Wednesday, November 12, 2008

The Next Era of Global Finance

The US economic crisis is different. The current credit crisis, more cleverly titled "Dis-intermediation Crisis" by Roubini, is an endogenous and central event emerging from the epicenter of the financial system. The periphery was supported by the inherent leverage and risk taking behavior of the deregulated financial system. In an all out search for yield the Western advanced economy speculators went abroad. The retraction of excessive risk taking behavior has brought us back to the fundamental elements of keeping our own financial house in order...i.e. holding U.S. dollars. This trend is particularly concerning to the authorities. Hoarding cash will be a self-reinforcing feed back process that will further destroy local and foreign economies. Macro-economic systems rely on transaction, credit, trust, confidence, consumption, and earnings. Simply put, the mammoth client in the room (the U.S. consumer) has stopped spending.

The exposure foreign economies have to the U.S. credit scenario will jar the central banks. Countries throughout Eastern Europe, South America, the Middle East, and across the globe have had a rude awakening to their global financial exposure. They will respond. Protectionist measures will prove to be a hard pill to swallow. Foreign economies have clustered industries, expertise, and policies that facilitate global trade. Try telling Brazil (a commodities based export economy) that they need to develop an advanced consumption based economy overnight. It simply will not happen. However, I suspect that surplus economies including the Middle East, China, and Russia will start spending their reserves domestically rather than abroad. Watch for a wave of global infrastructure developments, localized banking systems, and diversification amongst developing nations.

I'm hopeful that foreign measures to self develop will include localized banking regulations and impetus sufficient for broad financial propagation. Global de-centralization may be the unanticipated outcome of unregulated Western centralized capitalism. The tipping point of diffusion has been reached. This process, however, will most likely be seriously regulated. The next cycle of global finance could prove to be more hostile, protectionist, localized, regulated, politically driven, and government sponsored.

Sunday, November 2, 2008

Are the credit markets revived?

I've been watching quite closely the unfolding of the current economic crisis and it has been a series of staggering financial events. The core of the problem has been free market excesses that promoted self interest above the overall good. Financial engineering including the invention of structured credit products by JP Morgan in 1995 allowed banks to create off balance sheet credit conduits. Off balance sheet financing created a clear incentive for banks to pump volume rather than quality lending. The volumes were staggering. According to the Securities Industry Markets Association since 2001 more than $27 trillion dollars of structured finance products have been sold.

Issuance for 2008 is substantially lower. As of May 9, 2008 only $204.1 Billion has been issued in comparison to $434.9 Billion in the same period of 2007. Quite frankly, the system of securitization has come to a standstill. Money market managers are now fleeing the market. The only substantial volume left in the market is credit card securitization which is likely to suffer widening default spreads considering its tight correlation to unemployment. The reasons for the fall of structured finance are now well known.... conflicts of interests with rating agencies responsible for tranche categorization, risk managers unwilling to allow their firm to lose fees on trades, and market psychology that assumed housing prices never decline. The more important question is what will follow?

The red hot market concern should be what will replace the current American credit structure? Instead, the Fed is rushing to support the most fundamental money market mechanism that have been severely impacted from the collateral damage of the credit crisis. When I say fundamental market mechanisms I am referring to interbank lending and commercial paper issuance. It is no surprise that an implosion in structured finance has shaken the money markets to their core processes. It was the very nature of structured finance to leverage money markets to their greatest extent possible. In fact, we should all be proponents of structured finance because of its ability to maximize the efficiency of capital.

How will the credit market resolve? Ideally, these structured products become transparent, subject to objective credit quality analysis from truly independent third parties, and exchanged on accessible markets (i.e. NYSE, Chicago Mercantile Exchange, Chicago Board of Exchange). offers tranched pricing for asset backed securities. But the quality of the credit is unknown and seriously questioned as evidence of the current pricing. Until the process is standardized and the credit quality of its contents completely understood I fear that structured finance will remain at a complete standstill.

Furthermore, the positive feedback mechanism is in place populating a very negative trend. Less credit, means less consumption, lower earnings, depressed housing prices etc. The wealth effect feeds on itself. As consumers feel the effect of $10.5 trillion being wiped from world wide equity markets in October, you can guarantee that it is not going to be a record holiday season. These lower earnings will perpetuate themselves the same way they reinforced themselves in the boom years. The market is pricing in a 2 year recession, although a nasty one.

In short, I'm not at all convinced that the credit markets have been resolved. In 2006 the US Asset Backed Securities market underwrote an astounding $2.3 Trillion of securitized debt. What will a $13.5 Trillion GDP do when the underpinnings of a $2.3 Trillion credit market evaporate? I suspect, it will decline continually until an innovative and trust worthy credit mechanism is revived.

Saturday, November 1, 2008

All Clear or a Pause in the Deleveraging Trend

The Human mind looks for patterns. It can't help itself. Patterns allow our brain to bundle, classify, interpret, and store an enormous complexity of information. Market psychology is incredibly prone to this mode of thinking. Truly analyzing the data from international finance, currency relationships, inflationary causes or trends, economic fundamentals, etc. will likely puzzle even the brightest minds. Patterns or narratives take the center stage in market psychology. A misapplication of particular patterns can lead to valuations far from fundamentals. Consider the common market psychology from 2000 to present that housing prices always appreciate. Or consider the parabolic rise in oil prices despite the fact that commodity bubbles often are the last to crash in periods of credit contraction. A narrative, a pattern, a synopsis often drive market trends.

