UBS Sets the Rules
A few eternities ago, back when Wall Street's financial alchemy was still viewed as a monument to capitalistic ingenuity (as opposed to “printing money”), the first cloud on the horizon appeared in the name of Dillon Read Capital Management, UBS's subprime flagship fund-turned-leveraged blowout. In retrospect, DRCM's March shutdown marked the beginning of the first subprime unraveling, which culminated on August 13 when implied volatility peaked at 38 percent and worldwide central banks blitzed the markets with repurchase agreements (extremely short-term loans or “repos”) to major banks. The third quarter of 2007 was thus one of the most violent in market memory.
As the reporting deadline for the third quarter (July 15-September 15, or July 30-September 30) loomed, I confessed raw cynicism regarding the financial houses' third-quarter results after Lehman, Bear and Goldman all “trounced” market expectations. Investment banks have so many lawyers, captured regulators and raw dollars that they enormous latitude over how to report a loss – whether to take the “water torture approach” and write down a percentage of “Level III” assets over the next several quarters, or to air all the dirty laundry in one bloody swoop (and knock out top management in the process). One can guesstimate that the banks had heated internal arguments over who deserved the most blame (unless Goldman actually got as lucky as they said they did), but in all cases, top management survived.
For the sake of job security, those managers chose to “beat” expectations now, at the cost of writing down percentages of Level 3 and Level 2 assets against future earnings.
At UBS, the finger-pointing played out differently, both because they screwed up first, and because, as the market leader of laundering second- and third-world oligarchs' money private wealth management, a trustworthy reputation was disproportionately vital to UBS's core business (taking good, trustworthy care of secretively rich people's money, not earning spectacular returns based on outsized risks, is what matters most to secretively rich people). UBS thus faced much stronger incentives to hold its management accountable and defend its reputation.
UBS's new management had an incentive to not only report the true extent of UBS losses, but to go even further, and take a significantly pessimistic attitude to earnings valuation. New management is evaluated on how much it surpasses expectations, so to the extent that the new managers can attribute a problem to prior management, the new managers will be more likely to beat expectations even further. Regardless of the size of the writedown, prior management will get all the blame.
Therefore, UBS's $3.4 billion writedown is a very reliable guesstimate of the true extent of the subprime problem for UBS (about 3.3% of current market capitalization) – if not an overstatement. And while there's nothing “good” about UBS's loss, it offers the first trustworthy glimpse into the scope of the problem. Subprime liabilities are now a matter of risk, not uncertainty – they can now theoretically be quantified.
Of course, the more speculative banks probably have higher subprime exposure, and UBS's write-down will now force Lehman, Goldman et al. to mark down their own subprime assets significantly, which should precipitate another round of deleveraging. So although UBS is certainly favorable over Goldman, Lehman, Bear and Morgan, in my opinion, financials are sailing into a second tempest.
“The Federal Reserve Weekly Alpha”: Central Banking Game Theory
A loud, unmuffled guffaw rippled throughout the internets ™ as Fed guvnors Janet Yellen and Frederic Mishkin warned the financial community “not to take future rate cuts for granted,” according to Bloomberg. In the same breath, erstwhile inflation hawk Bill Poole said that “the 50bp cut was necessary.” Charles Plosser made noises that data would have to be “much weaker” for him to support a further rate cut (although he had similarly hawkish words in Hawaii the Saturday before the Sept. 18 FOMC meeting, and traders lost money to the extent that they lent credibility to him).
Last time around, with the dollar at a secular low and very close to an all time low, the markets listened to the Fed governors, publicly available data, and rumored private information. The markets reasoned that dollar weakness, and gold and oil strength, took precedence over maintenance of maximum liquidity, which would in any case be paid for by more deflation and less liquidity in a disproportionately short amount of time (according to neoclassical theory).
Two weeks later, there is nary a pundit who is not wringing his hands over the dollar's 5% loss since that rate cut. But that cannot have surprised the Fed. While I do indulge in the idea that I am a somewhat intelligent person – maybe two standard deviations above the mean on a great trading day – I do not ever think I am smarter than the Federal Reserve, and if I could forecast a disproportionate fall in the value of the dollar stemming from a 50-bp cut, so too would the Fed have understood this.
The Fed must also know that, even as Western policymakers feigned concern over rising inflation, inflation in other parts of the world is even more significant. Central banks are not interested in importing more inflation from the United States, and countries experiencing significant inflation, such as Saudi Arabia, have already begun to decouple from Fed policy. China's dollar peg is exacting a particularly severe inflationary toll.
Furthermore, the European Central Bank has every reason to remain hawkish for as long as possible. With the Fed's Sept. 18 decision, the euro is now an official reserve-currency competitor vis-a-vis the dollar. Despite the protestations of France and assorted other continental economies, Germany and Eastern Europe currently favor a strong euro, so the euro would not seem to be hostage to political pressures in the near future. In the meantime, the ECB can focus on its “core competency”: making the euro the preferred medium of commercial exchange around the world. (I simply don't buy the argument that the ECB will start cutting rates if the dollar loses much more value, because I don't see Fed/ECB interaction as the cooperative game it was before the euro's surge after November 2000.)
In the meantime, gold will retain its function as “reserve currency of third resort.” The incumbent global reserve currency (the dollar) is losing value at such a rapid rate due to political pressure that the market has begun demanding an alternative globally-accepted exchange medium (the euro). If the challenger's integrity remains intact and the incumbent's continues to depreciate, the challenger becomes more and more competitive. In the meantime, if the challenger currency succumbs to its own domestic political pressure, worldwide demand for a reliable reserve currency will shift to gold.
Gold's price is a measure of the confidence in the fiat currency system in general, and on the dollar in particular.
Credit Markets
I am honestly not sure if the ABX has traded at all in the past week. Some of the latest BBB and BBB- offerings on the ABX have displayed the same price for a week. Credit markets (CDX, LCDX, etc.) are more or less back in business, but structured finance markets (ABX, CMBX, others) remain in a catatonic state.
The credit markets will regain some liquidity until the next shock hits. The wealth managers' third-quarter writeoffs will probably exceed $15 billion in total (UBS and Citigroup alone notched approximately $10 billion in losses), and as banks mark to market based upon these pessimistic revaluations, the tremors will be felt. The European banks which stood at the epicenter of the August explosion will probably retch again. (Those banks are ABN Amro, Barclays, BNP Paribas, and Societe Generale.) Lehman and Bear will be pummeled, and I would be stunned for Goldman to dodge the revaluation bullet a second time. (However, I would note that I have already been stunned once.)
Recommendations
It's about that time of morning when the newsletter is getting too long, the hour is getting too late, and it's time to hit the send button. My recommendations today are identical to my recommendations from two weeks ago: long EUR, short GBP, short USD, long gold, short oil, and long cash.
I hope you enjoyed this week's newsletter. As always, please send any comments or questions to my e-mail address at alex.forshaw@gmail.com .
Best wishes,
Alex Forshaw
Editor in Chief
http://www.bestwaytoinvest.com
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