Floors, Ceilings, Camels, Straw

There was a very interesting article in the Pimco Investment Outlook for December 2006 by Bill Gross entitled “Reality Check.” Gross talks about a new derivative credit product retailed to institutional buyers under the sticker known as a CPDO or “constant proportion debt obligation.” It is a very interesting conversation, so let’s tune in:

“Things are seldom what they seem, Skim milk masquerades as cream.
— Gilbert and Sullivan, H.M.S. Pinafore…

“I write today not to expound on the cyclical economic outlook nor to unnecessarily repeat observations of prior Investment Outlooks conceding that risk spreads are compressed and potential alpha generation likely ‘anemic’…What I would like to speak to now is the current pricing (overpricing) of certain risk assets even under the idyllic conditions of continued Fed transparency and globalization and all of the other components which may have seemingly produced cream out of skim milk…Volatility and growth rate assumptions dominate risk asset prices, as do presumption of future real interest rates, liquidity, etc. The list of variables, if not endless, is certainly long and therefore more and more subjective the further one ventures out on the pricing limb. I, and I’m sure you as well, am always amazed at the pundits who claim that certain just-released information is already ‘priced in’ to the markets. How do they know and who did they ask?…But there are certain points in more definable, less ‘BS-able’ asset markets that approach certainty if only because they are more mathematically based. When the Fed cut interest rates to 1% in June of 2003, I could guarantee you that they could only cut them 100 basis points more. When 10-year yields on Japanese JGBs hit 0.35% at the same time, I could almost guarantee you that their incredible bull market run was coming to an end. Nasdaq 5,000? Easy in retrospect, but harder at the time, if only because the mathematics of value were being biased by the phantasms of hope. The floor was 5,000 points below, but the ceiling somewhere in the wild blue yonder.

“Because the bond market is more mathematically oriented than riskier asset markets, it stands to reason that a quest for certainty and reality in financial markets would begin there. Fed funds at 1%, JGBs at 0.35%, and ?. Where is the present-day counterpart where one could claim that prices could go no higher or risk spreads compress no further? We are beginning to find such evidence in the investment-grade corporate bond market, the narrowing spreads of which are displayed in Chart 1.


“While a rather obvious 25 or 35 basis points to 0 analogy could quickly be advanced here, a finer, more precise analysis emanates from the quantitative dissection of a new derivative credit product retailed to institutional buyers under the sticker known as a CPDO or ‘constant proportion debt obligation.’ Without too much explanation, these multibillion-dollar instruments lever investment grade indexes up to 15 times the amount invested and offer or have offered a spread of 200 basis points over LIBOR with a AAA rating. Hard to pass up, I suppose, recognizing that AAA securities are by definition blue chip with rare, only infinitesimally small annual default rates. But this AAA rating is subject to numerous (more numerous than usual) subjective assumptions on the part of the rating services and in turn vulnerable to quicker downgrades than your normal AAA GE credit rating (there GE, I’ve paid you back). My purpose in bringing up the CPDO, however, is not to denigrate the rating sources or to praise GE, but to state that under PIMCO quantitative modeling, current investment grade CDX spreads, shown in Chart 1, can only narrow by 3 or 4 more basis points before these CPDO instruments can no longer earn a AAA rating or offer such an attractive 200 basis point spread. More importantly, increasing multiples of leverage beyond 15 times near current yields spreads cannot maintain either a AAA rating and/or the 200 basis points in yield spread that have made this derivative so attractive and in turn helped to reinforce a declining trend in all credit spreads over the past few months. The increasing use of leverage, in other words, at least as applied to this particular area, appears to have run out of its magical ability to increase returns. Investment-grade corporate spreads, therefore, are not likely to narrow further. The perceived fat content in this supposed AAA ‘cream’ is as high as it’s going to get, and skim milk may eventually be the reality.”

Summary of Key Observations:

  • CPDOs have reinforced a declining trend in all credit spreads
  • Increasing leverage “appears to have run out of its magical ability to increase returns”
  • “Volatility and growth rate assumptions dominate risk asset prices, as do presumption of future real interest rates, liquidity, etc.” Those assumptions just may not be correctly “priced in”
  • We are much closer to the floor than the ceiling when it comes to corporate spreads
  • “Investment-grade corporate spreads, therefore, are not likely to narrow further”
  • The ability to lever any or all asset returns via increasing leverage is reaching a climax.

