreciation globally, typically to the detriment of the funding countries.
- Till recently, there has only been one country that has been able to absorb this torrent of investment: The US. Now, there are also China and India as options, and this is where money is now flowing to. (India, smartly, is trying to restrict hot hedge fund money, to prevent the asset bubbles that the US allowed).
- This historical fact, that the US has been the only investment arena where you could scale investments, is one of the main factors that has made the dollar the global store for value (also democracy, capitalism, etc. I'm not downplaying those factors, but at the margin, it's the scalability of investments). It has unfortunately, also made us complacent, and blind sided most of us to the emergence of other global investment arenas.
- There have been 3 funding countries in the last decade - Japan (big), Switzerland (small), and (drum roll) the US (while it lasted - 2001-2004).
- Yes, the US. Greenspan's bailout of LTCM made the US a funding country too. However, people have not historically referred to the US as a funding country, as the money raised through debt (also repo, margin,etc) also got invested in the US. To me this is just a coincidence. Fund managers will take cheap funding from anywhere.
- This led to waves of bubbles in the US. All this "free money" created from thin air thanks to the magic of leverage, at the time, really had no choice but to be invested in the US.
- Once we raised rates in the US in 2004, Dollar Carry collapsed, and Yen Carry became the main game in town again. To anyone that doubts that the Yen is driving the US Equity markets, almost at a tick-by-tick intraday basis, please see the SPY and Yen Charts attached.
ALL BOND MARKET PARTICIPANTS SHOULD LOOK AT THIS RELATIONSHIP.
The result:
- MANY FINANCIAL PRODUCTS AND REAL ASSETS WERE CREATED TO FEED THIS FRENZY OF CHEAP MONEY. Miles of fiberoptic cables, homes all over the US, subprime loans to get people into those homes. M&A investment banking morphed into the private equity market and created levered loans, covenant lite loans, highly levered private equity loans, equity bridge loans, etc.
- INSTEAD OF MONEY BEING RAISED TO INVEST IN CHEAP ASSETS, ASSETS WERE CREATED TO FULFILL THE SUPPLY OF CHEAP MONEY.
- SUBPRIME IS A SYMPTOM OF THE PROBLEM, NOT THE CAUSE.
- This is coming back to bite us. Subprime borrowers are the weakest of all the asset types created, and they are folding first. But, it is inevitible that levered loans will fold at some point too, as the lofty growth assumptions made to justify these purchases will no longer work. And with the collapse of currencies versus the Yen, so will the stock market.
- Assets that are being delevered are not finding homes, as they were excess assets without natural balance sheets to belong to. Thus the prices for ALL assets are falling, due to the incessant pressure from the sales. Weak assets and their collateral will need to get wiped out before equilibrium is reached. This will take a lot of time. So far, we've only seen a few CDOs hit their default triggers, but each one will typically be a billion or so.
- It is not far fetched to expect homes to actually be crushed to bring a market into equilibrium, I am hearing this is happening in Ohio already. I believe it happened in Dallas in the late 80s.
Rating agencies and CDOs.
This is the simplest way I can think of to explain CDOs and why theyfailed:
- CDOs were invented by Michael Milken, as he observed that in a diversified pool of junk corporate credits, only a certain percentage failed. This was due to the diversification in industries, which led to uncorrelated risks between bonds with the same ratings. Thus, you could issue a certain % of investment grade bonds from a portfolio of non-investment grade credits. The key here is lack of correlation.
- The rating agencies appear to have forgetten this fundamental fact - all resi ABS are correlated - the issuer does not matter much. Issuers compete for the same borrower - remember Lending Tree? This is not diversification. Unlike in corporate credits, you cannot take a portfolio of BBBs and call any significant portion of them AAAs.
- Thus the failure of CDOs, as the lousy collateral, created to feed the leverage monster via the CDO machine, all failed to make payments at the same time - it's a lack of UN-correlation.
Level 3 Category and Levered Loans
I assume many levered loans are in these Level 3 portfolios, with no observable markets, and thus marked to fantasy/model. What models are they using? I assume the hardworking analysts at the IBs, have cashflow models with growth rates and exit strategies embedded in them, to help advise the buyers of these companies, and to justify the fees the IBs took out for their "work". I'm sure the assumptions were not conservative, in order to justify the takeover premium. Well, they should be able to now put in more realistic scenarios: how about putting in 0% growth. Or be even more realistic - put in -10% to -30%. Given that they paid some premium (20-30%?) to the (inflated already due to carry trade) stock market price of the company to take it private, it should be real easy to value at least the subordinated paper and the equity bridges, given their leverage: 0. Unless, of course, they are still expecting the companies they took private to continue growing.
I think is the next time bomb waiting to happen to the investment banks.
Investment bank (in)solvency
Click here to see the attachment called Level 3 ratios.doc. I discussed this with a few people at ABS, and the blogs are all abuzz about it.This is pretty interesting stuff. Here's the data I lifted from
This is the ratio of Level 3 assets to Equity for the major IBs:
Citigroup: 134.8B Level 3 assets/128b equity = 105%
Goldman Sachs: 185%
Morgan Stanley: 251%
Bear Stearns: 154%
Lehman Brothers: 159%
Merrill Lynch: 38%
Another thing I've been saying all summer: the fate of the IBs really rests in the hands of auditors. After Enron, will any auditing firm be willing to risk extinction for a client? The next round of annual reports are going to be very interesting, as they are likely to be very conservative.
ABS CP & SIVs:
In the 8/10 piece I said that Nov / Dec would get ugly as CP extensions expired. This is now happening. Last week there was the appx $3BB liquidation of a SIV. The initial rumours were that it all went to one investor in a private transaction, and thus there was no color on where the market cleared. However, I heard at the conference, and I agree that this is more likely, that the ABCP providers took over the bonds. I hope they are not now owned by a money market fund.
