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Forex Blog - Leverage Is an 8 Letter WordLeverage Is an 8 Letter Word
November 21, 2008
|Leverage Is an 8 Letter Word|
|If Loans Are So Cheap, Why Don't They Sell?|
|Deflation and Helicopters: Time for a Review|
|Commercial Property Loans Start to Haunt the Banks|
|Warren Makes a Bet|
|Thanksgiving, Moving, and New Orleans|
Leverage is an eight-letter word, which the markets now regard as twice as bad as the two four-letter words debt and pain
(or fill in your own four-letter words). This week I try to give some
insight into what is happening in the credit markets, some of it below
the radar screen of most analysts. We will look at the potential for
deflation and the Fed's response. There is a lot to cover, so let's
jump right in.
If Loans Are So Cheap, Why Don't They Sell?
talked with a friend who runs a collateralized loan obligation fund, or
CLO. There are a lot of these funds in the Shadow Banking System.
Typically they buy certain types of debt, with a lot of it in the bank
loan space. In the "old" days of the last few years, banks would make
loans to corporations and then sell them to CLOs and other
institutions, making a spread on the loan and a profit on the servicing
business. Some funds would typically leverage up somewhat and make a
Today, many highly rated loans are selling for 80
cents on the dollar. There is nothing wrong with the collateral or the
corporation which owes the money; there is just no one with ready cash
to buy the loans. I asked my friend why he doesn't buy them, since they
offer very good returns.
The problem is that his fund, and most
other CLOs, have covenants in their offering documents that prevent
them from buying debt at less than 85 cents on the dollar. That
covenant is a good thing in normal markets, as it prevents possible
mischief by the manager, but right now it means that a lot of
opportunity is being missed. The only way he can buy these highly
undervalued bank loans is to create a new fund, which he is in the
process of doing. But getting the money is tough, as the pension funds
and endowments who would normally be the investors are waiting for cash
to come from their redemptions in other funds, which are of course
selling whatever they can to raise money for the redemptions, including
these very same bank loans. Can you say vicious circle?
news is that the market is (albeit slowly) responding to low prices and
a market for undervalued assets. But the bad news is that it could be
months before there will be meaningful recovery in asset prices. In the
meantime, these and many other assets are being marked down and
impairing the balance sheet of a lot of banks, funds, and institutions.
an aside, the prices for loans made for leverage buyouts in the last
few years have fallen significantly. Anybody want to buy some loans
made on the Chrysler sale to private equity fund Cerberus? I think not.
Just because a loan is cheap does not mean it is necessarily a
Commercial Property Loans Start to Haunt the Banks
I have written for a very long time, there are two aspects to the
current recession and financial crisis. The first is the fallout from
the subprime crisis, which has morphed into a full-blown credit crisis.
That coupled with a housing crisis has sent the nation into what looks
like it will be the worst recession since 1974.
The second phase
to hit banks and lending institutions is the normal recession problem
of increased losses on all sorts of loans. Credit cards, home equity
loans, residential mortgages, and especially commercial property
mortgages all suffer during a recession. As documented a few letters
ago, default rates are soaring on all types of consumer loans. That is
what you would expect to happen in a recession. The problem is that
many of the larger banks have already had their capital depleted
dealing with the credit crisis. Now they are going to have to raise
even more capital (or reduce lending) to deal with the normal loan
problems that come with a recession.
Let's look at a few charts from www.markit.com
which show the stress in commercial property lending. A number of very
large firms come together to create a market index for commercial
mortgage-backed securities, or CMBS (which is listed at market.com).
They put 25 different commercial property trusts, created by JPMorgan,
Merrill, UBS (the usual suspects), and so on into the index. Traders
can then trade on the market value of the underlying combined assets by
trading the index. In principle, this is just like trading a stock
index that gives you exposure to all the stocks included in the index.
you have bought commercial mortgages and want to hedge your portfolio,
you can do so with this index, or if you want to sell protection
(insurance) you can also do so. The price is determined by the spread
between the coupon and (I believe) the 10-year US Treasury bond. From
trading at a spread of 100 basis points in May and 200 basis points
(bps) in July, the spread on AAA-rated commercial mortgages skyrocketed
in the last few weeks to 850 before settling back to 667, or more than
six times what it was just a few months ago.
According to the Wall Street Journal,
at the peak a few days ago this meant that the AAA part of this index
was trading at $.70 on the dollar. That suggests there will be losses
of 70% on the lower tranches!
Every six months the 12 investment
banks that help create the index build a new index comprised of
recently created trusts composed of hundreds of individual mortgages.
As with most asset-backed paper, these trusts are divided into
different tranches, with the highest-rated tranche getting the lowest
return but first call on the return of principle and interest.
Lower-rated tranches take successively more risk.
