Miles to Go Before I Wake ... From the Nightmare-a-thon Mauling of “Mark-to-Myth” Modeling
Did you think the dollar was done falling? Dollar ready for a 'Fibonacci retrace,' as the technical artists would say? Not likely.
In late July, a bunch of hedge funds using leverage collateralized by very complex packages of debt – collateralized debt obligations/CDOs – suffered extremely severe losses, almost always exceeding 50 percent.
On July 28, Sowood, one of the biggest victims,was purchased at over a 50 percent discount by the Citadel Fund. Citadel, Ellington and Marathon began picking up CDOs at huge discounts. (As of early August, Ellington was hiring CDO specialists, presumably to re-price all the CDOs they had bought at such a deep discount. More on this in a second.)
As the structured finance indices collapsed, the reverberations ripped through the credit markets, then equities. Bernanke performed a transparent about-face on Fed policy after frenetic conversations with Ray Dalio, the revered recluse who manages the Bridgewater hedge fund colossus, and “Bailout Bob” Rubin, the former Secretary of the Treasury. On August 16, as we all remember, implied S&P volatility peaked at 38 percent. Although there were a couple of “echo spikes” through the rest of August, most of the volatility had evaporated by the end of September.
Gold had spiked again, as per my drumbeat prediction, but it seemed to be plateauing. As I noted in last week's letter, the credit indices were alive and kicking again, even though the structured finance indices were still dead. Equities, though they are still rich, are not fantastically overvalued by any traditional metric. Everyone remembers how ridiculous P/E ratios were in the late 1990's, and that simply won't happen again. Now, the market looks at the expected P/E ratio's denominator – earnings estimates – which are at historic highs. (Even factoring in “average” earnings from a very mild slowdown would inflate current P/E ratios to about 30, from their current level of approximately 18.)
Then, on Saturday, news broke that mortgage-backed securities giant Ellington Management was halting redemptions.
To investors who haven't been keeping score on the whowhatwhenwherehow of the structured finance explosion, that sounds like the latest non-surprise in a string of previously unexpected, but now largely unsurprising and “priced-in” MBS blowups.
More alert investors will realize that Ellington waded in at the bottom of this market, not the top. Ellington and Citadel built a floor on the assumption that the structured finance market, some classes of which had lost two-thirds of their initial value, was undervalued because of both rational repricing and irrational panic. That floor appears to be splintering.
It's not clear why Ellington halted redemptions, but Ellington was probably expecting prices to normalize significantly within one to two months, and that has not happened; instead, the market went into a deeper freeze. Ellington hasn't been able to move product off the books, and margin requirements are going up. Firms are still not bidding for structured finance products, and ultimately, if your “mark to model” models say that the “real value” of your product is much higher than the best available bid, something is wrong with your model. That's what the SEC appears to (finally) be enforcing.
Other funds will probably dump CDO product simply on the assumption that Ellington will have to in a short period of time.
If Ellington is in trouble, that cannot be good for Citadel or Marathon. Or any other holders of structured financial products: namely, the financial sector.
Level 3
In the last two newsletters, I noted (with no lack of cynicism) that the third-quarter accounting of the more aggressive banks had no credibility, specifically that they reported their profitable trades, while sloughing their bad MBS trades into the ingenious accounting innovation called “Level 3.” With the SEC banging down Bear's door, however, not only will MBS prices be depressed even further, but “mark to myth modeling” is in the process of being criminalized (for good reason).
Banks which marked down their MBS portfolios 30 percent for Q3 (whose models indicated “fair value” of 70 percent, for purposes of Q3 reporting) will be forced to mark down, de-lever, sell, depress prices further, and sell yet again. Expect that Level 3 category hemorrhage accounting value over the next two quarters.
The Comeback of the Off-Balance-Sheet Vehicle
Buried last week in the Financial Times was the diamond that private-equity behemoth KKR planned to form an off-balance-sheet vehicle with Citigroup (its main debt syndicator) to assume liability for $15 billion of debt that KKR needs to complete a buyout. How exactly does that work? I can hear you wondering.
