Posted on 07/01/2007 9:44:31 PM PDT by bruinbirdman
The near collapse of two Bear Stearns hedge funds has lifted the rock on our 21st century mutant capitalism, exposing the bugs beneath to a rare shock of naked light. When creditors led by Merrill Lynch forced a fire-sale of assets, they inadvertently revealed that up to $2 trillion of debt linked to the crumbling US sub-prime and "Alt A" property market was falsely priced on books.
Even A-rated securities fetched just 85pc of face value. B-grades fell off a cliff. The banks halted the sale before "price discovery" set off a wider chain-reaction.
"It was a cover-up," says Charles Dumas, global strategist at Lombard Street Research. He believes the banks alone have $750bn in exposure. They may have to call in loans.
Not even the Bank for International Settlements (BIS) has a handle on the "opaque" instruments taking over world finance.
"Who now holds these risks, and can they manage them adequately? The honest answer is that we do not know," it said.
Markets have been wobbly since the surge in yields on 10-year US Treasuries, the world's benchmark price of money. Yields have jumped 55 basis points since early May on inflation scares, the steepest rise since 1994. It infects everything; hence that ugly "double top" on Wall Street and Morgan Stanley's "triple sell signal" on equities.
Wobbles are turning to fear. Just $3bn of the $20bn junk bonds planned for issue last week were actually sold. Lenders are refusing "covenant-lite" deals for leveraged buy-outs, especially those with "toggles" that allow debtors to pay bills with fresh bonds. Carlyle, Arcelor, MISC, and US Food Services are all shelving plans to raise money. This is how a credit crunch starts.
"This is the big one: all investment portfolios will be shredded to ribbons," said Albert Edwards, from Dresdner Kleinwort.
The BIS had warned days earlier that markets were febrile: "more risk-taking, more leverage, more funding, higher prices, more collateral, and in turn, more risk-taking. The danger with such endogenous market processes is that they can, indeed must, eventually go into reverse if the fundamentals have been over-priced. Such cycles have been seen many times in the past," it said.
The last few months look like the final blow-off peak of an enormous credit balloon. Global M&A deals reached $2,278bn in the first half, up 50pc on a year. Corporate debt jumped $1,450bn, up 32pc. Private equity buy-outs reached $568.7bn, up 23pc. Collateralised debt obligations (CDOs) rose $251bn in the first quarter, double last year's record rate.
Leveraged deals are running at 5.4 debt/cash flow ratio, an all-time high. As the BIS warns, this debt will prove a killer when the cycle turns. "The strategy depends on the availability of cheap funding," it said.
Why has such excess happened? Because global liquidity flooded the bond markets in 2005, 2006, and early 2007, compressing yields to wafer-thin levels. It created an irresistible incentive to use debt.
What is the source of this liquidity? Take your pick. Goldman Sachs says oil exporters armed with $1,250bn in annual revenues have been the silent force, sinking wealth into bonds; China is recycling $1.3 trillion of reserves into global credit, a by-product of its policy to cap the yuan; Japan's near-zero rates have spawned a "carry trade", injecting $500bn of Japanese money into Anglo-Saxon bonds, and such; the Swiss franc carry trade has juiced Europe, financing property booms in the ex-Communist bloc. And, all the while, cheap Asian manufactures have doused inflation, masking the monetary bubble.
The deeper reason is the ultra-loose policy of the world's central banks over a decade. They "fixed" the price of money too low in the 1990s, prevented a liquidation purge to clear the dotcom excesses, then kept rates too low again from 2003 to 2006. Belated tightening has yet to catch up.
Don't blame capitalism. This is a 100pc-proof government-created monster. Bureaucrats (yes, Alan Greenspan) have distorted market signals, leading to the warped behaviour we see all around us.
As the BIS notes tartly in its warning on the nexus of excess, this blunder has official fingerprints all over it. "Behind each set of concerns lurks the common factor of highly accommodating financial conditions" it said.
Rebuking the Fed, it said Japan and Europe have turned sceptical of the orthodoxy that central banks can safely let asset booms run wild, merely stepping in afterwards to "clean-up".
The strategy leads to serial bubbles, creates an addiction to easy money, and transfers wealth from savers to debtors, "sowing the seeds for more serious problems further ahead".
If you think we are too clever now to let a full-blown slump occur, read the BIS report.
"Virtually nobody foresaw the Great Depression of the 1930s, or the crises which affected Japan and south-east Asia in the early and late 1990s. In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a 'new era' had arrived," it said.
The subtext is that you bake slumps into the pie when you let credit booms run wild. You can put off the day of reckoning, as the Fed did in 2003, but not forever, and not without other costs.
So the oldest and most venerable global watchdog is worried enough to evoke the dangers of depression. It will not happen. Fed chief Ben Bernanke made his name studying depressions. He will slash rates to zero if necessary, and then - in his own words - drop cash from helicopters. But his solution is somebody else's dollar crisis.
On it goes. Perhaps governments should simply stop trying to rig the price of money in the first place.
That's "DUMAS..."
Not "Dumb Ass..."
Some folks at the B.I.S., and for that matter, Ambrose Evans-Pritchard, sound like Austrians here.
To quote Howard Ruff (Ruffly): "The margin call. The only unqualified piece of advice you will ever receive from your broker."
ping
Thanks for your thoughtful analysis- minus tinfoil:)
This cycle...of multiple banking entities running loose led to the banking consolidation of the 1930’s, the S&L consolidation of the 1980’s...and, IMHO, is designed to lead to an international banking consolidation this decade that will be the runner-up to a world currency....
Your posts are a prime example of the best part of FR - experts talking about what they know. Thank you.
Wonderful analysis. Making the complex understandable for the financial dim bulbs such as myself.
Thanks
Many 401k’s are in stock funds,some bonds, foreign funds.
What’s a relatively safe place to put your money to ride out the possible fall?
Mattress? Bank ‘Passbook’ savings? :)
I appreciate your compliment, but I must make it quite clear to all here: I am NOT an expert on these matters. I’m not a professional in finance. Do not take anything I say as actionable financial advice.
I’m a hay farmer in central Nevada, who used to be a EE in Silly Valley. That’s it. I’ve forgotten more math (as a EE) than most finance people have every known, but the secret of modern finance is that finance “professionals” seem to get into more trouble the more math they know. The Black-Scholes option model is just one example — the academics thought they’d use the Gaussian distribution to make the math easier, and they assumed the underlying security price movement was like Brownian motion, when in fact the way that option pricing breaks down at the margins is anything but Gaussian and the movement of underlying securities prices is often anything but Brownian.
But hey, these eggheads (and a bunch of professionals like them) created these hedge fund models based on these academic notions of mathematics, and when human nature rears it’s ugly head in excesses, these models break down. Engineers can tell you that, because half of engineering is about “what can go wrong?”
Financial professionals only worry about the expected normal case, and how much money that they’ll make in these cases. Not how much they’re gonna lose when the statistical minority event blows up in their face. Go read up on Long Term Capital Management in 1998 for a wonderful display of how financial “professionals” with PhD’s act when their assumptions go wrong.
Never, ever in my worst nightmares did I ever think I would have to know crap like this CDO/CDO-squared/margin/hedge fund crap. Never. I’m just a dumb ol’ EE who wanted to be a farmer. That’s it. I’d much rather bale hay than deal with investment crap.
However, events transpired that necessitated me learning a great deal about finance because I make it one of my mottos in life that I’m never fooled twice in the same way. A financial “professional” fooled me once. Now I handle all our investments and retirements myself.
My only unsolicited advice for anyone dealing with a financial “professional” is to keep your hand firmly wrapped around your wallet if you’re ever being pitched ideas, products and services. There is nothing they do that you can’t do, if you have a little math background (as in, you could pass 8th grade math tests), a healthy dose of skeptical inquiry and a functional idea of your tolerance for risk vs. how much reward you want for taking that risk. That’s the real secret of America’s financial “experts” — they’ve been selling you, the investing public, a sack of organic fertilizer for years, trying to convince you that you MUST obtain “professional” advice, that you’re too stupid to do this stuff on your own.
You’re not. Matter of fact, 99% of the common public would not have done what the financial wizard “professionals” did with these CDO’s — either in creating them or buying them. Most of us non-professionals, the “ignorant masses,” would have demanded “hey, what is in this CDO thingie? Why can’t I just buy the investment-grade bonds directly? Why do they need to be wrapped up with all this other crap inside this ‘CDO’ shell? I don’t need that crap, just give be the AA-rated mortgage backed bonds and shut the hell up!”
That’s what you or I would have said if we were seeking to buy those tranches of debt. Why? Because we’re simple people, who want things broken down into stuff we can understand.
Financial “professionals” running billions of other people’s money bought into these CDO’s and CDO-squared without having much of any clue just how much risk they were buying, in what ways the risk would manifest itself, or gave a thought to the consequences of buying an illiquid investment asset.
That is very, very true.
No less a legendary investor than Jesse Livermore thought the same thing — that the margin call was his stop-loss. Livermore was trading/flipping stocks back in the day when you could get 10:1 margin on stocks, so as soon as you were down 10%, the broke would make a margin call.
Most all traders follow a firm rule: never meet a margin call. Let them sell you out. Meeting a call is essentially doubling up on a loss.
Schwarzman is legendary for knowing how to spot a top.
So the cynic in me says “Why take Blackstone public right now?” and then answers “Because Schwarzman knows this is a top, and he’s not going to get as good a valuation on the fund as he’s going to get now, so he’ll go public now, and when the fund’s share prices go down, he’ll buy them back at bargain basement prices.”
Yes, I think they’re timing this to maximize their return on a cash-out.
Well, one of the reasons why no one foresaw the Great Depression was that the Depression wasn’t caused by the stock market crash of ‘29. That kicked off a liquidity crisis and precipitated a great number of very stupid actions on the part of FDR, the Congress and the Fed.
The economy can survive stupidity by any one of those three; at worst, we’ll have a recession as a result.
But all three acting in concert at the same time? No economy is strong enough to survive a hat trick of stupidity.
In other words, too much money (at least on paper), too little real value.
>>I’m not a financial pro, but I can translate some of what is in that article. What would you like to know first?<<
What should a typical middle-aged American working man (renter; middle-of-the-road, DJ30-stocks-investor) do (assuming that whatever this article says is to be believed)?
Let me guess: Divest stocks and switch to physical gold?
No, right now you should keep an eye on what the market thinks of the situation.
If you see the market start to collapse under a cascade of hedge funds failing due to margin calls, and then investment banks who loaned money to hedge funds being stiffed for the margin loan because the hedge fund assets, when sold, brought pennies on the dollar — then I’d start getting defensive.
Until then, the situation bears watching by the small investor — possibly every day.
A Secret Life of Bill Clinton bump for Mr. Pritchard-Evans
Carolyn
Wow, all investment portfolios. Sounds scary!
Deflation, putting the De in Depression. Yeah, that's what we need. LOL!
Gold.
LOL!
In her vital and fascinating new book, "The Forgotten Man: A New History of the Great Depression," Amity Shlaes tells a story about national icon President Franklin Delano Roosevelt. Shortly after FDR took office, Shlaes explains, he began arbitrarily tinkering with the price of gold. "One day he would move the price up several cents; another, a few more," writes Shlaes.
One particular morning, Shlaes relates, FDR informed his "brain trust" that he was considering raising the price of gold by 21 cents. His advisers asked why 21 cents was the appropriate figure. "It's a lucky number," stated Roosevelt, "because it's three times seven." Henry Morgenthau, a member of the "brain trust," later wrote: "If anybody knew how we really set the gold price through a combination of lucky numbers, etc., I think they would be frightened."
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