The panicked wave of selling that hit all markets (currencies, commodities, equity, emerging markets, leveraged loans, corporate debt, municipal debt, asset backed securities, etc.) in October was quite alarming. The narrative and pattern that has captivated the market is de-leveraging. De-leveraging, is simply a process where highly levered balance sheets sell assets in an effort to reduce their asset to debt ratio. This kind of selling is chaotic and subject to market panic because there is a race to get out as fast as possible considering that everyone knows which direction prices are moving. The narrative is inherently unstable and fearful. The other aspect to this story that the market is well aware of is that a market wide de-leveraging process implies that there is no balance sheet left to buy assets.

I am not arguing that the fundamentals of all market narratives are inherently flawed. Our unique human ability to select the apt pattern is the primary cause for our success as a species. But, when these narratives are shared or mutated within a group, a movement, a market trend, a political movement, or other social contexts they can lead to ridiculous extremes. Case in point genocide.

So when do these extremes resolve or more importantly turn the tides? Typically when the self reinforcing elements of the narrative lose footing. I fear that the self reinforcing nature of the current panic hasn't fully played out. The US government has cleared nearly $1 Trillion dollars of balance sheet, but the US consumer, banks, hedge funds, and municipalities have not been resolved. More scary, is that another wave of selling could be faster and appear more bottomless considering that nearly all central bank efforts have been expended. A narrative of no relief. A narrative of zombie banks. A narrative of Japan's lost decade. A narrative of no lender of last resort. A narrative of defaulting sovereignty and the fall of the American empire. A narrative of selling that cannot be stopped.

Saturday, October 25, 2008

Bretton Woods 2....The next Shoe to Drop?

Recently I read Brad Setser's blog "The end of Bretton Woods 2?"( in which he referenced a paper written by himself and Nouriel Roubini in 2004. Bretton Woods 2 refers to the currency exchange rate relationship between industrialized nations that was negotiated and agreed to at the end of World War 2. 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States and agreed upon structures of international finance including the creation of the International Bank for Reconstruction and Development (IBRD) and the International Monetary Fund (IMF). The original Brenton Woods system sought to take advantage of the Gold standard and developed a system of fixed exchange rates. What emerged was the "pegged rate" currency regime. Members were required to establish a parity of their national currencies in terms of gold (a "peg") and to maintain exchange rates within plus or minus 1% of parity (a "band") by intervening in their foreign exchange markets (that is, buying or selling foreign money). A number of economists (e.g. Doole, Folkerts-Landau and Garber) have referred to the system of currency relations which evolved after 2001, in which currencies, particularly the Chinese renminbi (yuan), remained fixed to the U.S. dollar as Bretton Woods II. The argument is that a system of pegged currencies is both stable and desirable, a notion that causes considerable controversy.

According to Wikipedia:
"Bretton Woods II", unlike its predecessor, is not codified and does not represent any kind of a multilateral agreement. It contains the following key elements:

* The United States imports considerable amounts of goods, particularly from East Asian export-oriented economies such as China, Japan and various other Southeast-Asian countries.
* Since China and Japan don't have much demand for U.S.-produced goods, United States runs large trade deficits with both countries.
* Under normal circumstances, trade deficits would correct themselves through depreciation of the dollar and appreciation of the yen and the renminbi. However, the Chinese and Japanese governments are interested in keeping their currencies low with respect to the dollar to keep their products competitive. To achieve that, they are forced to buy large quantities of U.S. treasury securities with freshly-printed money.
* Similar mechanisms work in the Eurozone with the euro and its satellite currency (Swiss franc). The Eurozone is somewhat less coupled to the U.S. economy, so the euro has been allowed to appreciate considerably with respect to the dollar.

What I believe Roubini and Setser are arguing is that the pegged relationship of Asian currencies (primarily Renminbi)to the U.S. Dollar and the required reinvestment of Chinese surpluses into U.S. credit markets to maintain these pegs are inherently, unstable, self-reinforcing, and susceptible to a gross mis-allocation of capital (e.g. the U.S. Credit Bubble). I also think they are both surprised by the inverse nature of the current financial crisis and both believed that a weaker dollar would eventually jeopardize the China / U.S. trade relationship prior to cooling housing prices.

So will a rapid process of de-leveraging amongst financial intermediaries be the tipping point for the end of Bretton Woods 2? There is already very clear evidence that the Chinese and Petro-dollars are no longer chasing agency bonds (quite literally the only source of credit within the real estate market). Instead these funds are being shifted to treasury bonds and financing the TARP program recently put in place by Paulson. I suspect that cash strapped American consumer will continue to cut back on discretionary spending and cut the American lifeline to the Chinese and petro state economies. The wealth effect, permeating from the free fall in asset prices, will force American's to change their previously impenetrable spending patterns. By stopping this flow of funds to the Chinese and severely limiting the revenues of oil based economies the creditors of America's $800 billion current account deficit will be forced to rescind. The symbiotic twin engines of growth have stumbled upon a breaking point in their self reinforcing relationship. All signs point towards asset prices falling far below fundamentals.

