Friday, November 30, 2007

No Bid

With respect to CDOs, naked capitalism describes them as “so arcane, so complex, and so highly differentiated on so many axes that one is likely to need to have a large number of CDOs trading to capture enough permutations to allow for realistic pricing.” For example, “underlying assets (they can contain any tranche of asset backed securities, other CDOs or even CDOs of CDOs, whole loans, mortgages), degree of credit enhancement (whether via overcollateralization or the use of guarantees), leverage, use of synthetics. As a result, the maturity of the deals vary, and the structures used to achieve the desired credit ratings are all over the map.”

In addition, NC says that “you can't get the deal documents.” Here’s his backup for that assertion: In "Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions," by Joshua Rosner and Joseph Mason (pages 83-4) the authors state that “At present, even financial regulators are hampered by the opacity of over-the-counter CDO and MBS markets, where only “qualified investors” may peruse the deal documents and performance reports. Currently none of the bank regulatory agencies (OCC, Federal Reserve, or FDIC) are deemed “qualified investors.” Even after that designation, however, those regulators must receive permission from each issuer to view their deal performance data and prospectus in order to monitor the sector.”

That is an absurd state of affairs. NC’s logical conclusion is that “if regulators can't get the description of the securities, market participants certainly won't.” No wonder there is little to no bid for these securities. Adding to the confusion is the fact that “many CDOs are "active" or "managed" CDOs, meaning blind pools…That means the investors pony up money before the fund…is formed, and the manager gets to trade it over its three to five year life. No CDO manager is going to disclose his holdings (it would put him at a competitive disadvantage) but how can you value it otherwise?” So many of these CDO’s are essentially opaque mutual funds, not all that different from the garden variety scam where a promoter offers great returns on your money on something like diamond mines in Argentina but you can’t ask what they’re actually doing with your money.

So now that the values of assets making up some CDOs have collapsed, investors want to know what’s in all the other ones they’ve bought into and are discovering how opaque these things really are. So no one wants to buy unless they can see what they’re buying, and if CDO managers aren’t giving in on the disclosure issue no one is going to be making any offers. It would be like buying a used car just from an ad in the newspaper without going to inspect the vehicle at the lot. Now that this has all come to light, situations like the one described at Florida Schools Hit by Fund Freeze are going to appear everywhere. Managers of public funds aren't going to be going anywhere near this type of investment.

Tuesday, November 27, 2007

A different kind of credit cycle

Back in June, the following comment(slightly edited by me) was posted to a thread at Calculated Risk:

“A tougher market for LBO bonds/CLO's means less bank capacity(investment or commercial?) for additional lending, which means less deals. All this should remind us why this cycle is so different: the marginal dollar of credit is coming from levered lenders with concentrated portfolios and unstable sources of funding, or from "non-natural" buyers such as the hand-over-fist Chinese buying of Agencies. The nature of these creditors is that their provision of credit is a) correlated with one another and b) highly variable.

And yet we continue to compare this cycle to 2001, 1998, 1991, and 1981.

They are as different from today as chalk and cheese. It’s not about assets, it’s about how they are funded. We should prepare to see a different type of credit cycle, perhaps more similar to the "Golden Age" late 1800's downturns we experienced before the advent of regulated financial institutions.” David Pearson | 06.27.07 - 1:44 pm |

I agree with Pearson’s conclusion that this credit cycle will be different than any in the US since the establishment of the Federal Reserve system. None of the crises that Pearson mentions were brought about by asset overvaluations based on issuance of CDOs. According to the July 2007 issue of Bloomberg magazine, “Worldwide sales of CDOs—which are packages of securities backed by bonds, mortgages and other loans—have soared since 2003, reaching $503 billion last year, a fivefold increase in four years..” One aspect of CDO issuance is that these securities were designed so that illiquidity and low transparency were selling points; i.e. the risk due to those two factors implied that yields would naturally be higher than traditional asset classes. Given that in the post dot com bust recovery most asset classes were providing relatively low yields, the popularity of CDOs is not surprising. Of course, very few were paying much attention to what might happen should these investments run into trouble. People were ignoring the risk side of the risk-return equation.

Pearson comments a couple of days later at Calculated Risk along these lines

”I believe the opacity is very much by design, and that these securities are a direct analog to Enron's opaque "Special-Purpose Entities". The hedgies need securities which they can "mark to model" (again like Enron) so as to support claims of huge short-term profits from which to take their 20% cut.”

I don’t think there is any question that hedge funds have been a primary target market for securitizers. However, I believe that just about every type of investment vehicle out there has purchased some type of CDO during this boom.

To elaborate on Pearson’s comment above that this credit cycle will be similar to those that occurred pre-Federal Reserve, there is no regulatory agency in the US with the specific ability to manage debt securitization activity. One of the Fed’s purposes was to reduce the volatility of business cycles by regulating the creation of credit. Now that a major portion of credit creation has been occurring outside the control of the Fed, we have seen a massive explosion of credit and are likely to now see a massive implosion of credit.

