Market-Made Shock Waves
Look up, dear reader. There, over The Daily Reckoning headquarters in London – in the building with the golden balls on the roof – is our Crash Alert flag…flying proudly.
Why bother? The stock market looks healthy. The problem in the housing market is “contained” in the subprime sector. And M3 is growing at 13% per annum – the fastest rate in 30 years. With all that new money coming into the system, how can prices do anything other than float higher?
But the risk of loss is always at its highest on the precise moment that most people judge it of least concern. Most likely, there will be no crash tomorrow…nor the day after. But there are some things you are better off preparing for, even though they may not happen for a while.
When money and credit are free and easy, people become free and easy with them. They begin spending more than they should…and investing recklessly. Eventually, there is a shock…a tipping point…a moment of desperate reality, in which people feel the ground give way beneath their feet. They look down and panic.
What kind of a shock? It could be almost anything. Sometimes it is a war…sometimes a bankruptcy…sometimes a market shock – such as a sudden increase in the price of oil…or the collapse of a stock market. Then investors, as if they shared a single mind, begin to worry not about the return ON their money; they are concerned about the return OF their money.
What could cause a shock today? Any number of things.
1) The Chinese stock market is getting hit hard. Its CSI 300 Index is down 17% in the last three weeks. Brokerage account openings have dropped by two-thirds. Could global hot money…and local cold cash…turn bearish on Chinese shares? Could Chinese officials say something particularly stupid? Could the market fall another 20%…50%? Could this trigger a worldwide equity sell-off? Yes to all those questions.
2) The dollar is in trouble. On Wednesday, it hit its lowest level against the pound (GBP) in 26-years. It is now near its lowest level ever against the euro (EUR). Trillions worth of dollars now sit in foreign vaults – while reserve managers openly talk of diversifying away from greenbacks. Foreigners don’t have to abandon the dollar en masse to knock it down…all they have to do is to let up on their purchases of dollar-denominated assets – such as U.S. Treasuries. Could it happen? Could the shock cause a crash in major financial markets? Why…yes…again.
3) All paper currencies are dangerous. The dollar is not the only paper currency in the world whose supply is growing rapidly. Practically every central bank is printing up its own money in vast quantities – trying to keep up with the U.S. brand. This is why the world has so much “liquidity.” It’s why so many assets are rising in price so steeply. But could investors suddenly become fearful of so much monetary inflation? Could consumer prices shoot up…as asset prices already have? Could the world’s people want to get rid of their paper currencies in favor of other stores of value – notably gold, as The Wall Street Journal warns in an article entitled “Money Meltdown”? And could this lead to a worldwide crash? Yes…yes…yes.
4) A Milan-based bank, Italease, has just seen its derivative portfolio blow up. So has Bear Stearns (NYSE:BSC). Large lenders are getting skittish of complex debt instruments…just as more deals than ever before come to market. So far this year $1 trillion in deals have been done in the North America – a rate of deal-making nearly 50% higher than the year before. What happens if the wheeler-dealers don’t find the credit they’re looking for? What would investors think if even one of these mega-deals blew up badly?
Reports Bloomberg: “The world’s biggest bondholders have had their fill of leveraged buyouts…
“TIAA-CREF, which oversees $414 billion in retirement funds for teachers and college professors, is boycotting some debt offerings used to finance LBOs. Fidelity International, a unit of the world’s largest mutual fund company, and Lehman Brothers Asset Management LLC, the money-management arm of the third- biggest bond underwriter, say they’re avoiding debt from buyouts.
“You cannot do fundamental analysis and believe that those are creditworthy companies,” says an analyst.
“More securities than ever have the lowest rankings, with CCC ratings assigned to 26.5 percent of the new debt, according to New York-based Fitch Ratings. That compares with 15 percent in 2006 for debt that Fitch says has a ‘high default risk.’
“Traders demand 3 percentage points in extra interest to own U.S. junk bonds rather than government debt, compared with a record low of 2.41 percentage points on June 5, Merrill Lynch & Co. index data show. That’s the fastest increase in spreads since April 2005, just before General Motors Corp. and Ford Motor Co. lost their investment-grade credit ratings.”
