Ground Control to Major Tom

Your Circuit's Dead, There's Something Wrong!

The above advertisement was e-mailed to me this morning. When I read it, the immortal words of the great Yogi Berra sprang to mind,
“This is like déjà vu all over again!”

For starters, just read the left hand side of the advert slowly:

“Low Monthly Payments”
“4 out of 5 approved”
“No Up-Front Costs Or Obligation”
“Loans For Homeowners With Less Than Perfect Credit”

Pardon me, but did I miss something? Have I lost the plot? Does Countrywide not yet get it? Have they heard there's a wee crisis in the mortgage market, especially in sub-prime? Apparently not.

Unfortunately, it does not end with this advertisement. Countrywide, one of the main underwriters of the sub-prime crisis, rather than pleading mea culpa to the banks, the Fed and the market are busy trying to build their "dominance" of the sub-prime market even picking up sales people that are being let go by their failing competitors. In an internal memo released to the press on Monday, 20 August, they stated,

"Countrywide continues to recruit and hire sales professionals in its pursuit of profitable market share growth. The success of our strategy to expand our retail and wholesale market share relies heavily on our ability to recruit and retain talented people as they become available during the industry's consolidation."

But I suppose I should not be surprised given that the hand on the Countrywide tiller is that of CEO Angelo Mozilo whose ambition for continued growth knows no bounds.

You have to hand it to Mr. Mozilo (who, by the way, was recently ranked by Forbes as the 7th best compensated CEO in the US, 1st among all CEOs in the financial industry,"earning" $142 million in 2006 / $296 million over the last five years), for sheer audacia - that's Italian for chutzpah.

On the one hand he attacks industry's regulators, telling The America Banker yesterday that the Office of Federal Housing Enterprise Oversight are "endangering the safety & soundness of the mortgage market" because they have refused to raise the portfolio caps and conforming loan limits for Fannie Mae and Freddie Mac. He goes on to state,

"The mandate to the American people in creating both of these entities was to provide liquidity that the public sector could not and to cap them at a time when there's no liquidity in the private sector seriously impacts the people, the borrowers, who need them the most."

On the other hand, Mr. Mozilo has sold off (some would say "dumped") 15.5% of his shares of Countrywide - 85 million out of 545 million - in 2007, almost 60 million of which he sold between January and June. I guess his liquidity takes precedence over "the people, the borrowers, who need "him" the most."


But thanks to Mr. Mozilo I now understand the root cause of the crisis! The problem is not of Mr. Mozilo and Countrywide and their ilk's making, rather its the fault of the US Government for not opening the flood-gates and pouring more taxpayer money into the market thus allowing Mr. Mozilo to continue business as usual whilst gobbling up his competitors.

Mr. Mozilo actually started his offensive on "The Call Show" on CNBC on Thursday 23 August. He began his attack by going after Kenneth Bruce of Merril Lynch, not only for his sell recommendation but also his comment that were circumstances in credit markets to worsen sufficiently, Countrywide could face a cash crunch serious enough to make bankruptcy a possibility. Mr. Mozilo condemned him saying,

"the irresponsible behavior on part of that analyst from Merrill Lynch to yell fire in a very crowded theater in environment where you had panic already setting in the overall markets. It was totally irresponsible and baseless. And it, affected the lives of 61,000 people here at Countrywide our employees and more importantly, or as important, senior citizens who stood on-line (removing their deposits) frightened to death that Countrywide would go bankrupt and lose their money. "


Mr. Mozilo went on to decry the panic in the present market whilst engendering more himself:

"Panic has to go away. Confidence has to return to the market. What is driving this is form it's not real. A lot of what is driving this lack of confidence, this panic. This is, one of the greatest panics I’ve seen in 55 years financial services. And, so something has to be done to restore the confidence the market. If we turn that around. Most of that was driven by form not substance. But form has become substance. Fear has become real. What you have a two handle on one year t-bill, the other day, that means, all the liquidity is going into it. Bills. That's how panic this market is."

Not content with stirring an already roiling pot, Mr. Mozilo, when asked directly by Maria Bartiromo if he thought the housing crisis would lead the US into recession, decided to turn up the flame, stating,

"I still think so. I've not been proven wrong so far. I can't believe when you're having level of delinquencies; equity is gone; tide has gone out that this doesn't have material effect a on psyche of American people and eventually on their wallet."

Is this how a senior banker should behave when faced by the regulators refusal to act as he or she wishes - you throw the cat amongst the pigeons? You tell the world that the present housing crisis could lead to one unless the Feds do more to create liquidity in the mortgage market. In other words, when at fault blame the Government - hey it worked for Charlie Keating, almost.

I am not trying to demonize Mr Mozilo; he truly has had an Horatio Alger-like rise from the son of immigrants, the poor boy from the Bronx, whose great ambition was to make housing affordable for the average family - to help them be part of the "American Dream" of owning their own home. I grew up just a few blocks from him in similar circumstances and I know how my parents dreamed of owning their own home. I am sure that he was focused, throughout a good part of his career, on what he told The Graziadio Busines Report of Pepperdine University were the theree basic principles underlying Countrywide's success:

1. Improve technology to lower the cost of home financing.
2. Lower the barriers of entry for home-owners
3. Educate potential buyers to their rights & opportunities

These are all good intentions, noble aspirations; the problem is that somewhere along the way they got lost in the pursuit of market share and the bottom-line. Principle number two has been achieved by dropping the underwriting requirements below a sensible risk threshold and, as in the case of number three, has become driven, indeed overwhelmed, by the needs of their business model. Their model is simple, quickly issue mortgages then securitise them and flip mortgage-backs into the market. However, it's Achilles' heel is that without a steady stream of mortgages there is no growth in market share and in the bottom-line. Now the bottom-line is in jeopardy, as is the whole enterprise. So now he looks for the Feds to bail him out and allow him to re-float his game of "Find the Lady" ("Three card Monte" to my friends in the States, "Bonneteau" à mes amis français).

