US auto dealers in pain

The auto dealers in the US have been hit hard in this recession - possibly harder than most businesses. They are pressured from two sides. On one hand the blunt approach the US manufacturers (and their new shareholders - the US government) have taken with respect to dealer closings and other drastic measures have devastated the industry. The video below of NADA Chairman John McEleney testimony before the U.S. Senate gives a good overview.




On the other hand the banking industry has all but abandoned floor plan (inventory) financing (as well as working capital loans). Floor plan financing is a lifeline of a dealer because the inventory is so expensive (it's not like running a diner.) There are two reasons the banks have been so reluctant to provide dealer financing. One is that banks (shaken by 08) had little guidance as to how the auto industry will shake out in the US until very recently. Until there was some certainty, they simply put in blunt policies not to provide floor plan financing at all. See this video from earlier this year:



The other issue for banks is that in the past they were able to finance pools of floor plan loans via the ABS markets. They could securitize the loans, sell the senior tranche or sell the whole thing and keep some of the fees. This way they had little balance sheet utilization and got great returns on capital. Well that market is gone and the only buyer of AAA ABS paper these days is the US government. In fact the Fed doesn't actually buy the paper but takes it in as collateral and lends banks or investors money - all via TALF. From the Fed:

Floorplan loans will include revolving lines of credit to finance dealer inventories. Eligible floorplan ABS issued by a revolving (or master) trust must be issued to refinance existing floorplan ABS maturing in 2009 and must be issued in amounts no greater than the amount of the maturing ABS. Eligible floorplan ABS may also be issued out of an existing or newly established master trust in which all or substantially all of the underlying exposures were originated on or after January 1, 2009. Eligible floorplan ABS must have an average life of no more than five years.

TALF for floor plans financing has been really slow to get going. The hope is that non-bank investors will show up to the party and kick start the market. The Fed is there with leverage and there is money to be made. Once we have some stability with respect to the manufacturers, the financing will be there. But for now it's rough times for dealers and many will not survive.

Note: thanks to one of our readers for shedding some light on this issue.

Divergent views on CDS

Here is a great excerpt Michael Johnson's (M.S.Howells & Co) write-up on CDS. It addresses the fact that many equity and credit investors have highly divergent views of credit default swaps. He points out that a heavily restricted CDS market will make the equity market tank.

The equity market's perception of CDS and its importance to the credit markets is materially different than the opinion of many fixed income professionals. Many equity based investors consider CDS to be destructive while fixed income investors consider it to be one of the most important tools available to manage credit risk. The difference is larger than many fixed income professionals might wish to acknowledge.

Fixed income professionals might not wish to acknowledge the difference because the elimination of CDS - besides likely restarting the credit crisis – would essentially force credit providers to "marry" credit risk rather than date credit risk. For example, equity and fixed income investment committees often require PMs and analysts to specify loss limits on positions that force the firm to reduce their exposure by selling the risk or hedging the position.

Hedging an equity position by using puts or selling short equity in liquid names is a relatively straight forward process. However, without CDS a credit investor can be stuck holding a position for an extended period of time (maturity or death) even as its borrower increases the credit providers risk (drawing down a revolver) without an effective hedging tool.

This is a bigger deal than many might wish to consider. The underwriting process of even the most basic loan agreements are likely to become more restrictive and a larger portion of the economic value that has historically flowed to the equity markets will be captured by credit providers. Zero loss underwriting standards will be rolled out at some firms and that will reduce credit availability. (Zero loss underwriting will become more necessary due to the inability to hedge credit deterioration and potential losses associated with LGD.)

Although many investment professionals will argue that CDS provided banks with a tool that allowed them to become reckless and extend too much credit, it is also critically important to remember that bank losses during the 2008 could have been materially worse if the banks did not have CDS hedges in place.

CDS also provides broker dealers with the ability to hedge large fixed income trading books. The elimination of CDS would require them to reduce their portfolios and could jump start another round of deleveraging... remember how that felt?

Credit markets need CDS to function properly....and the equity markets need the credit markets to function properly... so......CDS is here to stay….

Speculating on oil? Go for it.

A nice write-up R S Eckaus discusses the oil price bubble that we've experienced last summer and may be experiencing now. He disputes the argument that we have this tremendous new demand from China as well as some other justifications for oil price being where it is. As we discussed earlier (Oil price will stall on fundamentals), we've had some real demand destruction due to this financial crisis. Some of that destruction is also driven by substantial increases in production and delivery capabilities of liquefied natural gas (LNG) around the world. The Russians wanted to diversify from pumping gas to Europe via the Ukraine (Ukrainians can get a bit "restless" at times) as well as sell their natural gas to other markets. So they are completing some LNG capability, while consumers like China and the US have been building de-liquefaction capacity to diversify from oil. With natural gas prices at current levels, energy users are shifting wherever they can away from oil.

With all this, the IEA finally admitted that the demand will be lower than what thay have been predicting all along. They are now in line with the Credit Suisse forecast of under 90 million barrels per day by 2013.

So why are oil prices on the rise given such demand destruction? Eckaus argues it's speculation. Then what , if anything, can be done about it? Some would argue speculation in oil should be prohibited. Well, that could become a slippery slope. If you buy a piece of land as an investment, that's speculation. Should that be prohibited also? How about buying gold? What about the largest speculative bubble of all, the stock market?