Easy. Citigroup “underwrote” (signed a contract to come up with) debt for buyouts which would be performed by KKR. KKR wants the the buyouts to go through on the terms Citigroup promised, which aren't favorable to anybody other than KKR anymore after the gutshot the credit markets suffered recently. But nobody will buy the debt on the terms Citigroup promised for KKR. KKR is still pretty tight with Citigroup, and doesn't want to completely screw it over, so KKR and Citigroup form a subsidiary company to buy Citigroup's debt (at a small discount). So they invest $5 billion cash into this new fund, lever it up a couple of times (because who's afraid of 2x leverage?), and thus sell the debt to themselves. Voila, the buyout is complete.
Meanwhile, investors will see a $5 billion “alternative investment by Citi and KKR, but they won't see the $10 billion borrowed against it, or the fact that KKR and Citi syndicated $10 billion of debt to themselves by putting up $5 billion. Folks, this is what we on the Street call “genius.”
Yeah, yeah. I hear you. I shouldn't be giving KKR and Citi all the credit for this masterstroke, when they really just copied the idea from two luminaries of a bygone age. Said luminaries fell so in love with their idea that they gave it a name – the Raptors – and, unfortunately, lost everything for its sake.
The geniuses I'm talking about, of course, are Jeff Skilling and Andrew Fastow.
On the brighter side, KKR and Citi are about as close as you can get to “too big to fail.” If they do, we are going to have a lot of problems beyond one $10 billion off-balance-sheet vehicle. But in the meantime, don't expect Citigroup's or KKR Financial's stock to outperform the broader market, and don't think that these credit market problems are over. They aren't. KKR and Citi are assuming that the economy will get better, and they will be able to pay these debts back. But that's an assumption on their part, not a fact. And these vehicles are beginning to pop up everywhere, not just with KKR and Citi. $300 billion of unsyndicated debt is going to require an awful lot of “raptors,” all predicated on an economic comeback which looks more dubious by the day.
Japan Keeps Digging
According to the Nikkei, Japan will “revise the way future statistics are published.”
As one writer memorably put it, “All you need to know about Japan is that one year ago, Yasuo Fukuda was considered too old to be prime minister.” After Shinzo Abe utterly squandered Koizumi's legacy of modest reforms, the LDP didn't even bother nominating a faux-reformist this time. In a triumph of honesty over modesty, they chose Yasuo Fukuda, a wheeling and dealing careerist whose promises hold him hostage to growing the parasite – the so-called “Liberal Democratic Party” of Japan – at the expense of the wider Japanese economy.
Given that the LDP could easily choose to confront Japan's problems (a deficit equal to 170% of GDP, an addiction to colossal deficits) head-on if it believed they were bad enough, I conclude that the LDP can only get away with more sips from the trough if it fools investors into believing an even more-cooked set of statistics than the undeniably pessimistic picture projected by Japan's current, less-dishonest set of numbers.
I have a lousy track record of predicting the JPY on the occasions I've tried. JPY should go up in the long run, but it will remain massively undervalued for much longer than any forex speculator can remain solvent. In the meantime, Japan is an investor's deathtrap, a budgetary basket case and a demographic disaster. But the current LDP regime would be far too weak to upset the Japanese status quo even if it showed any willingness to do so. The carry trade will not be disturbed from Japan's end as long as the LDP is in power.
China's 17th CPC Plenum
Michael Pettis, a former bond trader and current finance professor at the University of Beijing and whose China finance blog is high on my mandatory reading list, says that all indications are that, even though the alarm bells are going off in Chinese elite economic circles, nobody wants to take the risk of accelerating China's currency appreciation (a forcibly devalued currency is effectively an export subsidy that gets around WTO rules, but it also causes higher internal inflation) in the run-up to the Olympics, for fear of stoking urban unrest.
Because of China's fateful choice, I am not as bearish on oil as I used to be; however, I am still more bullish on gold, which has uncannily tracked the Asian bull market (and which showed surprising resilience after a 3% fall earlier last week). Industrial commodities are not going to cool off by much, either, as long as China keeps priming the pump, at the price of a massive commodities bust later.
Stay long the euro; long cash; long gold; short the USD; and short the GBP. For the more speculative, the Swedish krona holds promise as a port of call for “hot money” leaving the UK.
And, of course, short financials.
--Alex Forshaw,
Editor in Chief
http://www.bestwaytoinvest.com
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