Rather than point fingers it would do the market, his customers - present, and future - good to hear Mr. Mozilo tell the truth and simply say,

"We screwed up. We lost sight of the downside and over-sold some mortgage products, especially those to people who are only marginally able to maintain themselves. We need to go back to basics and work to get things right."

Those would be the words of a true leader and visionary. One who can help to restore confidence, not only in his company and its products, but to a market and a nation in need of honesty and accountability. What do you say, Mr. Mozilo, will you rise to the occasion?

Cassandra

Diamond Is A Market's Best Friend

Bob Diamond, President of Barclays PLC and the visionary behind the creation and rise of Barclays Capital, gave an insightful interview in today's Financial Times "View From The Top." It was quintessentially Bob - controlled, concise and erudite. Cagey when he needed to be and direct when he wanted to be: a tour de force. Watch in on the FT website
http://publish.vx.roo.com/ftvideo/portal/viewfromthetop/

Mr. Diamond held forth on the intervention of the Fed in their cut last Friday of the discount rate and their widening of the collateral base for borrowing (the position we took in our post of last Friday “Chairman Bernanke Rises To The Occasion"):
“I think we have to give somewhat of a chance for the actions that were taken most recently to take hold. When one is looking for the positives, I think the connection between the European Central Bank and the Fed, I think the thoughtfulness with which they’ve implemented action, and I think particularly of Friday with the change to the discount rate. The Federal Reserve has two primary objectives. One is as a lender of last resort and the other is to regulate the economy, to be part of regulating the economy. I think, in the first role as lender of last resort, the actions were quite thoughtful. It addressed the types of collateral that can be used, it addressed the number of participants in the market that can access liquidity, it also addressed term versus just overnight funding.”

Mr. Diamond went on to repeat his call for more time when questioned on the issue of a further cut in the Federal Funds rate:
"I think fundamentally the issue that the Fed is dealing with right now, having already taken some thoughtful and concrete action, is really one of confidence. And I think if they believed that the right thing to do, to put a bolt of confidence into the markets, was to reduce rates, I think they would do that. I think it’s appropriate to see how this works for a while more. I think there are other things they can do besides cutting rates, and as I mentioned earlier, the other role of the Fed is a regulator of the economy, and they’re certainly concerned that in past experiences like this, certainly in 1998, the success of rate cuts boosted the economy beyond which I think they would have been happy. ….. I think 20/20 hindsight is easy and I think economic growth, post the crisis in the summer of 1998, was ahead of what the Fed would have thought with those rate cuts. This is not a credit crisis, this is a liquidity and a confidence crisis.

While I agree that the 1998 rate cuts did over-accelerate the economy, the issues faced in August/September 1998 were, whilst different in their cause (Russia v. sub-prime), very similar in their outcome – illiquidity causing panic and market “freezing” resulting, among other things in the failure of Long Term Capital Management which lost $4 billion in a similar “confidence crisis”. Having watched him as we lived through the 1998 meltdown, I do not believe that Mr. Diamond is ignoring this episode. Rather, in his present role, his job is to try to calm the markets and dampen the panic in the hopes of not adding another name to LTCM on the wall of the fallen.

Being the consummate professional, Mr. Diamond gave his view on Bear Stern by passing on giving his view on Bear Sterns, stating,
“I would never comment on a competitor in the market.”

Although he did respond to a re-phrased question on the issue that has plagued Bear Sterns, the liquidation of conduits, saying,
“The markets seemed to be showing some very, very, very early signs of being able to price some of these liquidations. So I think we need to give this a little bit of time before we try and make a conclusion.”

When queried on the role, if any, the rating agencies have played in the sub-prime problem (and, by extension, in the CDO problems), Mr. Diamond took the appropriate diplomatic stance,
“I wouldn’t want to make a comment there.”

I would not take that as comfort if I were Moody’s, S&P or Fitch but rather only be glad that he is circumspect and happy to leave their “shellacking” to the SEC/FRB/FSA/ECB et alia.

It was only on the subject of whether the LBO and Private Equity “boom” was over that Mr. Diamond allowed himself a bit more latitude and telegraphed, quite clearly the new reality in credit, stating
“We’ve had three or four or five years where the originators have had pricing power. And for the first time in four or five years, fixed-income investors have pricing power. And we’ve seen a real cracking of the liquidity bubble, we see fixed-income investors now with pricing power, and we’ve seen a slowdown on the market, which frankly, I think is quite healthy. It isn’t a question of which side of the market is winning or losing. We probably went too far in terms of covenants, we probably went too far in terms of leverage, we probably went too far in terms of pricing. Not by any major extreme, but the market was a bit out of balance and it’s moving back the other way now. … What I’m saying, is that the situation in leverage finance is very important to us because we’re one of the leaders in that business, and we’re thinking the October/November, November/December timeframe, that market will likely be back to more normalised levels, but it will be back to those levels at a different pricing."

As I said in my earlier posts this is the sign that I have been looking and hoping for – a major well-respected and highly thoughtful banker who heads a leading player has told the market that whilst they are open for business the terms have changed. This cannot be downplayed or naysayed; rather, it should be applauded. Mr. Bernancke last week, Mr. Diamond this week, should be lauded for their willingness to face the reality of what has occurred and not to flinch from talking about and taking decisive action.