There are seven
different indexes on the Markit platform, from AAA to lowly BB. Each
index is composed of the corresponding tranche in the 25 trusts within
the index. Let's look at what the lowest-rated tranche has done.
lowest tranche is now trading at 4,750 basis points or, if you add in
the Treasury price, at over 50%! If you were an institution or fund and
wanted to buy protection on a BB-rated CMBS in your portfolio, you
would have to be willing to pay 50% annual interest!
On the web
site, they note that they have not created a new series that was
planned for October 25th of this year, as there have not been enough
new commercial mortgages created to actually build an index. Why?
Because any commercial mortgages that the banks now make will have to
be kept on the books of those banks, since the price to securitize the
loans is prohibitive. Is it any wonder there has been a serious
reduction in large commercial property loans?
On a rather sad
note, look at the logos of the banks involved in creating this index,
from the marketing brochure that Markit uses to inform potential buyers
and sellers of the CMBS index:
banks were involved as of a few months ago, but now? Bear, Lehman,
Wachovia, and Merrill have either passed from this world or have been
swallowed up. It makes you wonder who is next. (Side bet: the Treasury
or Fed will inject some capital into Citibank this weekend.)
could do the same analysis on high-yield bonds. Interest on high-yield
bonds is now approaching 20%. Credit default swaps on many issues are
simply out of sight. That means that if a lower-rated company wanted to
issue bonds, they would have to pay 20% or more! There are very few
projects that can justify 20% in a low-inflation world. And without
access to capital, it will be difficult for businesses to grow. It also
means they have to cut costs and jobs. As noted above, even highly
rated corporate bonds are selling at steep discounts. Deleveraging is
going to be a problem for a few years. We need to get used to it.
Deflation and Helicopters: Time for a Review
wrote six years ago (November 2002) about Ben Bernanke's speech on
deflation, where he tried to make a joke about beating back deflation
by dropping money from helicopters. He was immediately tagged as
"Helicopter Ben." My thoughts on that speech took up about half of one
chapter in Bull's Eye Investing, and I still think it is a very important speech.
have been saying for a long time that we would be dealing with
deflation next year, and that has been met with a lot of reader
skepticism. And when inflation hit 5.6% last July, that skepticism was
understandable. But this would be a strange world indeed if you had the
twin bubbles of housing and credit burst and didn't see a whiff of
deflation. Recessions and the bursting of bubbles are by definition
And I have been giving thought to the idea that
we may have seen a mini-bubble in the price of many commodities, and
that bubble has been bursting as well. And since commodity prices were
the main cause of inflation, as they retreat the rise in the inflation
rate is retreating. This week the latest inflation numbers showed a
drop to 3.7% on a year-over-year basis.
But the Consumer Price
Index (CPI) fell by a full 1% in October. You have to go back to the
1930s to find a one-month drop as large. And I don't think this is just
a one-month anomaly caused by falling energy prices. The housing
component, which is 32% of the index, is based on Owners' Equivalent
Rents (OER). As I have written elsewhere, over very long periods of
time this works as well as actual housing prices. You simply have to
pick your basis for comparison and stick with it.
instance, we had been using house prices for the last ten years, we
would have seen large increases in inflation up until a year ago, and
since then the index would have been in outright (and serious)
deflation. But we use OER, so prices in the CPI have been more stable.
But that looks like it could be changing.
OER has been rising
steadily over the last decade as rents went up. The index showed a 3%
rise in 2007, for instance. The recent trend has been down from there,
and last month there was no rise in the cost of shelter. Given the
number of houses for sale and a weakened economy, I think it is likely
we will see outright reductions in the cost of rent, which will
translate into a much lower inflation number.
Lower prices are a
two-way street. When they result from improved productivity and
efficiency, that is considered to be a good thing. But when they are
the result of lower demand, that can be problematic.
There is the
likelihood that the Fed will lower rates to 50 basis points, and some
major and very seasoned economists are now predicting a zero percent
Fed funds rate early next year. Given that Fed funds are actually
trading at 38 basis points, a drop to 50 basis points would change
nothing on a practical level. (Can we say Japan?)
With that in
mind, let's revisit Bernanke's speech. Every central banker is mindful
of Japan and the 1930s in the US. Deflation is something that will not
be allowed. But what if the Fed lowers interest rates to zero and
demand does not pick up, along with a little inflation? Quoting Ben:
stimulate aggregate spending when short-term interest rates have
reached zero, the Fed must expand the scale of its asset purchases or,
possibly, expand the menu of assets that it buys. Alternatively, the
Fed could find other ways of injecting money into the system -- for
example, by making low-interest-rate loans to banks or cooperating with
the fiscal authorities. Each method of adding money to the economy has
advantages and drawbacks, both technical and economic. One important
concern in practice is that calibrating the economic effects of
nonstandard means of injecting money may be difficult, given our
relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it.