Also, speculating on oil is generally done via futures, unless you own an oil storage facility. That means that eventually you will either have to sell your futures contract or someone will deliver you physical oil in Cushing, Oklahoma and make you pay for it. Plus being long oil futures is expensive because the curve is quite steep, making contracts worth less as time goes on (negative carry). That means that it's not the "fast money" that is doing all the buying but some more strategic players who store oil or hold it in tankers. Controlling or prohibiting that would be ridiculous - we would all be standing in lines to buy government issued gasoline. Socialism anyone?

So oil speculation can definitely hurt the consumer and corporations, but controlling trading is not the answer. It is no more productive than controlling speculation in the housing market that ended up hurting everyone - you just can't legislate whether people can buy or sell homes and at what price. The answer is to prove to the market that diversification away from oil is possible and it works. That will be the most effective way to burst the bubble.

Buying CDS protection could be prohibited

From Epitome Weekly

The climate-change bill passed by the U.S. House would expand federal regulations by banning "naked" credit default swaps (CDS) and requiring over-the-counter (OTC) derivatives to go through central clearinghouses. Further it directs the Commodity Futures Trading Commission to set position limits on energy traders across all markets and brings energy swaps under CFTC oversight. The CFTC is the futures market regulator.

CDS instruments were censured for amplifying last year’s credit turmoil. The steep decline in financial markets prompted proposals for tougher federal regulation. Some of the proposals in the climate bill, such as mandatory clearing of OTC derivatives, are part of the Obama administration proposal for financial regulatory reform. A bill pending in the House allows suspension of trading in "naked" CDS, but would not ban them outright.

Looks like some politicians snuck something into the climate-change bill that doesn't belong (we will discuss the the climate-change bill and cardbon trading later.) Not clear what is meant here by banning "naked" credit default swaps. Certainly writing protection without posting margin is a problem. But buying protection on a name that one doesn't actually own shouldn't be an issue.

People get annoyed hearing this because it feels like buying insurance on a house you don't own. But this is no different than buying a put option on IBM without owning any IBM shares. Except CDS is a put on credit rather than equity. Are we so far gone that we will allow the government to potentially prohibit us from buying put options? Pathetic.

Housing contunues to get pounded but the rate of decline is slowing

The housing market is maintaining its massive decline. Here is the Case-Shiller composite of 20 cities home prices:



The pace of year over year drop may be slowing a bit:



The bottom is still way off, but the rate of decline may be no longer as severe.

From MarketWatch:

On a month-to-month basis, prices in 20 selected cities fell 0.6% in April, with declines in 11 cities, compared with a decline of 2.2% in March. The overall annual pace of decline has slowed, said David Blitzer, chairman of the index committee for Standard & Poor's, which compiles the Case-Shiller index.

"Thirteen of the 20 metro areas also saw improvement in their annual return compared to that of March. Furthermore, every metro area, except for Charlotte, recorded an improvement in monthly returns over March," Blitzer said in a statement. "While one month's data cannot determine if a turnaround has begun; it seems that some stabilization may be appearing in some of the regions."

The Fed is taking a stake in AIG's subsidiaries

The Fed has agreed to swap it's senior AIG debt for preferred equity in American International Assurance Company (AIA) and American Life Insurance Company (ALICO), extinguishing $25 billion of AIG debt. AIA is the Asian insurance firm and ALICO is the international life insurance and wealth management business. Both are profitable. Looks like the Fed got tired of waiting for AIG to sell assets and repay (at least some of) it's debt and took an ownership stake in a couple of it's stable businesses. Not clear if the Fed got a fair price, but at least the central bank will try to extract some value from this mess.

The various government support for AIG has shifted from secured loans to equity holdings, which will benefit AIG's unsecured debt holders. See chart from Moody's:



The key mistake the US government made with AIG is committing to make the preexisting creditors whole. Those who relied on AIG debt's "AAA rating" should have felt the pain as did so many others who trusted the "AAA". Unfortunately in September that wasn't a consideration. Many creditors of AIG were foreign institutions, but at the time Hank Paulson didn't feel like spreading the pain. Some even feel that Paulson pushed to make creditors whole in order to support his former employer Goldman, who was one of the creditors. If the government negotiated with the creditors even remotely as vigorously as they did with the auto debt holders, the taxpayer would be in great shape with respect to AIG.

The way it looks now, the Fed will probably get it's money back at some point in the future as the foreign subs of AIG may interest some strategic buyers - possibly in China or Singapore for AIA and someone like AXA for ALICO. That's assuming some stability in the capital markets. The Treasury's holdings are another story - AIG's US operation has a bit of a "brand" problem.

TATA takes on Ford's pain

Buying top luxury brands while going into the recession was a mistake. But then again many in India (including many in the financial sector) were convinced in 07 and even early 08 that the crisis was isolated to the "US subprime mortgage market". Oops.



From Bloomberg:

...consolidated net loss was 25 billion rupees ($520 million) in the year ended March 31, compared with a net income of 22 billion rupees a year ago, the company said in a statement in Mumbai today. Year-ago numbers don’t include Jaguar and Land Rover, which Tata bought from Ford Motor Co. in June last year.

From TATA:

Jaguar Land Rover: Jaguar Land Rover made a profit in 2007 and continued to do so in the first half of 2008. However, the global meltdown, especially after July 2008 with vehicle financing and demands drying up, impacted the auto industry worldwide, including Jaguar Land Rover. In 2008 therefore, Land Rover sales fell considerably. However, Jaguar was able to maintain the sales level primarily on the back of a very strong consumer response to the newly launched XF sedan.