Saturday, September 20, 2008

The Treasury's New Hedge Fund

Legislation is on the table proposing a $700 Billion taxpayer floated hedge fund operated by the Treasury Department. Who knows if the Democrats will make amendments that the White House can or cannot live with. The urgency, pressure, and patriotism seem to be brewing that often bring about non-partisanship decision making on Capitol Hill. The situation is dire. We are facing an all out collapse in the financial system of the United States. After Lehman's failure the most stunning news was the collapse of the money market system and the prospect of an all out run on the banks exposing the fractional reserve system. Furthermore, overnight lending stopped and the tri-party repo-system came to a screeching hault as banks hoarded cash. It should have came as no surprise that the federal government stepped in. The Federal Reserve was modified by legislation in the Great Depression that charged it with the responsibility to stabilize financial systems and use all of the tools necessary as the lender of last resort. What was inconsistent and unpredictable was the White House's policy towards bail-outs and rescues as it appears those decisions are less based on principal or economic philosophies as they are executive practicality, favoritism, and fear.

Paulson may be putting on the best trade in history. However the requirement to avert financial catastrophe by announcing his new hedge fund hasn't optimized his entry price. Paulson's proposal of a treasury hedge fund injecting $700 billion of liquidity into the frozen asset backed securities market is ironic to say the least. The biggest advocates of free market principals and the invisible hand are proposing the most socialist market bail-out in history. The biggest beneficiaries are likely the Broker Dealers on the cusp of free fall, Goldman, Merrill, and JP Morgan. After all, they will surely survive if this measure is approved. It's interesting that the largest financial transaction of human history was publicly announced prior to its execution. Try finding a Sovereign Wealth Fund that will let on any hint of potential investments. The treasury, of course, has done this purposefully to drive up the perceived value of Mortgage Backed Securities. Most participants in this market believe that Mortgage Backed Securities are priced far below their fundamental value as a liquidity hole exists in the market. Nearly all of the major asset backed security market players had on the same trade.

Where will these events take us next? The empire of debt has taken on an enormous new loan. A loan that was necessary to prevent an all out fire sale of assets and chaotic de-leveraging of the financial system. But our temporary relief will not change the fact that we are a nation of debtors living leveraged and beyond our means. A new era of economic hierarchy is among us as the cost of servicing our debt and recognizing the "true" value of our assets will limit our means of production and consumption. An economic stagnation similar to the lost decade of Japan will prevail and the dollar depressed unavoidable asset sale of the United States will push the boundaries of protectionism and independence.

Regional Banks

I think the Regional Banks are next. They are so dependent on big broker dealers like Lehman, Merril, etc. and liquidity in the money market. During the last couple decades they've flourished because interest rates were so low, and their was so much cash in the financial system. This allowed them to make big spreads on the difference between their borrowing rates and lending rates. Considering that the Ted Spread and Libor (London Inter Bank Overnight Rate) has spiked the last few days so dramatically (from 2% to 6% for libor) its will leave regional banks unable to cover deposit withdraws. The fed fund rate is low, but the actual cost of borrowing between banks has skyrocketed as their is no trust within the financial system. Banks have to borrow between one another to cover cash deficits and effectively use surpluses. I suspect a run on the regional banks as the main street phase of this problem. Regional banks also became very dependent on securitized lending. WAMU, National City Corp, etc. aggressively brokered auto, student, and housing loans regardless of the credit ratings of the borrowers. They made huge origination fees, closing fees, etc. The volume in the mortgage business was stunning. The loans were sold to big broker dealers like Lehman, Goldman, etc. who partitioned and put the paper back into the money market (pension funds, money market funds, and insurance companies bought it all up). The Fed is trying to inject the liquidity back (at the expense of the dollar). Regionals have been perceived as not particularly at risk considering that they have millions of customer deposits. A public run on the bank, not an inter-bank run will probably be next. There are Exchange Traded Funds that allow shorting of the regional indices.

Saturday, July 26, 2008

Credit as a Source of Market Instability

Banks are far more speculative endeavors than market prices reflect (perhaps until now). They always have been and could continue to be. Banks are the primary participants of market credit and credit is typically collateralized. Collateral is the speculative fever of the era. Nearly by definition. According to the Webster Dictionary collateral is "property (as securities) pledged by a borrower to protect the interests of the lender". Americans have typically held the majority of their wealth in the speculative collateral of that period. Weren't you in tech stocks in the late 90's, aren't you currently cutting spending to cover your mortgage? Don't blame congress, don't blame speculative sellers, blame the market's tolerance for credit. Credit has been the speculative class that is always revived. Not real estate, not equities, not commodities, not technological innovation.... Credit was extended to the tulip connoisseurs of the mid 17th century, credit was extended to the investors of the Japanese commercial real estate bubble, credit was extended to the "tigers", credit was extended in phenomenal portions to the American working class. Hence the reason why I am surprised that economists say the market will bounce back when housing prices bottom. The market will bounce back when the credit markets find a new source of collateral. And this time, I don't anticipate it will be the average American Consumer.