Now Bob, if you would only get real about the Red Sox and Chelsea - please!!

Cassandra

"Don't Look Now But The Water Is Still Rising!"

On CNBC today, Secretary of the Treasury, Henry "Hank" Paulson stated, ”As the Fed addresses liquidity this makes it possible, this makes it easier, for the market to focus on risk and pricing risk. This will play out over time and liquidity will return to normal when the market has a better understanding, investors have a better understanding, of the risk-return trade off.”

As I live and breath, Risk AND Return in the same sentence coming from the lips of King Hank (I almost named this piece "The Return of Risk" .) What a change of heart! Less than one month ago, he stated, again on CNBC, "There has been a very significant housing correction. I think we're at or near the bottom there. I don't deny there's a problem with subprime mortgages, but I really do believe that's containable."

In fairness to Mr. Paulson, he went on in that interview to say, "When I came to Washington, one thing I knew we needed to focus on is how do we get ready for a financial shock? We weren't predicting a financial shock. I'm not predicting one, but they're not predictable. And it's been since 1998 since we've had a financial shock. So we need to be ready. And there have been a lot of changes in the markets since 1998. We're much more integrated into the global economy. Private pools of capital are playing a more important role. There is expanded use of financial derivatives. All of which, I think, have made the markets more efficient and more liquid. But again, the next time we have a financial shock, we'll be seeing how some of these things perform under stress for the first time. But again, I believe we fortunately have a very strong global economy and a very strong US economy."

Well, he was right, at least partially - "private pools of capital are playing a more important role" and "there is expanded use of financial derivatives" and "the next time we have a financial shock, we'll be seeing how some of these things perform under stress for the first time." The problem is he, like so many others, assumed that the growth in the global economy was the be all and all that would keep our boats afloat. Sadly, as he feels the water lapping at his feet, King Hank now is getting a painful lesson in the reality of models and markets.

I know some of my colleagues believe that I have gone off the deep end about models. Truly, I have not; I’ve made these same remarks for years. I have always believed that we need to strike a balance between the advanced analytical and diversification techniques that we have at our disposal and the common sense we have gained through experience. From tulips to “dot coms” to sub-prime and private equity junk, this need for balance has not altered. We forget, at our peril, that risk and reward are two sides of the same coin.

I think that among the greatest dangers we face in the markets is hubris, which my old adversary the Greeks saw as the one fatal flaw in the human condition – it was the sin of overbearing presumption and arrogance which they believed most deeply offended the gods. It is the classic flaw of the risk taker, who, revelling in the euphoria of a “win”, fails to judge where that “win” is leading. It perhaps would help us if we remembered that for those same Greeks euphoria was a feeling of great happiness or well-being commonly exaggerated and not necessarily well founded!

Cassandra

Chairman Bernanke Rises to the Occasion

On Friday, Federal Reserve Board Chairman Ben Bernanke took a courageous stand followed by by an equally resolute move. First, he acknowledged the real danger that exists to the markets due to sky-rocketing volatility (yesterday's post). He then took much needed action to shore up liquidity for more than just a day or two by lowering the discount rate 50 basis points as well as by easing banks' borrowing requirements at the Fed discount window.

C'est pas vrai, Monsieur Le Président Jean-Claude Trichet?

It should not be ignored that the Fed in its statement went out of its way to mention that they "will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets", thus giving banks, nervous about accepting sub-prime paper from the likes of Countrywide, an injection of intestinal fortitude to go along with the cash!

Chairman Bernanke weighed a doubt against a certainty - the risk of a short-term rise in inflation if he cut rates against a severe market downturn if he did not - and chose the right path.

Whilst I do not believe that this phase is over by a long shot - remember what a former Chancellor of the Exchequer, then Prime Minister, Mr.Winston Churchill said after the Battle of El Alamein, "Now, this is not the end. It is not even the beginning of the end, but it is, perhaps, the end of the beginning" - I do hope the Chairman's actions will have a calming effect. This could give the markets and their regulators the time they need to get their houses in order.

However, this one action alone will not be sufficient; we need to see, among other things, action on the issue of CDOs/CLOs - their "grading" as well as their marketing - and a return by lenders to sensible covenant structures and pricing of risk - KKR and others already are chomping at the bit to take advantage of the lower prices that the present market has delivered to them. It is imperative that the present excesses are curtailed or else we will see that Chairman Bernanke has only put off the day of reckoning.

The UK Government can give vital help by restructuring of the tax code to curtail the excessive "taper relief" non-loop-hole (it is, sad to say, the law) used by the Private Equity barons by lengthening their hold time from 2 years back to the 4 years it was before 2002 and increasing the tax rate from 10% to 20%. The other much needed reform is to grant tax relief to individual savers so as to boost the deplorable savings rate in the UK (this goes for the US, too).

These steps require Chancellor Alistair Darling to have the same strength and vision as Chairman Bernanke and strike a blow for stable growth rather than the "irrational exhuberance" we have lived with all too long. My plea is simple - Be Daring, Darling, Carpe Diem!

Cassandra


Federal Reserve Statements - Friday 17 August 2007

Policy Statement
Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

Federal Funds Rate Statement
To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 basis point reduction in the primary credit rate to 5-3/4 percent, to narrow the spread between the primary credit rate and the Federal Open Market Committee's target federal funds rate to 50 basis points. The Board is also announcing a change to the Reserve Banks' usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower. These changes will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding. The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. Existing collateral margins will be maintained. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York and San Francisco.