The company has actively responded to this changed situation by taking a number of urgent and long term measures. These include cutting costs drastically and working on a plan of substantial cost reduction, aligning production with demand and tight control over cash flows. In addition, the company has introduced successfully new variants on both Jaguar and Land Rover brands, and is to unveil the all new XJ sedan shortly.

TATA underperforming the market since the purchase:

The Reserve and the SEC - the saga of money market funds

In September of 2008 about $300 billion of cash has been withdrawn from US money markets funds. This was the direct result of the events at The Reserve fund. The Reserve broke the buck due to their excessive holdings of Lehman's commercial paper. Bruce Bent, the owner of the oldest money market fund believed the government will not let Lehman go. His claim to fame was that he avoided asset backed commercial paper in 07 - he was a hero in the press. However, with money markets being his only business, he wanted to compete on yield and juiced up returns by loading up on short term debt of financial firms (mostly banks). In fact nearly 100% of the Reserve's Primary Fund were in financials.

After the Lehman default, redemptions from The Reserve (who had both corporate and individual accounts) were so massive, that the SEC had to step in and freeze further withdrawals. One of Putnam's funds also broke the buck shortly after that.

Here is an update from the SEC on The Reserve:

The SEC charged several entities and individuals who operate the Reserve Primary Fund in an enforcement action on May 5, 2009, and is seeking to return the fund's remaining assets to investors expeditiously on a pro rata basis.

The Reserve Primary Fund "broke the buck" last September when its net asset value fell below $1 per share. Since then, the fund has withheld a significant amount of money from investors pending the outcome of numerous lawsuits filed against the fund, its trustees, and other officers and directors of the Reserve entities.

The Reserve has been returning funds as portfolio holdings mature. Other than Lehman, which was 3-7% of the fund (more than one of their funds had exposure), The Reserve had not experienced further credit events. So you would think they should be able to figure out the fund's NAV by now to let people know what their holdings are worth. They haven't:


People still have no idea what the value is of their trapped funds. Also it's quite amazing that they are charging fees:



The fund has set aside a "special reserve" of $3.5 billion to deal with all the law suits. That's some nice attorney fees:

Pursuant to the Plan of Liquidation and the Fund’s governing documents, the Board of Trustees created the Special Reserve, which will be used to satisfy (a) anticipated costs and expenses of the Fund, including legal and accounting fees; (b) pending or threatened claims against the Fund, its officers and Trustees; and (c) claims, including but not limited to claims for indemnification, that could be made against Fund assets.

Now the SEC is moving in with their regulation proposals, some of which make sense while others rely on the rating agencies. From the SEC:

The proposed amendments would, among other things:

* Require that money market funds have certain minimum percentages of their assets in cash or securities that can be readily converted to cash, to pay redeeming investors.

* Shorten the weighted average maturity limits for money market fund portfolios (from 90 days to 60 days). <=== not clear if this helps with anything other than a run on the fund. A portion a 90 days should be fine.

* Limit money market funds to investing in only the highest quality securities (i.e., eliminate their ability to invest in so-called "Second Tier" securities). <=== this would not have helped The Reserve. Lehman paper was "highly rated" by the rating agencies.

* Require funds to stress test fund portfolios periodically to determine whether the fund can withstand market turbulence.

The proposals also would:

* Require money market funds to report their portfolio holdings monthly to the Commission and post them on their Web sites.

* Require funds to be able to process purchases and redemptions at a price other than $1.

* Permit a money market fund that has "broken the buck" and decided to liquidate to suspend redemptions while the fund undertakes an orderly liquidation of assets.

Here is a talk from the SEC's Schapiro on the topic. We definitely need action on money market funds, if anything just for the sake of confidence. One can't have confidence in other asset classes if the stability of cash itself is in question. As we discussed earlier, the key is to make sure the SEC doesn't make things worse.

FDIC guaranteed notes - opening up the credit markets

With a large slug of the TARP funds returned, many are questioning whether the "TARP-free" banks are truly on their own or are still relying on some form of government support. Here is a commentary from Adrienne Carter (Businessweek)

The big banks returning the TARP money show no signs of giving up this perk. Goldman has $21 billion of such debt; JPMorgan Chase $40 billion; Morgan Stanley $23 billion. (JPMorgan and Morgan Stanley did say they wouldn't issue any additional bonds backed by the FDIC. And JPMorgan recently sold corporate bonds without the U.S. backing.)

She is referring here to the FDIC guaranteed notes issued by banks in the early part of the year. This has been an extremely effective program, not only to help banks raise debt capital, but to also open up the credit markets as a whole.

In terms of giving up this FDIC guarantee however, the "non-TARP" banks have mostly already done so. Existing notes (those that have already been issued) obviously can not drop the guarantee. Otherwise if you are the Fidelity government money market fund, and you bought dome FDIC paper early in the year, you have a problem. If the guarantee is now all of a sudden lifted, not only are you violating your prospectus (because the government paper turned into corporate notes), but you will also take a loss. This would unfairly and severely punish those who have cash in money market funds.

However any new paper issued by these banks is no longer guaranteed by the FDIC. For example on May 11th Goldman issued 6.75% coupon notes maturing 5/15/19. The paper is NOT FDIC guaranteed and is also unsecured. It now trades above par, yielding 6.64% (3.1% above treasuries). The demand for paper is out there and unless you are GMAC (who sold FDIC notes early this month), FDIC guarantee is no longer absolutely necessary (at least for now). Even Citi can now sell non-FDIC paper (although Citi continues to use the program because it's so much cheaper).

