Tuesday, December 25, 2007 9:28:17 PM
2008 - a year pregnant with risk
http://www.freebuck.com/articles/daanj/071225daanj.htm
by Daan Joubert
With one day to go to Christmas and 6 days to the end of 2007 - what a tumultuous year; but not a patch on what 2008 will bring - I would like to place a few market risks for 2008 on record. Let's begin with a review of the background to the disaster that is likely to unfold next year in the US and thus by implication also for the rest of the world; with varying effect and duration depending on local circumstances and exposure to various credit sludge.
Since 1994, US households increasingly had been adding debt at a faster rate than the increase in their disposable income. By 1999 the trend was so marked and so well-established that I could write that if the trend is sustained, the US is on the way to major problems. On the other hand, if households stopped making new debt at such a rate, the economy would slide into recession - something Clinton with his winning slogan in 1992, "It's the economy, stupid.", would never allow to happen. As we now know, the debt binge continued unabated and in fact since 2000 it increased as other sources of cash dried up
[See: http://www.gold-eagle.com/gold_digest_99/joubert121399.html and also http://www.freebuck.com/articles/daanj/060622daanj.htm ]
· The perceived wealth of the late 90's had a marked effect on the price of property - with coastal regions at the forefront of the property bull market. After the Wall Street collapse of the early 2000's and the rate cuts down to 1%, the property market really took off. As people used the low rates to migrate upwards to more expensive homes, a vacuum developed at the lower end of the market where buyers were scarce and often did not qualify for a mortgage. Mortgage brokers, who were being squeezed by funding banks for more issuances of mortgages, exploited this sub-prime segment and lowered qualification criteria until in many instances there were no criteria at all
· The reason why brokers were being pushed for more mortgages lies in the very low interest rates. Investors were keen on and paid good commissions for investments that offered substantially better returns than ruling money market rates. It was a global phenomenon - this demand for high return investments - and US banks made the most of it. However, foreign investors or US pension funds did not want to be proxy owner of mortgages on 500 US houses, having to collect monthly installments and to act when a home buyer goes into default. The banks therefore sliced up into tranches a large number of accumulated mortgages, had these rated by ratings agencies who concocted a transmutation of BBB and even worse rated mortgage debt into AAA rated investment paper, based on some statistical alchemy that was premised on the infantile assumption that the relatively low rate of default of the past would hold true indefinitely into the future. The banks sold these ‘mortgage derivatives' - CDO's and MBS's (Collateralised Debt Obligations and Mortgage Backed Securities) - much of which has become known as toxic waste, to unwitting fund managers and investors who naively believed in the transmutation
· The assumption was ludicrous; anyone who took an objective look at how many US households were being mired deeper and deeper in debt would recognise the fact. An important reason for the over-abuse of easy credit by households - apart from the example set by the Federal Government - can be traced back to the Clinton years. In an attempt to boost the economy and sustain a strong dollar policy, the CPI number was being ‘cooked' to reflect lower than actual inflation. However, since increases in wages and in Social Security are tied to official CPI figure, incomes of pensioners and many people who relied on sub-prime mortgages to own a house, lagged behind their rising real cost of living. To maintain their living standard and for some just to survive, they had to take on more and more credit. Living on debt became a US habit
· Meanwhile, back at the ranch, the banks themselves were keen for higher returns than what they could obtain from normal lending activity. Taking advantage of a very high level of liquidity - translation: lots of money floating around looking for good returns - hedge funds and other forms of investment vehicles proliferated. A bank would put a billion or two into a fund and then sell more shares in the fund to investors keen to get onto the bandwagon. With the larger pool of money, the bank would now gear up through derivatives of some kind, earning good profits - while the strong bull trends of recent years held. In addition, they were being paid management fees by investors in the fund as well as taking a larger cut of profits when the returns were particularly good. Massive profits were being made as investors scrambled to obtain high-return investments and prices of these investment derivatives soared. It really looked like a win-win situation - for the banks and the investors - until the wheels came off
· This had to happen sooner or later. The squeeze of higher rates on rising levels of debt, with wages lagging the true cost of living, and ARM's - the preferred mortgage according to Sir Alan - starting to kick in at much higher than original teaser rates, put an increasing number of marginal households in the position where they could no longer balance their budgets, even with new credit. For many, the decision on what to do as fixed living expenses ate into disposable income was easy. They had bought a house with no money down and so had no equity stake in it and when it started to cost more to own the house - higher installments, rising rates and taxes and having to do more maintenance as time passes- than the rental they had paid earlier, a move back to the ‘old place' looked very attractive. When prices failed to increase at expected rates and therefore the anticipated cushion on the mortgage evaporated, ceasing to pay installments on the mortgage actually looked like the best option
· As defaults mounted, expert insiders knew they had a problem on their hands. A PR campaign by government and institutional spokespeople first told the US that the problem was a minor one limited to a few under-performing mortgages; the economy was safe as can be. However, as some people knew well, the real problem was not the mortgages themselves, but the domino effect once the defaults started to mount. Keep in mind the rating agencies had dressed low quality mortgage credit in a new AAA suit that appealed to uninformed investors. However, now the chickens spawned by a cooked CPI, by artificially low rates and pleas for consumers to ‘Spend, Spend and Spend" to save the US economy, by lax regulation of mortgage practices to keep the property bubble from being pricked, are coming home to roost. No wonder the AAA suit came to look tattered, more like BBB-; so that the dominoes began to wobble
· Two interlocked things started to happen. Nobody wanted anything to do with the mortgage derivatives; demand was gone, prices were dropping fast and banks and their hedge funds were stuck with stocks of mortgages and their derivatives for which there was no market. Further, many pension and other mandated funds who bought into this derivatives market in pursuit of higher returns, found they have to sell their ‘investments', because these were no longer of investment grade, as required by their charters. On all fronts, holding mortgages and CDO/ABS derivatives were a no-win situation, losing value day by day - in real terms, even while models used to price them tried to maintain the pretence that these products were close to fully priced.