If You Wonder How To Define Volatility ...

DJIA - Thursday, 16 August 2007

It Can't Happen Here! Hmmm, Yes, Ah-Huh....

I received a great critique from my old associate - Odysseus - that deserves its own posting. Yes, I know he was the one who thought up the Horse but you have to admit it was a clever idea and if those stupid people had just listened to me ... but I digress.
My response follows his comments.

Greetings Cassandra,

A good first effort; I like your style - you make good use of humour and the "stats" bolster your arguments.

However, I believe that you have chosen to look only on the present weaknesses in the market not on its resilience or how it differs from markets of the past. Not every market downturn is destined to be the end of life as we know it!

My concern is that some of the counter arguments (which have some cogency) are not addressed or commented upon. Let me mention a few:

a) The mortgage position is very sensitive to timing. If I took out a mortgage prior to 2005 I am probably still ahead of the game although my new found wealth did turn out to be ephemeral. This is also true in the U.S. market where there is little evident distress in anything written prior to 2003.

b) The total amount of sub prime mortgage losses cannot ever reach even a fraction of the losses that were sustained in the dot com meltdown. The dot com losses in value ( peak to trough) were in excess of 10 times the loss estimates for the sub prime sector. The market shrugged those off in part because they were so widely distributed.

c) Mortgage defaults defy economics in that people seldom exercise their default option preferring to continue to make payments even when the debt exceeds the equity. Selling costs are substantial and people have to live somewhere.

d) With some limited exceptions, it has not been the banks that have fuelled the dumb mortgage market in the U.S. It is the Countrywides and other broker-like operations that have created this mess aided by the brokers that help them fund it with structured credit that was bought largely on trust of the ratings process. But that debt is almost 30% foreign owned and otherwise widely distributed.

e) I think there are a lot of unpleasant facts and you cite many of them. The Chinese buy U.S Treasuries with their surplus partly because they have to. Their fear is that if they do not do so the urge to 'protect' against Chinese imports will get political support. Loss of that market would create great credit issues in China where capacity has largely been created by leverage.

f) The key issue that you identify is liquidity. This is probably one of the least understood elements in risk management and it is very significant that the ECB and the Fed are reacting by pumping in liquidity. Remember however that the banks are better capitalized, better organized and have not led the way in the crappy mortgage game. Moreover, although it cannot be denied that the equity markets were overvalued (witness the absurd P/E levels) there is also no doubt that corporations are far less leveraged than they were in the last quarter of the last century. You cite the private equity people and rightly so but they are a fraction of the market even now and those that lose on these (eg the Chinese Government) can afford to learn the lesson.

g) Funds have to move somewhere. In these circumstances rates will be held down by the central banks and pension funds and other institutional investors will have to stay the course.

I was thinking of an article on this topic myself except my title was "Chicken Little or a Little Chicken" with the theme that it was time for caution but not panic. Your advice to run for the hills brings the question "which hills?"

Looking forward to continuing the discussion.

Odysseus
_____________________________________________________________________

Hi Odysseus,

Thanks for taking the time to read the first posting and providing your thoughts and comments. And now down to business - I believe the best way to respond is to annotate your points one by one. I hope the style is to your liking.

Odysseus
My concern is that some of the counter arguments (which have some cogency) are not addressed or commented upon.

Let me mention a few:

a) The mortgage position is very sensitive to timing. If I took out a mortgage prior to 2005 I am probably still ahead of the game although my new found wealth did turn out to be ephemeral. This is also true in the U.S. market where there is little evident distress in anything written prior to 2003.

Cassandra
You are correct, as the adage goes “timing is everything”. However, in the UK market, the timing issue is not of when you took out a mortgage but when was the last time you paid down your mortgage principle or when will your interest rate change.
1. According to the UK Council of Mortgage Lenders (CML), at the end of May 2007, 17 ½% of all extant mortgages are “interest only”; this is up from 14% at the end of 2006.
2. Two million household’s 2-year fixed rate mortgages “mature” every 12 months. That’s 18% of all UK mortgages every year. Each of these needs to be renegotiated and re-priced.
3. The pricing issue in the US is not only a sub-prime issue. A Fannie Mae chart I studied last week showed that resets on adjustable rate mortgages in the US will not peak until the December 2007 / January 2008 time-frame.
It seems to me that, in terms of potential loan defaults, the worst is still yet to come. If the markets are experiencing all of these serious issues now, when ARM resets have just really begun, what’s to prevent a far worse meltdown of financials after ARM resets hit their peak?

Odysseus
b) The total amount of sub prime mortgage losses cannot ever reach even a fraction of the losses that were sustained in the dot com meltdown. The dot com losses in value ( peak to trough) were in excess of 10 times the loss estimates for the sub prime sector. The market shrugged those off in part because they were so widely distributed.

Cassandra
Once again you are correct, but the issue, in my view, is not about size of the losses in the mortgage market, sub-prime or otherwise, v. the dot.com bust. Rather, it is about our over-extension, across the board, in the credit markets. By any measure, the average household in the UK and the USA is too much in debt and the pinch is only starting to be felt.

The catalyst may have been sub-prime but we are also seeing an amazing jump in interest rates on “jumbos” in the USA – from circa 6.25% to over 7.75% in the last month. Indeed, I checked with my local WAMU office (they holds the mortgage on our US house) and asked what a $1,000,000 mortgage would run and was given a rate of 11.2%!! They told me they are seeing more and more people selling their larger more expensive homes and buying homes that can be financed with conformed mortgages or are paying down their existing floating rate mortgages to levels that allow them to re-mortgage with a conforming product. This is driving down house prices on the larger more expensive homes in the area. His concern is that falling demand for expensive houses will lead values to fall. Rising rates eventually could lead to more foreclosures, which would add to the supply of similar-priced houses, sending their values lower, creating a vicious circle of falling prices and rising foreclosures. I believe that there is the possibility that this is the case we will be facing ‘ere long.

One of the quotes I did not use in this article was from Yale economist Robert Shiller who said in 2005, "Once stocks fell (in the dot.com crash), real estate became the primary outlet for the speculative frenzy that the stock market had unleashed. Where else could plungers apply their newly acquired trading talents? The materialistic display of the big house also has become a salve to bruised egos of disappointed stock investors. These days, the only thing that comes close to real estate as a national betting obsession is poker."

Odysseus
c) Mortgage defaults defy economics in that people seldom exercise their default option preferring to continue to make payments even when the debt exceeds the equity. Selling costs are substantial and people have to live somewhere.

Cassandra
Okay, three in-a-row spot-on points by you – ready for my third rejoinder? I agree that in normal times, people will keep paying everything they can to keep their homes. What I am forecasting is not a normal time but rather a property crisis like those of the mid-‘70s, in the UK, the mid-80s in the US “oil patch” (the one that took out Texas Commerce Bank) and in the early-‘90s in both the US & UK markets. If you examine the foreclosure (repossession) rates they were substantial:

UK 1975-1977 135,000 homes - 2.08% of all mortgages
UK 1990-1993 248,000 homes - 2.53% of all mortgages

Now, bear in mind that consumer debt in the UK has trebled since 1992, that the median size of a mortgage has gone from £39,200 in 1991 to £124,488 as at May 2007 (3.17 times) while median family income has grown from £13,671 to $28,848 (2.1 times). Add to this that liquidity, despite the billions the Fed, European & Asian central bankers have poured into the system in the last week, is still growing thinner by the day and the issue of re-pricing and re-negotiating that I mentioned in my response to you first point and you see why I believe this “squeeze” will have a nasty ending.

Odysseus
d) With some limited exceptions, it has not been the banks that have fuelled the dumb mortgage market in the U.S. It is the Countrywides and other broker-like operations that have created this mess aided by the brokers that help them fund it with structured credit that was bought largely on trust of the ratings process. But that debt is almost 30% foreign owned and otherwise widely distributed.

Cassandra
Sorry but here I disagree. The banks may not have fuelled some of the sub-prime market (although Countrywide and others are being held up by drawing on their bank lines) but WAMU, BOA, JPM/Chase, Citibank, and every regional have helped to fuel the excessive amounts of jumbos and second mortgages. The “structured credits”, CDOs/ CLOs, across the spectrum, have been affected by the contagion, even if not all are actually infected with sub-prime debt because the bloom is off the rose in terms of the validity of the rating process that lured investors to consider them equal to corporate debt (I had commented in my article about the imprudence or naiveté of their investors in these “products”.) The fact that a certain percentage are foreign owned means that the contagion is spread across the globe – witness the collapse of IKB – and is no real comfort. In so many ways it looks much like all the crisis we have lived through.

Odysseus
e) I think there are a lot of unpleasant facts and you cite many of them. The Chinese buy U.S Treasuries with their surplus partly because they have to. Their fear is that if they do not do so the urge to 'protect' against Chinese imports will get political support. Loss of that market would create great credit issues in China where capacity has largely been created by leverage.

Cassandra
Okay, we are back on track and you are right about the Chinese motivation but (sorry about another one!) they are learning that they do not have to buy exclusively or even predominantly US T’s. Their buying pattern has shifted in the last year due to issues regarding yield and the devaluation of the US$. According to the ECB, Europe has replaced the US in terms of inward investment. The Chinese in 2006 for the first time borrowed more in Sterling and in Euros than they did in Dollars. We may think that their options are limited but I think that those of the US, as the debtor nation, are even more limited.

Odysseus
f) The key issue that you identify is liquidity. This is probably one of the least understood elements in risk management and it is very significant that the ECB and the Fed are reacting by pumping in liquidity. Remember however that the banks are better capitalized, better organized and have not led the way in the crappy mortgage game. Moreover, although it cannot be denied that the equity markets were overvalued (witness the absurd P/E levels) there is also no doubt that corporations are far less leveraged than they were in the last quarter of the last century. You cite the private equity people and rightly so but they are a fraction of the market even now and those that lose on these (eg the Chinese Government) can afford to learn the lesson.

Cassandra
One more point on which we agree but no entirely. I think that the issue of volatility is the flip side of liquidity. It is what caused the liquidity, which was so “abundant” just 6 or 8 weeks ago, to dry up to such an extent that the Fed/ECB/BOJ etc. have had to pour in over $325 billion in three days to try and stabilize the banking system as well as the market. Having just been in one of the major High Street lenders at the core of their decision making process I can tell you that it, at least, does not fit the mold of “better capitalized, better organized“; they look remarkably like the same old hat – a bloated balance sheet, driven by consumer debt on the one hand and high-leveraged deals on the other. Talking to my colleagues at other High Street Banks, the pattern appears to be the same. I believe that the lessons that were so painfully learned over the past few decades are being forgotten, Basel II not withstanding.

In my talks with the FSA they have voiced concerns that our addiction to “models” has inured us to the realities of markets that do panic (the prescient Mr. Greenspan strikes again). The article in the FT of 15 August “Why computer models proved unequal to market turmoil” by Gillian Tett and Anuj Gangahar makes this exact point.