Meanwhile, the Bank of England raised its key interest rate on Thursday by twenty five basis points to 5.75 percent – another six-year high. This is the fifth time this year. The ECB’s Trichet held steady this month but hints that rates will go up in the future. Elsewhere, banks are likely to hike rates too. And watch out if the Chinese decide to do some serious tightening.
Could there be even bigger blow ups waiting to happen? And could they cause a stampede for the exits? Anthony Bolton, Britain’s most successful fund manager, worries about it. So does the Bank of International Settlements. And so do central bankers in Madrid, London and who knows where else. And if the pros stop lending so freely, mightn’t it trigger a credit crunch…and a crash? Why, yes…now that you mention it.
5) The great millstone of housing debt continues to grind America’s middle and lower classes.
The LA TIMES: “Slow job growth and declining home prices are causing financial problems for more Americans, who are falling behind on consumer debt, including home equity loans, at the highest rate since 2001, the American Bankers Assn. said Tuesday.
“Credit counselors said consumers were paying the price for reckless attitudes about debt fostered by years of easy credit, particularly in the mortgage market.
“‘It’s a monster we all created,’ said Todd Emerson, president of Springboard, a nonprofit consumer credit management organization in Riverside.”
Let’s see, Chinese companies depend on consumer buying from America…which depends on U.S. consumer spending…which depends on consumer credit…which depends on mortgage lending…which depends on a secondary market in mortgage backed securities…which depends on rising housing prices! But housing prices aren’t rising; they’re falling.
Could housing prices go lower? Could lower housing prices cause consumers to stop spending so much? It seems so. The sale of light motor vehicles in the United States dropped 3.4% month-to-month in June to a seasonally adjusted rate of 15.6 million units, according to Northern Trust’s Paul Kasriel. A number of retailers have lowered sales guidance as buyers tighten their belts.
Could an attack of consumer thrift one day swarm over financial markets like Japanese bombers over Pearl Harbor? Your guess is as good as ours, dear reader.
Will there be a crash on Wall Street today? Will the Chinese economic bubble find its pin? Probably not quite yet. But we will keep our eyes open anyway…and keep our ear to the ground for you.
So the great debate continues… shall we carry on as we have been, waving our Crash Alert flag…or are we ‘full of malarkey’? Decide for yourself: join Agora Financial’s best and brightest for a crash course in global investing at this year’s Investment Symposium in beautiful Vancouver. The Symposium will be our biggest ever, and we think you’ll be pleased with the special guests and events that we have up our sleeve. Click here for all the details – and hurry…this event is sure to sell out.
The Daily Reckoning
Thursday, July 2007
Addison Wiggin, reporting from Baltimore…
“Now that CDO funds like Bear Stearns’ infamous duo are washing up D.O.A., commercial banks and institutional buyers are taking deals off the table. A $1.15 billion bond offering to fund a buyout of ServiceMaster Co. was cancelled yesterday. And last week, the $3.6 billion meant to be raised for U.S. Foodservice was postponed. Another $540 million deal for Thompson Learning was pulled.
“And in yet another deal, underwriters for a buyout of Dollar General Corp were left holding $725 million in bonds after that deal was called off. They plan to liquidate the bonds in a separate public offering. Good luck.”
For more from Addison, and his trusty sidekick “Extreme” Ian, see today’s issue of The 5 Min. Forecast
And more thoughts:
*** Henry went off to Cambridge University yesterday. It was Open House at Cambridge’s many colleges yesterday, and Henry, almost 17, is considering his options.
“What did you think?” we asked when he returned.
“Well, they look pretty nice. They’re better looking than those places I saw in Boston (MIT, Boston University). And it looks like it would fun to go there. But I don’t know if I could get in. And besides, they make you choose your major right away. I don’t know if I’m ready. I think I want to study medicine…but I’m not sure. It might be better to go to the U.S.”
Henry’s mother, on the other hand, loved the place.
