Vigilant Investor

…A whole lot of liquidity.

Last week was ugly, but not unexpected. After what could just be the beginning of the long awaited market correction due to the unwinding credit bubble – we think the cavalry will ultimately come to the rescue. To be precise, a more modern cavalry. The kind that comes in helicopters – and drops a whole lot of money. While we wouldn’t be surprised to see the Dow drop to as low, or lower, than 12,000 – we are confident that “Helicopter Ben” Bernanke will fire up the engines. In the process the Dollar will be sacrificed.

Over the past several years, we’ve been writing about the dangerous effects, and false hopes, created by the massive expansion of liquidity. The average person couldn’t really explain why the price of their home (and portfolio) was going through the roof. Or why their grocery bill and the price of a cup of coffee steadily keeps rising. And why their paycheck, in general, just isn’t going as far. The reason obviously is one and the same. Simply, record levels of credit (much created out of thin air) injected into the economy is the culprit. Today, Americans (and the world) now begin to overtly learn the painful lesson that printing money does not create wealth. That an economy based predominantly on credit, will need more and more credit to keep it going. And that in the end – all this newly created money significantly (and steadily) dilutes the value of a currency – along with the hard earned savings of every investor. Like a junkie needing a bigger and bigger fix — the ending is often a sad one.

We don’t think the Fed will stand by and watch U.S. stock markets drop to zero. Nor will it sit by idly and watch the economy grind to a halt. If the upcoming weeks and months do in fact continue last week’s trend – the increased amount of liquidity could be dramatic. As could the decrease in the value of your dollar.

We’ll keep you posted!

Indeed, that’s the headline being run all over the news. Is this, finally, the recalibrating correction many have waited for so long?

Certainly the media has woken up to the symptoms, but do they or the mainstream market fully understand the problem? Let’s take a look at the AP Oil Headline: Oil Near All-Time High Over $77. Ok…. And the byline? “Oil Settles Over $77, Near All-Time High, on Technical Buying and Economic Data.”

Yes, technical buying drives short term moves. A supposedly growing economy does to. You might as well throw in instability in key oil producing countries: Nigeria is dealing with rebel attacks on its infrastructure. Hugo Chavez is ruining Venezuela’s.

But all that aside, once again, not a word about what’s been going on with money supply or the vast ability of expanding credit to drive up asset prices across the board.

Here are a few other headlines showing the current momentum.

• Bear Stearns seizes troubled hedge fund’s assets
• Banks burnt by credit meltdown
• Bond Risk Soars by Record as Investors Flee Corporate Debt
• Financial crisis just one ‘Bear-like’ event away: Economist
• Cadbury Schweppes halts sale of beverages arm
• Global Markets Tumble as Credit Worries Deepen
• Dollar Rebounds From Record Low Versus Euro on Risk Aversion

If you read our associated 2007 Wealth Report (From Ernharth Group Wealth Management), you knew it was only a matter of time before the house of cards that is the global credit system would find itself over extended to where it could no longer support itself. That is the nature of any massive credit / money supply expansion. The economy is so badly perverted by easy money and the associated mentality, that caution goes to the wind as newfangled justifications for the formerly unjustifiable become commonplace replace the timeless truisms.

Our favorite is probably this one: you don’t create wealth by saving; you create it by expanding debt. That’s a corollary to the soon to be (hopefully) discredited “paradox of thrift”, where Keynes and many generations of ideologically related schools of economics theorized that too much savings is a problem because the very act of savings ends up slowing the velocity of money — no one is buying or selling, to the point of recession and depression — a theory not terribly comfortable with the free market purpose of prices in relation to interest rates. (For more on that, see our recent post “The Dollar Sinks Amid Systematic Credit Risk“) Based on such a foundation, credit has been ginned up to the stratosphere — as have the asset prices it supports. But with it, so went common sense and good old fashioned measured risk taking — as one might have learned from Benjamin Graham or Warren Buffet.