Wednesday, July 16, 2008

Fannie and Freddie Bailout: Politics and Financial Implications

Here we are on the cusp of a government led financial bailout for Fannie Mae and Freddie Mac. If credit markets reached a pinnacle of potential massive structural change, now is that peak. Freddie and Fannie are the current mortgage market. With the collapse of the "shadow banking system" Government Sponsored Enterprises are the only firms lending. Where does all of this money come from? Overwhelmingly, the Chinese. The Chinese are the largest buyers of Agency bonds. Agency bonds provide a better rate than T-Bills and they are "Government Sponsored", but not Government backed, I should add. The Chinese investment in US Agency Bonds fueled the housing boom. But now, the boom has gone bust along with the equity of the GSEs. The bonds have severely deteriorated in value, thereby eroding the lender's asset valuations. So how much is needed to bail out these enormous financial institutions? Paulson has proposed a $300 Billion bail out plan. Let me say that again...$300 Billion. Paulson will extend both a line of credit and allow the Treasury to purchase equity in Freddie and Fannie may. Clearly, Paulson's plan created new demand for GSE stock in the midst of a total collapse. A plan, not necessarily a congressional approval is shoring in its own right. I think the US Government lacks the resources for a bail-out of this size. It can lend to the GSEs and continue to pay the Chinese interest on non-performing mortgage backed bonds. I suspect the demand for such bonds will fall sharply considering the public knowledge agency debt is only backed by the Government and not performing assets. As bonds are dumped on the market interest rates will rise as they react inversely to the value of the paper. I see a flight of capital from the US, a continued fall in the dollar, the eventual de-pegging of the Chinese and Middle East Currencies (including the Yuan and Riyal), and higher interest rates as bidding for loans gets more competitive. The question is, where will all of the "conservative" quality capital go?

Thursday, July 3, 2008

Securitized Debt Issuance 2006, 2007, 2008

Let's project the current pace of global securitized debt issuance from the first half performance of 2008 until the end of year. According to the July 4, 2008 edition of Asset Backed Securities; $510.3 Billion worth of asset backed securities including Mortgage, Credit Cards, Student Loans, Auto, and others have been issued so far this year. Assuming issuance remains at the same pace for H2 as H1 issuance would total $1.2 Trillion Dollars.

2006 ABS Issuance: $2,600,000,000,000
2007 ABS Issuance: $2,200,000,000,000
2008 ABS Issuance: $1,200,000,000,000 (Extrapolated $510BX2)

Initial estimates for the beginning of the year were far too optimistic as many analyst expected only a 30% decline from 2006 levels (i.e. $1.8T). Clearly, we are in much worse shape.

As far as U.S. Securitized Debt is concerns the figures are as follows:

H1 2008: $113,700,000,000

2006 ABS Issuance: $906,500,000,000
2007 ABS Issuance: $594,200,000,000
2008 ABS Issuance: $227,500,000,000 (Extrapolated $113.7BX2)

Here are some more interesting figures:

2006 U.S. GDP $13,194,000,000,000
2007 U.S. GDP $13,841,000,000,000
2008 U.S. GDP $13,979,000,000,000 (at 1% Growth)

Asset Backed Securities as a Percentage of U.S. Gross Domestic Product

2006: 6.87%
2007: 4.29%
2008: 1.62%

Considering that $679 Billion and $1.4 Trillion of credit has been removed from the US and global market respectively between 2006 and 2008 I expect a dramatic reduction in consumer spending.

Saturday, May 31, 2008

Housing Bubble vs. Tech Bubble Loss of Wealth in Dollar Denominated Terms

How much wealth has actually been destroyed in the current housing decline verse the 2001 tech burst? According to the Case Shiller Indices (the most accurate housing guage available) In 2006, the value of U.S. residential real estate totaled US$ 22.4 trillion. Since this recording the national pricing indices (based on 20 metropolitan areas) has decline 19.87%. This is a loss of asset valuation equal to $4.5 Trillion. To put this loss into perspective, according to the International Monetary Fund the U.S. Gross Domestic Product in 2007 was 13.8 Trillion. So is this decline in value a direct hit to the Net Worth of the United States. Absolutely. If the value of liabilities declined proportionally to asset price then the answer would be no, but they clearly do not. The United States has significantly overstated it's wealth. Sound familiar?

In 2001 the bubble was another significant overstatement of wealth. The Nasdaq Composite Index is a market capitalization weighted index of more than 5000 stocks. Comprising all Nasdaq-listed common stocks, it is the most commonly used index for tracking the Nasdaq. The Dow Jones Wilshire 5000 Total Market Index represents the broadest index for the U.S. equity market, measuring the performance of all U.S. equity securities with readily available price data. No other index comes close to offering its comprehensiveness. For comparison, the NASDAQ listed securities compose 19% of the 5000 Total Market Index. The Market Capitalization of the Dow Jones Wilshire 5000 Full Cap was $16.7 Trillion as of April 30, 2008. Comparatively, the market cap at the end of Q1 in 2000 was approximately $16 trillion (only slightly smaller). However, between 2000 Q1 and Q1 2003 the index lost a stunning 43% of its valuation. In other words, $7.1 Trillion of wealth was lost. This stunning number includes the completeness of the crash. The 2001 bust was a U.S. equity based event and did not impact the real estate market (except for parts of tech specific markets, i.e. silicon valley). I assume this decline was not contagious because interest rates were so low at the time that demand for real property was accelerating.