Gross goes on to say, “No gloom and doom message here” (refer to the article for context), but I think the implications are obvious and can hardly mean anything but doom and gloom when this mess starts to unwind. I encourage everyone to read the entire article.

Default Insurance

John Rubino on DollarCollapse asserts, “Everyone Is Writing Default Insurance!”:

  • “The stocks that make up Bearing’s Credit Bubble Index (banks, brokers, homebuilders) didn’t miss a beat when tech crashed in 2000; they kept on rising and have now, despite the homebuilders’ recent weakness, hit levels comparable to the Nasdaq before its crash
  • Subprime lending has driven the latest stage of the credit bubble, which puts it on very shaky ground, indeed. From Bearing: ‘32.6% of new mortgages and home-equity loans in 2005 were interest only, up from 0.6% in 2000; 43% of first-time home buyers in 2005 put no money down; 15.2% of 2005 buyers owe at least 10% more than their home is worth (negative equity); 10% of all homeowners with mortgages have no equity in their homes (zero equity); $2.7 trillion in loans will adjust to higher rates in 2006 and 2007’
  • Instead of a single isolated bubble, there has been a series of rolling bubbles, with new ones forming to replace those that burst. Each, in other words, is part of one mega-bubble that’s fueled by an ongoing flood of new dollars.”

Click on this link to see some interesting charts with thanks to John Rubino and Bearing Asset Management. Even as some components of subprime lending are now blowing up, expanded leverage in CPDOs was ready and waiting in the wings. One can only wonder, “What the BLEEP is next?”

Fannie Mae & Freddie Mac

I find it interesting that the “Treasury Drops Demand That Fannie, Freddie Cut Their Portfolios”:

“Dec. 1 (Bloomberg) — The U.S. Treasury is no longer demanding that Fannie Mae and Freddie Mac reduce their combined $1.4 trillion mortgage portfolios as part of legislation creating a new regulator for the government-chartered companies, according to a document the Treasury gave to Democrats in Congress…

“Treasury officials in July backed legislation that passed the Senate Banking Committee requiring a new regulator to cut the mortgage assets, rather than just giving it authority to do so.

“Fannie Mae says such constraints could reduce its portfolio to less than $100 billion, from $720.9 billion. The bill hasn’t moved to a Senate vote, because of opposition from Democrats.”

Inquiring minds are probably wondering what happened to that systemic risk at Fannie Mae that the Fed and the Treasury department had both been harping about for several years now. Bear in mind that Fannie Mae also has a derivative mess so big that it still has not filed is annual report for 2004 or any quarterly reports since then.

Forbes talked about the filing problems of Fannie Mae on Nov. 8, 2006:

“Fannie Mae said it determined financial statements from January 2001 through the second quarter of 2004 should no longer be relied upon, due to issues with accounting practices and material weaknesses in internal controls over financial reporting.

“The company plans to restate earnings for fiscal years 2002 and 2003, as well as the first and second quarters of 2004.

“The company plans to file restatements, its quarterly report, and annual report for 2004 by the end of this year. In the meantime, because of the late filing, Fannie Mae will need to request extensions from the NYSE in order for its shares to remain listed on the exchange.”

Let’s review the testimony of Secretary John W. Snow on proposals for housing GSE reform before the U.S. House Financial Services Committee:

“In order to protect against the systemic risks posed by the GSEs’ mortgage investment business, the administration recommends that limitations be placed on the size of the GSEs’ retained mortgage investment portfolios. An appropriate phase-in period for the reduction of the existing portfolios would be needed so as not to disrupt mortgage or financial markets.”

In addition to Snow’s testimony, various Fed members have also talked about systemic risk at Fannie Mae numerous times. Am I the only one who finds it odd that the Fed is no longer concerned about the systemic risk at Fannie Mae or the derivative mess it is in, even though Fannie Mae has not filed a quarterly report since 2004? Did systemic risk vanish overnight? Or is the Fed now more fearful of the housing implosion than the systemic risk it was previously worried about? If Bernanke sends me an e-mail answering those questions, I will be more than happy to post it.

