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5 CREDIT BUBBLE
BULLETIN No simple repeat of LTCM
fiasco Commentary and market
watch by Doug Noland
"After hubris comes
nemesis," warns the Economist on February 29. "On
January 24th more than 1,000 leading figures in
the European hedge-fund industry gathered for a
dinner at the swanky Grosvenor House hotel on
London’s Park Lane to witness the EuroHedge awards
for 2007. Out of the 20 awards, two - credit fund
of the year and new fund of the year (for
non-equity strategies) - were awarded to Peloton
Partners, a credit manager set up by ex-Goldman
Sachs employees in 2005."
I'll go out on a
limb and suggest that this week provided another
critical juncture for the unfolding credit and
economic crisis. Peloton Partners, commencing the
year with about US$3 billion under management, is
run by smart, seasoned investment
managers. One of the fund’s
founding managers was previously a co-head of
macro proprietary trading at Goldman. They
recognized and profited handsomely from last
year’s subprime collapse, with their flagship
"ABS" (asset-backed securities) fund ending 2007
up 87%.
By recent industry standards,
their strategy was not particularly risky. To
capitalize on the dislocated credit market and
depressed prices, the fund increased leveraged
exposure to AAA securities. It was reported that a
week ago Friday the fund had posted losses for the
month of about 8%. A few days later Peloton funds
was in full crisis, forced to halt redemptions and
seek liquidation. On Thursday evening, the Wall
Street Journal reported that some of its Wall
Street lenders had moved to seize assets.
Investors will suffer huge losses on AAA-rated
securities bought at a discount.
The
co-founders stated in a letter on Thursday to
investors: "Credit providers have been severely
tightening terms without regard to the
creditworthiness or track record of individual
firms, which has compounded our difficulties and
made it impossible to meet margin calls." They are
clearly not the only funds pounded abruptly by
sinking asset values, illiquid markets, and
increasingly distressed lenders. In the case of
Peloton, leverage of four to five times was used
commonly, with sinking prices on $9 billion of
assets quickly burning through equity. It’s
convenient to blame an implosion on the margin
clerk, although in this highly unstable
environment playing with leverage is playing with
fire.
Also on Thursday, Thornburg Mortgage
- seasoned leveraged AAA MBS (mortgage-backed
securities) players that last year had
aggressively retrenched, cut holdings to $37
billion from $53 billion, and had seemingly
weathered the subprime storm - reported that they
were once again hit with margin calls and forced
liquidations on a portion of their mortgage
holdings. The root of the problem was a 10% to 15%
drop this month in the values of Alt-A
mortgages - Alt-A refers to a risk categorization
that falls between prime and sub-prime. With an
estimated $950 billion of Alt-A mortgages in the
marketplace, such a dramatic price decline pelted
scores of investors/speculators in these
mortgages, mortgage-related collateralized debt
obligations (CDOs), and myriad derivative
instruments.
Leveraged players, such as
Peloton, were crushed. Forced liquidations and a
rush to hedge in the derivatives market
exacerbated the spiral. The troubled major banks
and Wall Street firms have significant direct
exposures in this area, as well as huge indirect
risk on such collateral used by their leveraged
clients. The impaired lender community today has
no alternative than to manage risk very
diligently, which means an aggressive approach to
margin requirements and forced liquidations has
become part of the new (post-bubble) marketplace
reality. The "smart guys" who had jumped in over
the past months to capitalize on market tumult,
have been humbled, chastened, and in some cases
bludgeoned. Many are coming to recognize that the
market backdrop has fundamentally changed.
Compounding systemic stress, this week
also saw significant forced liquidations in the
municipal bond market. This has been a hot area
for sophisticated leveraged trading and
derivatives strategies. Today, one can add this
huge market to the List of Bubbles Burst. It is
difficult to know the scope of the unfolding
liquidation and resulting inventory of muni bonds
overhanging the marketplace. It is easy analysis,
however, to suggest that liquidity for this key
market will be scarce for some time. The
ramifications for municipal finances, state and
local borrowings, and overall economic activity
are disconcerting.
In many respects,
systemic stress from de-leveraging is more intense
today than even during the Long-Term Capital
Management fiasco of 1998 (when the hedge fund
lost $4.6 billion in less than four months before
the Federal Reserve organized a bailout by leading
creditors). Many have been eagerly anticipating an
LTCM-style Federal Reserve-orchestrated
"reliquefication". It’s not forthcoming. I will
again remind readers to think in terms of this
being the first post-credit bubble "reflation"
attempt.
The Fed’s influence on risk asset
prices has been dramatically diminished. Unlike
LTCM (or 2002 and the collapse of the dot.com
bubble for that matter), it is simply no longer a
case of the Fed lowering the cost of funds for the
leveraged players and in the process enticing them
to increase holdings of mortgages, MBS, junk
bonds, stocks and derivatives (all on leverage).