The current collapse has a very different flavor. While the 2001 decline impacted large tech equity owners the current housing collapse impacts the average American consumer. This decline in wealth as it effects consumer spending is not particularly well known. The self propelling positive feedback cycle has not fully played itself out. There is potentially a 1/2 to $1 Trillion additional loss in the financial sector. Only $350 Billion of losses have been recognized on these balance sheets so far. What about the effect on the broader companies? Sears, Lowes, Home Depot, Microsoft, Alcoa, Catepillar, Merk, Wal-Mart, Disney, etc. The global firms do not seem to have much to fear. But remember, that the United States has the largest Gross Domestic Product in the world. A cyclical retraction of spending could take an enormous bite. U.S. Consumers are responsible for 2/3 to 3/4 of the U.S. GDP (that is approximately $9 to $12 trillion dollars of goods and services). The World's GDP was $54 Trillion in 2007. We're talking about 20%.

There is a strong offsetting effect of the US consumer pullback. Emerging market growth and the weakening U.S. dollar are the most prominent. The taste for leisure, life style, and technology is disseminating out of Western cultures into more agricultural and commodity based economies. A weak dollar makes the United State's taste for leisure, technology, and lifestyle a potentially cheap commodity. U.S. exports are booming. Ironically, emerging market demand, devalued currency, and outrageous commodity prices have created a golden age for the American farmer. Same goes for the steel industry, computer software, etc.

In another ironic twist, the Chinese peg their currency to the U.S. dollar. As the dollar declines because of mounting debt, cheap monetary policy, and a weakening economy, the Chinese are forced to keep the Yuan in step with the U.S. dollar. Allowing the Yuan to rise relative to the dollar would kill Chinese exports (the crux of their economy). The Chinese keep currencies pegged by buying dollar denominated T-bills. Their reserves (a word our culture is completely unfamiliar with) are pushed back into the U.S. financial system. As demand for T-bills is a must for the Chinese, prices are driven up and yields driven down. The United States' symbiotic relationship with the Chinese is largely responsible for the low interest rates obtained in the fixed income markets guessed it....30 year mortgages. Chinese reserves were approximately $1 Trillion last year.

Monday, May 26, 2008

S&P, DJIA, NASDAQ, Russell, Broad Index Declines

The US Stock market is poised for a broad sell off. The rallies we've seen since the mid-March Fed rescue of Bear Stearns are tapped out, and the broader effects of the plummeting US housing market are beginning to impinge on the average American's budget. The US consumer's average debt to income ratios have risen from approximately 90% in the mid 1990's to an impressive 130% at present. Similarly, the mounting trade deficit cannot remain. Financing our consumption with debt from over priced assets has left the consumer between a very hard rock and a very hard place. At the center of this recession is a more complex problem than defaults on subprime mortgages. This is an economically driven correction of financial culture that has lived beyond its means. You cannot consume more than you produce perpetually into the future, particularly when your assets to finance your overspending are rapidly devaluing. Banks are rapidly de-leveraging in a process of selling off assets to improve the asset to equity ratio. Similarly, new risk management criteria including a standardized international banking regulation known as Basel 2 are being embraced by large US broker dealers. These regulations force banks to recognize more complex off balance sheet assets, previously used to fudge capital requirements. To further exacerbate the problem, US consumers are facing rapid commodity price inflations. A number of analyst have tried to identify the causal link including rapid emerging market demand, a flight of capital from dollars to hard goods, and the creation of financial instruments on Wall Street that make commodities an available part of any speculators (or pension fund managers) portfolio. Simply put, there is no room for expansion of consumer spending. Instead, there are very convincing reasons to believe, the average consumer will have to retract, and retract significantly. Consumer spending is approximately 3/4 of the United States Gross Domestic product.

Tuesday, May 6, 2008

Level 3 Assets: Meanings, Markets, and Recent Performance

Level 1
Financial assets and liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in an active market (examples include active exchange-traded equity securities, listed derivatives, most U.S. Government and agency securities, and certain other sovereign government obligations).

Level 2
Financial assets and liabilities whose values are based on quoted prices in markets that are not active or model inputs that are observable either directly or indirectly for substantially the full term of the asset or liability. Level 2 inputs include the following: a) Quoted prices for similar assets or liabilities in active markets (for example, restricted stock); b) Quoted prices for identical or similar assets or liabilities in non-active markets (examples include corporate and municipal bonds, which trade infrequently); c) Pricing models whose inputs are observable for substantially the full term of the asset or liability (examples include most over-the-counter derivatives, including interest rate and currency swaps); and d) Pricing models whose inputs are derived principally from or corroborated by observable market data through correlation or other means for substantially the full term of the asset or liability (examples include certain residential and commercial mortgage related assets, including loans, securities and derivatives).

Level 3
Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability (examples include certain private equity investments, certain residential and commercial mortgage related assets (including loans, securities and derivatives), and long-dated or complex derivatives including certain foreign exchange options and long dated options on gas and power).

