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5 CREDIT BUBBLE
BULLETIN Confirmations on the bleak
side Commentary and weekly
review by Doug Noland
There have been
several key credit bubble bulletin themes for
early 2008. First, expect credit
problem-associated economic weakness to gain
momentum. Second, we're witnessing the evolving breakdown of Wall Street
alchemy." Third, watch for especially
atypical Federal Reserve-induced "reflation"
dynamics. Fourth, the year will likely mark the
bursting of the "leveraged speculating
community" bubble. And, fifth, the
unfolding credit crisis will become especially
problematic as it converges toward our system’s
functional "money" supply – the anchor of our
monetary system. This week saw important
confirmations with respect to all of the above.
Economic weakness related to faltering
availability of credit and
marketplace liquidity has
been especially prominent in the data of late.
This week was no exception. The February reading
for the Philadelphia Fed index sank to the lowest
level since February 2001. January Housing Starts
were reported near the weakest levels since the
early nineties’ recession, while early February
auto sales are said to be running 16% below last
year’s level. Out in California, dwindling state
revenues led legislative analysts to raise the
estimate of the state’s budget shortfall to an
alarming US$16 billion, an increase of $1.5
billion from last month’s guesstimate.
Despite the faltering US economy, pricing
pressures are accelerating – a dynamic I’ve heard
referred to as the "new conundrum". January
consumer prices were up 4.3% year on year. Major
commodity price indexes surged to yet new record
highs and, if anything, inflationary pressures are
broadening. I’ve suggested that this "reflation"
will have consequences divergent from those of the
past. With the historic bubble in Wall Street
finance now bursting, the powerful monetary
mechanism linking Fed rate cuts directly to asset
price inflation (in particular, real estate, risky
debt, and stocks) has been severely impaired if
not completely severed. The link between US
interest rates, dollar devaluation, faltering
confidence in currencies in general, and inflating
commodities prices has never been stronger.
During the 2001-2003 reflation, hedge fund
managers were quoted as saying "the Fed wanted me
to buy stocks and junk bonds". Today, the Fed
would surely hope to send a similar message, while
the sophisticated interpret things altogether
differently. Today, investors and speculators
alike are much keener to buy precious metals,
energy, and commodities. And while the US economy
is succumbing to powerful recessionary forces, it
is no longer the sole global engine of (credit and
economic) growth.
It’s worth repeating
that global credit expansion remains brisk, while
bubble dynamics and economic growth remain in
place throughout Asia, the Middle East and in the
emerging economies, especially for the powerful
boom in Bric countries (Brazil, Russia, India and
China). In concert with the bursting of the Wall
Street bubble, global inflationary dynamics now
strongly favor "things" as opposed to securities.
In particular, necessities and stores of value
available in relatively limited supply are seeing
extraordinary inflationary effects.
Here
we see one of the key dynamics (monetary
processes) differentiating the current reflation
from those of the past: Previous Wall Street
finance-dominated inflationary booms enveloped the
securities markets, where the supply of stocks and
bonds could be readily expanded to meet booming
demand. Today, the world is faced with a very
challenging prospect of increasing the supply of
crude, natural gas, ethanol, precious metals,
industrial metals, wheat, soybeans, grains,
coffee, cocoa, tea and literally scores of things
now in great demand by end-users, investors, and a
bloated leveraged speculating community.
Keep in mind that foreign official
reserves have inflated $1.35 trillion over the
past year - and the US is still on track for yet
another year of massive current account deficits.
Recognize also that the hedge fund and sovereign
wealth fund communities have ballooned to the
multi-trillions. US deficits and resulting dollar
devaluation continue to spur unwieldy bubbles in
China, India, the Middle East and elsewhere.
The bottom line is the world remains awash
in dollar liquidity that many are content to
exchange for tangible things deemed of greater
value than suspect US financial assets. There is
no inflation conundrum, only increased supply
constraints and bottlenecks, global hoarding, and
an unambiguous speculative fever in markets for
many of our economy’s basic necessities.
This week provided confirmation of a
worsening backdrop for the leveraged speculating
community.
Mathematical models that traders use
to calculate prices in the $2 trillion market
for collateralized debt obligations don’t work
anymore, according to UBS AG. The so-called
correlation model, which shows the odds of one
default by an investment-grade company spreading
to others in a group, now exceeds 100% ... said
Geraud Charpin, a structured credit strategist
at UBS … 'The banks realize the model doesn’t
work and it needs to be changed,' Charpin said …
Banks are changing the model by reducing the
amount of money they expect to recover when a
company defaults to 30% from 40%. That means
they have to protect against bigger potential
losses by purchasing more credit-default swaps,
driving prices of the contracts to the highest
on record. [February 22 - Bloomberg (Hamish
Risk)]
And the breakdown in models is
anything but limited to CDOs and the banking
community. Bloomberg at the end of the week
reported that AQR Capital Management, manager of
$35 billion of assets, has suffered significant
losses to begin the year. Its largest hedge fund
is said to be down 15% already, with slightly
larger losses for at least one of its smaller
funds. This wasn’t supposed to happen, and I’ll
take this development as important confirmation
that troubles that hit the "quant" fund community
this past summer have worsened significantly so
far this year.