Trends in land use and attitudes regarding the same in Europe

Newsweek International posted a story this summer to its website from its July 4, 2007 issue with a summary line as follows: “Economics and declining birthrates are pushing large swaths of Europe back to their primeval state, with wolves taking the place of people.” The article describes a trend in Europe’s rural areas of “ultralow birthrate(s) and continued rural flight”…to the extent that “rural flight continues to suck people into Europe's suburbs and cities.” The UN and EU are quoted to the effect that by 2030 the rural areas of the EU 25 “will lose close to a third of its population.”

The article describes some examples of changes in wildlife populations:

“In 1998, a pack of wolves crossed the shallow Neisse River on the Polish-German border. In the empty landscape of Eastern Saxony, speckled with abandoned strip mines and declining villages, the wolves found plenty of deer and rarely encountered humans. They multiplied so quickly that a second pack has since split off, colonizing a second-growth pine forest 30 kilometers further west.”

“In Swiss alpine valleys, farms have been receding and forests are growing back in. In parts of France and Germany, wildcats and ospreys have re-established their range.”

Bizarrely, some environmental groups in Europe don’t want farmland to revert to a wild state. The article claims that “The scrub brush and forest that grows on abandoned land might be good for deer and wolves, but is vastly less species-rich than traditional farming, with its pastures, ponds and hedges”, and quotes Jan-Erik Petersen, a landscape biologist at the European Environmental Agency in Copenhagen as saying that "Once shrubs cover everything, you lose the meadow habitat. All the flowers, herbs, birds and butterflies disappear…a new forest doesn't get diverse until it's a couple of hundred years old." Such ideas seem to contradict the goals of environmental groups in the US which as far as I can tell seek to allow farmland to revert to a natural state. I doubt that there is meaningful research that supports Petersen’s assertion.

The article states that ‘Keeping biodiversity up by preventing the land from going wild is one of the reasons the EU pays farmers to mow fallow land once a year. France and Germany subsidize sheep herds whose grazing keeps scenic heaths from growing in.” That seems absurd to me. The article goes on to say that “Outside the range of these subsidies—in Bulgaria, Romania or Ukraine—big tracts of land are returning to the wild.” I seriously doubt that biodiversity will be a problem in these areas.

The article describes an attitude toward the landscape such that it “is glued to the European identity, reflecting what the Germans call "Kulturlandschaft"—a landscape shaped by centuries of human care”, and says that “Many Europeans are reluctant to just let nature do its thing.” This attitude doesn’t seem to square with the seeming momentum of Europe’s Green movement, and certainly has received very little attention in the US.

Friday, November 09, 2007

US gasoline prices have hit a wall

I found the news that oil refiners' margins have been squeezed by the high crude oil prices to be quite remarkable; typically I think it has been safe to assume that crude price increases were immediately passed on to the gas pump. As Calculated Risk points out, the implication is that domestic gasoline demand is weak. Another way to say it is that gasoline has reached a price point where US users either limit their use or find a substitute. I don't have hard data at my fingertips, but I believe that businesses have been a strong driver of finding ways to limit or reduce gasoline consumption. It is interesting to know that gasoline prices can't just spiral to the stratosphere. Here is a chart of US gasoline prices posted 11-7-2007 by the US Energy Information Administration:

Tuesday, November 06, 2007

Black Tuesday?

General Motors has dropped a $39 billion bomb described here: by my calculations that puts the company's stockholder equity in the range of -$43 billion. We'll see what the actual number is tomorrow. It must have taken a long time for GM's executives to swallow making this move; usually it is the accountants that push for writedowns like this and they typically don't have much sway. Maybe GM's accounting firm was threatening to quit.

This link points to a Bloomberg story posted at 2 PM Eastern today that "Japan's Leading Economic Index Drops to Decade-Low 0". The explanation in the story states that "A reading of below 50 indicates the economy may slow in three to six months" the actual reading was ZERO! So Japan's economy is literally going nowhere. I had assumed on seeing the news item about this index that the result of zero was due to an equal number of positive versus negative components. That is not the case...if you follow the link in this post you will see that every single available component was negative. So the headline number is a bit misleading if you are not familiar with the details of how the index is calculated. It's hard to see how Japan can avoid a recessionary 4th quarter.

Meanwhile, " The U.S. doesn't have enough information to predict the outcome of events in Pakistan or whether President Pervez Musharraf can hold on to power, according to a Bush administration official." So the US's primary partner in restraining Islamic militants in south Asia is teetering on the brink of political collapse. It's hard to say whether this crisis will lead to increased insurgency in Afghanistan as Pakistan's military is focused on events in its own capital; or whether the insurgents focus on Pakistan themselves to try and help topple Musharraf. I think it's safe to say that there are more than a few people in Washington not getting a lot of sleep at the moment.