· Strangely, there is little news of forced sales by funds that are compelled to sell parts of their portfolio which gets down-rated to below investment grade. It is very quiet on that front and the possibility exists that banks are quietly buying back all the junk that comes onto the market in order to prevent low prices being made public and thereby down-rating their own holdings of the toxic watse. They might even be doing such to forestall any lawsuits that could be launched by buyers of garbage who bought in the belief that it was truly AAA rated and thus, like Treasuries, impervious to default
· It is clear from the above the early estimate of $200 billion for the sub-prime sludge is a fraction of the problem. The pyramid of derivatives piled on top of this amount - to be augmented as the contagion of defaults spreads through higher rated parts of the mortgage market - increases the full amount at risk by a factor one can only guess at; perhaps 10 times? $2 trillion at risk? Consider the practice of default swaps; a means of taking out insurance on credit paper one holds on the off-chance it may lose value or become worthless. The credit swap market seems to have two main player groups - pension funds and others who saw the premiums earned by issuing insurance in a market that has very low risk as money from home. This income could be earned without laying out a significant amount of money. These players cannot really be blamed for taking on the insurance role to augment their income; who in their right mind would not do so for AAA rated and thus gold plated paper? Secondly there are specialised credit insurers who, also with relatively little capital, insured vast amounts of credit instruments on the assumption they would never have to pay on any claims, beyond a few exceptions, on such high grade investments. Given low risk, premiums were also low and the key to success was to insure large volumes of credit. Because of the low perceived risk, these insurers were themselves rated AAA by the agencies. In the consistent bull market of the previous decade, many pension fund managers did what seemed the right thing to do. they purchased, for their higher returns, AAA rated CDO's, insured with an AA rated insurer, while they had the funds to do so. After that, they went for credit swap insurance on the AAA rated paper, thus earning an income that did not require a large outlay of money. For many of these managers it is now a case of, "Welcome to the nightmare!"
· Two concepts are becoming popular in the wake of this mess; the black swan analogy [See: http://en.wikipedia.org/wiki/Black_swan_theory] and long tailed events. It was long believed swans were white - until black swans were discovered; an unexpected event. Probability curves have fat bellies and long thin tails. The fat belly is crowded with events that have a high probability of happening, but out on the tail of the curve events happen rarely and, if the tail is long enough, the probability of those events are so rare one would be foolish to lay out money to bet on their happening in a lifetime. In the investment market, AAA rated investments were like white swans - the odds of a AAA going into default were so negligible nobody considered them and insurance was thus very cheap, so that a holder of remotely questionable AAA debt was foolish not to insure. Yet today we have an epidemic of black swans and a shower of long tailed events - things nobody really could imagine happening. (Except some did warn of disaster ahead, but they were not heeded). No wonder the markets cannot hope to cope with this extreme situation
· Finally, banks operate under a rule that says if the bank has X amount of own capital, then it can lend out Y amount, much larger than X. The ratio Y/X is known as capital adequacy, and there is an upper limit to Y/X that used to be rather tight and strictly enforced. When a bank suffers a loss, the loss has to be covered from its own capital, not from the money of depositors. This enforced limit exists so that a bank would not extend loans beyond a point where there is still a good probability that it could cover a loss without risking the survival of the bank. So, if a bank has capital X and loans outstanding of Y and then suffers a loss, which is then written off against X to bring its capital to X1, it has to call in loans to bring the total amount on loan down to Y1. Doing so is very traumatic for lenders who have to find money to repay their loans. Also, when a bank has to do this, it sends a most disturbing message into the market and a bank run on it and even on other banks is not unlikely.
With this background, we can begin to look at recent events and then speculate about what is likely to happen during 2008.
Much of the chain of events is already evident from the above discussion. Here we only list a few highlights, largely because of their relevance for 2008.