“It was so beautiful,” said Elizabeth. “The colleges have beautiful gardens…with magnificent trees. I saw the biggest plane tree I have ever seen. The buildings are gorgeous. Even the dining halls have beautiful paintings on the ceilings. And the colleges are saturated with history. You walk along and you step on these worn stones…and you realize that Charles Darwin walked on those same stones…I would have loved to go to Cambridge. And I hope Henry goes there…because I think he’d love it too…and we can go to visit from time to time.”
*** Last night we were standing in line with a group of well-dressed men and women while a light rain fell…when a grumpy fellow got out of a cab. About 70 years old, with a familiar-looking rosy face and abundant white hair, he went up to the doorman:
“What’s the meaning of this…making us all wait out in the rain like this?”
“I have my orders,” replied the bouncer. “I let people in when they tell me to let people in…”
It is a little odd to have professional bouncers at the door of a magazine’s annual cocktail reception, but this was The Spectator. And its champagne garden party is a crowded, stylish affair – tout London attends, including leading political, literary and intellectual figures.
The red-faced man then butted in line ahead of us…and tried to push his way past the bouncer, with another man in tow. He flashed his invitation…then we realized that the boor in front of us was Paul Johnson, whose works of history we greatly admire. Too bad he has no sense of courtesy or gallantry. We can forgive stupidity and even vanity. But there is no excuse for bad manners.
When finally we entered, we found the place packed. We had to push our way through the crowd in order to talk to friends at the far end of the garden.
“Wasn’t that the Prime Minister whose feet you just stepped on?” Elizabeth asked.
We turned around. And there we saw the face of Gordon Brown, not smiling.
“Pardon us,” we said…and continued on our way.
The Daily Reckoning PRESENTS: With the housing market in free fall, it is sometimes difficult to decipher exactly where everything began to go wrong. This week, Bill Bonner sifts through CDO’s, MBS’s, and falling asset prices to explain what is really happening. Read on…
BEAR’S MARKET BLUES
No nation should know what goes into its laws, its sausages or its CDO’s. Indeed, most of the time, the contents are of no interest to anyone. But once in a while, a little curiosity pays off. Here, we poke around in the innards of the mortgage derivatives market, just to see what we can find.
Collateralized Debt Obligations, CDO’s, and Mortgage-Backed Securities, MBS’s, are as much a mystery as andouille to the typical investor. But they might be of greater importance. For on top of these capital letters, associated swaps, synthetics and various elaborations delicately rests a derivative market of as much as $500 trillion in nominal value.
Readers who really want to know how these instruments work are advised to consult a financial engineer who knows what he is talking about. What we have learned about them is little more than hearsay and conjecture. Not admissible in court, it nevertheless tells a remarkable tale.
Down on the sultry bayous of Louisiana or out on the windy prairies of Nebraska, homeowners are feeling the pinch of a peaked-out housing market. Prices are falling. Sales are slow. And many householders have seen their adjustable rate mortgage payments ratcheted upwards massively. Local sheriffs are said to be working overtime, padlocking houses whose owners can no longer afford to pay for them. As foreclosures rise, so does the inventory of unsold, unloved, uncared-for houses. Occasionally, one is auctioned off on the courthouse steps. That is when Mr. Market speaks clearly…and when we find out what it is really worth – often, as little as 50 cents on the dollar.
America’s subprime market includes approximately six million abodes mortgaged to nearly 100% of their value. When these houses begin to sell at big discounts, the whole mortgage industry – from the Bayou’s Best Mortgage Deals to Wall Street’s Enhanced Leverage CDO Funds – begins to stink.
Usually, a local mortgage lender gets rid of his mortgages as soon as he is able. He makes money by writing mortgages, not by holding them. So he sells them on and uses the proceeds to write more of them. The buyers of these mortgages, usually large investment banks, package them into mortgage-backed securities. These are divided into tranches, based on credit quality, and sold to other institutional investors as collateralized debt obligations. The best tranches are easily marketed to solid investors – pension and insurance funds, for example. Less credit-worthy parts – Wall Street’s equivalent of double-wide trailers and paycheck lenders – pose a problem. They are not as safe, and not as easily swallowed by the financial industry. A little extra grease is needed to get them down.
Often, a big financial house will create its own hedge funds, specifically for the purpose of digesting risky tranches of mortgage debt. The hedge fund raises some capital…and then typically borrows additional money in order to leverage its returns. One of Bear Stearn’s funds, for example – the High-Grade Structured Credit Strategies Enhanced Leverage Fund – borrowed nearly 20 times its investment capital, controlling $12 billion worth of mortgage assets with just $699 million in actual cash.
Anyone who would lend money to something called the High-Grade Structured Credit Strategies Enhanced Leverage Fund deserves the indigestion he gets. But given the huge size and ubiquitous grasp of the derivatives market, it could be that even the rest of us will soon get a taste of it. The whole worldwide boom depends on low lending rates. And lending rates are low because so many people are so eager to lend in so many different ways – with much of the lending stuffed in the derivatives market like corn down a goose’s gullet. When Merrill Lynch lends to Bear’s hedge funds, it enables the funds to buy Bear’s portfolio of slippery mortgage loans, which permits Bear to buy more subprime loans from sweaty mortgage lenders, who in turn, now have more money to spread all over the levees and plains.
Each link in the food chain has its own delusions. Bear Stearns has merely brought them to light. When its Enhanced Leverage hedge fund lost 23% of its value from January to April of this year, creditors started eyeing the furniture, wondering what they could haul off and what they could get for it. Then, when they saw what houses were going for when they put them on the auction block, they panicked. Creditors, notably Merrill Lynch, wanted their money in the worst possible way, but it simply wasn’t there. The Financial Times reported this week that when vulture funds began to bid on the Bear’s holdings the highest bid was only five cents per dollar of face value. Meanwhile, investors in the funds were offering their positions at 11 cents on the dollar – with no takers.
“That is the big ugly secret of this market,” said a hedge fund manager quoted in the FT, the market clearing price is far below the price people are willing to accept.
Whether you are a desperate homeowner…or a desperate hedge fund…when you are in a jam, the price of your assets usually goes down fast. At least with a house, potential buyers can drive by before the auction and see what they are getting. Every house has some value; buyers can even imagine living in them. The value of the High-Grade Structured Credit Strategies Enhanced Leverage portfolio, on the other hand, may be zero. You can list the ingredients in these wieners on the side of the package or report them on a 10-Q form, but what they were worth is anyone’s guess. And Bear Stearns didn’t want to guess at all. In an open auction, Wall Street would discover what they were really worth. But that is exactly what Wall Street doesn’t want to know. At least, not now. Bear Stearns is not the only outfit with billions invested in these hot dogs. None of the big investment houses want to discover that their assets and their collateral are worth a lot less than they thought. So there will be no auction. The mess will be cleaned up in private. Mr. Market will have to hold his tongue.
Complex derivatives have been one of the biggest hits of 21st century finance. The math geniuses who create them probably won’t get Oscars or their names on any public monuments, but they deserve some recognition. They didn’t merely package gristly lumps of dodgy loans. Their great breakthrough was to separate the mortgage income stream from the risk of loss. A “credit default swap” – CDS – is, in effect, an insurance plan. Holders of CDO’s can off-load their risk to a third party, paying a premium, just as though it were an insurance policy. So, with the risks supposedly controlled, the way was cleared to sell some of the foulest securities as if they were Treasury debt. Spreads narrowed, because the danger had been swapped out of the risky credits – at least, in theory.
Then, the quants at Goldman, Bear, and elsewhere, went a step further. They took the stream of insurance income itself – the swap payments – and created yet another derivative – a “synthetic CDO.” Those are sold to hedge funds too. And now we have a whole alphabet of derivative sausages…all cross-insured, counter-partied, tranched and retranched…spliced and diced…and all desperately counting on some Cajun yahoo down on the bayou to pay more for his house than it is really worth.
What are all these mortgage-backed securities really worth? We don’t know. We doubt anyone knows. The whiz kids on Wall Street have their formulae. But we want to hear what Mr. Market says when he finally gets to speak.
The Daily Reckoning
July 6, 2007
Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).
In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is – an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt at a discount – just click on the link below: