Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his newsletter.
Prudent Bear
Five Years Of Supposed Prosperity! Cost? Possibly The End Of About A Century Of Hegemony Inducing Growth?
China buys a piece of Blackstone, a company being perhaps the ultimate in capitalistic finance. When the Yellow Peril/Communists start buying the private equity players, something has certainly changed. Not too long after the gang in Beijing joined the rush to have their investments complemented by participation in leveraged buyout players, global interest rates started a significant climb. Coincidence? Time will tell but there has to be a suspicion that there is some congruity.
If you are a Kudlow and Co. disciple, the natural reaction is to continue to embrace “goldilocks” and utter or mutter, the old Mad comic’s character, Alfred E. Neuman’s” phrase, “What! Me Worry?”
If ridiculously Big numbers, comprising monstrous aggregations of capital/liquidity alarm you, the new acronym, SWF or Sovereign Wealth Funds comes very much to mind. Global reserve assets, including the pitiful $78 billion in the U.S., now total (Another Monstrous number), about $5.4 TRILLION. Of that total, approximately $2.5 Trillion are in or headed for one of these SWF creations. The purpose of having such an instrument for the sovereign creator is to enhance return on the pile. This isn’t done by continuing to sit in U.S. Treasuries where the return has been denuded by the crowded trade already in there with you.
We had the dotcom/telecom etc. bubble succeeded by the GSE induced residential bubble, succeeded by the structured finance/financial engineering residential bubble, succeeded by the CRE/financial engineering bubble, succeeded by the private equity/leveraged buyout/return of the conglomerateurs/no covenant, no guarantee bubble, and they were all looking a bit exhausted. Are we now to witness the SWF buys all of the foregoing bubble? Since the total amount of reserves available for growth and movement into these SWF’s is more or less the annual amount of the United States Current Account Deficit of $1 Trillion, on top of the aforementioned $2.5 Trillion approximately already thrown in, this could be an incredible self-sustaining bubble if only viewed from the aspect of resources and liquidity. In some of the more obscure financial publications, there has recently been some cognizance of this possibility. All this in aid of finding the next bubble since our past thoughts that we would run out of big enough new bubbles to keep the game humming have obviously been in error. It is also worthy of note that a requisite of a successor bubble is to have resource and leverage sufficient to equal or exceed its fading predecessor. Also, for the last five years or so, beneficent interest rates globally have been, at a minimum, a strong aid, perhaps an inherent necessity to this leverage addicted wealth creation methodology.
Most of the liquidity/inflation generated by the massive $1 Trillion+ U.S. annual foreign deficit has, so far, been channeled into: first U.S. Treasuries and Agencies, and then corporate or other debt, with the local currency generated to purchase the $ going, until recently, into residential or commercial real estate and/or local equity markets. Neither the ROW (Rest of the World as it is called in the Federal Reserve Z1 report), nor the bubble blower (The United States) has had terribly painful domestic inflation at the consumer level. In fact, asset inflation in houses and investment indexes has been a pleasant trend for all of these nations.
As the ability to extend asset inflation bubbles reaches or exceeds market possibility, the inflation increasingly spills over into the more visible parts of the consumption economy. Central banks are increasingly forced to recognize the Hydra-headed monster they have accommodated, and raise rates/tighten liquidity. Some such as Kuwait and Syria have been so extreme as to sever their link to the $. New Zealand shocked the markets with an 8% short term rate. Euro rates and other global rates are up and/or rising and, it can be argued, are pushing up U.S. rates concomitantly. This is the counter force that we would argue will constrain the potential glee in the markets in anticipation of the Petro states, and The BRIC (Brazil, Russia, India and China) nations, as well as reserve rich others, such as Korea, Taiwan, maybe even Japan, from all buying their very own Blackstones. Obviously, should they be such buyers, with the leverage the Blackstone’s can employ, the limits to an SWF bubble are imponderable but truly immense.
Another restraint to this emerging new global bubble is the question of to whom do these reserve rich players sell their enormous holdings of U.S.$ Treasuries and Agencies, purchased, at the best, at breakeven yields today, with much of the portfolio surely underwater with Greenspan rates in effect for many of the last five years.
With the U.S creating well over a $Trillion of new sovereign paper in recent years, obligating the buyers thereof to create the equivalent in local currency and find a home for the dollars bought, the merry-go-round has been continuously working with the recycling of those dollars back into the sovereign or near sovereign (Agencies) debt of the U.S. There was thus a natural purchaser as the dollars issued by the U.S. Treasury. The SWF’s can be a disturbance on the merry-go-round as they look for Yale Endowment yields.
Yet another potential problem for those embracing “goldilocks” (Particularly for those surveying the global scene from behind the diaphanous blur of the United States knowledge screen) is the perhaps invidious state of the longstanding global reserve currency, the United States $. For going on a century, Seigneurage privileges (globally accepted) have enabled the U.S. to print money to pay global debts. This is a rare historic privilege accorded few sovereign entities. Even more rare is the status accorded the currency on emergence from World War II; that of sole hegemonic issuer. More rare still was continuing global acceptance when “Guns and Butter” Nixonian policies severed the currency’s last link to outside control of issuance, the supposed redemption availability in bullion. Basically, at that point, the global reserve currency stands on “The full faith and credit” of the U.S. Government. We forswear politics in these ramblings but would not be surprised if “some of the people, some of the time” are not as completely convinced of the value of such full faith and credit.
After a series of successes from the 1987 dip onward at thwarting any economic downturn with lowered rates and tsunami’s of liquidity, the Fedheads really went to an extreme with their 1% interest rates more than 5 years ago, ushering in the most massive global debt bubble, arguably, in the history of mankind. This crescendo of debt permits the globe to have simultaneously expanding economies virtually everywhere, a couple of exceptions such as Lebanon and Zimbabwe out there to be noticed by the few still thinking that a debt culture must eventually be constrained. As noted above, deluging liquidity everywhere has enabled simultaneous global expansion, unusual phenomena in the history of mankind.
A couple of thoughts here. The U.S. expansion, driven by the Fed cuts, and largely centered in 1.Real estate of all varieties 2. Buy-out/M&A/Leveraged lending. 3. Financial Engineering/Structured Finance creation, distribution and fee administration and investment and 4. The massive expenditures on Defense related and Security related to prosecute the ever-expanding utilization of militant activities. The cuts of interest rates by the Fed bought this going. (Oh, we have forgotten the “saving” temporarily of such industries as “auto” with low interest rates.) There are signs of satiation and aggravating credit risk in the credit sensitive areas of these sectors. Oh, by the way, do any readers actually give credence to the Commerce Dept. consumer inflation statistics (If so, read John Williams’ “Shadow Government Statistics” to find the 10.2% REAL consumer inflation rate in the U.S.) In any event, the reported (not the nonsensical core) rates last week were demonstrating that lifestyle is being negatively impacted in the U.S. by dripover inflation.
The foreign central banks largely followed ours into the trough of rates. And their expansion started a little later. Asset inflation, as in the U.S., took over first. The two culprits in the U.S. stand out in the foreign markets: residential real estate and equity markets.
Nevertheless, the inevitable occurs; housing bubbles, affordability problems, equity bubbles that produce P/E’s that are untoward and, finally, lifestyle inflation that impinges on the central banks. As an example, the ECB, a central bank that actually has an inflation containment mandate in its constitution, is raising rates and warning of probable necessity to do more. A rising rate currency looks attractive to a stable one, possibly accounting for some $ defection in the recent past.
I met a young entrepreneur who opened and expanded a bikini factory in Brazil some years ago. The enterprise was/is a success, however, the climbing real is rendering him non-competitive. His solution: sell out to one or another of the private equity guys currently soliciting and go into the wealth management business. Such examples and the potential consequences are seldom seen in the U.S. media.
The Belief In Our Own Worldview Is Our Own Most Powerful Intellectual Imperative!
Here we hearken back to what we believe to be the consensus “worldview” in the U.S.; most particularly in the financial sectors thereof. Obviously not universal and imbued with the author’s prejudices, a construct thereof follows:
The U.S. economy is emerging from a “soft” landing. Although occasioned by the residential bubble in significant part, particularly sub-prime, that area is contained without widespread contagion and employment, production, efficiencies through privatization, growing exports and technological breakthroughs will lead to a new, burgeoning expansion.
Accompanying this renewal of “Goldilocks” seems to be a guiding belief that once out of the trough, another expansion similar to the pleasant 2002-2006 will follow as night follows day as has occurred for approximately 20 years.
This worldview, predicated on the Universal Empire the U. S. was at the beginning of the new millennia, is not a worldview shared by the ROW!
1. This 5-year period of prosperity, kicked off by the massively excessive Fed rate cuts and ensuing global liquidity started from a pitiful foreign reserve assets number globally (Much of which had been accumulated by Japan as it sought to recover from the bubble we taught them). The budget surpluses in the U.S. more than offset the then midget trade deficit, and the currency stood on a pinnacle. With the aforementioned exception of Japan and the inscrutable Swiss, the reserves and currencies of most of the rest of the world ranged from pitiful to disastrous. Argentina went on to a sovereign default and theft from creditors, Brazil devalued, Russia defaulted etc.,etc.
Five years later, the players have the aforementioned $5.4 Trillion in reserves and the U.S. currency is held aloft on generosity after an average fall in the 30% range. The domestic economy, driven by the afore-mentioned continuous bubble machines, has exhausted a debt laden U. S. consumer to continue to propel the machine. Foreclosures and defaults are hitting new records, not at the bottom of a recession but with record low unemployment rates. The only game still running at breakneck speed is the leveraged private equity play, still battening on low relative rates and tax advantages. The press of ROW, by and large, see and present this worldview in contrast to Bubblevision and Goldilocks.
2. We normally eschew the “It’s Different this time” approach as an exegesis for a thesis but find it necessary when confronted by the unprecedented.
Five years ago, the financial sector, both within the U.S. and globally, while having small entries into some of the following fields of risk and finance, was struggling to recover from the blows of the Asian debacle, the Russian default, 9/11 (although it actually served as an economic expansion ignition.), the 2000/2001 U.S. Recession and the afore-mentioned Latin imbroglios. True, the U.S. banking system had been hit by some, many or all of these, depending on the institution. Frankly, this opened the door for the previously intermediary giant Broker and Universal banks to vault into the new world of Financial Engineering/Structured Finance on a global basis.
Five years later, world finance has significantly and nearly totally changed. As an example, Fed NY Governor Corrigan only had to hit the rolodex for a dozen and a half names to suck up $4 Billion to stop the panic about LTCM. Today he admits that the number affected by a systemic event could go into very large numbers.
There really is no infrastructure in place to deal with a contagional systemic financial crisis! One has not yet occurred in the era of RMBS’S, ABS’S, CDO’S, CLO’S, SYNTHETIC CDO’, ‘S’S and the legions of forms of CDS’S and their progeny, CPDO’S, CPPS’S etc.
I recently looked at an 190 page report on this “market” which has enough other gibberish in it to confound any but the math ph’d’s who create, manipulate sell, buy and, occasionally run from this stuff. It is mindboggling. In previous efforts, we have described how BBB- securities can be transformed into 80% AAA. The weekend WSJ described how a fund of some of this stuff is coming unglued. One of the players, Merrill, has seized and is auctioning some of the collateral, impolitely screwing up “rescue” loans and other attempts to salvage. Mixed in will be some of the insurers, in front of the pension funds, endowments, foundations etc. presumably the ultimate owners of this smoldering wreck. Remember, we are at the beginning of the problem in residential real estate with still record unemployment! There is only some $7 Billion directly and peripherally mixed up in this Bear Stern’s directed vehicle, but it could serve as a eye-opening lesson as it burns on the way to sinking.
3. We mentioned the insurers above. At the beginning of the decade and in the early stages of the post 2000 downturn, these two entities guaranteed and/or absorbed into portfolios hundreds of billions per year in mortgages and mortgage-backed securities. Then it became apparent that the Financial results reported by these entities were suspect, that Management possessed less integrity and they were clueless as to the risks they were assuming. Investigations, Resignations and ability to provide limitless buying strength for the mortgage origination world disappeared!
The world of Financial Engineering/Structured Finance has largely operated without the two prior foremost liquidity providers, Fannie and Freddie, as they languished in Congressional hearings on their fraudulent or incompetent doings. They have recently re-emerged as large players as investigations came to a close, reparations were determined and some semblance of financial reporting was re-instated. The recent return of the yield curve to a positive slope has also been a tremendous help to these inveterate players of this type of curve with their Congress-given subsidy and their willingness to make noises about the alleviation of the Brokers sub-prime default and foreclosure-laden results to years of Financial Engineering/Structured Finance garbage.
In order to perform the legerdemain necessary to take less than investment grade and other slightly unsavory assets to the public type buyers described above, they had to throw in some sauce. This came, in the absence of the GSE’s from the private world of insurance, the AMBAC’s, MBIA’s, MGIC’s, RADIAN’s etc. Functioning in a not dissimilar way to the rating Agencies, these worthies would look a prospective issue over and then insure the higher rated tranches. Much like a GSE guarantee, such insurance would serve to make the issue palatable to the institutional buyer as all the due diligence necessary.