There are these days much greater financial and
economic forces at work.
This week the
California Association of Realtors reported that
January home sales were down almost 30% from a
year ago, with median prices sinking 21.9%
year-on-year. Median prices dropped $46,010 during
the month, putting the decline from June’s high at
an astounding $163,900. These "averages" are being
skewed by the lack of mortgage credit - hence
transactions - at the upper end. Inventory is up
to almost 17 months supply and will likely grow
rapidly as thousands of foreclosed properties hit
the market in the coming months. Keep in mind that
the California downturn is relatively recent,
running about a year behind Florida, for example.
Increasing recognition of the dimensions of the
unfolding real estate collapse in California (and
elsewhere) certainly is a major factor for the
sinking valuations of Alt-A, jumbo mortgages
(which have a loan amount above the
industry-standard definition of conventional
conforming loan limits) and MBS generally in the
markets. And the resulting further tightening of
lending standards by the mortgage companies,
banks, GSEs (government-sponsored agencies such as
mortgage financiers Fannie Mae and Freddie Mac),
and mortgage insurers will only exacerbate the
unfolding real estate bust.
This is no
LTCM. The current financial and economic backdrop
is altogether different. Speculators that would
typically seek to capitalize on depressed
securities prices now confront enormous
uncertainties. How bad will things get in
California, Florida, and elsewhere? How many will
walk away from underwater mortgages - for starter
homes and million dollar-plus California
bungalows? How badly will the US "services"
economy be hit by housing and financial woes? How
bad are the unfolding credit problems in state and
local finance? Will pinched consumers also turn
their backs on credit card, auto and student
loans? How long will the seizing up of the
securitization markets last? How will corporate
credits hold up in the event of prolonged credit
restraint and economic tumult? What are the
ramifications if the "monolines" (bond insurers),
GSEs, private-label MBS/ABS, the credit
derivatives marketplace, and Wall Street
"structured finance" (more generally) don’t
recover? None of these pertinent questions were
even remotely contemplated or relevant in 1998.
The problem today remains a highly
leveraged credit system now confronting massive
and unquantifiable - credit losses. And Moody’s
and S&P can continue to claim that the major
monolines are AAA - while the GSEs can pretend
they are adequately capitalized. But the
marketplace is not buying it. Sinking securities
valuations are not a "technical" market issue that
will be resolved when the margin calls are
satisfied. Indeed, the credit crisis and the
economic downturn are gaining significant
momentum.
Throughout the system, risk
models have broken down. They will now be
functionally inoperable for some time to come. At
the heart of the now unfolding systemic
de-leveraging are some newfound realities.
Leveraging, as Peloton Partners realized
this week, has become a perilous endeavor. The
markets have become hopelessly illiquid, providing
no escape route for even the perceived safest
securities. Worse yet, the greatest leverage has
accumulated in the perceived safest securities -
creating atypical de-leveraging risk and acute
systemic fragility. Credit costs are now spiraling
higher, and it is today impossible to accurately
forecast either the timing or scope of losses for
securities from subprime to munis to agency debt
and MBS. Meanwhile, Wall Street and the securities
lending community are reeling and will over time
impose only tighter standards (less leverage and
more collateral).
Importantly, the nature
of systemic liquidity and credit risks has become
a major risk factor working against leveraged
speculating. Or, said differently, the bubble in
leveraged speculation has burst. Today’s reality
is one of a credit system severely impaired, with
the ABS, junk, and CDO markets basically closed
for business. Now the huge muni and
investment-grade bond markets are badly faltering.
This week also saw the Swiss franc and the
Japanese yen as the best performing currencies,
gaining 4.7% and 4.2% respectively. For those
borrowing in these low-yielding currencies to
finance leveraged speculations in higher-yielding
US (and other) securities, there is now also
recognition of acute currency risk. The stage is
set for a panic out of the crowded leveraged
trades.
This is no LTCM. And a very strong
case can be made that Fed rates cuts have
destabilized the credit system. While the argument
that Fed rate cuts worsen an already problematic
inflation problem certainly has merit, there is a
greater risk that goes unrecognized. During the
Greenspan tenure, the Fed was keen to use the
leveraged speculating community as its key
monetary reflationary mechanism. This, over time,
became an instrumental facet of the credit bubble;
the bubble in Wall Street finance; and the US
bubble economy.
Recent Fed desperate
efforts to sustain both the bubble in leveraged
speculation and the deeply mal-adjusted US economy
are futile. As for the leveraged speculating
community, it would be better for the long-term
health of the system to let the bust run its
course. Today’s reflationary efforts are clearly
fueling further wild and destabilizing global
speculation and excess, with major - and
increasingly obvious - negative consequences here
at home.
As for the US bubble economy,
throwing additional credit at the
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