Here is the historical yield on some early Goldman FDIC notes. This paper was issued at the end of last year and matures at the end of 09. You can see that in March-09 the market came to realize that the FDIC is not going away (in spite of the bank rescue mess they are in) and neither is Goldman (at least for now).


Here is a rough measure of the note's spread to a 1-year T-bill.


The FDIC notes opened up the credit markets. When fear ruled the day, this paper got placed, serving to calm the jittery credit investors' nerves. In March-09 (which will be remembered as the turning point in the credit markets), Pfizer sold $13.5 billion of bonds. About $1.25 billion of that was a 2-year floating note (LIBOR + about 2%), which looked similar to the FDIC notes placed by banks. This was a signal that corporates can in fact issue debt without the goverment guarantee. The market was starved for high quality investment grade corporate paper. We were off to the races. Huge amounts of both bank and corporate paper has been placed since.

Clearly FDIC guarantee together with TAF, as well as other programs created a thaw in the credit markets. Now let's hope these programs are soon going to become obsolete.

A story of risk management: Rebonato and RBS

Riccardo Rebonato still (amazingly enough) holds a senior role at the Royal Bank of Scotland (RBS). He recently wrote a book called the Plight of the Fortune Tellers and was interviewed by Russ Roberts of EconTalk.

In that interview, it's incredible to hear Rebonato distance himself from "quants", whom he calls "the instruments" of the banking system. Rebonato however is in fact the ultimate quant. Years back he left Barclays (a subsidiary known as BZW) after his department took a massive loss. For many years now Rebonato has been the global head of market risk management and quantitative analysis at RBS.

So was Mr. Rebonato an "instrument" of the RBS bankers? Greenwich Capital, RBS's US trading operation/broker dealer was running a massive whole loan and securitized mortgage portfolio. The bank was also aggressive in building a structured credit portfolio globally. In fact RBS made Citi look like your local community bank an some respects. So this begs the question - what was Mr. Rebonato doing while RBS was amassing it's portfolios? The answer is simple. Mr. Rebonato was writing his book.

RBS share priice


RBS effectively became insolvent, and after a series of UK's version of "TARP medicine" (equity injections) has been nationalized by the UK government.

Having said all this, Mr. Rebonato makes some good points, particularly about Value at Risk, regulatory capital, and the famous regulatory "MULTIPLIER" (which we touched upon a few days ago.)

Enjoy!

Bloomberg hypes up derivatives revenues, but the headline is misleading

Let's take a sober look at this Bloomberg story - here is headline: "Banks Reap Record $9.8 Billion Trading Derivatives". Wow!

But now let's glance under the hood and check Bloomberg's sources. They site the OCC, and here is the actual OCC Press Release:

U.S. commercial banks reported record trading revenues of $9.8 billion in the first quarter of 2009, compared to losses of $9.2 billion in the fourth quarter of 2008

This is "trading revenue" that includes derivatives and cash securities - all sorts of bonds, loans, stocks, FX, commodities, as well as derivatives. Banks don't have a "derivatives division". Interest rate products may include swaps, caps, floors, swaptions, futures, as well as government bonds and repo. Credit products may include corporate bonds, high yield and distressed bonds, CDOs, mortgage bonds, as well as credit default swaps. Derivatives are tightly integrated with securities.

Here is the banks' revenue by trading business from the OCC. One can't really separate pure derivatives revenue. It's also hard to separate how much is market making (taking the spread) vs. proprietary or strategic position taking or hedging.



Below is the actual report from the OCC. The moral of the story is don't trust the hype of the headlines - even from guys that are usually solid like Bloomberg. Check for yourself.




Update: Note that a reference to "interest rate contracts" doesn't necessarily mean derivatives. Much of it is repo. Asset managers refused to leave cash with prime brokers, lending it to dealers on a secured basis via a reverse repo. The sheer volume of such transactions generated nice revenues for dealers.

Americans are saving like there is no tomorrow

The Commerce Department is showing an enormous spike in personal savings as we continue with the deleveraging theme. People are not paying down their debt, sitting on cash instead. The 6.9% savings rate we hit in May is actually a 50-year average for the US - if anything, we just reverted to the mean.

Savings rate as % of disposable personal income


Some are attributing this to the government stimulus spending (see CNN: Personal income boosted by stimulus). But that's unlikely, as only about $50 billion of the $787 billion stimulus bill is expected to be spent this year - most of that going to various state programs. Except maybe for the increase in unemployment benefits, it's hard to attribute this to anything but uncertainty that's on the minds of the consumer.

The dollar amount of personal savings has jumped to a record.



From WSJ:

...there is still no sign that Americans are taking that money to the shops. Personal consumption expenditures, a favored gauge of inflation among Federal Reserve policymakers, were up just 0.1% on both the month and the year. The core rate, which strips out food and energy prices, was also 0.1% higher on the month.

In the long term however, this trend will help repair the severely damaged consumer balance sheet.

TAF - the Fed program that worked

The Term Auction Facility (TAF) got little attention in the media but was actually one of the key ingredients in stabilizing the financial system. It provided the lubricant when other sources of funds became scarce.

Money markets actually went into a disarray late in the summer of 07, long before the media started calling it the financial crisis. At the time people were only referring to this as the sub-prime problem, but in fact it was an utter destruction of the asset-backed commercial paper market. Money market investors concerned with rising sub-prime default rates refused to roll some half a trillion of commercial paper. Remaining asset backed commercial paper mostly shifted to overnight maturities (with participants rolling daily). The interbank market became jittery as well, with limited term funding. Related to this there was worry about Bear Stearns who's major hedge funds got hammered directly by the sub-prime losses.