We were recently privileged to read an in depth credit review of the Insurer group with particular emphasis on the Ambac and MBIA numbers. We remember a scholarly look at MBIA a couple of years ago which would have given pause to thoughtful analysts except for coincidence with the Greenspan rush to Zero rate structure. The insurers have responded to slow times in the low rate environment by diving headlong into the Structured Finance world. The thing about insuring munis is that you either have taxing power (full faith and credit) or revenue generating capability (toll roads, airports) etc. It is not clear that these worthies fully understood that, in the absence of the appreciation which appeared to happen inevitably to houses in the immediate period in which they leapt headlong into insuring CDO’s composed of BBB- or equivalent to get them to AAA, that houses don’t mystically create debt service revenue, they eat it!
The leverage these critters have taken on historically may have been speculative when they were playing muni’s but it is outright outlandish in the game of Structured Finance. 900 to 1 leverage makes LTCM look cautious. Equity and Reserves are infinitesimal and not growing in proportion to the non-muni game they are playing.
The afore-mentioned analysis asks: “Who is holding the bag?” In the game, and points to the insurers. Since a 10% drop in house prices wipes out their equity, we agree with the analysis that they are too slender a reed to support the ratings they carry and that there is going to be tremendous disillusionment when the axe falls. We would then repeat the question, Who is holding the bag? The ultimate buyers of these things are the ultimate bag holders, pension funds, the equivalent of Orange Counties all over the country, university endowments trying to emulate Yale, maybe the Gates Foundation but certainly the foundation industry and others seeking the yield in alternative investments that will pay for their commitments.
Not to be forgotten are the latter day monopolists, the rating agencies, Moody’s S&P, Finch etc. Their revenue streams went ballistic when Wall Street created the Age Of Structured Finance. They get paid for rating. Isn’t there a conflict in here somewhere? In my days as a practicing credit guy, the watchword was that the rating agencies were a lagging indicator. I will never forget classifying a then fabled Texas bank substandard after a merger in the ‘80’s, only to have a giant argument with headquarters when Moody’s gave them a AA rating. They failed. Put all of this together and maybe this time it Is Different! Only not the kind of different I want to be a creditor of!
4. What else has happened while the United States happily built houses, bought cars and remodeled for the last five years as the Financial sector, particularly Wall Street emerged as the most significant earnings stream in the S&P? Well, going back to that word used before, “worldview,” the U.S. convinced itself that the most important problem internationally was something called “The War on Terror. Hey, I’m against terror too. I just think it’s necessary to know and be sure who it is we need to go to war with. We don’t seem to have done too good a job on that front. It has been expensive but not effective. In a different “worldview”, the costs might have been ascertained in advance. The swing from a Federal surplus to a deficit, the curtailment of a current account deficit before it headed into dangerous territory, the maintenance of a sound currency, the maintenance of world/global respect and, at least, reasonably cordial relations with sovereign states all have a value to be measured, before lost, in pursuit of consumption and the War On Terror.
During this semi decade, the ROW, on its proverbial back when we began this crusade, reinvigorated. A possible “worldview” NOW must encompass a China with $1.3 Trillion in reserves and an industrial/manufacturing base of unbelievable proportions. Courtesy of Chian Kai Shek, their WW2 leader, they sit on the Security Council and are in a position to permit Iran to become what it wishes. Five years ago would have been a more propitious time for being bellicose about Iran. On the same Council is a Russia with $400 Billion in reserves, risen from the defaulting dead.
I don’t know a thing about Putin’s “soul” but I do know he and his Administration are ex-KGB, jingoistic about their nation, loaded with petroleum and still a powerhouse in terms of weaponry. We probably could have bought the weapons five years ago with a fraction of the funds since gone in the aforementioned War and its counterpart, the War on Drugs.
Net net, in the opinion of the writer, there is a very real danger that our worldview for the last five years has risked a century long hegemony as the reserve currency nation as well as creating a Credit Bubble, largely Unregulated, that has expanded far beyond the worst nightmares of the writer. It is also our opinion, as a long time credit troglodyte, that this bubble is leaking air and is in danger of bursting. With no infrastructure to deal with the first truly global bubble, we have an interesting time in front of us.
Labels: bearish bigtime, credit