As to the USA, here is another quote I did not use “In sum, U.S. banks seem well positioned to withstand a modest decline in house prices, especially a localized decline. Still, empirical evidence from the United States and other countries indicates that declines in housing wealth can have severe macroeconomic repercussions, especially if banking system capital does become impaired. David Wheelock of the Federal Reserve of St Louis, October 2006."

Like Mr. Wheelock, I am not positing that Armageddon is necessarily the outcome of this crisis, only that this is not the time to be complacent and think that all is bright and beautiful. I know we share that belief.

Odysseus
g) Funds have to move somewhere. In these circumstances rates will be held down by the central banks and pension funds and other institutional investors will have to stay the course.

I was thinking of an article on this topic myself except my title was "Chicken Little or a Little Chicken" with the theme that it was time for caution but not panic. Your advice to run for the hills brings the question "which hills?".

Cassandra
Pardon, but I did not say, “run for the hills”. I was telling investors that they should “run away” from the equity markets, as the volatility was too much for the average player. I believe the proof lies in the intra-day volatility and the trading levels. This is not an arena for the average investor. I watched at the last melt-down whilst so many people saw their holdings in 401ks and other investments drain away before their eyes, always hoping that the market would lift the next day, the next week, the next month (I watched as one of my oldest friends, a skilled risk expert, rode their children’s college fund down to near oblivion waiting for the “correction” to end.) While I may not like the return in the cash market (I’m getting about 5% versus the 16% I earned last year in the equities market) at least I have maintained my investment principal intact for a future market.

You may think me “chicken” but I think I am calling for (and have made) a strategic withdrawal. To quote the old doggerel “He who fights and runs away, lives to fight another day!” The panic is not mine; it is the markets.

Odysseus, I want to thank you for your most thoughtful, provocative points but most especially for your taking the time to help get this forum up and running.

All the best to you, Penelope and Telemachus,
Cassandra

The Impact Of The Current Situation On Vital Portfolio Management Tools

I received the following from Dr. Colin Burke, one of the most gifted risk modellers and practitioners I have ever known. Rather than place his remarks as a “Comment”, I believe that the issue that he raises deserves to be highlighted in its own posting. Cassandra
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Our IT security policy prevents me from posting a comment and so I'll put an initial one below . Would you please post it for me? CB.

I agree with many of your observations. One thing that I think is noteworthy for portfolio managers past, present and future is the role of CDO's in the current situation. It has been pointed out that model based valuations have been found wanting and that the risks and value in these are not transparent. I don't disagree. However they are pretty much an essential tool for loan portfolio managers and it would be unfortunate if their use for portfolio management is severely effected.

Interestingly, it can be argued that the occurrence of sub-prime losses in unexpected places like Germany and the Netherlands could be seen as the originating banks using portfolio tools effectively by spreading the risks (or losses in this case).

Obviously many of the current troubles can be put down to questionable underwriting standards at some institutions, nevertheless I worry that risk management tools like CDO's and syndications may be tarnished.

Colin Burke

Timeo Danaos et Dona Ferentes.....

8 August 2007
Volume 1, Issue1
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Probability distributions estimated largely, or exclusively, over cycles that do not include periods of panic will underestimate the likelihood of extreme price movements because they fail to capture a secondary peak at the extreme negative tail that reflects the probability of occurrence of a panic.

“Measuring Financial Risk in the Twenty-first Century”
Alan Greenspan, October 14, 1999
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“When will they ever learn? When will they ever learn?”

“Where Have All The Flowers Gone”
© Words and Music by Pete Seeger, 1960
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On what is a rare, gloriously sunny day in this otherwise rainy English summer of 2007, the conventional wisdom amongst the City bulls appears to be just as bright and storm-cloud-free. The markets, one hears, are going through a “case of nerves” due to the continuing “correction” in the US sub-prime market, but once this latest case of hiccups passes (like those experienced in February this year), the upturn will proceed, and we will continue ever onward, tickety-boo.

I find myself thinking “Yes, quite” or, for those of you across the pond, “Yeah, right.”

Reality, from where I sit, is quite different. The problem for the markets is, in a sense, the same as the problem with all summers, English or otherwise – every sunny day must come to an end. As difficult as it is to accept, we are in the dying days of the longest growth spurt in modern times. This record-breaking boom is going, going, gone. Though the markets may rally in the next days and weeks ahead, it will be nothing more than a dead cat bounce. The party is truly over – at least for the foreseeable future.

What, you ask, makes you the harbinger of such apparent gloom and doom?

My answer comes in two parts. First, we need to examine the confluence of four factors in the US with four factors in the UK. Whilst these are seemingly poles apart, they are actually two sides of the same coin and are related to the largest item in an individual’s investment profile – their home.

In the USA

+ The continuing collapse in house prices and housing sales;
+ The concomitant collapse in the sub-prime market;
+ The devaluing of the US dollar and what I see as
+ The continuing shift away from US dollar-based investment.


In the UK

+ The continuing, albeit slowing, rise in home prices & sales;
+ The rise in interest rates;
+ The growing strength of the Sterling, and
+ The cranes

Lest you think I have taken up augury in my off-hours, the cranes I am referring to are those dotting building sites and appearing like a new forest across the London horizon, as well as points north, south, east and west.



All eight of these factors can be summed up in this: The battle for ever-increasing return on our monies has caused the average family in the US and UK to overextend themselves both in terms of the amount of indebtedness and the level of risk they have incurred. The difference in the two countries’ markets, one seemingly falling and the other still seemingly booming is simply one of timing. The US reached saturation first but do not be fooled by pundits who tell you “that’s a US phenomenon that won’t happen here” because the UK is not far behind.