The video below is the famous Cramer freak-out. Remember this is August, 2007. Cramer is trying to say that Bernanke is not picking up the fact that money markets have become dysfunctional. He's pushing to have the Fed open the discount window to investment banks.




The Fed listened, but was just slow to respond. They also had a legal problem lending to broker dealers directly, as only commercial banks could legally use the discount window. The Fed decided to deal with the problem by providing term liquidity to all commercial banks across the country and hope that liquidity will find it's way across the financial system.

Banks needed term funds - funds much longer than overnight. No bank treasurer wanted to wake up one morning to find her bank can't roll short term debt. It's lights out. So the Fed came up with the Term Auction Facility (TAF) that helped replace some of the lost term commercial paper and term interbank lending (which is what sets LIBOR). TAF loans had to be securitized with the same types of securities and haircuts as the Fed's discount window. The Fed later massively broadened the types of collateral it takes. The maturities were 1 month and 3 months. The funds were auctioned at preset amounts. The chart below shows the history of TAF auctioned: supply provided by the Fed (green), demand that participants indicated (blue), and the actual funds placed with the banks (purple).

Now roll forward a year to November-08. Not only was the asset backed commercial paper market nearly gone (banks effectively bought their own commercial paper just to keep the programs going), but now the interbank marked has collapsed (even the overnight market was in trouble.) LIBOR settings were all fake - there were basically no term loans among different banks. The repo (overnight securitized lending) markets became shaky as well. After Lehman anybody could be next: Citi, RBS, UBS, BofA? Name it.

TAF went into overdrive. The Fed was taking all sorts of securites as collateral now and pushed the auction far above the perceived demand. It was no longer a limited supply that banks had to bid for (the green line went above the blue). $300 billion of funds was offered in October and $600 billion in November. TAF effectively became the term interbank market. In 09 as things started to calm down, the Fed brought the auction levels back to $300 billion a month and kept it there. The message was simple: you need to borrow funds and you are a bank, here it is, as much as you need. It was the only way to put some confidence back into the system.

Just in the last 3 months or so the interbank market started to stabilize as banks realized that all governments will go to extremes to keep the banking system alive. Given the slope of the LIBOR curve,



banks can borrow overnight and lend term, making a good spread. Corporate and retail deposits are up significantly and banks now feel comfortable placing the money term with other banks (vs. buying treasury bills as they have been doing earlier.) That got the interbank market moving. The Fed now wants to reduce dependency on TAF as the gap between the green and the blue line widens. From the Fed:

In recent months, conditions in wholesale funding markets have improved, and partly as a result, usage of the TAF and the dollar facilities provided by foreign central banks has declined notably. For some time, amounts bid at TAF auctions have fallen short of the amounts auctioned. In view of the decreasing need for TAF funding, the Board has reduced the amounts auctioned at the biweekly auctions of TAF funds from $150 billion to $125 billion, effective with the auction to be held on July 13. The Federal Reserve anticipates that, if market conditions continue to improve in coming months, TAF funding will be reduced gradually further.

"from $150 billion to $125 billion" is twice a month, so we are looking at going from $300 a month to $250 and lower. Because of all the hype around TARP, people paid little attention to this program, but it turned out to be quite effective. Going forward, tracking the "blue line" on the graph is going to give us an idea of the demand for funds outside of the wholesale funding markets, which is an indicator of the health of the financial system.

Housing prices drove borrowing and GDP - link proven

An excellent paper recently came out of University of Chicago by Mian and Sufi called House Prices, Home Equity-Based Borrowing, and the U.S. Household Leverage Crisis.

There has always been a debate on whether housing price increases drove household leverage and spending. Some argue that housing prices and household debt were just correlated, not that one led to the other. People felt good about their future, equities were up, there were more jobs, households borrowed more, and house prices went up driven by optimism (not that house price increase caused more borrowing.)

The way Mian and Sufi got around this is by separating the population into two categories: those who live in areas where housing supply was very limited (inelastic) and areas where new construction could add to the supply (elastic). The inelastic areas saw rapid house price increases that were not related to equity prices, job growth, optimism, etc.

What Mian and Sufi show is that it was the inelastic areas that saw the most borrowing - that is higher house prices were directly responsible for increased borrowing. Furthermore it was the poor credit consumers in inelastic areas who leveraged the most.

First one can see that consumer debt rose much faster than corporate debt,



and consumer leverage far outpaced corporate leverage:



House prices experienced most of the growth in the "inelastic" areas:



Leverage consequently grew most in the inelastic areas as well,



driven mostly by the low credit quality borrower.



Thus the lower credit quality borrower in inelastic areas experienced the high default rates:



Mian and Sufi proceed to show that home equity based borrowing was used mainly for consumption and added 2.3% to GDP every year between 2002 and 2006. This has enormous implications on any recovery from this recession. All other factors aside, over 2% of US GDP has been near permanently taken out, making it highly unlikely that we revert to pre-recession growth levels any time soon.

A bullish sign? Maybe not.

A bullish reader sent us an e-mail indicating that today we had an unusual alignment of events: the S&P500 move up by 2%, the VIX move down by almost 3 points, and the 10-year treasury yield drop by more than 15 bp. This must be a sign of renewed confidence and a signal that we’ve turned the corner.