a) The CDO mess blew up to place the value a whole pyramid of derivatives in doubt; as derivatives lost value, easy credit dried up so that the mortgage market experienced a liquidity squeeze, which has now spilled over into other markets. Central Banks try to alleviate the squeeze by adding liquidity, with little success
b) Money center banks have had to rescue some hedge funds they had started and which were rapidly sinking. The outlook for some hedge funds was poor, even with their ‘investments' still ‘marked to model' and thus not reflecting the worsening market situation. Much is being done behind the scenes to forestall a fire sale of poor quality paper that would thereby set a low ‘true market price' to replace ‘mark to model'
c) Investors shun corporate term loans (typically 30 days), widely used by corporations to fund work in progress. The reason: lenders are not sure whether the corporation whose bonds they hold has exposure to the toxic waste market and therefore prefer to play safe. The change in this market represents progress from a credit squeeze to a confidence squeeze; much more difficult to alleviate, even with Central Banks adding more liquidity to the economy. Institutions hoard cash in case they have to rescue one of their own funds, else they may have to write down a real loss which would force them to look for fresh capital in a difficult market, while corporations starve for cash
d) Some banks have already admitted to writing off large amounts of losses, compelling them to seek equally large capital injections in order to avoid having to call in loans. The sums involved ($billions) appear to be freely available from oil producers in the middle east and investor funds in China, among others; countries mostly not very US friendly, but nobody complains about that as long as the banks are rescued. In fact, Wall Street cheers when age-old US institutions sell off to foreigners. The loans are typically of a two tier nature - initially, there are convertible shares, mostly with very high interest rates (11% in at least one case), thus offering the investors a high return until there is a conversion to shares in the bank at what would be a very good price should the markets return to normal during the next few years. In this way, foreign investors obtain a far better than average return combined with the prospect of a large stake (from about 5-10% in cases so far.) in venerable US financial institutions at what may well be a bargain price. Only a few banks so far have come clear on their positions, yet there is widespread awareness in the markets that the ones that have made public their losses until now, are certainly not the only banks/institutions/funds that are in trouble. It is very human to think the banks that have come forward with a statement on their losses are those that can afford to do so. Others, in real deep trouble, have said nothing - yet - while they desperately search for means to recover from their situation. What used to be a crisis of confidence has now transformed into a crisis of survival, with the capital base of institutions and funds under threat. That would imply that even the massive amounts of funds that have been pumped into the market by Central Banks, working together in concerted fashion, will not solve the problem. It is not funds that are needed, but investment. The ECB has announced that $500 billion is available, while a rumour floats around that if need be the total amount available from the Central Banks is really unlimited. The problem is that if a bank or fund is in real trouble with its own capital being eroded, getting a loan does not help; it needs fresh capital, which is only available if an investor can be persuaded to make a definite purchase of a share in the bank. With $billions needed in one go, sources of that kind of money are very limited - and almost certainly foreign based.
e) Exacerbating the problem is the fact that the rules for capital adequacy were relaxed during the boom years when little went wrong in the financial markets, so that banks could feed the demand for credit. This meant that for a fixed amount of capital, as the years passed, banks could lend out more into the growing demand for credit. While few of the loans outstanding went bad, this was fine - banks were coining profits like never before. However, now these banks are sailing into two headwinds: many more than usual of their clients are going into default and the money lent to them have to be written off. Secondly, a good many banks, themselves in pursuit of high gains in the derivatives markets, have also sought to either invest in these markets or to start up funds to play those markets, relying on heavy gearing to boost the profits. With these investments in CDO's and in hedge funds also trouble and having to write off losses, the banks are suffering a double whammy on their capital base
2008
That is how 2007 is rushing to its close, just a week away. This gloomy end to 2007 spells nothing good for 2008 - not if, as some others and I suspect, what we have seen so far is only the beginning, the tip of the proverbial iceberg. If so, 2008 is going to be a chilly year for US financial institutions and many others; for investors and for the general household.
So, what can we expect of 2008 if what has been happening sets a trend?
· Despite the Bush/Paulson (or is it Paulson/Bush?) plan to slow the rising incidence of foreclosures by freezing installments on certain selected mortgages ( a measure that is bound to have its own negative effect on CDO's etc), forecasts by informed sources anticipate the number of foreclosures to mount as more and more mortgages pass out of their teaser period into being subject to the ruling rate. ‘Easy' mortgages were the rule from late 2005 to early 2007 and many of these are due to mature to higher rates in 2008, with disastrous results for the home owners, and for owners of CDO's, etc.
· Banks have had to ‘sell' even up to a 10% share to investors who could provide the amount of funds needed to secure their capital - and this on write downs flowing from losses during and just after 3Q of 2007. There is widespread suspicion that the write-offs will be as great, or even greater, at the end of 4Q 2007 - with further large losses to come in 2008. How long, then, before one of two events, or both, happen: a major financial institution fails on capital adequacy and either calls in its loans, or simply folds. In both cases, a wave of potential counter-party claims erupt all over the market place with great destabilizing effect. Alternatively, the government has to step in and institute measures to protect the US financial system before it falls under the control of perhaps not the most friendly of foreign investors
· There has been a spike in the (official) US Inflation rate - and it is not clear whether this is a one-off event or a new trend. It would not surprise at all if the US dollar were to resume its weaker trend - the rally over the days prior to Christmas coincided with the coordinated blast of liquidity from a group of Central Banks and the firmer dollar clearly was part of their strategy. With the US situation looking frail, it would not do if the dollar were to plunge even lower and thereby give a boost to the inflation ogre, thereby demanding higher US rates.