Over the last several years, the lack of yield on traditional investment products caused a flight to, rather than away from, higher risk categories. Many individuals in both nations eschewed the options of equity investment in favour of moving up the housing ladder to improve their lot in life (pun intended) and to seek an increased return on their investment. Unlike equities, home purchase (real estate) is viewed traditionally as an investment class that holds its intrinsic value longer than other investments, save cash or precious metals. Given the finite amount of available property, especially in the UK housing market, most investors see it as something that will hold its value and rebound faster than equity markets post a major re-valuing or a crash. (In a poll taken in May 2007, 68 per cent of investors believed property is a good way of saving for their old age.) At least that is the conventional wisdom. Unfortunately, once again our old friend “CW” is wrong. The one sector of a depressed or recessionary economy historically likely to recover most slowly is real estate.

To better understand this issue consider the present cycle. After the 1990-1991 recession in the UK, the overbuilt phase lasted almost 4 years, and then the gradual absorption phase also lasted 3 plus years - both longer than usual. The development boom phase of the late 1990s began about 1998 and lasted 2 plus years. This was followed by an overbuilt phase, which began in late 2000 and lasted through mid-2003, and then transformed into the gradual absorption phase as markets started to soak up their high vacancy levels. In mid-2006 another overbuilt phase commenced that is continuing apace. This is most apparent in commercial development –- the aforementioned cranes -– but is also alive and well in innumerable house building sites throughout the countryside. Based on prior cycles, we would normally see the downturn circa late 2008 or early 2009. However, given rising interest rates and the downturn in equities markets, I believe that this might occur earlier than usual (early to mid 2008).

Why?
For one explanation, look at the situation in personal debt v. savings in the UK:

£10,200
The average amount of unsecured debt owed by 21 million debtors.

£96,648
The average outstanding mortgage debt owed by 11.7 million households.

£606
The average annual savings set aside from the average income per household.

975,000
Buy-to-let mortgages (£42 billion) issued to predominantly “amateur” landlords.

14,000
Homes repossessed in the first six months of 2007, up 30% from 30 June 2006.

125,000
Mortgages in arrears, 1% of all mortgages at 30 June 2007.

1.62
The ratio of household debt to personal income in the U.K., compared with
1.42 in the U.S., 1.36 in Japan and 1.09 in Germany.

Now, envision the amount of liquidity that would be sopped up if a major rupture in the equity markets occurs and financial institutions, feeling the sting of their excessive lending in the form of increased bad debts, need to cut back on financing of all kinds to stem the haemorrhaging.

The exact outcome, lying as it does in the future, is unknowable. However, given the present situation we could face a property devaluation, especially in the South of England, of 15% to 20%. Indeed, if a worst-case scenario played out, the collapse could well be more in line with the 1974 property crash than that of 1992, with prices plummeting 30%.

The second part of my answer lies in the almost inconceivable VOLATILITY being exhibited in the present credit markets.
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“Credit feels like it has just had a bad case of schizophrenia, where a year’s worth of credit volatility has been achieved in a little over 24 hours.”

Alan Ruskin, chief international strategist, RBS Greenwich Capital
© The Financial Times, 31 July 2007.
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“The question plaguing everyone is whether the ‘credit event’ is over or the next shoe has simply not yet dropped.”

TJ Marta, fixed income strategist, RBC Capital Markets.
© The Financial Times, 31 July 2007
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“US and European banks are now trading in the credit derivatives market at levels usually associated with companies rated at “junk” …. although in reality they all carry investment grade ratings. A disjunct of this magnitude is extremely rare.”

Allerton Smith of Moody’s Credit Strategies Group
© The Financial Times, 31 July 2007
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It must be noted that all these quotes preceded a week that saw the average intra-day movements in the Dow Jones Industrials swing by 349 points. The intra-day movement for the last two weeks has averaged a 326 points swing with the month of July witnessing an average intra-day swing of 237 points. By way of comparison, the average intra-day swing for 2006 was 167 points while the five-year intra-day average movement was 96 points. There can be no doubt that we are in a period of hyper-volatility.

After considerable thought, I have a word of advice to individuals looking to invest in the equity markets at this point in the cycle: RUN AWAY!

Quite seriously, nowhere is the danger more immediate to investors than in equities. This is not due to the problems or vagaries of a few names or a few industries or even a few product-based equity issuers (e.g., oil companies). Rather, this is an issue of systemic volatility. In point of fact, the markets are simply too hot to handle.

This has come about through yet another related set of events:

+ The boom in “private equity” buy-outs and buy-ups based on highly leveraged but low interest-rated “junk” debt (fuelled, not in a small part, by the misguided belief that only companies with ever-growing quarterly profits are good investments).

+ The meteoric growth of CDOs, CLOs and other securitised structures, the imprudence or naiveté of their investors, and the initial stages of the dissolution of these products

+ The rapid slowdown in IPOs.

+ The continuing ups and downs in the US economy.

As is shown in the following graph, what the Wall Street Journal calls the “Buyout Boom” has grown by leaps and bounds, more than doubling the 2005 numbers in 2006 and well on the way to a new record in 2007. Highly leveraged deals represent 20%+ of global M&A finance, almost quadruple the percentage just 5 years ago.