So let’s go back in history to see when was the last time this happened. Actually it wasn’t that long ago. It was on 12/16/08 when S&P500 was up 5%, VIX down 4.4. points, and the 10-year note yield down almost 26 bp. In the next week however, the S&P500 gave it all back and some. And we all know what happened in January.

Mutual funds that invest in hedge funds

Hedge funds are trying to get some retail capital. Achieving that via a mutual fund is one approach.

From the NY Post:

After making billions off the backs of rich people, a growing number of hedge funds are betting they can strike gold by morphing into mutual funds and targeting the middle class.

Well it's not like the mutual fund industry has been doing charity work. Billions have been made in fees by mutual fund managers of some absolute dogs. Long only funds that charge 1% - 1.75% fees for "stock selection" have gotten rich on the backs of the middle class.

In 08 an average hedge fund lost about 22%, while equity mutual funds got hit with a loss that's about double that. And there were some real winners in the mutual fund space, like the Winslow Green Growth which is down 62% or the Legg Mason Opportunity, down 66%. Many would rather take their chances with a diversified portfolio of hedge funds.

"If you're a half decent hedge fund, it shouldn't be that difficult for you to become a top-quartile mutual fund," said one hedge exec.

With that in mind, even in this regulatory environment, firms are trying to launch mutual funds that invest in a pool of hedge funds. Here is a press release from Van Eck:

Van Eck Launches Multi-Manager Alternatives Mutual Fund; Designed for Retail Investors Seeking Exposure to Hedge-Style Investment Strategies

... launch of its new Van Eck Multi-Manager Alternatives Fund (ticker: VMAAX), an open-end mutual fund designed to give investors exposure to a variety of investment strategies, including absolute return strategies. This launch was a natural fit for Van Eck, as the firm has been managing a similar strategy for over six years as an investment option for variable life and variable annuity insurance contracts

So this option to allocate to hedge funds already exists for investment choices in various insurance products.

From Reuters:

AQR Capital Management LLC, among the world's largest hedge fund managers, will introduce another hedge fund-style mutual fund next month, as it expands its reach beyond the biggest investors.

AQR has actually already launched a hedge fund mutual fund called AQR Diversified Arbitrage Fund (ADAIX). Here is a description from the prospectus:

AQR Diversified Arbitrage Fund (Absolute Return Fund)
The Fund invests in a diversified portfolio of arbitrage and alternative investment strategies employed by hedge funds and proprietary trading desks of investment banks, including merger arbitrage, convertible arbitrage, and other kinds of arbitrage or alternative investment strategies described more fully below. The Sub-Adviser tactically allocates the Fund’s assets across alternative investment strategies with desirable anticipated returns based on market conditions.
...
The Fund will also engage extensively in short sales of securities.

Finally a mutual fund that can short (without necessarily being a bear fund.) However, this one isn't exactly for the "middle class":



And they hit you with some nice fees that are on top of what the portfolio hedge funds charge. But that's the price you pay for getting the liquidity of a mutual fund while investing in what effectively is a hedge fund of funds.

The performance is shown below - a nice steady climb typical of a hedge fund of funds (until there is a systemic problem like in 08). This is likely to track something like the Credit Suisse Tremont index (with some lag due to higher fees).



But given how limited the choices are in the traditional mutual fund space (even though there are thousands of funds), this type of product will be welcomed (hopefully with some lower minimum investment requirements).

Surprise examination by your neighborhood public accountant

Here is a quick overview from Katten on the proposed SEC changes to the Custody Rule (206(4)-2 of the Investment Advisers Act of 1940).

The proposed amendments would require that all registered investment advisers with custody of client assets engage an independent public accountant to conduct an annual surprise examination of client assets. This is significant change from the current Custody Rule...

This actually seems to be a better solution than relying on the SEC to do the audits. The big audit firms stand to make some good money on this, but it's the sort of thing that would have prevented the major fraud cases.

In addition the independent public accountant would submit the results of the suprise audit to the SEC:

Under the proposed amendments, the independent public accountant conducting the surprise examination would be required to notify the SEC within one business day of finding a “material discrepancy” (a term not defined in the proposed rule), and to submit a Form ADV-E to the SEC, electronically, accompanied by a certificate within 120 days after commencement of the surprise examination.

For those investment managers already registered with the SEC, this wouldn't be a major change, though the costs will definitely go up. The SEC estimates that over 9,500 registered advisers would pay an average of $8,100 in accounting fees. For those who are not yet registered, get your wallets out; this is going to get expensive.

Smaller accounting firms may try to get into the surprise audit business even if they are not the fund's primary auditor by offering a lower cost solution. The overall approach from the SEC's perspective may be quite effective.

Russia's latest troubles

If you think the US banks have a long road to recovery, take a look at Russian banks. The Russian banking system struggling, and more pain is on the way.

From Reuters:

March 27 - Hundreds of small Russian banks could go bankrupt because the level of bad loans is likely to hit 15-20 percent by the end of the year, Alfa Bank President Pyotr Aven said.

May 19 - Problem loans could soar to 35-50 percent of total lending in Russia, Ukraine and Kazakhstan, though actual loan losses will be no more than half that level in Russia, Standard & Poor's said.

June 1 - Russian banks may need around 1.3 trillion rubles ($41.51 billion) for recapitalisation in 2009, Moody's said, predicting capital erosion would be the major trigger for rating downgrades.

Ak Bars Bank, Gazprombank, Bank Saint-Petersburg, Credit Europe Bank Ltd., Bank SOYUZ, JSCB are on Moody’s downgrade watch (whatever that’s worth).

$41.51 billion may seem like a small number by the US standards, but it's a tough nut to crack for the Russians.