Now let's reference rule SFAS 157. According to the Financial Accounting Standards Board:

The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.

Rule SFAS 157 was created as an accounting standard for valuing "hard to value assets" including securitized debt instruments. The rule became effective on November 15, 2007. Banks have been forced to come clean with their true exposure. If an investment bank wants to list an asset it is going to have to be marked to market. The rise in the popularity of level 3 assets amongst America's biggest investment banks has also given rise to the transparency of the market. "Markit" posts daily trading values for Residential Mortgage Backed Securities, Commercial Mortgage Backed Securities, Credit Default Swaps, Leveraged Loan Securities, European and Asian Securitized Credit tranches, and Corporate Default Swaps. The derivatives market and securitized debt market dwarfs the U.S. equity market. But, until recently, its transparency was only well known to institutions, hedge funds, broker dealers, and banks. Real estate has seemed to taken similar shape, as illiquid markets inherently have less transparency. Wall Street's appetite for risk, illiquidity, and easier to arbitrage instruments has undermined itself again (reference Long Term Capital). Derivative instruments have created risk contagion in lieu of efficient markets via risk transfer. This time, the Bankers have lost a big sucker to lay these hard to know instruments off on...the institutional money market investor.

Monday, May 5, 2008

Are the Tupi and Jupiter fields the real thing?

Petrobras claims that by 2009 they will be pumping oil out of the massive Tupi field, discovered off the coast of Brazil discovered last year, ahead of schedule (I must add) Let's review the figures...Petrobas claims that the Tupi oil reserve could produce 5 to 8 Billion barrels of oil. More shockingly, their have also been claims made that adjacent oil fields in the same salt layers contain another 33 Billion barrels of light sweet crude. Those are bold claims. Brazil, seems to have a lot going for it this year. A potential discovery of 41 billion barrels of oil off the coast line, and now investment grade ratings from our jeopardized and overly optimistic credit rating agencies including Fitch. The EWZ, an ETF representing Brazil's major equity indices, rallied 9% on the rating news. Similarly, Petrobras and Brazil has roared on the markets this year (reference Brazil's Sugar Loaf Oil Field and American Oil Dependence). The discovery and investment class rating seems to be thoroughly priced into the market. Even the most sincere skeptics must concede to a correlation between the events. But will these wells produce and when? The most confirming evidence I can find that these reserves are likely the real thing is that Petrobras is multiplying (many times over) its corporate bond issuance (approximately $3.6 Billion this year compared to $800 million on average) . They are betting big on themselves, and tallying up a lot of debt to finance the mobilizations. Are these Brazilian oil men falling for their own narrative fallacies, or are their hard technical indicators that they are going to become extremely rich?

Monday, April 28, 2008

What will prick the Commodities Bubble?

Despite weak economic indicators, rapidly deflating housing prices, and flat to negative consumer consumption commodity prices soar. Why? When looking at the price trending of commodities one can't help but notice that in the fall of 2007 rapid price appreciation starting taking place. Is it coincidence that as commodities roared fears of defaulting bond insurers, collapsing "bears", and credit market evaporation spread like wild fire? The correlation should be noted, but also take note that the commodities market has not corrected as equities market have seemed to heal (with the exception of tanking gold). Has fear of a housing market collapse driven investors to hold their wealth in terms of gold, oil, wheat, sugar, and aluminum? It couldn't be. Housing prices drive construction ....a major consumer of the economic nuts and bolts (i.e. commodities). It must be the fear that the dollars in our pockets have decayed in value faster than nearly all natural phenomena. U.S. Dollars, however, are not decaying at any rate, magnitude, or depth near that of appreciating commodities. Another interesting development (suspiciously timed with the boom in this market) is the creation of commodity linked Exchange Traded Funds. An interesting experiment was conducted in an undergraduate economic course I took in college. The professor created a "mock" economy with goods, services, and specific wealth allocated to each student. We then sprung into action, with instructions to act as economic agents. We placed bids for various valued items and services. We learned how price discrepancies were arbitraged by "rational economic agents". Then, the professor dramatically increased our means, by introducing credit. Prices, like our purchasing abilities soared. The rage in recent commodity prices are similar. A fundamental market shift has occurred by the introduction of new trading instruments to the novice speculator. Just as debt securitization turned risk taking activities on their head, Exchange Traded Funds have created a niche for commodities to be part of any "balanced" pension plan portfolio.

Saturday, April 26, 2008

Brazil's Sugar Loaf Oil Field and American Oil Dependence

Petroleo Brasileiro SA, Brazil's behemoth oil driller and producer has seen its stock rage from $25 / share in September 2007 to $84.59 on Friday April 26, 2008. Similarly Brazil's Exchange Traded Fund iShares MSCI Brazil Index Fund has more than doubled in the same time period. There is huge market demand for Brazil's equity. Why? Brazil may provide a much more significant percentage of America's oil needs in the future. Those are very big needs. The Carioca/Sugar Loaf field is a potential deepwater oil field in the Atlantic Ocean off the coast of São Paulo, Brazil. The field is part of an important emerging petroleum basin known as the Santos Subsalt Basin. Two other large oil fields have been discovered in this basin in 2007 and 2008, the Tupi and Jupiter fields. By now the state and size of the Carioca/Sugar Loaf field has not been clarified, but estimates are between 25 and 40 billion barrels.