Harvesting Currencies

I am wondering how long it takes before this “harvesting operation” blows sky-high.

PowerShares DB G10 Currency Harvest Fund Description: Seeks to track the Deutsche Bank G10 Currency Future Harvest Index by (1) entering into long futures contracts on the three G10 currencies associated with the highest interest rates, (2) entering into short futures contracts on the three G10 currencies associated with the lowest interest rates, and (3) collateralizing the futures contracts with United States 3-month Treasury bills.”

Derivatives Trading

Bloomberg is reporting, “Derivatives Trading Soars to $370 Trillion”:

“Nov. 17 — The use of derivatives grew at the fastest pace in eight years during the first half of 2006, boosting earnings at securities firms and reducing costs for investors.

“The face value of derivatives based on corporate bonds, currencies, interest rates, commodities, and stocks jumped 24%, to $370 trillion, according to the Bank for International Settlements. It was the biggest percentage rise since the bank began keeping records in 1998.

“Trading in credit-default swaps, the fastest-growing derivatives market, helped spur record earnings for banks, including New York-based Morgan Stanley and Goldman Sachs Group Inc. At London-based Barclays Capital, derivatives accounted for more than 60% of revenue and profit, Chief Executive Officer Bob Diamond said in May.

“‘The pace of growth is going to have continued unabated in the second half of the year,’ said Kit Juckes, head of fixed-income research in London at Royal Bank of Scotland Group Plc.

“The amount of outstanding credit-default swap contracts jumped to $20.3 trillion, from $13.9 trillion at the end of last year, the Basel, Switzerland-based bank said on its Web site today. The securities are financial instruments based on bonds and loans that are used to bet on an increase or decrease in indebtedness…

“Alan Greenspan, the former chairman of the Federal Reserve, has been saying since 2002 that derivatives reduce risks by making financial markets resilient to shocks. In May, he told a Bond Market Association gathering in New York that derivatives are the most significant change on Wall Street ‘in decades.'”

Modern Financial Wizardry

In other news, a spokesman claiming to represent Greenspan reported that the entire risk of all derivatives trading to date has now officially been offloaded to Mars. A Martian spokesman verified that claim and went on to state that Martian risk has been offloaded to France. France in turn claims to have offloaded the risk to the MMMM corporation better known as Madame Merriweather’s Mudhut Malaysia, the ultimate guarantor of $370 trillion in derivatives.

Leverage on the trade has not yet been calculated, but Madame Tandalayo Merriweather of Kuala Lumpur has e-mailed me personally, stating, “Don’t worry, my Mudhut is priceless.” The key point here is the priceless nature of the Malaysia Mudhut, which is a good thing given that it has taken two years and counting to straighten out the derivatives mess at Fannie Mae alone. In a miracle of modern financial wizardry, no one, it seems, has any risk associated with these derivatives, given they are all backed by something priceless. This is exactly as Greenspan envisioned.


It is staggering the amount of credit that is sloshing around on totally unproductive activities. As proof, I offer “Citadel Trading Costs Hit $5.5 Billion”:

“The importance to Wall Street of a handful of large hedge funds was starkly illustrated by the disclosure that Citadel Investment Group paid more than $5.5 billion in interest, fees, and other investment costs last year.

“Although the net asset value of Citadel’s two funds is only about $13 billion, its costs are high because its managers trade frequently and take on huge leverage…

“Citadel is raising $2 billion in a debt issue managed by Lehman Brothers and Goldman Sachs. Fortress Investment Group, which has $26 billion in hedge fund and private equity assets, last month filed for an initial public offering that is expected to value it at about $7.5 billion.

“But the banks are expected to fight hard to retain hedge fund business. Sylvie Durham, a lawyer at Greenberg, Traurig who represents hedge funds, said: ‘They will cut spreads on deals and loosen restrictions they have on how money they lend can be used.'”

Banks “will cut spreads on deals and loosen restrictions they have on how money they lend can be used” in order to retain business. Well, isn’t that special?