Russia has been hit by the global credit crisis (including a domestic mortgage problem), while relatively low oil prices are causing havoc. A complete luck of foreign investment (given the government’s nasty attitude toward foreign shareholders) doesn't help either. Unlike China and India, the Russians have little going for them in terms of exports outside of the oil and gas and maybe the defense sector. They never truly encouraged small business (either manufacturing or technology). The country is producing at nearly half capacity.



From Bloomberg:

Russia’s economy will probably shrink 6.8 percent this year because the government was slow to launch its anti-crisis plan, the Organization for Economic Cooperation and Development said.

An even more pessimistic assesment came from the World Bank: Forbes::

Russia's economy will shrink by 7.9 percent this year, plunging millions of people into poverty and pushing the unemployment rate to 13 percent, the World Bank said Wednesday.

If oil prices don’t recover significantly, there could be further trouble. The Russian sovereign CDS levels are indicating increased concerns.

The steepening volatility skew

From Bloomberg:

Downside skew, which gauges the relative cost of buying insurance against a slide in stocks, is now higher than it was when the Standard & Poor’s 500 Index dropped to a 12-year low on March 9. That indicates a “relatively high chance of downside moves,” the brokerage wrote in a report dated yesterday

Option skew is back to Feb-09 levels with out-of-the-money puts are getting bid up again as people are getting uneasy with the rally. The chart here shows how the skew (implied volatility for different strikes) flattened through the rally and steepened again recently (1 month options on SPYs with option strikes represented as % in or out-of-the money.)

Put risk managers on corporate boards (particularly the self-promoting ones)

A Sober Look reader pointed out an article written by Mr. Donald van Deventer from Kamakura (a software firm named after a town in Japan). The commentary on RiskCenter.com is called "Where are the Risk Management Experts on Bank Boards?".

And indeed we could use some risk management expertise in the boardroom. But where does one find such expertise and what qualities should that person possess? Well according to Mr. van Deventer here are some "suggestions".

Qualifications:

Education: The board member needs a graduate education, preferably a Ph.D

hmmm, maybe some common sense with that Ph.D?

Specialist Training. It's not enough to be "a doctor" if the specialty needed is brain surgery, not urology.

Does that mean that any doctor can be a urologist? Maybe Mr. van Deventer will change his mind when he needs one.

Experience. An academic background in finance needs to be combined with training in the hard knocks of risk as a business person or advisor to business people.

With some hard knocks, no doctor will be able to help at all. How about a board member that knows how to build a business?

Guts. The director will ultimately have to take a stand against the CEO on risk issues.

Guts? There you would need a GI specialist. And by the way, taking on CEOs has little to do with being a risk manager. It has more to do with the Board's independence and shareholder involvement.

Mr. van Deventer provides a curious list of potential candidates for the "risk manager on the board" position. The list covers academic celebrities, quants who developed models for banks, financial software gurus, etc. Not clear how many know anything about running a business (which may be helpful to being on the board.) It includes celebrities like Fischer Black, Robert Merton, and William Sharpe. There is also Allen Wheat who nearly brought down CSFB with their exposure to Russia and even John Meriwether (Salomon, LTCM). Both are perfect for a BOD of a bank.

Warren Buffett is not on that impressive list of risk management talent because he either doesn't have a Ph.D., doesn't understand risk management, or can't stand up to corporate CEOs. But there is one candidate on that list who stands out, and it is none other than Mr. Donald van Deventer from Kamakura.

The shifting regulatory landscape

This is a great summary from the FT, showing how financial regulation is shaping up.

It's interesting to see how it is categorized: systemic risk, bank capital, consumer protection, OTC derivatives, and hedge funds. Items excluded are money markets, securitization, off-balance sheet financing, rating agencies, and some other issues that may be just as critical.

What did it take to stabilize the US financial system?

The number is difficult to fathom. If you add up all the "temporary loans, liability and asset guarantees, and other government programs supporting financial institutions" put together during this financial crisis, what would you think the number will add up to?

Over 13 trillion dollars. That's what it took to stabilize the financial system (assuming it has been stabilized). That is roughly one full year of the US GDP. Granted much of this is guarantees and future commitments. Only a fraction was actually funded with taxpayers money. But the sheer size of these programs is mind boggling.

From FDIC (keep in mind the figures in this table are in billions):

IMF hedging it's bets on economic recovery

If you look at the IMF (www.imf.org) recent projection of economic growth for the World, you will see a nice V-shape picture. Everything will be back to normal shortly.

However the words from IMF according to CNBC last week were quite different:

Worst of Crisis May Be Yet to Come: IMF Chief

The head of the IMF questioned on Monday debate about when to roll back stimulus spending, saying the world economy had yet to weather the worst of a recession that claimed a record number of European jobs.

Now the the chart above and the statement just don't reconcile. Of course CNBC is known to "stretch" what was actually said. So let's take a look at another source:

From Reuters:

* IMF says need to be cautious about economic recovery

* Strauss-Kahn says worst of crisis not over yet
...
The worst of the global economic crisis is not yet over but there are signs that the world has started to crawl out of recession, International Monetary Fund chief Dominique Strauss-Kahn said on Monday

It is clear that IMF is trying to hedge it's bets. They projected a nice quick recovery and if it doesn't happen, well, they told us the worst is not over.