If we do fall into deflation, however, we can take comfort that the
logic of the printing press example must assert itself, and sufficient
injections of money will ultimately always reverse a deflation."
a thought here. We could see real drops in the CPI next year. We could
also see a US government deficit approach $1 trillion and go right on
through that heretofore unthinkable number. As I wrote last week, a
reduced trade deficit means that there will be fewer dollars abroad to
buy our debt. The difference will have to be made up by either
increased savings in the US or higher rates to attract buyers OR the Fed monetizing the debt.
think the Fed would be highly reluctant to monetize debt in a period of
inflation like we have been in, no matter what problems we face. But in
a period where we could be facing deflation? It is very possible they
would consider monetizing the debt, as will central banks all over the
We are in unprecedented times. A (1) deep recession
coupled with (2) financial institutions deleveraging, added to (3) a
consumer who is going to be forced to save more and spend less while
(4) commodity prices are falling, on top of (5) a serious slowdown in
the velocity of money, and you have the makings of a perfect
deflationary storm. The Fed would be forced to fight it.
would they do if lowering the Fed rate to zero was not enough? As
Bernanke stated, they would simply set the rates for 1- and 2-year
notes and further out the curve if they felt they needed to. And if
Goldman Sachs is right in its latest revised forecast, the economy is
going to need some help:
"Goldman said it now expects U.S. GDP to
fall 5 percent in the current quarter, with unemployment rate reaching
9 percent in the fourth quarter of 2009. It also forecast the 10-year
yield to fall to 2.75 percent by the end of the first quarter of 2009,
as compared to previously estimated 3.5 percent.
combination of weaker real activity and slower inflation means that
profits of U.S. companies will fall even more sharply than we had
previously expected,' Goldman said in a note to clients. Goldman now
sees economic profits falling 25 percent in 2009 on an annual average
basis, the biggest drop since 1938. It had earlier expected a fall of
20 percent. Goldman expects unemployment rates to further go up in 2010
as well, as there is little chance of the economy returning to trend
growth by that year."
Other mainstream economists think GDP might
fall this quarter by as much as 5%. That does not bode well for retails
sales this Christmas.
Warren Makes a Bet
And let's close on this note brought to my attention by Bill King.
"MSN Money's John Markman: Shares of Warren Buffett's insurance holding company are on the ropes this month, plunging 30% in part because the famed investor dabbled in an area of the market he has long publicly derided: derivatives. And due to a tangled web of financial relationships, they may be taking Goldman Sachs shares down with them.
Investors are concerned about a $37-billion bet that Buffett made last
year that U.S. and world equity values would be higher in 15 to 20
years than they were then, when the Dow Jones Industrials were trading
around 13,000. Through his firm, Berkshire Hathaway, Buffett sold
option contracts, known as "naked puts" to an undisclosed group of
investors for around $4.85 billion, reportedly using Goldman as
"Because of its solid-gold credit rating,
Berkshire Hathaway was not required to put up collateral to make this
trade. But now rumors are flying on Wall Street that the owners of the
contracts have demanded that broker Goldman Sachs put up collateral for
the rest of the amount due. Since the value of the trade could be
infinite, the collateral demands are said to be large, and fears that
Goldman will struggle to make good on its obligation has panicked
shareholders. Indeed one theory making the rounds this week is that Buffett put
$5 billion into Goldman at around $125 per share in September not as an
investment but to help provide funds for the collateral.
"Isn't this the oracle that called derivatives, 'financial weapons of mass destruction'?"
personally think that Warren made a very good bet. I would be shocked
if the Dow was not at 13,000 in 20 years. Inflation will do most of
that heavy lifting. But it does make for an interesting discussion now.
Thanksgiving, Moving, and New Orleans
has decreed that I am going with her to New Orleans in a month to spend
four days huddled away from the office, pouring over the research for
our new book Eavesdropping on Millionaires and getting started on the actual writing. Somehow, she thinks I will be distracted if I am in the office.
am looking forward to Thanksgiving next week. Most of my kids and some
of my family will be coming to my apartment. I will be cooking all
morning, preparing prime, lots of mushrooms and veggies, and more. I
really get into it when I get the chance. And a very thoughtful reader
has sent Tiffani and me some really great wines, which we will uncork.
this year we can avoid a fire in the building and having to carry my
91-year-old mother down 21 flights of stairs. And then the next day we
pack everything up and move a few miles away to a house that will
become my office a few weeks later. I am really quite excited about the
move, as I really do like the house and am really enamored of the
thought of a ten-second down-the-hall commute. Ask me in three years
how I like it.
Congratulations are in order to my assistant of
the last three years, Sommer Dooley, who has passed the exams for her
nursing degree. She will be leaving us soon. She has been a real help
the last few years and will be missed.
Next week I am going to
write a special letter on why I am optimistic that we will come through
this whole financial mess, but now it is time to hit the send button.
Have a great week and enjoy your family and Thanksgiving! I think it is
my favorite holiday.
Your thinking life is really pretty good analyst,
Copyright 2008 John Mauldin. All Rights Reserved
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