According to Bloomberg:

*Among discoveries in the past 30 years, only the 15-billion-barrel Kashagan field in Kazakhstan is larger than the Tupi's field estimated 8 billion barrels.
*Haroldo Lima, director of the country's oil agency, last week said another subsea field, Carioca, may have 33 billion barrels of oil. That would be the third biggest field in history, behind only the Ghawar field in Saudi Arabia and Burgan in Kuwait.
*The U.S. imports about 10 million barrels of oil a day, or 66 percent of its needs, according to the Energy Department in Washington. Saudi Arabia was the second-largest supplier in January, behind Canada.
*Persian Gulf nations accounted for 23 percent of U.S. imports, compared with Brazil's 1.7 percent share. Brazilian crude output rose 1.9 percent last year to 2.14 million barrels, according to the International Energy Agency.

With Oil trading at $116 US Dollars per Barrel...this means that Brazil may have recently added 2.9 to 4.6 Trillion Dollars to their national wealth. It is kind of like finding 15 to 25% of the U.S.'s total value of outstanding equities ($20 Trillion) off the coast of Sao Paulo.

According to Peter Zeihan, vice president of analysis at Strategic Forecasting in Austin, Texas.``The finds they've got so far are just the tip of the iceberg,'' Zeihan said. ``Brazil is going to change the balance of the global oil markets, and Petrobras will become a geopolitical supermajor.''

Tuesday, April 22, 2008

Bracing for Phase 2 Decline

Get ready.....

*Dollar reaches all time low versus Euro. Is China converting reserves into alternate currencies? Dollar tipping point in question. Currency devaluation of world's largest borrower.
*Crude Oil reaches all time high.
*Nearly every financial institution posted losses in Q1...Market rallies because pessimism already priced in. Reference CitiGroup / Merrill. Bank of America / Washington Mutual bring surprises.
*Housing price decline accelerates. Biased National Association of Realtor's number indicates increasing decline. Case Shiller number due August 29. CME Case Shiller futures pricing major declines into August of 2009.
*Securitized debt underwriting trending towards 20% of 2006 and 2007 issuance. Mortgage Litigation skyrockets.
*Fed may be out of financial fixes (i.e. Overnight Fed Funds Rate / Term Auction Facility)...inflation concerns rising. England Central Banks mimic fed's toxic debt purchasing maneuver.
*VIX (CBOE Volatility Index) begins new rally after fears allayed by Fed fixes and successful hybric (equity / debt) funding by Wall Street investment banks.
*Credit Default Swaps and Interbank Counter Party risk concerns still near all time high. Ted Spread still posting impressive highs.
*ABX (Securitized Home Equity Indices) reaches all time lows in non-prime and sub-prime tranches....additional 50% declines from January 2008. Reference ABX-HE-BBB 07-2 Roll. $32.5 Oct. 07, $22.5 Jan. O8, $10 Apr. 08.
*IMF warns of systemic risk and $1 trillion credit losses, $250bn posted so far.

Tuesday, April 15, 2008

What about when Financials start writing assets up?

`Totally Uncorrelated'

The latest version for AAA rated subprime mortgage bonds slumped by 43 percent since it began trading in August, according to Markit, as rising U.S. home loan delinquencies triggered a surge in the cost of credit-default swaps. That implies a 53 percent loss on the underlying mortgages, according to Schultz, almost four times the 13.75 percent rate predicted by Wachovia.

The cost to protect $10 million of AAA commercial mortgage securities jumped 10-fold during one six-month period to $100,000 a year, based on the first CMBX index from Markit. That implies about 13 percent losses on the underlying loans, more than four times the 2.8 percent forecast in the event of a recession by JPMorgan Chase & Co. analyst Alan Todd in New York.

``ABX, CMBX, any kind of X you like, are totally uncorrelated to any kind of underlying market,'' Swiss Re's Aigrain said at the Dubai conference.

Friday, April 11, 2008

Are GE's Earnings Indicative of Bigger Declines?

America's largest corporation has failed to live up to wall street expectations. American consumers (who accounts for 70% of America's GDP) are being held accountable for the short fall. At least that is what the market's tanking this Friday indicates. Is GE at fault, high energy prices, or the overly debt burdened American buyer? Regardless, Wall Street expects the other big boys to follow suit. Next week will be an interesting one.

Wednesday, April 9, 2008

Is it time to start investing in Financials?

There seems to be cautious optimism that the worst of the Credit freeze is over. The federal government (after all) has provided a means for financial companies to off load risky, depressed, and illiquid loan instruments. The simple swap pays market rate for complex wall street created debt securities in the currency of U.S. T-bills. My question is, what percentage of average bank assets are Level 3 (i.e. difficult to price, illiquid derivative instruments)? Bloomberg estimates are in the range of 7-8% of underwriting business. According to recent reports Goldman Sachs (the one investment bank with little Level 3 exposure during the credit crisis) has increased their exposure to these assets by 83% in Q1. I think we can only anticipate this to mean that Goldman went bargain shopping after loan instruments were driven through the floor. But will prices ever return to fundamental values??? The credit quality of these instruments have driven certain investors away indefinetly. I think speculation and market craze has overly depressed financial stocks. Don't get me wrong...they've lost billions, but they've weathered it. Collatoralized loans are not the only product sold on Wall Street....they just happen to be a product kept somewhere near banker's books.

Tuesday, April 1, 2008

Are Asset Backed Securities Oversold?

The ABX indices

is probably oversold at this point. While I don't have the models to verify the risk analysis, the investment banking community is claiming that current prices anticipate a 75% defaul rate in the BBB rated securities. I'm guessing that these securities are oversold, any buyers.

Monday, March 31, 2008

Who is Regulating the Federal Reserve?

Treasury Swap Auctions have begun where the U.S. treasury department has agreed to buy (or trade) highly liquid T-Bills for Mortgage Backed Securities from "Primary Dealers". What has been hailed as the economic move of the millenium that saved the country from the 2nd Great Depression is legally questionable? Bernanke's extension of U.S. backed credit in exchange for "non-agency" AAA and Aaa rated Mortgage Backed Securities has greatly extended the government's role in America's free market. It is shocking that the news headline of the day was that JPMorgan and the Federal Reserved bailed out Bear Stearns, when a massive political action was truly in progress. In times of crisis we seem to be blinded by our patriotism, and often open doors that should not be opened. The Fed has seriously violated its seemingly Laissez-faire economic policy and set in stone its monetarist fundamental as the economic auctioneer (i.e. lender of last resort).

Housing Declines of 50%

Some have estimated the severity of the housing decline to include drops as much as 50% from peak to trough in certain markets. People don't just expect it. The markets are betting on it. Below are values of where the Case Shiller futures markets are trading.

S&P/Case-Shiller Index - January 2008 v Highs

High High Jan 2008 High v Nov 2012 High v

Month Index Index Jan 2008 Futures* Nov 2012
Atl Jul 07 136.47 127.08 -6.88%

Bos Sep 05 182.48 162.59 -10.90% -11.80% -22.70%
Char Aug 07 135.88 131.70 -3.08%

Chi Sep 06 168.60 156.47 -7.19% -7.10% -14.29%
Clev Jul 06 123.49 108.49 -12.15%

Dal Jun 07 126.47 118.56 -6.25%

Den Aug 06 140.27 128.98 -8.05% -13.90% -21.95%
Det Dec 05 127.05 100.17 -21.16%

LA Sep 06 273.94 224.41 -18.08% -27.70% -47.78%
LV Aug 06 234.78 186.05 -20.76% -16.80% -37.56%
Mia Dec 06 280.87 225.40 -19.75% -30.80% -50.55%
Min Sep 06 171.12 151.16 -11.66%

NY Jun 06 215.83 200.49 -7.11% -19.00% -26.11%
Pho Jun 06 227.42 180.06 -20.82%

Port Jul 07 186.51 178.81 -4.13%

SD Nov 05 250.34 197.45 -21.13% -21.80% -42.93%
Sea Jul 07 192.30 181.62 -5.55%

SF May 06 218.37 183.81 -15.83% -15.70% -31.53%
Tamp Jul 06 238.09 194.64 -18.25%

WDC May 06 251.07 212.83 -15.23% -22.00% -35.23%
10-C Jun 06 226.29 196.06 -13.36% -21.50% -34.86%
20-C Jul 06 206.52 180.65 -12.53%

* based on CME Settlements March 18, 2008
Source: S&P, Bloomberg, TFS

Saturday, March 29, 2008


I think that this link is telling of a few things. First the fact that asset backed security issuance was 83% lower the first quarter of 2008 compared to 2007, means the effects of the credit contraction are huge, but haven't been felt by the average consumer. A change of issuance from $702 Billion in Q1 of 2007 to $120 Billion in Q1 of 2008 means we are trending to a yearly credit issuance that is 1/5 of the approximate $2 Trillion issued last year. Those are big numbers. It also leaves you wondering who is lending all of the money (i.e. buying the securitized debt)? One source is leveraged money management funds, another Sovereign Wealth Funds (including the Middle East, China, India, etc. / after all one cannot both lend and borrow to oneself). Those countries have reserves instead of deficits. The dollar crunch is making paying back all this debt even harder (as we all know). So what happens next? The lagged consumption (the largest percentage of US GDP) contraction tsunami has got to hit (I think the stock market has priced in the pain, but John Doe hasn't felt it...yet). Surprisingly, recent consumption numbers only remained even. It is coming, don't worry. I think this will be the dampening effect from run away inflation (and the cause of the recent retraction of commodity prices), and I think the fed knows it. I think we are in for a massive asset price contraction (most of which we've already had). I think we are also in for a significant reshaping of the American Economy because of the dollar crash. I think America will become perceived as the cheap getaway and an influx of European and Asian travelers / opportunists will arrive. The potential recovery will be what is interesting. When I get to pessimistic, I remind myself of how many cars are packed on the 405 going to work every morning. There are a lot of educated ambitious people going to work everyday. The question is, what kind of demand will their be for their services? Likely to shift to foreign, currency strong preferences.