Benchmarking the current recession

The Council on Foreign Relations (www.cfr.org) published an excellent paper that visually (using charts) compares the current recession to previous down cycles including the Great Depression. Here are some of the more striking results:

In spite of the recent rally, credit spreads remain wide relative to previous cycles:




The world trade has come off the cliff. Of course this is not a fair comparison, given that globalization is a more recent phenomenon.




The housing price move relative to the great depression is stunning in it's appreciation as much as the collapse:




This chart shows just how severe the government spending vs. tax receipts has been relative to the Great Depression. Supposedly the idea now is not to repeat the mistakes of the Great Depression and immediately push through the massive stimulus. But at what cost? And what happens when the stimulus spending ends?

The LBO model on trial

Since it has become fashionable to push around large creditors of bankrupt corporations, a new development is taking place that may redefine the leveraged buyout landscape. Mass media is not covering it - mostly due to a lack of understanding of the potential impact.

The subordinated creditors of Lyondell Chemical are seeking to file a lawsuit alleging that the acquisition of the company by Basell constituted a “fraudulent conveyance”. The leveraged acquisition according to the claim was bound to make the company insolvent the minute it was completed.


From Reuters:

Unsecured creditors of bankrupt Lyondell Chemical Co are seeking approval to sue billionaire Len Blavatnik and the group of banks and advisors that led the petrochemical maker's $12.7 billion leveraged buyout by Basell AF S.C.A in 2007, saying the deal left the company with too little capital to fund operations.

The unsecured creditors are saying that Basell massively overpaid for Lyondell and did it mostly with newly minted debt of $22 billion in secured loans. $12 billion of that went to Lyondell's original shareholders ($1.2 billion to Blavatnik who was a 10% holder.) The rest went to pay pre-existing debt. Nothing improper so far. But the crux of the case is that this much debt "left the company with too little capital to fund operations" and it was bound to go under from the start.

To a large extent the unsecured creditors are right. It was obvious to many from the start that there was a high risk of this much leverage chocking the company. And here is what the unsecured creditors want to do:
From Reuters:

The creditors are seeking the return of billions of dollars of "fraudulently transferred" assets, and say the potential recoveries to the company's bankruptcy estate would be "enormous."

They are trying to extinguish all of the senior secured debt, all $22 billion of it. They are calling the debt fraudulent.

The defendants in the suit are the usual suspects that provided senior financing: Citi, Goldman, Merrill, ABN Amro, UBS, Apollo, Barclays, Deutsche. In addition they named Lyondell’s directors, Basell's directors, and of course Blavatnik who orchestrated the whole thing.

So what does it all mean? Well this debt and this transaction are actually fairly typical of the leveraged buyout deals completed in recent years. Hundreds of billions of LBO transactions resemble the Lyondell buyout. And in most cases (of course after the company fails) one could make the argument that the original shareholders who sold the company got paid hadnsomly, while the excessive leverage choked the company's operating ability.

In the good old days, recoveries on senior bank debt in the case of bankruptcy was modeled to be 80-90%. Even in cases of fraud, recoveries were high. Remember Refco? Senior loans actually recovered at par.

These days DIP financing and rolling of existing debt is much harder to come buy. Asset sales and acquisitions are difficult because financing is not there. Recoveries look more like 50% - 60% or even lower for secured paper.

But now if the unsecured creditors win, the $22 billion of Lyondell loans will be worth:


From First Data to TXU, as we discussed earlier, LBO loans will face a wall of maturities. The Lyondell case may set a nasty precedent that will create a bit of a headache for the holders of hundreds of billions in senior secured LBO debt.

A letter to Mr. Murdoch

Dear Mr. Murdoch:

When you took over the Wall Street Journal not long ago, you made a promise you will not influence the editorial integrity of the paper. We understand that you have to sell newspapers. Sensationalism works in the media and it has worked for you numerous times in the past. But does it justify turning the Wall Street Journal into a tabloid?

The photo you chose to plaster on the front page doesn't belong there. People certainly must know what is happening in Iran. We discussed that issue in detail, including that gruesome video. The goal was to expose the brutality of the regime and the struggles of Iran's people.

But Neda and her family deserve better than to be used to sell copies of the Wall Street Journal. This is not significantly different than a certain New York City tabloid who chose to print a photo of Eric Clapton's dead child (after a tragic accident) on the front page some years back. This is just in bad taste.

Sincerely,

Sober Look

World Bank report is getting markets back to reality

From the World Bank:

Amidst global economic recession and financial-market fragility, net private capital inflows to developing countries fell to $707 billion in 2008, a sharp drop from a peak of $1.2 trillion in 2007. International capital flows are projected to fall further in 2009, to $363 billion
...
Developing countries are expected to grow by only 1.2% this year, after 8.1% growth in 2007 and 5.9% growth in 2008. When China and India are excluded, GDP in the remaining developing countries is projected to fall by 1.6%, causing continued job losses and throwing more people into poverty. Global growth is also expected to be negative, with an expected 2.9% contraction of global GDP in 2009.
...
“Many corporations will be hard pressed to service their foreign currency liabilities with revenues earned in depreciating domestic currencies at the same time that export demand has plummeted,” noted Mansoor Dailami, Manager of International Finance in the Prospects Group and lead GDF author.

The announcement in and of itself is not surprising. What is interesting however is how strongly the markets are responding, all pointing to a higher risk in the system. Here are the reactions:

S&P500


Oil:


Brazilian real spot (BRL dropping vs. USD)


VIX


Private capital inflows have stalled and are projected to fall further. The reality must be finally setting in that the "V" looks more like an "L" (as we discussed earlier).

Here is the video on this report from the World Bank: