Debt Rattle, April 23 2008: The Crunch Continues

Wal Mart 2012

Dorothea Lange Crossroads Store, Person County, North Carolina 1939

Ambac Posts Loss on CDO Writedowns, New Business Drop

Ambac Financial Group Inc., the bond insurer that lost 93 percent of its stock market value in the past year, posted a wider loss than analysts estimated after $3.1 billion in charges for subprime-mortgage securities.

The world's second-largest bond insurer tumbled as much as 37 percent in New York Stock Exchange trading after reporting a first-quarter net loss of $1.66 billion, or $11.69 a share. The company's operating loss of $6.93 a share was more than three times the $1.82 estimated by six analysts surveyed by Bloomberg.

Ambac, MBIA Inc. and the rest of the industry have posted record losses and put their AAA ratings at risk after expanding from guaranteeing municipal bonds that rarely default to insuring securities linked to mortgages that are now going delinquent at the highest rate since 1985. Ambac's new business slumped 87 percent last quarter as bond issuers were reluctant to take out policies at insurers with questionable creditworthiness.

This ``could send a negative ripple effect through the market,'' said Wayne Schmidt, senior portfolio manager at AXA Investment Management in Minneapolis, which has about $14 billion in assets under management. ``It sends a message that we're not out of the woods yet.''

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Stoneleigh: The credit crunch is by no means over, in fact it has barely begun. Statements to the contrary are reflections of the optimism associated with a counter-trend rally, but that rally is nearing an end. Despite the rise of commodity prices, inflation is not the problem - deflation is. Credit is being destroyed - due to writedowns, the need to increase reserves and most fundamentally a lack of trust - faster than central banks can inject liquidity.

The Credit Crunch is Dead! Long Live the Credit Crunch!

Most observers have deemed the credit crisis to be over, and are now focusing on such pressing questions as how fast the recovery will be and how bad inflation might get.

Perhaps I am inflexible and unable to adapt to new information, but I don't see what has been accomplished beyond kicking the can down the road three to nine months. As reader Scott noted:

Basically what's happened is that we've moved bad paper from the banks, where it needed to get marked to market, at least at some point, to the Fed, where that doesn't have to happen. It's a sort of out of sight out of mind phenomenon. But all those CDOs and MBS and CLOs are made up of individual mortgages, and of hung LBO loans. They will either be paid off in the end, or they'll go into default. Assuming, as I think seems right, that some of them default, the Fed will have another line item on its balance sheet, REO. So as I see it, it's absurd to say the credit risk has been "disappeared"; it's just been moved from the banks to the public.

Let's consider just a few unpleasant realities. The Journal today points out that banks are increasing reserves, which means they need more capital (um, guess regulators are riding them to provide for likely losses ex ante rather than when they can no longer avoid taking them). The US consumer at some point is going to have to reduce spending as a percent of GDP; the open question is whether that happens in time to avert a dollar crisis (given the Fed determination to reflate assets and preserve demand, we seem to have an answer as far as the intent of policy is concerned). But then again, as reader Steve pointed out, Fed governor Frederic Mishkin testified before Congress last week that small businesses, the big engine of job growth, are starting to have trouble getting credit (they are heavily dependent on loans collaeralized by real estate and credit card borrowing, both of which are scarce and costly now).

And our old litany of woes has merely retreated from the fore rather than gone away: we still have the monolines almost destined to come apart at some point, the fact (as John Dizard pointed out) bigger GSEs are systemically destabilizing due to their pro-cyclical hedging, the not trivial problem that the housing market won't bottom till 2010 at the earliest, with more writedowns resulting, and my pet worry, CDS. As I understand it (and better informed readers can chide me if I am wrong), the CDS market basically has to keep growing to stand still. Again, perhaps I am too old school, but with inadequate margining/equity provisions, it seems guaranteed to go into crisis. You don't get happy endings with ever mushrooming bets on underlying equity that fails to show corresponding growth.

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Triple-A Failure

Nothing sent the [credit ratings] agencies into high gear as much as the development of structured finance. As Wall Street bankers designed ever more securitized products — using mortgages, credit-card debt, car loans, corporate debt, every type of paper imaginable — the agencies became truly powerful.

In structured-credit vehicles like Subprime XYZ, the agencies played a much more pivotal role than they had with (conventional) bonds. According to Lewis Ranieri, the Salomon Brothers banker who was a pioneer in mortgage bonds, “The whole creation of mortgage securities was involved with a rating.”

What the bankers in these deals are really doing is buying a bunch of I.O.U.’s and repackaging them in a different form. Something has to make the package worth — or seem to be worth — more that the sum of its parts, otherwise there would be no point in packaging such securities, nor would there be any profits from which to pay the bankers’ fees.

That something is the rating. Credit markets are not continuous; a bond that qualifies, though only by a hair, as investment grade is worth a lot more than one that just fails. As with a would-be immigrant traveling from Mexico, there is a huge incentive to get over the line.

The challenge to investment banks is to design securities that just meet the rating agencies’ tests. Risky mortgages serve their purpose; since the interest rate on them is higher, more money comes into the pool and is available for paying bond interest. But if the mortgages are too risky, Moody’s will object. Banks are adroit at working the system, and pools like Subprime XYZ are intentionally designed to include a layer of Baa bonds, or those just over the border. “Every agency has a model available to bankers that allows them to run the numbers until they get something they like and send it in for a rating,” a former Moody’s expert in securitization says. In other words, banks were gaming the system; according to Chris Flanagan, the subprime analyst at JPMorgan, “Gaming is the whole thing.”

When a bank proposes a rating structure on a pool of debt, the rating agency will insist on a cushion of extra capital, known as an “enhancement.” The bank inevitably lobbies for a thin cushion (the thinner the capitalization, the fatter the bank’s profits). It’s up to the agency to make sure that the cushion is big enough to safeguard the bonds. The process involves extended consultations between the agency and its client. In short, obtaining a rating is a collaborative process.

The evidence on whether rating agencies bend to the bankers’ will is mixed. The agencies do not deny that a conflict exists, but they assert that they are keen to the dangers and minimize them. For instance, they do not reward analysts on the basis of whether they approve deals. No smoking gun, no conspiratorial e-mail message, has surfaced to suggest that they are lying. But in structured finance, the agencies face pressures that did not exist when John Moody was rating railroads. On the traditional side of the business, Moody’s has thousands of clients (virtually every corporation and municipality that sells bonds). No one of them has much clout. But in structured finance, a handful of banks return again and again, paying much bigger fees. A deal the size of XYZ can bring Moody’s $200,000 and more for complicated deals. And the banks pay only if Moody’s delivers the desired rating. Tom McGuire, the Jesuit theologian who ran Moody’s through the mid-’90s, says this arrangement is unhealthy. If Moody’s and a client bank don’t see eye to eye, the bank can either tweak the numbers or try its luck with a competitor like S.&P., a process known as “ratings shopping.”

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Stoneleigh: What Mish describes here is already happening, just as it did in Japan - credit destruction is outpacing the attempts of central banks to create liquidity - and this is still near the beginning of the deleveraging process. I agree with him that the recent actions of central bankers have only postponed an unwinding that they cannot prevent. Central bankers are hoping they can oulast what they see as a temporary period of market uncertainty, a period that they are betting will end before they run out of ammunition. This is a gamble the central bankers are destined to lose.

Unfortunately for all of us, the credit that was interchangeable with money for so long during the expansion phase will not be considered so during the contraction. Thanks to that credit, the effective expansion of the money supply in recent years has been vastly larger than conventional money supply measures would suggest. The on-going destruction of that credit, which should pick up speed considerably once the current counter-trend rally is over, will therefore amount to a crash of the effective money supply.

Deflation In A Fiat Regime?