So here we sit today with one of the consequences of underpriced and ever-expanding credit: a credit unwind and contraction. Consider:

“Bloomberg Radio reported this morning that the monthly issuance of Collateralized Debt Obligations (CDOs), or packages of debt instruments bundled together to form a “portfolio” of debt, dropped from $42 billion to $3 billion in the latest month. That 93% drop represents a significant tightening of liquidity that is starting to ripple throughout the credit markets. The fixed-income markets appear to be starting to understand that the days of free-flowing liquidity are likely to be behind us. Most credit spreads are widening.”

That’s Merrill’s Richard Bernstein discussing a drop we mentioned a few weeks ago. That’s a severe contraction that’s causing many deals to fall apart. Just the same, existing CDOs are getting repriced at a rapid pace — which ain’t pretty. Barry Ritholzt has some great charts documenting how the supposed good stuff — the AAA to A CDOs are feeling the wrath of finally being marked to market in an environment that truly is coming to terms with the rot beneath the surface.

It’s not pretty, and anyone thinking this is not going to bleed further into other areas of the market needs to get on top of the situation. As we stated two days ago, this is not just a credit market issue — this is a fundamental problem of massive dislocations in the economy. A massive perversion of dislocation built upon dislocation built upon dislocation.

The only question remaining is, will the ultimate end game be temporarily papered over with another blast of money supply? That’s a tool that grows less effective with each blast, and as such, the consequent price inflation is spilling out of the financial markets and into the general economy — never mind the nearly laughable indicator that CPI has become.

As for the market swings of the past few days, keep your head low. Always remember, though, that those in the policy seat are terrified of a massive contraction and are ready to open the MZM spigots as far as they are needed. In such an environment, all bets are off — expect wild volatility — including even new equity market highs time and again until the dust ultimately settles. But, as we’ve been saying for over a year now, measure your returns not in terms of dollars or relative to CPI, but against other currencies and hard assets — the latter which cannot be printed so easily as fiat currencies that are used by all governments across the world.

“If you look at the Dow Jones and the S&P since February measured in euro or measured in gold the S&P hasn’t bettered its February high, also the S&P is up say 8% in U.S. dollar terms but since the beginning of the year in euro terms it’s only up 3% – and in gold terms it is down. So you can print money like the fake stuff and still pursue an expansionary monetary policy – but that doesn’t mean that asset prices across the board will increase in value.”

That’s economist Dr. Marc Faber in an interview from July 23 that’ll update you to his latest thoughts on what’s transpiring in the global economy and markets.

We’d also encourage you to watch a BloombergTV piece where you can hear Dr. Faber, commodity guru Jim Rogers, and Ken Fisher of Fisher Investments. (You may recall Ken Fisher being the fellow we lambasted earlier this week for suggesting that the U.S. does not have enough debt — to the point of it being immorally so!)  Rogers and Faber vs. Fisher!
A separate article at Bloomberg has some other valuable tidbits.

There’s no doubt the dollar is feeling pressure from currency traders. More records have been broached in declines against the Euro, while the dollar slides vs. other major currencies.

Here’s the USDX on the last year — Not promising as it nears a heavy support point of 80.

The Euro has been doing well against the dollar as well:

As for the important Yen carry trade, the Yen’s broader trend continues to weaken, although the last few weeks have showed it strengthening. Given so many trades are based on hedge funds and others borrowing in Yen and converting to Dollars for leveraged trades, that’s a lot of rooting for the Dollar against the Yen — with so many trades depending heavily on the Yen not gaining strength vs. the dollar. Should the Yen gain in strength vs. the Dollar, the cost of the trade will increase because it will take more dollars to pay off the borrowed yen. Consequently, quantitative risk formulas will require a rebalancing of risk to reflect the loss — which translates into selling of securities for liquidity.

Which leads us to one of the concerns folks should have in this era of high finance — systematic risk in the credit system and the unintended correlation of traditionally non correlated assets.

When it comes to high structured finance — the stuff invented by Ph.D.’s and MBAs coming out of MIT and Carnegie Mellon’s high finance departments (also known as “quants”)– there’s a lot of fancy footwork going on in order to slice and dice up traditional portions of risk. This gives a lot more headroom for the system to absorb additional credit risk (loans or otherwise) that it might have been previously rejected or priced more expensively. There’s no doubt this does a lot of good. However, there are two factors that are underweighted when measuring what’s actually going on.

Continue Reading »

Where to begin? Tune in to tomorrow’s discussion on the dollar and systematic risk. In the meantime, here are some more sobering headlines:

• The latest Chinese export may be inflation
• $100 Oil Price May Be Months Away, Say CIBC, Goldman
• Cost of debt insurance hits highs
• States Aim to Stem Tide Of Home Foreclosures With Funds for Refinancing
• Wells Fargo ends sub-prime loan
• Miami condo glut pushes state’s economy to brink of recession

Investors in the Bear Stearns hedge funds that blew up in June received the news they dreaded: The High-Grade Structured Credit Strategies Fund — the less leveraged of the two funds, is worth only 9 cents on the dollar, down 91% from the end of 2006. The High-Grade Structured Credit Strategies Enhanced Leverage Fund, it turns out, is broke. No investor capital is left.

Such is the fun of investing in securities made possible by lax lending standards, ever more exotic mortgages — both of which supported and frothed housing prices in virtually every market across the nation. For that, we can thank enabler number one: reckless expanding credit that has created a global credit bubble. Bubble mentalities take hold, and suddenly there’s little concern among the deal makers slapping such securities together and rating them.

The New York Times has a decent postmortem detailing some facts we’ve not yet covered:

The drama surrounding the two funds began in May when investors in the more leveraged hedge fund were told losses through the end of April totaled 23 percent, not 10 percent as they had been told earlier. As securities markets declined, even the more conservative fund registered losses starting in March.

Investors tried to get out of the funds, but in May, Bear Stearns halted redemptions. Shortly after that, several banks and brokerage firms that had provided loans began demanding more cash as collateral. On June 26, Bear Stearns said it would offer a $1.6 billion loan to shore up the more conservative fund and unwind its positions.

In yesterday’s letter to clients, Bear Stearns said that some $1.4 billion of the loan remains untapped.

The real question that should be on everyone’s mind is, how did securities being held on the book at one value go to being worth nothing almost overnight? Moreover, how can so many other funds go on continuing to value these securities by models showing similar high values in the wake of this near total implosion?

As this rattles through the structured credit market, we expect other managers will be looking for liquidity to cover margin calls on these securities. When they do, they’ll be selling assets otherwise unrelated to subprimes into the market, thus effecting valuations on those, which in turn could kick in a series of cascading trades for cash.

With so many asset values tied to newly minted credit, caution is the word.

The New York Times joins us in knocking the hoopla over new highs in the equity markets, which ain’t so hot since 2000 when measured against inflation. Says The Times:

“The S.& P. 500…closed yesterday at 1,549, just 1.4 percent higher than the peak it reached in March 2000. Think about what that means. While the price of nearly everything has risen over the least seven years — while the price of bread has increased almost one-third, for instance — stocks have barely budged. They have only marginally outperformed cash sitting in a bureau drawer. So if we are going to talk about a stock market record, we should be doing the same for a whole lot of other things: Loaves of Bread Surge to New Highs.”

Obviously, if we were to measure equity price inflation over a longer period, the argument falls flat. However, folks would be wise to monitor if indeed a paradigm shift has taken place given the rapid appreciation since 2000 of many other prices — bread included. Oil is hanging out above $70. Gas is at the hurricane crisis levels of a few years ago, yet there’s yet to be one this season. Food is up well above CPI, as is housing — albeit on shaky footing.

With that in mind, investors would be advised to measure their returns in relative terms, vs. only against the dollar. The dollar is dropping vs. all sorts of other assets and currencies. Given the precarious dependency of the U.S. economy on cheap credit and good from abroad, there’s more than the smell of smoke that should have you perking up.

Fiduciaries (investment stewards for others) pegging their returns against the comparatively benign, if not deliberately understated CPI, really need to rethink the wisdom of that if the paradigm has shifted to inflationary recession.

A short summary of geopolitical concerns for vigilant investors:

Iran requests that Japan buy their oil in Yen vs. dollars.   The dollar is supported by the general global system of the petro-dollar, an institution dating back to 1944 and the Bretton Woods agreement, where oil deals between nations are transacted nearly exclusively in dollars.  Not any more, which means there’s a spring in the dike supporting the petro dollar.   Will Iran ask for Euros next?  And then, will Venezuela be next?   Will this add one more reason for policy hawks to go after Iran?

Whatever the case, its just the latest move of a foreign nation looking to diversify away from the U.S. dollar.

Russia and Britain Row Heats Up:  Its West vs. East again as Britain expelled four Russian diplomats as retaliation for Britain’s assertion that Russia was behind a politically motivated assassination of a former KGB agent and vocal critic of Putnin living in Britain.   Russia vows a response .   We should also not forget Putnin’s efforts to secure / nationalize Russia’s energy resources.

Last week the IEA (International Energy Association) released a sobering report about energy tightness starting early next decade, essentially confirming peak oil warnings.  While foreign coverage has been quite comprehensive, U.S. reporting has essentially focused on short term prognostications that tightness will ease in 2008.  Meanwhile, with Britain acknowledging it will be a net importer as the North Sea fields are drying up, oil rockets north of $77 a barrel.  Goldman analysts are suggesting oil may be as high as $95 by this fall.

 Hugo Chavez is accusing Washington of attempting to isolate his government in Venezuela.  Of course, creating a totalitarian Marxism is a great way to isolate yourself pretty quickly.  With Chavez having nationalized most of his nation’s vast energy resources, investors need to note how this might effect oil prices in the U.S.  Somewhat ironically, a top U.S. State Department official criticized Chavez for practicing the “politics of fear and division.”

Those looking for a trade war with China ought to be looking at what’s been happening to the dollar / yuan exchange rate.   Granted, an adjustment is long overdue with China subsidizing U.S. purchasing power at the expense of its own citizens.  That’s gradually changing, though, since the decision by China two years ago to allow the yuan to gradually adjust:

This should translate into slow price inflation on goods purchased from China.  Of course, that could all change if some in Congress get their ways — although we can assume some of the noise is saber rattling.

Finally, the U.S. and Iran are planning fresh talks on Iraq and  other issues with the Bush administration is teetering on action against Iran over its nuclear program.  Recently, on June 21, 2007, Congress affirmed through non-binding resolution “Calling on the United Nations Security Council to charge Iranian leader Mahmoud Ahmadinejad with violating the 1948 Convention on the Prevention and Punishment of the Crime of Genocide and the United Nations Charter because of his calls for the destruction of the State of Israel.”  Expectations of olive branches being extended from both sides are low.

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing… The depth of the pools of liquidity is so much larger than it used to be that a disruptive event now needs to be much more disruptive than it used to be. At some point, the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way. I don’t think we’re at that point.”

Chuck Prince, CEO, Citigroup

Well, that should calm all your fears!  Party on! Everyone else is.
Our expectations are that we should see a quickening pace of the credit bubble issues coming to a head.    As Bill Fleckenstein muses, the reason so much of Wall Street suspected the subprime mess would remain ‘contained’ was because so very little of it was actually getting marked to market.  Rather, all assets were being marked to a model, which is really nothing more than being marked to theory.

That’s the past. Most everyone on the street now recognizes the market value is going to be nothing close to what’s been carried on the books.   However, given few of these securities are actually getting a market value, the real cost is still guesswork.  The guessing so far does not bode well:  Credit Suisse estimated last week that $52 billion will have vanished when this all plays out.  Deutsche Bank AG estimates the number closer to $90 billion.

Problems will begin unfolding once the risk formulas used by managers are fed the less than pleasant real market values.  They’ll then be forced to account for sharp losses by reducing risk in other classes, a problem only exacerbated by the heavy use of leverage by many players.   These problems will likely cascade into unrelated asset classes — not because they are ordinarily correlated, but for the simple fact that they must be sold by managers holding them who must reduce risk and / or raise margin ratio capital.