August was a terrible month
for model-based quantitative strategies, although
most funds quickly recovered much of their losses
as the markets stabilized in the fall. This time,
however, I do not expect the environment to
accommodate. Last summer’s hope that the situation
was a short-term aberration has been replaced with
this year’s reality of bursting bubbles, credit
quagmires, model breakdowns, hopelessly crowded
trades, acute marketplace illiquidity and, it
would appear, highly problematic fund redemptions.
Importantly, the game of leveraged speculation -
albeit quant fund strategies, "market neutral," or
"global macro" - works wonderfully only for as
long as the industry enjoys (as it had for years)
robust inflows.
A steady flow of incoming
funds for years ensured ample liquidity to build
positions, press bets, increase leverage, and
bolster the perception of endless marketplace
liquidity, while working to boost industry returns
(and overheated expectations). A reversal of flows
- especially when abrupt and significant in scope
- would pose quite a dilemma for individual funds,
the industry overall, and the impaired US credit
system. It will be interesting to follow how the
"quant" types respond to an environment of model
breakdown, losses, redemptions, and forced
position unwinds. I have a hunch they are not well
programmed for such a radical change in the
environment. We can only speculate at this point
as to whether the industry is on the precipice of
major redemptions.
New York hedge fund DB
Zwirn & Co is winding down its principal funds
after investors - rattled by lapses in internal
controls … - said they would withdraw more than $2
billion. Investors started pulling their money
after the group, which has almost $5 billion under
management, disclosed in March last year that an
independent internal review had uncovered improper
transfers among funds and improper handling of
operational expenses … On Thursday night, Zwirn
sent a letter to investors outlining its plans to
liquidate assets, about 60% of which are not
easily tradable and mostly involve illiquid loans
made both in the US and abroad. [February 22 -
Financial Times (Henny Sender)]
DB Zwirn obviously has
its own issues. But it would provide an
interesting case study in fund dynamics. At one
point, it was a booming fund group with a stellar
reputation, stellar returns, 15 offices worldwide
and more than 1,000 employees. It is now suffering
catastrophic unwinding, faced with the specter of
huge redemptions and illiquid positions (including
credit derivatives). Apparently some positions
will take up to four years to unwind. Investors
that believed they had the option to redeem their
interests now confront the likelihood of
significant losses and long delays in the return
of their capital. I suspect this will be an
increasingly common industry predicament.
Throughout the markets, this week provided
further confirmation of serious liquidity
constraints. The unfolding breakdown in Wall
Street alchemy was underscored by further issues
with structured investment vehicles and the
auction-rate securities fiasco. Many individuals,
funds, and corporations that believed they had
invested in safe and liquid ("money"-like) cash
equivalents now instead hold illiquid positions in
long-term debt instruments of varying quality.
Ethanol maker Aventine Renewable
Energy Holdings Inc warned on Friday it may be
forced to delay construction of two new plants
because some of its assets have become
unexpectedly tied up in investment securities …
Aventine … said it may not be able to sell its
investments in auction-rate securities (ARS),
forcing it to draw on revolving bank debt or
delay work on the plants that are expected to
begin operating early next year … Aventine’s
securities carry AAA ratings and are backed by
federal student loan guarantees. Chief financial
officer Ajay Sabherwal said the company would
not immediately try to sell them into the
moribund auction market, but would likely need
to do so in the next few months. 'Should we not
be able to liquidate a substantial portion of
the remaining portfolio of these ARS securities
on a timely basis and on acceptable terms, we
will have to either attempt to raise additional
funds or slow down the construction of our new
facilities, or both …' [February 22 -
Reuters]
No one knows for sure who the next
Bristol-Myers Squibb Co might be, but one
thing’s for sure: There’s no shortage of
candidates. Dozens of companies have warned of
potential problems with their holdings of
auction-rate securities, a survey by Dow Jones
Newswires has found … The market for these
securities has seized up recently, prompting
some companies that hold them, like
Bristol-Myers, to write down their value. Beyond
those dozens, other companies, including some
big names, hold large amounts of these
securities … Without buyers, the securities
aren’t liquid. And since many companies classify
them as short-term 'available-for-sale'
investments that are supposed to be marked to
market … As it happens, some auditors and their
clients had a dispute a few years ago about
whether to treat auction-rate securities as
equivalent to cash … FASB [Financial Accounting
Standards Board - the private sector
organization in the US that establishes
financial accounting and reporting standards]
ultimately decided not to address the issue of
how to account for the auction-rate securities.
A lot of holders of the securities are probably
wishing they had that same option right now.
[February 22 - Dow Jones (Michael
Rapoport)]
Egregious
excesses I have in past analysis suggested
that the perceived soundness of US corporate
balance sheets was extending a "hook" for those of
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