· Higher inflation - so recorded despite cooking the statistics - requiring higher rates from the Fed, would be a death blow to the US economy at this stage of the melt-down and freeze-up in the financial system. A strong dollar policy was never needed as much as now, but now that would be a really tough challenge to surmount. Central Banks can do much to boost the dollar for a short period, but with fundamentals so far out of kilter, the odds of their doing so for the medium term appear rather thin. If the dollar goes - when? - the wheels will really start to come all the way off
· It is clear from the preceding discussion and above comments on 2008 that we are in a precarious multi-factorial situation. There is no single factor that one can watch and follow to see which scenario unfolds and how; to gauge the degree of unfolding risk. The analogy is more like a number of dominoes standing in a circle - if any one of them goes over, the rest all fall down. In real life, the dominoes represent, among others, US households and their ability to add even more debt and spend; the foreign investor who has to decide whether keeping his dollar investments intact and putting even more funds into dollar assets is a wise thing to do; the ECB who has to judge what effect its decisions will have on the US situation; Asians, with the Chinese very prominent, whose official policy towards the US and investments in dollar assets are of critical importance to what will happen; the US government and how they react to real and perceived threats to national security and the stability of US markets - and the degree to which the PPT can maintain the pretense of a strong Wall Street to show that all is OK and normal; no need to worry. Finally, to what extent can US banks and financial institutions manage to keep the ‘going into liquidation' wolf from the door
· One should remember that the US has not been above board to Asian investors, in China in particular, in recent months. Just before the CDO mess blew up, a senior US official - a member of cabinet no less! - flew off to China to inform them of the advantages of investing in AAA rated US mortgage derivatives. No need to guess what the Chinese now think of that suggestion. Add to that recent news that CDO's were specially designed so that toxic waste mortgage, under AAA camouflage, could be sold to naïve and trusting foreign investors and fund managers. As was mentioned earlier, there has been relatively little - if any - reaction from Asia on the subject of being stuck with rapidly devaluing investments. However, it is as certain as can be that their investors will react to this development at a time of their own choosing and in a manner that will not be pleasant to US interests.
· Recent news abounds with articles on first time losses at US major banks; on insurers of US credit instruments that are very much over-extended should the melt-down in the credit market continue. For example, MBIA insures about $700 billion of debt; if only a fraction of that amount arrives at the front door as claims, MBIA won't have a hope of settling them - not without mortally depleting its capital base, however large that is. The other large insurers are in the same boat: when the markets were calm and bullish, it made sense to gear up as much as possible on the available capital. That was the way to ensure good profits and sky-high bonuses; why worry about black swans, which do not exist in this new and wonderful economy! No wonder the ratings agencies assigned the insurers AAA ratings; they faced such low risk. Now it seems likely that S&P and Fitch and Moody's may decide, in view of their fiasco with the CDO ratings, to play it safe and reduce the ratings on insurers. That implies the debt they have insured would also be down rated and, if ratings drop far enough, it means that pension and other funds which hold that debt may be forced to sell. Should this come to pass in 2008, a massive amount of erstwhile safe credit derivatives, including municipals, would be dumped within a short time. That would really tear apart the US credit markets with little hope that even greater injections of liquidity would solve the problem. The most likely course of action sees the Fed buying up all the lower rated debt that come onto the market in an attempt to rescue the financial markets; yet, by doing so, they may well cut the legs from under the dollar.
There is more one can add to these dismal scenarios, but the above should suffice to paint a bleak picture of the prospects for 2008.
Other factors to ponder
The core problem is the US credit situation and what flowed from it - as laid out above. But this mess is not happening in isolation; there are ramifications across the whole economic landscape. Some of them are:
· How will members of pension schemes react when they hear of multi-million and even multi-billion dollar write-offs against their retirement money
· The dollar gained much over the past week, primarily, one assumes, with concerted support from a number of Central Banks who feel that a stronger dollar will alleviate the problems being experienced in the credit markets; they need foreign investors to feel confident of their US investments, not worried about a currency collapse. But can support last? Once the dollar resumes its slide - as seems inevitable - the pressure on the US balance of payments and on US inflation will increase again. The last thing the US now wants is higher (official) inflation that would necessitate raising rates and placing many households deeper in trouble
· The foreign factor cannot be disregarded. There is a theory that Asian and other large holders of US financial assets cannot afford to let the dollar drop because that would result in their reserves being down valued. However, there is also a widely respected saying that it is foolish to throw good money after bad. If dollars can be used to fund major and long term contracts for food and oil and resources, thereby using their current value to the full, why use them to purchase US assets that are bound to lose intrinsic value and even more as the dollar sinks. Couple that to the chagrin foreigners must feel over being caught in the CDO scam and one can imagine they will relish payback time when they have the US over a barrel. 2008 might just be that time!
· As markets turn more fragile, the US government might feel compelled to step in and try to keep matters on even keel. However, governments all over are well known for their propensity to unleash the law of unintended consequences. Watch what comes out of Washington in election year 2008 to stop the rot; do not be surprised when this law comes into play, with negative effect on the US economy and on relations with countries on which floundering US institutions rely to supply funds for their rescue.
A long review and a ‘stick my neck out' effort. But the risks for 2008 appear so clear cut that it seems safe to take the chance. Even if this analysis misses the boat by a wide margin, the fact remains that 2008 will be a most interesting year, full of surprises of the more unpleasant variety. Almost certainly, some of the items mention here will be among them.