Oil, Gold, inflation and the dollar:
The rise in oil and gold was discussed briefly at a lunch meeting at ABS East, and dismissed as being a result of global demand, and not due to the dollar decline, as "they went up against the euro too".
The dollar has long been the global store of value, with most things of value being denominated in the dollar, now that currencies are not on gold standards. With the problems in the US, the dollar is no longer the safe-haven currency, so cash, in all currencies, is being moved to hard commodities, gold out of habit, and oil as its the new "black gold". Sure there is speculation, but there is a fundamental reason for it - things of value are no longer denominated in the greenback.
This will lead to US inflation, as raw material costs go up in dollar terms. I just heard Bernanke respond to Rep Ron Paul, that the devaluation in the dollar does not matter as US consumers have their assets in dollars. I can't imagine a statement I disagree with more. A decline in the dollar will KILL the stock market as foreign capital providers take losses on their currency exposure, and thus bail out of our stock markets, and out of the carry trade. Say goodbye to our savings and pensions, and plans for retirement! Most retiree's will need to go back to work! I agree with Ron Paul - a decline in the dollar reduces American wealth (he used the word steal), and is likely to lead us to a recession.
Japanese economy, and forecast for the US:
I don't know if you saw, but Japan's index of leading indicators hit zero for Sept 2007. Quoting from FT: "Japan's five year expansion has produced jumps in corporate profits but has done little to stimulate consumption and wage growth among average workers. A sharp downturn in the US - an increasingly likely prospect - would threaten the export businesses that have been the strongest engine of growth"
I believe this is because, due to its low interest rates, Japan has been a "funding country" and a capital exporter for the past decade. This has benefitted the world, and especially the US, to the detriment of Japan itself. This is the fate that awaits the US if we continue on a course to drop rates - our capital (what little is left) will flee, and fund India and China.
Some people I have spoken to say that this is not a bad thing - ie, letting exports revive our economy. What Americans don't get is that, unlike Western countries, that are happy to let other people produce things, India and China are both pretty neurotic. They view economic independence (and energy independence) as having the same importance as defence and sovereignty. They will not be content to import capital goods - they will use their new found resources to learn to build the things they are importing. China and India are already building decent cars, and with forced joint ventures with Western partners, will improve emissions technology to the point that they will be globally competitive. I have heard that India probably already has the capability to build jet engines and power turbines to the tolerances needed, for example, as well. How long GE and Boeing will be able to export huge things to either of these countries, is anyone's guess, but I'll bet thats its next on the list after they get done with infrastructure. So, in my layman's view, any export boom will be short lived. And then what?
The Investment Bank Model - Someone else's money:
- Those of you that saw my business plans this summer for starting up a new Broker Dealer have seen this before. And it got discussed in the papers today as well.
- IBs have a trader driven model, at least in Fixed Income, where the traders get to take risk with the firm's capital.
- The trader's have a call option on the capital. They get to deploy capital in bull markets, leverage to the hilt, and stock up the shelves with product, often indiscriminately. They make a huge amount of money due to the leverage they deploy, and get paid huge bonuses, that are not (as far as I can see) risk adjusted for usage of, and risk to, capital. Why worry about risk - it's someone else's (the shareholder's) money!
- They have no downside if they blow up, that risk is borne entirely by the equity holders. At worst, they loose their jobs.
- Risk management is usually not powerful. In some cases, there is none (Merrill).
- This explains the current crisis - many banks and investment banks might be technically insolvent, not due to subprime problems, or leverage, BUT BECAUSE THEIR BUSINESS MODELS ARE FLAWED.
- They need to fix their business models and align employee's interests with those of the shareholders, and the clients.
- My recommendation is for all cash compensation should be limited to some amount, say 1mm to 2mm, so everyone can live well. But the big earnings above that, should be held in escrow for a number of years to see if any problems emerge, and paid out on a deferred basis (3-5 year lag?), so the risk takers are also taking personal risk.
- Risk management should have the same powers as trading, or even more, to liquidate positions etc. It should really be a mirror group that second guesses what the traders are doing, and should be as senior and skilled as the traders, with similar compensation. In this market, it should not be hard to hire such experienced people.
- This is a very Pavlovian business we work in, and changes in incentives are very effective in changing behavior. We have very smart people in our business, and firing experienced traders, that arbitrage their incentive structures, is not a solution - they were simply doing what they do best: making money. The CEOs and boards need to take responsibility for the flaws in their models, and restructure the compensation and risk rules and rewards.
I will rephrase my comments from the 8/29/07 article: Cutting rates will lead to capital flight and inflation at the same time, as the dollar depreciates. Yen carry trades will be unwound, and the deleveraging will be extremely painful. With our banks mostly in distress, they may not be able to increase money supply enough to replace leverage lost from yen carry exits. IT'S A HUGE MISTAKE TO CUT RATES. The Fed needs to prevent capital flight, and retain foreign investments and leverage.
The only 'elegant solution' I see to this problem is to CUT MARGIN REQUIREMENTS for banks, and give incentives for investors to recapitalize them. Cutting reserve requirements will allow our banks to lend, and thus reinflate money supply. The Fed and Treasury HAVE TO DEFEND THE DOLLAR. Keep rates unchanged, to even raise them, to retain and attract capital. Keeping rates high will keep foreign money invested in the US, funding our excesses and lifestyles, in addition to our stock markets.
There are 2 potential sets of casualties here: the American citizen, and the Investment Banks that brought us these problems due to their bad business models.
For whom will Big Ben toll?