The driver of this “boom” has been the ready availability of what, by any definition, can be called cheap credit. The perverse part of all this is that cheap credit was actually brought about by the battle for ever-increasing return on our monies. We have watched as “junk” bond pricing has dropped from the 5% - 10% range over funding costs to as little as 1% over funding costs as more and more money poured into fewer and fewer quality investment opportunities. In addition, what were normal safeguards (for example, “tight” financial covenants) have disappeared from most loan agreements.

Unfortunately, the corollary is that what one borrows, one must pay back. This is the Achilles heel of not only this boom but of this entire cheap-credit-based economy we have lived in all too long. Repayment all hinges on one word – LIQUIDITY.

The markets’ liquidity has been aided by the influx of Asian (read the People’s Republic of China) and Middle Eastern (read the Kingdom of Saudi Arabia) monies being invested first in US Treasuries and more recently in LBOs/Private Equity transactions. However, there are increasing signs that these sources are drying up. Witness the internal arguments in the PRC over its US$3 billion investment in the Blackstone Group, which, at the time of this article, has lost US$590 million in value in 6 weeks. The US bond markets have been depressed for months over the PRC’s increasing movement out of USD-based investments into Sterling and Euro-based products. Couple this with the ongoing arguments in senior circles in the KSA over the fact that their return on investment made in US vehicles is continuing to wane with the ever decreasing value of the US dollar (over the last decade, an estimated 60% of the KSA’s global investments, passive and direct, have been in US government or US market securities) and our liquidity worries only mount

Turning off these and other liquidity taps, whether by raising interest rates as the Bank of England has been doing (which while tempering UK inflation also draws investment away from the US) or by a massive downward market movement (what Chairman Greenspan called in the quote that began this piece “an occurrence of panic”), will result in a drying up of the pool of new investors in housing, equities or other investment vehicles. All of these lead us to the same ending - the music stops and not just someone, but many “someones,” will have to pay the piper.
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“Aunty Em, Aunty Em! It’s a twister!”

Stephen Stucker as “Johnny” in “Airplane” (© Paramount, 1980)
mimicking Judy Garland as ” Dorothy” in “The Wizard of Oz”
(© Warner Brothers, 1939)
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There is an old tale told about a country bumpkin who is taken by his city cousin on a tour of New York City. Having traversed the canyons of Wall Street, seen the wealth of 5th Avenue and Central Park West and been mesmerized by the affluence of the great buildings, public and private, he is led to the 72nd Street Boat Basin to admire the yachts riding high in New York Harbour. After hearing his city cousin relate the various and sundry names of the wealthy bankers and stockbrokers who owned the craft, the country cousin turns to his gentrified relation and asks, naively, “And where are their customers' yachts?"

Call me a cynic, but I believe the recent partial sell-off via IPO by Messrs. Peterson and Schwarzman of Blackstone Group had less to do with offering new investors their first opportunity to share the “kill” than it had to do with insuring that they could cash-out at the top and keep their “yachts” afloat. Of the US$4.7 billion raised, the two founders netted US$2.33 billion, and continue to own close to 28 percent of Blackstone. All that is on top of the $615 million they took out last year. Not bad for an initial investment of US$400,000. Of note is the fact that the Blackstone IPO gave investors units of a limited partnership. These units do not provide their owners with any real control of Blackstone and, indeed, the unit owners specifically waive their legal rights to make claims against the General Partners for any of their actions past, present and future. The owners of these limited partnerships units are literally just along for the ride with Mr. Schwarzman (Mr Peterson is slated to retire at year end) firmly in the driver’s seat.

Henry Kravis announced a similar move to sell common units of “Limited Partner Interest” in KKR on 3 July 2007. The question is two-fold, “Will KKR be able to complete their IPO before the market moves against it? If so, will Louis Gerstner, Leon Black (who held extensive talks with a number of investors in Abu Dhabi in late June with the hopes of raising a capital investment prior to an IPO), Steve Fineburg, David Bonderman & Jim Coulter and the other Private Equity barons want to do or, indeed, be able to do IPOs of their firms before the music stops?”

Truth be told, we have not yet hit the real crunch time. The real test for Private Equity firms and their investment bankers will come in September when an estimated $330 billion in bonds and loans will need to be raised to finance corporate buyouts already announced and in the pipeline. A retreat from these commitments or the failure to raise the funds, save at much higher prices, will have a long-term deleterious effect on this market, not unlike that seen in the post-Milken years.

I believe, and have acted personally on the belief, that all that is left in this current cycle is a sucker's rally. Equities will rise by enough to tempt the last players to invest, or recent sellers to reinvest, and will then dive back down – to what depths I cannot hazard a guess. Sucker’s rallies are like roulette. The croupier will never spin the wheel whilst there is an easy target willing to put money on an inside bet. The reality for the player at the table, or in the market, is that eventually the wheel does stop. and it is the House Percentage that rules.


N.B.
For those of you who have forgotten your classics or are still puzzling over this blog’s title, Cassandra was a Trojan Princess whose beauty caused Apollo to fall in love with her and grant her the gift of prophecy or, more correctly, prescience. However, when she did not return his love, Apollo placed a curse on her so that no one would ever believe her predictions. This would not have been such a big problem if she hadn’t been the one to tell the people of Troy “DON’T BRING THAT HORSE INTO THE CITY!” And did they believe her? Of course not, that’s the whole point! Now, fast forward some 32 centuries and ask yourself the same question, “does anyone want to believe someone who tells them what they don’t want to hear?” Proof that Alphonse Karr was dead right when he said “Plus ça change, plus c’est la même chose!” You’ll have to look that one up yourselves!

Cassandra

© Lord & Associates Limited, 2007