GDP vs. M3

Credit is soaring in every which way, but none of it is benefiting the real economy. One can look at the plunging GDP and increasing inventories as proof. No additional production capacity has been added by any of this financial activity, and none is needed anywhere in anything anyway, as I pointed out in “Bernanke’s Box.” Thus, we have finally reached the point at which all credit expansion is now nothing but pure speculation. This is an extremely dangerous limbo of sorts, in which monetary policy is actually restrictive on real-world productive activities, and also restrictive on individuals overleveraged in debt, but nowhere near restrictive enough (for the time being) to stop further speculation by financial wizards seeking profit. See “An E-mail From Bernanke” for the problems facing Bernanke.

Let’s now return to floors and ceilings for a bit:


  • Credit standards
  • Corporate spreads
  • Volatility
  • Interest rates.

Interest rates are closer to the floor than the ceiling, but still are quite far above where they are in Japan. One difference now is the fact that the U.S. dollar index was at 120 when the Fed started its last slash-and-burn operation, but is now sitting at 82.5.


  • Leverage
  • Risk-taking
  • Bullishness
  • Housing starts
  • Housing permits
  • Credit default swaps
  • Derivatives in general.

As Bill Gross points out, it is easier to estimate the bottom than the top, but if credit standards and credit spreads are at the bottom, it is likely to imply the top is near at hand on all kinds of things. The top is clearly in on housing starts and housing permits, and in spite of a significant plunge in both, they remain much closer to the ceiling than the floor on a historical basis.

It has been amazing, to say the least, to see the progression that has taken place. Anything and everything was done to keep the credit bubble expanding.

Credit Bubble Expansion History

  1. In the wake of a dot-com bust that Greenspan refused to let play out, interest rates were slashed to 1%
  2. Low rates fueled massive overinvestment in housing
  3. The Fed started hiking
  4. To keep the housing bubble going, credit lending standards dropped with each rate hike
  5. Housing prices soared and pay-option ARMs and other products were invented to keep housing affordable
  6. Stock funds resorted to selling options to “gain income”
  7. Speculation in credit default swaps soared
  8. With each rate hike in the U.S., the carry trade in yen became more and more attractive. Speculation in various carry trades soared
  9. Carry trade speculation compressed yields across the board in all kinds of things
  10. The housing bubble eventually burst due to pure exhaustion, but CPDO speculation came to the forefront to keep things humming. This further suppressed credit spreads
  11. Hedge funds unhappy with gains on CPDOs resorted to increased leverage
  12. Derivatives trading soared to $370 trillion
  13. Running out of room on CPDOs, money started pouring into leveraged buyouts
  14. End of the line?

Leveraged Buyouts

Leveraged buyouts appear to be the latest toy for the speculative crowd. Leveraged buyouts are not a new concept. Can this rehash be the end of the line?

The Atlanta Business Chronicle is reporting, “Texas Pacific Eyeing Home Depot”:

“According to a New York Post report Thursday, Fort Worth, Texas-based Texas Pacific and New York-based Kohlberg Kravis Roberts & Co. are among the buyout firms considering a buyout deal that could be worth $100 billion…

“The buyout, if it occurs, would be the largest leveraged buyout in history, according to the news reports.”

On Friday, Dec. 1, John Succo, one of my favorite Minyanville professors, wrote about The H boys…

“Home Depot (HD) is up over a dollar preopen on LBO rumors. My firm’s thoughts are that an LBO for HD (or any retailer) makes little financial sense. Most of these rumored and actual transactions these days are making little sense, but companies like this, it is especially the case. The only positive factor going for such a deal is that HD has virtually no debt. But it has little in the way of hard assets and thin margins, which makes an LBO very dangerous.

“But crazier things have happened. After all, that delevering by companies in 2002 they are now all in a rush to relever. Lessons not learned.

“If the U.S.’s new Treasury secretary wants to worry about financial meltdowns as a function of risk-taking by hedge funds, he needs to call up Mr. Bernanke and talk about the real source of risk: super-easy money finding its way into pure speculation. Today’s LBO funds are a form of hyperspeculation, as they are forcing too much risk into the system.”

Although $100 billion is clearly not what it used to be, the proposed leveraged buyout of Home Depot is still the largest in history. Can this be the proverbial camel that breaks the straw’s back?

Mike Shedlock ~ “Mish”
December 4, 2006