Best wishes for 2008
daan
daanj - at - telkomsa.net
25 December, 2007
Roodepoort, South Africa
http://www.freebuck.com/articles/daanj/071225daanj.htm
by Daan Joubert
With one day to go to Christmas and 6 days to the end of 2007 - what a tumultuous year; but not a patch on what 2008 will bring - I would like to place a few market risks for 2008 on record. Let's begin with a review of the background to the disaster that is likely to unfold next year in the US and thus by implication also for the rest of the world; with varying effect and duration depending on local circumstances and exposure to various credit sludge.
Since 1994, US households increasingly had been adding debt at a faster rate than the increase in their disposable income. By 1999 the trend was so marked and so well-established that I could write that if the trend is sustained, the US is on the way to major problems. On the other hand, if households stopped making new debt at such a rate, the economy would slide into recession - something Clinton with his winning slogan in 1992, "It's the economy, stupid.", would never allow to happen. As we now know, the debt binge continued unabated and in fact since 2000 it increased as other sources of cash dried up
[See: http://www.gold-eagle.com/gold_digest_99/joubert121399.html and also http://www.freebuck.com/articles/daanj/060622daanj.htm ]
· The perceived wealth of the late 90's had a marked effect on the price of property - with coastal regions at the forefront of the property bull market. After the Wall Street collapse of the early 2000's and the rate cuts down to 1%, the property market really took off. As people used the low rates to migrate upwards to more expensive homes, a vacuum developed at the lower end of the market where buyers were scarce and often did not qualify for a mortgage. Mortgage brokers, who were being squeezed by funding banks for more issuances of mortgages, exploited this sub-prime segment and lowered qualification criteria until in many instances there were no criteria at all
· The reason why brokers were being pushed for more mortgages lies in the very low interest rates. Investors were keen on and paid good commissions for investments that offered substantially better returns than ruling money market rates. It was a global phenomenon - this demand for high return investments - and US banks made the most of it. However, foreign investors or US pension funds did not want to be proxy owner of mortgages on 500 US houses, having to collect monthly installments and to act when a home buyer goes into default. The banks therefore sliced up into tranches a large number of accumulated mortgages, had these rated by ratings agencies who concocted a transmutation of BBB and even worse rated mortgage debt into AAA rated investment paper, based on some statistical alchemy that was premised on the infantile assumption that the relatively low rate of default of the past would hold true indefinitely into the future. The banks sold these ‘mortgage derivatives' - CDO's and MBS's (Collateralised Debt Obligations and Mortgage Backed Securities) - much of which has become known as toxic waste, to unwitting fund managers and investors who naively believed in the transmutation
· The assumption was ludicrous; anyone who took an objective look at how many US households were being mired deeper and deeper in debt would recognise the fact. An important reason for the over-abuse of easy credit by households - apart from the example set by the Federal Government - can be traced back to the Clinton years. In an attempt to boost the economy and sustain a strong dollar policy, the CPI number was being ‘cooked' to reflect lower than actual inflation. However, since increases in wages and in Social Security are tied to official CPI figure, incomes of pensioners and many people who relied on sub-prime mortgages to own a house, lagged behind their rising real cost of living. To maintain their living standard and for some just to survive, they had to take on more and more credit. Living on debt became a US habit
· Meanwhile, back at the ranch, the banks themselves were keen for higher returns than what they could obtain from normal lending activity. Taking advantage of a very high level of liquidity - translation: lots of money floating around looking for good returns - hedge funds and other forms of investment vehicles proliferated. A bank would put a billion or two into a fund and then sell more shares in the fund to investors keen to get onto the bandwagon. With the larger pool of money, the bank would now gear up through derivatives of some kind, earning good profits - while the strong bull trends of recent years held. In addition, they were being paid management fees by investors in the fund as well as taking a larger cut of profits when the returns were particularly good. Massive profits were being made as investors scrambled to obtain high-return investments and prices of these investment derivatives soared. It really looked like a win-win situation - for the banks and the investors - until the wheels came off
· This had to happen sooner or later. The squeeze of higher rates on rising levels of debt, with wages lagging the true cost of living, and ARM's - the preferred mortgage according to Sir Alan - starting to kick in at much higher than original teaser rates, put an increasing number of marginal households in the position where they could no longer balance their budgets, even with new credit. For many, the decision on what to do as fixed living expenses ate into disposable income was easy. They had bought a house with no money down and so had no equity stake in it and when it started to cost more to own the house - higher installments, rising rates and taxes and having to do more maintenance as time passes- than the rental they had paid earlier, a move back to the ‘old place' looked very attractive. When prices failed to increase at expected rates and therefore the anticipated cushion on the mortgage evaporated, ceasing to pay installments on the mortgage actually looked like the best option
· As defaults mounted, expert insiders knew they had a problem on their hands. A PR campaign by government and institutional spokespeople first told the US that the problem was a minor one limited to a few under-performing mortgages; the economy was safe as can be. However, as some people knew well, the real problem was not the mortgages themselves, but the domino effect once the defaults started to mount. Keep in mind the rating agencies had dressed low quality mortgage credit in a new AAA suit that appealed to uninformed investors. However, now the chickens spawned by a cooked CPI, by artificially low rates and pleas for consumers to ‘Spend, Spend and Spend" to save the US economy, by lax regulation of mortgage practices to keep the property bubble from being pricked, are coming home to roost. No wonder the AAA suit came to look tattered, more like BBB-; so that the dominoes began to wobble
· Two interlocked things started to happen. Nobody wanted anything to do with the mortgage derivatives; demand was gone, prices were dropping fast and banks and their hedge funds were stuck with stocks of mortgages and their derivatives for which there was no market. Further, many pension and other mandated funds who bought into this derivatives market in pursuit of higher returns, found they have to sell their ‘investments', because these were no longer of investment grade, as required by their charters. On all fronts, holding mortgages and CDO/ABS derivatives were a no-win situation, losing value day by day - in real terms, even while models used to price them tried to maintain the pretence that these products were close to fully priced.
· Strangely, there is little news of forced sales by funds that are compelled to sell parts of their portfolio which gets down-rated to below investment grade. It is very quiet on that front and the possibility exists that banks are quietly buying back all the junk that comes onto the market in order to prevent low prices being made public and thereby down-rating their own holdings of the toxic watse. They might even be doing such to forestall any lawsuits that could be launched by buyers of garbage who bought in the belief that it was truly AAA rated and thus, like Treasuries, impervious to default
· It is clear from the above the early estimate of $200 billion for the sub-prime sludge is a fraction of the problem. The pyramid of derivatives piled on top of this amount - to be augmented as the contagion of defaults spreads through higher rated parts of the mortgage market - increases the full amount at risk by a factor one can only guess at; perhaps 10 times? $2 trillion at risk? Consider the practice of default swaps; a means of taking out insurance on credit paper one holds on the off-chance it may lose value or become worthless. The credit swap market seems to have two main player groups - pension funds and others who saw the premiums earned by issuing insurance in a market that has very low risk as money from home. This income could be earned without laying out a significant amount of money. These players cannot really be blamed for taking on the insurance role to augment their income; who in their right mind would not do so for AAA rated and thus gold plated paper? Secondly there are specialised credit insurers who, also with relatively little capital, insured vast amounts of credit instruments on the assumption they would never have to pay on any claims, beyond a few exceptions, on such high grade investments. Given low risk, premiums were also low and the key to success was to insure large volumes of credit. Because of the low perceived risk, these insurers were themselves rated AAA by the agencies. In the consistent bull market of the previous decade, many pension fund managers did what seemed the right thing to do. they purchased, for their higher returns, AAA rated CDO's, insured with an AA rated insurer, while they had the funds to do so. After that, they went for credit swap insurance on the AAA rated paper, thus earning an income that did not require a large outlay of money. For many of these managers it is now a case of, "Welcome to the nightmare!"
· Two concepts are becoming popular in the wake of this mess; the black swan analogy [See: http://en.wikipedia.org/wiki/Black_swan_theory] and long tailed events. It was long believed swans were white - until black swans were discovered; an unexpected event. Probability curves have fat bellies and long thin tails. The fat belly is crowded with events that have a high probability of happening, but out on the tail of the curve events happen rarely and, if the tail is long enough, the probability of those events are so rare one would be foolish to lay out money to bet on their happening in a lifetime. In the investment market, AAA rated investments were like white swans - the odds of a AAA going into default were so negligible nobody considered them and insurance was thus very cheap, so that a holder of remotely questionable AAA debt was foolish not to insure. Yet today we have an epidemic of black swans and a shower of long tailed events - things nobody really could imagine happening. (Except some did warn of disaster ahead, but they were not heeded). No wonder the markets cannot hope to cope with this extreme situation
· Finally, banks operate under a rule that says if the bank has X amount of own capital, then it can lend out Y amount, much larger than X. The ratio Y/X is known as capital adequacy, and there is an upper limit to Y/X that used to be rather tight and strictly enforced. When a bank suffers a loss, the loss has to be covered from its own capital, not from the money of depositors. This enforced limit exists so that a bank would not extend loans beyond a point where there is still a good probability that it could cover a loss without risking the survival of the bank. So, if a bank has capital X and loans outstanding of Y and then suffers a loss, which is then written off against X to bring its capital to X1, it has to call in loans to bring the total amount on loan down to Y1. Doing so is very traumatic for lenders who have to find money to repay their loans. Also, when a bank has to do this, it sends a most disturbing message into the market and a bank run on it and even on other banks is not unlikely.
With this background, we can begin to look at recent events and then speculate about what is likely to happen during 2008.
Much of the chain of events is already evident from the above discussion. Here we only list a few highlights, largely because of their relevance for 2008.