I was asked by professor Lance Lewis (and many others) to reply to on a post by Doug Noland called Setting the Backdrop for Stage Two. Before reviewing Noland's post I would first like to comment on this statement made by Professor Lewis: " I have never been one to believe you can have a true deflation with a fiat currency."

Before we can begin any discussion, it is imperative to agree on the meaning of terms. I happen to believe in Austrian economics and the definition I use when I speak of inflation is a net increase in money supply and credit. Deflation is the opposite, a net decrease in money supply and credit. For more on those definitions as well as rationale for discarding seven other definitions, please see Inflation: What the heck is it?

Assuming that there is agreement as to what inflation and deflation are, it is quite easy to refute the idea that deflation cannot occur in a fiat regime. Japan was in deflation for a decade.

However, some still argue that Japan never went through deflation. One basis for that argument is that "money supply" as measured by M1 or base money supply never contracted over a sustained period. The other argument is that prices as measured by the CPI never fell much. Those are flawed arguments (at least from an Austrian economist point of view) given the focus on consumer prices and money supply alone as opposed to money supply and credit.

Although Japan was rapidly printing money, a destruction of credit was happening at a far greater pace. There was an overall contraction of credit in Japan for close to 5 consecutive years. Property values plunged for 18 consecutive years. The stock market plunged from 40,000 to 7,000. Cash was hoarded and the velocity of money collapsed. Those are classic symptoms of deflation that a proper definition incorporating both money supply and credit would readily catch. Those looking at consumer prices or monetary injections by the bank of Japan were far off the mark.

Yes, there was deflation in Japan. Furthermore, if deflation can happen in Japan, then there is no reason why it cannot happen in the US as well.

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Why Wall St. Needed Credit Default Swaps

Take a CDO with a 50 basis point spread over US Treasures. Banks will buy credit default swaps costing them 20 basis points, but by doing so, even they seem to make less profit (50 vs. now only 30 bp spread), banks can actually book the difference in spread for the whole life of this CDO instantly, something called negative-basis trade.

If this CDO life is 10 years, banks can book the whole 10 years of phantom profits this year, even if this CDO defaults sometime in next 10 years. And I don't need to mention its implications for the bonuses of the structured product groups at Wall St firms, or hedge funds with 2/20 fee structure.

In other words, who cares whether this CDO defaults next year, let us just realize the next 10 years of bonuses today! There is a common secret at Wall St. - it doesn't matter whether a product is good or bad, the only thing matters is how you structure it. As former Secretary of the Treasury, John Connely, said to European central banks in 1970s' "It might be our currency (US dollar), but it is your problem". Same thing here. If CDO defaults, they have already bumped up the stock price, cashed out the stock options and their vested shares, collected the yearend bonuses, now it is investors' problem.

This kind of accounting manipulation can fool people for a few years, but not forever, since the well of CDOs gets sucked dry very quickly when every single firm on Wall St. has found out about this and is doing it. Any firm owning a mortgage originator has a competitive "advantage" since it guarantees the source for the well. Now you know why Stanley O'Neal at Merrill Lynch wanted to buy First Franklin (a mortgage loan originator) so badly, because for every loan First Franklin originates, Merrill Lynch executives and their structured product groups will advance 10 years of their firm's earnings and future bonuses today.

Now you understand why Wall St wants to package and collateralize everything from residential to commercial, from mortgage to credit card to auto loan. Now you also realize what is behind the major shift and increase from traditional M&A fees in the good old days to the so-called trading "profit" in recent years "earned" by investment banks.

But at the same time, this raises a lot of questions about how real are the past earnings reported by both Wall St firms and hedge funds with large CDO profits. For example, if a hedge fund manager can trade minor reduction of profit (from 50 to 30 bps) with an immediate bonus of 10 times (1 vs. 10 years) paid today, what would he choose?

He would be nuts for not using credit default swaps to "structure" his CDO holdings. If the CDO defaults next year and take his fund under the watermark, it's no a big deal. He already collected 20% money from the "profit" the year before. He can just close the fund and open another new one, raising money probably from the same sucker pool of investors. If you want to see a pyramid scheme, there is nothing more live and vivid than this.