Meanwhile, more countries  contemplate backing off the dollar peg and their pace of dollar and U.S. debt accumulations.   Takatoshi Ito, an adviser to Japan’s prime minister, suggested Japan ought to invest $700 billion of its currency reserves in higher yielding assets vs. U.S. Treasuries.   Central banks in China, Taiwan and South Korea are making plans to buy assets with better returns as well.  The U.S. has financed and refinanced about as much as it could over the last few years.  Refinancing that again in a higher rate environment (caused by higher rate demands from foreigners) will present issues.

Bloomberg Markets magazine has done a nice piece pointing out that insider trading is alive and well on Wall Street, suggesting the 1980s mentality immortalized in the 1987 film “Wall Street” is back, alive and well. We are not surprised given the vast amounts of credit fueled deals that are going down these days that there’s more than enough money-induced ethics blurring activity going on. The subprime market is confirming this already, as deal-makers simply offloaded garbage into the secondary market as soon as the deal was done (and the commission made).

Meanwhile, Moody’s is Facing the Storm according to the WSJ, as their ratings methods start getting scrutiny from lawyers and short-sellers alike. Given the fees they and other major ratings agencies (e.g. S&P and Fitch’s) were generating from these deals, one wonders if they were willing to properly rate (and potentially undermine the viability) of RBMSs, CMOs, CDOs, and other related derivative issues laying the golden eggs.

How things play out is to be seen, but given the dramatic amounts of excess elsewhere, we’re not holding our breaths for a good outcome. Consider the recent $200 million fraud case that’s landed 26 individuals in and around New York City with federal indictments. Reports the Financial Times, “Those who have been charged include real estate appraisers, a loan settlement agent, mortgage brokers and loan processors in addition to people who purchased the property. They allegedly conspired to lie to a series of lenders to obtain mortgages between 2004 and 2007.”  Fraud of that level doesn’t even touch the very hazy area of mortgage lending and deceptive practices used by both mortgage brokers and many loan-application-fudging borrowers.   All the same, that easy liquidity and “let’s just get the deal done and move on” mentality is going to land more and more related parties in hot water, even if the deals were perfectly legal — even if a touch shady.

And as always (and as if on cue), the politicians are readying to close the barn doors now that the beast they created (fiat currency and a fractional reserve banking system / central bank) has shoved all the animals out into the north 40.  States are pushing to refine lending laws so that such abuses never happen again. This from the nannies that are supposed to be ever watchful.  Expect much blame to be incorrectly assigned to the free market when in reality it is the spawn of the credit bubble environment they benefit from as well.

Such is the consequence of easy money supply and credit. Bubbles only make that worse, and we’re fairly sure there’ll be more than a few law suits cleaning up the messes.

Today on Vigilant Investor Live (stream-cast live worldwide 3:30 p.m. ET) we’ll be discussing more about the credit environment.  We’ll also discuss the disconnect between the bad news and  all news is good news mentality that appears to have swamped Wall Street.  That, and lots more!

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We missed this one earlier. Before Bear Stearns was exposed in mid-June with two imploding hedge funds that were knee deep in leveraged subprime related securities, they were busy hawking the riskiest portions of collateralized debt obligations to public pension funds.

Reported Blooberg on June 1:

At a sales presentation of the bank’s CDOs to 50 public pension fund managers in a Las Vegas hotel ballroom, Jean Fleischhacker, Bear Stearns senior managing director, tells fund managers they can get a 20 percent annual return from the bottom level of a CDO.

“It has a very high cash yield to it,” Fleischhacker says at the March convention. “I think a lot of people are confused about what this product is and how it works.”

Fleischhacker, 45, says she doesn’t associate toxic waste with the equity tranches she’s selling. Pension funds in the U.S. have bought these CDO portions in efforts to boost returns.