a) The CDO mess blew up to place the value a whole pyramid of derivatives in doubt; as derivatives lost value, easy credit dried up so that the mortgage market experienced a liquidity squeeze, which has now spilled over into other markets. Central Banks try to alleviate the squeeze by adding liquidity, with little success
b) Money center banks have had to rescue some hedge funds they had started and which were rapidly sinking. The outlook for some hedge funds was poor, even with their ‘investments' still ‘marked to model' and thus not reflecting the worsening market situation. Much is being done behind the scenes to forestall a fire sale of poor quality paper that would thereby set a low ‘true market price' to replace ‘mark to model'
c) Investors shun corporate term loans (typically 30 days), widely used by corporations to fund work in progress. The reason: lenders are not sure whether the corporation whose bonds they hold has exposure to the toxic waste market and therefore prefer to play safe. The change in this market represents progress from a credit squeeze to a confidence squeeze; much more difficult to alleviate, even with Central Banks adding more liquidity to the economy. Institutions hoard cash in case they have to rescue one of their own funds, else they may have to write down a real loss which would force them to look for fresh capital in a difficult market, while corporations starve for cash
d) Some banks have already admitted to writing off large amounts of losses, compelling them to seek equally large capital injections in order to avoid having to call in loans. The sums involved ($billions) appear to be freely available from oil producers in the middle east and investor funds in China, among others; countries mostly not very US friendly, but nobody complains about that as long as the banks are rescued. In fact, Wall Street cheers when age-old US institutions sell off to foreigners. The loans are typically of a two tier nature - initially, there are convertible shares, mostly with very high interest rates (11% in at least one case), thus offering the investors a high return until there is a conversion to shares in the bank at what would be a very good price should the markets return to normal during the next few years. In this way, foreign investors obtain a far better than average return combined with the prospect of a large stake (from about 5-10% in cases so far.) in venerable US financial institutions at what may well be a bargain price. Only a few banks so far have come clear on their positions, yet there is widespread awareness in the markets that the ones that have made public their losses until now, are certainly not the only banks/institutions/funds that are in trouble. It is very human to think the banks that have come forward with a statement on their losses are those that can afford to do so. Others, in real deep trouble, have said nothing - yet - while they desperately search for means to recover from their situation. What used to be a crisis of confidence has now transformed into a crisis of survival, with the capital base of institutions and funds under threat. That would imply that even the massive amounts of funds that have been pumped into the market by Central Banks, working together in concerted fashion, will not solve the problem. It is not funds that are needed, but investment. The ECB has announced that $500 billion is available, while a rumour floats around that if need be the total amount available from the Central Banks is really unlimited. The problem is that if a bank or fund is in real trouble with its own capital being eroded, getting a loan does not help; it needs fresh capital, which is only available if an investor can be persuaded to make a definite purchase of a share in the bank. With $billions needed in one go, sources of that kind of money are very limited - and almost certainly foreign based.
e) Exacerbating the problem is the fact that the rules for capital adequacy were relaxed during the boom years when little went wrong in the financial markets, so that banks could feed the demand for credit. This meant that for a fixed amount of capital, as the years passed, banks could lend out more into the growing demand for credit. While few of the loans outstanding went bad, this was fine - banks were coining profits like never before. However, now these banks are sailing into two headwinds: many more than usual of their clients are going into default and the money lent to them have to be written off. Secondly, a good many banks, themselves in pursuit of high gains in the derivatives markets, have also sought to either invest in these markets or to start up funds to play those markets, relying on heavy gearing to boost the profits. With these investments in CDO's and in hedge funds also trouble and having to write off losses, the banks are suffering a double whammy on their capital base
2008
That is how 2007 is rushing to its close, just a week away. This gloomy end to 2007 spells nothing good for 2008 - not if, as some others and I suspect, what we have seen so far is only the beginning, the tip of the proverbial iceberg. If so, 2008 is going to be a chilly year for US financial institutions and many others; for investors and for the general household.
So, what can we expect of 2008 if what has been happening sets a trend?
· Despite the Bush/Paulson (or is it Paulson/Bush?) plan to slow the rising incidence of foreclosures by freezing installments on certain selected mortgages ( a measure that is bound to have its own negative effect on CDO's etc), forecasts by informed sources anticipate the number of foreclosures to mount as more and more mortgages pass out of their teaser period into being subject to the ruling rate. ‘Easy' mortgages were the rule from late 2005 to early 2007 and many of these are due to mature to higher rates in 2008, with disastrous results for the home owners, and for owners of CDO's, etc.
· Banks have had to ‘sell' even up to a 10% share to investors who could provide the amount of funds needed to secure their capital - and this on write downs flowing from losses during and just after 3Q of 2007. There is widespread suspicion that the write-offs will be as great, or even greater, at the end of 4Q 2007 - with further large losses to come in 2008. How long, then, before one of two events, or both, happen: a major financial institution fails on capital adequacy and either calls in its loans, or simply folds. In both cases, a wave of potential counter-party claims erupt all over the market place with great destabilizing effect. Alternatively, the government has to step in and institute measures to protect the US financial system before it falls under the control of perhaps not the most friendly of foreign investors
· There has been a spike in the (official) US Inflation rate - and it is not clear whether this is a one-off event or a new trend. It would not surprise at all if the US dollar were to resume its weaker trend - the rally over the days prior to Christmas coincided with the coordinated blast of liquidity from a group of Central Banks and the firmer dollar clearly was part of their strategy. With the US situation looking frail, it would not do if the dollar were to plunge even lower and thereby give a boost to the inflation ogre, thereby demanding higher US rates.