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Stoneleigh: I disagree that the dollar is in danger of ceding its global dominance to the euro. The dollar has indeed declined against the euro for several years, but extrapolating current trends into the future is simplistic. It does nothing to anticipate trend changes, and I think we're very close to a reversal of that trend as well as many others - commodity prices, equities, treasuries, the perception of inflation etc.

Tremendous internal pressures are developing in the eurozone as economic fortunes diverge across member states. In contrast, the dollar should benefit from a flight to safety once the current counter-trend rally in the market is over.

A rising euro threatens American dominance

As the dollar continues its relentless six-year slide against the euro and other main currencies, the question is being asked more and more: what would it mean if the dollar ceded its global dominance to the euro?

The question is a serious one because the US Federal Reserve is pumping new dollars into the global economy at an astounding pace. A broad measure of US money supply growth is increasing at a rate not seen since 1971 when President Richard Nixon imposed price controls and ended the dollar's convertibility into gold, which recently roared above $1,000 an ounce. With consumer prices having climbed 4 per cent from a year ago, and wholesale prices having soared 6.9 per cent, presaging higher consumer price inflation around the corner, we are living witnesses to Milton Friedman's famous dictum that "inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output".

The Fed is acting with the best of intentions to head off a recession. But in a rapidly globalising financial marketplace it is in fact accelerating the demise of its own unique powers. Virtually all national economies show a positive link between currency depreciation and inflation and between depreciation and interest rates, meaning that their central banks cannot use loose monetary policy to stimulate their economies – it only fuels capital outflows and a rise in market interest rates to attract it back. Not so the US, whose currency has commanded a unique premium as the global store of value and the transaction vehicle for international trade. But this may be changing. The dollar is looking more and more like a typical developing country's currency, with long-term market interest rates, crucial to determining borrowing and investment behaviour, climbing as the Fed pushes hard in the other direction.

If international use of the euro were to continue to rise, the Fed would lose other important powers. In a financial crisis, central banks are supposed to act as "lenders of last resort", printing money to prop up banks and reassure their depositors. This does not work in developing countries. People withdraw money anyway, not because they fear the governments will let the banks collapse but because they fear the inflation and depreciation that printing money brings. So they exchange it for dollars, undermining the putative powers of their central banks. But what if Americans were to do the same, selling dollars for euros in a crisis? The Fed would become impotent. This is not science fiction. American investors have lately been pouring money into foreign bond funds at a record rate.

What about currency crises, the bane of developing countries? These happen when investors, local as well as foreign, fear that the country may face a shortage of foreign money, necessary to pay off its debts. If America were to become obliged to trade and borrow in euros, rather than dollars, it would face the very same risks.

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Stoneleigh: I agree with the description that any return to economic growth will be facing "super-headwinds" from the financial sector. The economic effects are only just beginning to be felt and there's a long, long way to go to the downside. An "L-shaped recession" doesn't begin to describe the severity of what's coming.

Road to ruin? America ponders the depth of its downturn

Will it be a V-shaped recession – short, shallow and followed by a rapid return to normal rates of growth? Will it be U-shaped, in which the initial downturn is followed by a protracted period of weak growth and a slow return to the trend rate? Or could it even be an L-shaped recession – with economic weakness lasting for many years, as in the US during the Great Depression or Japan in the 1990s?

The answer will have enormous significance for the world economy and is likely to determine whether the recent improvement in some financial markets marks the beginning of the end of the credit crisis, or simply another false dawn.

The Federal Reserve believes the single most likely outcome is a V-shaped recession, though it sees significant risks of a deeper and more prolonged downturn. Fed staff expect economic activity to contract in the first half of this year, with a pick-up in growth beginning in the second half. They predict growth will be above trend – more rapid than normal – in 2009, when measured from the final quarter of 2008 to the final quarter of 2009....

....Alan Blinder, a professor of economics at Princeton and a former Fed vice-chairman, says the economy will struggle to return to normal growth in the face of "super-headwinds" emanating from the financial sector.

With banks under balance-sheet pressure and the financial system as a whole deleveraging, the credit squeeze on the real economy could continue even after the risk of a systemic crisis in the banking sector recedes.

Moreover, the impact of the tightening to date is only now beginning to be felt in the economy. Richard Berner, chief US economist at Morgan Stanley, who expects a lacklustre recovery, says that "given the time lags between when financial conditions tighten and when it shows up in the economy we still have a long way to go."

With the markets for housing finance still dysfunctional, the downturn in both construction and home prices could prove more protracted than the Fed expects. Global growth could also weaken as the effects of the credit crisis are felt in Europe and possibly even in emerging markets such as China.

Yet at the centre of the debate is consumer spending, which accounts for about 70 per cent of the US economy. Consumers are grappling with falling net worth, tightening credit conditions, higher energy and food costs, and a softening labour market.

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Stoneleigh: Flows of hot money into agricultural commodities are having a highly destabliizing effect. They fuel volatility, which in turn creates the uncertainty that can lead to the development of a hoarding mentality. Once that line is crossed, it becomes far more difficult to keep the market adequately supplied.

Price Volatility Adds to Worry on U.S. Farms

Fred Grieder has been farming for 30 years on 1,500 acres near Bloomington, in central Illinois. That has meant 30 years of long days plowing, planting, fertilizing and hoping that nothing happens to damage his crop.

"It can be 12 hours or 20 hours, depending," Mr. Grieder said.

But Mr. Grieder's days on the farm in Carlock, Ill., are getting even longer. He now has to keep a closer eye on the derivatives markets in Chicago, trying to hedge his risks so that he knows how much he will be paid in the future for crops he is planting now. And the financial tools he uses to make such bets are getting more expensive and less reliable.

In what little free time he has, Mr. Grieder attends Illinois Farm Bureau meetings to join other frustrated farmers who are lobbying officials in Chicago and Washington to fix a system that was designed half a century ago to reduce uncertainty for food producers but is now increasing it.

Mr. Grieder, 49, is shy about complaining amid so much prosperity. Prices for his crops are soaring on the updraft of growing worldwide demand, and a weak dollar is making the crops more competitive in global markets.

But today's crop prices are not just much higher, they also are much more volatile. For example, a widely used measure of volatility showed that traders in March expected wheat prices to swing up or down by more than 72 percent in the coming year, three times the average volatility for that month and the highest level since at least 1980. The price swing expected in March for soy beans was three times its monthly average, and the expected volatility in corn prices was twice its monthly average.

Those wild swings in expected prices are damaging the mechanisms — like futures contracts and options — that in the past have cushioned the jolts of farming, turning already-busy farmers into reluctant day traders and part-time lobbyists....

.....Since 1959, grain producers have been able to hedge the price of their wheat, corn and soybean crops on the Chicago Board of Trade through the use of futures contracts, which are agreements to buy or sell a specific amount of a commodity for a fixed price on some future date.

More recently, the exchange has offered another tool: options on those futures contracts, which allow option holders to carry out the futures trade, but do not require that they do so. Trading in options is not as effective a hedge, farmers say, but it does not require them to put up as much cash as is required to trade futures.

These tools have long provided a way to lock in the price of a crop as it is planted, eliminating the risk that prices will drop before it is harvested. With these hedging tools, grain elevators could afford to buy crops from farmers in advance, sometimes a year or more before the harvest.

But that was yesterday. It simply is not working that way today.

Futures, for example, are less reliable. They work as a hedge only if they fall due at a price that roughly matches prices in the cash market, where the grain is actually sold. Increasingly — for disputed reasons — grain futures are expiring at prices well above the cash-market price.

When that happens, farmers or elevator owners wind up owing more on their futures hedge than the crops are worth in the cash market. Such anomalies create uncertainty about which price accurately reflects supply and demand — a critical issue, since the C.B.O.T. futures price is the benchmark for grain prices around the world.