Many pension funds, facing growing numbers of retirees, are still reeling from investments that went sour after technology stocks peaked in March 2000. Fund managers buy equity tranches, which are also called “first loss” portions, even though those investments are never given a credit rating by Fitch Group Inc., Moody’s Investors Service or Standard & Poor’s.

We can only imagine how well those investments have been doing given the news over the last four weeks — with CALPERS (the California Public Pension –the nation’s largest) having invested $140 million in such unrated securities.     I’m sure the lawyers are lining up, but those serving as investmetn stewards — as fiduciaries — should know better than to be lured in by the siren song of such securities.   Anyone on an investment committee ought to be scouring their portfolio ASAP to find the details before things get worse.

“May you have the hindsight to know where you’ve been, The foresight to know where you are going, And the insight to know when you have gone too far”
– Irish Blessing

It is said that hindsight is the injury foresight might have prevented. When it comes to understanding what is transpiring in the U.S. economy, we worry that far too many players will learn only in hindsight they’ve made huge mistakes given so many appear to not be properly discounting much of what stands next in the line of dominoes that have started to fall in the subprime debt sector. This suggests to us a fundamental misunderstanding of the intrinsic nature of the problems we’ve covered for several years nowhere at Vigilant Investor, and since 2002 in our prior hard copy publication, The Ernharth Wealth Report.

Certainly a handful were ahead of the Curve with subprime. Deutsche Bank joined our side of the fence last year by predicting doom and gloom for the sub prime sector. Today DB is joining VI in criticizing the excesses in leverage finance in general, albeit tepidly so.

As for subprimes, the the carnage is now contained to another continent as Sydney, Australia based Basic Capital, a hedge fund manager with $1 billion in structured credits and junk rated loans warned investors it will probably restrict withdrawal requests in order to prevent a collapse from selling assets into an extremely thin market. That’s just the kind of message that should give any holder of subprime related debt instruments lots of confidence: “the market’s so thin now we can’t liquidate.” In a letter to investors, Basis Capital notes they’ve been hit by “indiscriminate” repricing of “otherwise fundamentally sound collateral.” Hmm. Not seeing the forest from the trees, anyone? Mind you, this comes in the wake of Denver based Braddock Financial closing down its $300 million Galena Street fund due to redemption requests.

The best analogy for this sort of denial comes from an editorial by John Authers, who reminds us all of Warner Brothers cartoon character, Wile E. Coyote, running off the edge of a cliff:  So long as he keeps running, he’s ok.  Its only when he looks down to acknowledge his predicament does he actually fall.  Indeed, the attempts to keep these mortgage backed securities from being priced at market are not dissimilar.  (If we don’t mark them to market, they’ll never drop!)

Meanwhile, the dollar is taking serious blows as the rest of the world further questions the U.S. economic situation. Yesterday the Euro hit as low as $1.3798 — a record low, $2.03 to the pound, and 122.48. While the general assessment is that this is related to the sub prime situation (which clearly does not help), we can’t help but tie the dollar’s woes to the global inflationary breakout we’ve seen since 2000 in hard assets that can’t so easily be printed as the dollar and other currencies. With all the world’s major currencies running their M3s in the double digit, you have to take note.

That the dollar is losing vs. the USDX despite that all, well….

With that, we’ll remind you that vigilant investors — fiduciaries or otherwise — know that every exit used means you’ve simultaneously used an entrance to another space. Doom and Gloom? Hardly! That’s where opportunities may be found.

Amid the breakdowns of leveraged funds, and growing criticism of the leverage buyout craze being driven the record levels among Private Equity groups, we learn from the WSJ that “‘Margin Debt’ Hits Record $353 Billion on NYSE.”

NYSE officials attribute the trend to recent regulatory changes effectively allowing both small and big investors to take on more leverage, or borrowed money, from their brokers. So-called margin debt, a broad measure of leverage, jumped 11% to $353 billion at NYSE in May, up from nearly $318 billion in April.

My, oh, my: how current valuations are dependent on ever more support from expanding credit.

As Ben Stein (I think it was) astutely observed some years ago, that which cannot logically go on forever usually doesn’t.   Plan on it.