· Higher inflation - so recorded despite cooking the statistics - requiring higher rates from the Fed, would be a death blow to the US economy at this stage of the melt-down and freeze-up in the financial system. A strong dollar policy was never needed as much as now, but now that would be a really tough challenge to surmount. Central Banks can do much to boost the dollar for a short period, but with fundamentals so far out of kilter, the odds of their doing so for the medium term appear rather thin. If the dollar goes - when? - the wheels will really start to come all the way off
· It is clear from the preceding discussion and above comments on 2008 that we are in a precarious multi-factorial situation. There is no single factor that one can watch and follow to see which scenario unfolds and how; to gauge the degree of unfolding risk. The analogy is more like a number of dominoes standing in a circle - if any one of them goes over, the rest all fall down. In real life, the dominoes represent, among others, US households and their ability to add even more debt and spend; the foreign investor who has to decide whether keeping his dollar investments intact and putting even more funds into dollar assets is a wise thing to do; the ECB who has to judge what effect its decisions will have on the US situation; Asians, with the Chinese very prominent, whose official policy towards the US and investments in dollar assets are of critical importance to what will happen; the US government and how they react to real and perceived threats to national security and the stability of US markets - and the degree to which the PPT can maintain the pretense of a strong Wall Street to show that all is OK and normal; no need to worry. Finally, to what extent can US banks and financial institutions manage to keep the ‘going into liquidation' wolf from the door
· One should remember that the US has not been above board to Asian investors, in China in particular, in recent months. Just before the CDO mess blew up, a senior US official - a member of cabinet no less! - flew off to China to inform them of the advantages of investing in AAA rated US mortgage derivatives. No need to guess what the Chinese now think of that suggestion. Add to that recent news that CDO's were specially designed so that toxic waste mortgage, under AAA camouflage, could be sold to naïve and trusting foreign investors and fund managers. As was mentioned earlier, there has been relatively little - if any - reaction from Asia on the subject of being stuck with rapidly devaluing investments. However, it is as certain as can be that their investors will react to this development at a time of their own choosing and in a manner that will not be pleasant to US interests.
· Recent news abounds with articles on first time losses at US major banks; on insurers of US credit instruments that are very much over-extended should the melt-down in the credit market continue. For example, MBIA insures about $700 billion of debt; if only a fraction of that amount arrives at the front door as claims, MBIA won't have a hope of settling them - not without mortally depleting its capital base, however large that is. The other large insurers are in the same boat: when the markets were calm and bullish, it made sense to gear up as much as possible on the available capital. That was the way to ensure good profits and sky-high bonuses; why worry about black swans, which do not exist in this new and wonderful economy! No wonder the ratings agencies assigned the insurers AAA ratings; they faced such low risk. Now it seems likely that S&P and Fitch and Moody's may decide, in view of their fiasco with the CDO ratings, to play it safe and reduce the ratings on insurers. That implies the debt they have insured would also be down rated and, if ratings drop far enough, it means that pension and other funds which hold that debt may be forced to sell. Should this come to pass in 2008, a massive amount of erstwhile safe credit derivatives, including municipals, would be dumped within a short time. That would really tear apart the US credit markets with little hope that even greater injections of liquidity would solve the problem. The most likely course of action sees the Fed buying up all the lower rated debt that come onto the market in an attempt to rescue the financial markets; yet, by doing so, they may well cut the legs from under the dollar.
There is more one can add to these dismal scenarios, but the above should suffice to paint a bleak picture of the prospects for 2008.
Other factors to ponder
The core problem is the US credit situation and what flowed from it - as laid out above. But this mess is not happening in isolation; there are ramifications across the whole economic landscape. Some of them are:
· How will members of pension schemes react when they hear of multi-million and even multi-billion dollar write-offs against their retirement money
· The dollar gained much over the past week, primarily, one assumes, with concerted support from a number of Central Banks who feel that a stronger dollar will alleviate the problems being experienced in the credit markets; they need foreign investors to feel confident of their US investments, not worried about a currency collapse. But can support last? Once the dollar resumes its slide - as seems inevitable - the pressure on the US balance of payments and on US inflation will increase again. The last thing the US now wants is higher (official) inflation that would necessitate raising rates and placing many households deeper in trouble
· The foreign factor cannot be disregarded. There is a theory that Asian and other large holders of US financial assets cannot afford to let the dollar drop because that would result in their reserves being down valued. However, there is also a widely respected saying that it is foolish to throw good money after bad. If dollars can be used to fund major and long term contracts for food and oil and resources, thereby using their current value to the full, why use them to purchase US assets that are bound to lose intrinsic value and even more as the dollar sinks. Couple that to the chagrin foreigners must feel over being caught in the CDO scam and one can imagine they will relish payback time when they have the US over a barrel. 2008 might just be that time!
· As markets turn more fragile, the US government might feel compelled to step in and try to keep matters on even keel. However, governments all over are well known for their propensity to unleash the law of unintended consequences. Watch what comes out of Washington in election year 2008 to stop the rot; do not be surprised when this law comes into play, with negative effect on the US economy and on relations with countries on which floundering US institutions rely to supply funds for their rescue.
A long review and a ‘stick my neck out' effort. But the risks for 2008 appear so clear cut that it seems safe to take the chance. Even if this analysis misses the boat by a wide margin, the fact remains that 2008 will be a most interesting year, full of surprises of the more unpleasant variety. Almost certainly, some of the items mention here will be among them.
Best wishes for 2008
daan
daanj - at - telkomsa.net
25 December, 2007
Roodepoort, South Africa
Lactose Free Milkman
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