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Commodity Volatility Creates Problems for Farmers (and May Explain an Inventory Mystery)

The recent upswing, and the entry of speculative capital, has led to a sharp increase in volatility (note that that's the reverse of what theory says you ought to expect. More liquidity is purported to lower volatility). And that has created new problems, Crop insurance is more expensive when prices are erratic. Worse, grain elevators refusing to buy crops in advance, forcing more farmers to hedge themselves, which is particularly risky since they might not have enough cash on hand to meet margin calls.

Aside: would a forward sale to a grain elevator be counted as inventory by the elevator company? If so, some of the apparent inventory tightening might be an accounting phenomenon (although the US may not be a big enough player in the commodities in which this is happening for that factor to have much impact).

Aside from the difficulties that the farmers are facing, the article does contain signs that speculation is overwhelming fundamental activity. One big warning sign mentioned in passing: trading has outgrown the delivery system. If I read this correctly, it means that the volume of futures contracts is so large relative to the actual deliverable commodity that arbitrage (via taking physical delivery) won't force convergence of futures prices to cash prices at contract maturity.

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The Moral Hazard Club

I know some people applaud the Fed for being creative. I believe it's played the ultimate moral hazard cards for investment banks. The banks take low quality loans, turn them into esoteric securities, sell them to investors, pay themselves huge bonuses, lever their balance sheets with esoteric securities and are then allowed to simply ship them off to Fed in exchange for Treasuries. The Fed has now become nothing more than a hedge fund in disguise. The notable exception is that unlike a fund like ours, the Fed doesn't have a 'P & L'. The Fed can take these securities onto its balance sheet -- just like the Resolution Trust Corporation did in the early 1990's -- except eventually the assets will probably be written down and taxpayers will foot the bill.

What strikes me as particularly odd is that there seems to be some favoritism displayed here by the Fed. Millions of people have lost their homes or will likely soon lose their homes, the economy is sinking into recession, companies are going bankrupt and what do we do? We allow brokerage firms and banks to shamelessly exchange their 'supposedly AAA rated Mortgage Backed Securities' for Treasury securities of the Federal Reserve.

I use the word 'supposedly' because if they were really AAA and had a market, why wouldn't these firms just sell them in the open market? Because there is no market.

I've been referring to our economy as an 'asset based economy,' one based on high levels of money and credit growth, for the better part of ten years. Now credit growth and leverage have finally caught up with the creators of this mess, namely the Fed and the broker-dealers themselves. Since the government has begun to rescue them from their own self inflicted wounds, I guess you can call the dealer community 'the Moral Hazard Club'.

What I want to know is why I didn't get an invitation into the club. We manage money on behalf of clients and ourselves, yet when we make mistakes, I can't just call up Chairman Bernanke and ask how I exchange my mistakes for Treasuries at 2.5% per year. It would be nice -- and would feel shameless -- but I have to admit that if I had a free put option underneath every trade, I would take a lot more risk. Wouldn't you?

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Delta, Northwest report huge losses, write downs

Delta Air Lines and Northwest reported dramatically wider first-quarter losses on Wednesday because of billions of dollars in one-time charges related to their decline in market capitalization and the sky-high cost of fuel....

.... On April 14, Delta and Northwest Airlines announced their intention to merge operations to better compete with international rivals and more effectively combat the impact of fuel record-high fuel prices.

"The merger with Northwest will create an airline with the size, scale and global presence to weather economic downturns and compete long-term in the global marketplace," said Richard Anderson, Delta's chief executive.

The deal is expected to close by the end of the year, but is also expected to face significant antitrust scrutiny.
Before then, Delta expects to mothball between 15 to 20 mainline aircraft and between 60-70 regional jets, which should cut domestic capacity in the second half of 2008 by 9% to 11%, and system capacity to be between flat and down 2%. The move is expected to trim costs by removing older, more expensive aircraft form the fleet and by eliminating lower yielding routes.

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