SIV, RIP
Two newsletters ago, I predicted that “time could well be running out” for the “super SIV,” also known as the M-LEC (Master Liquidity Enhancement Conduit) or as I termed it, the “one SIV to scam them all.”
To review: corporations of all types raise capital by issuing bonds on the “asset-backed commercial paper” market. Assuming the ABCP market is functional, it offers a much more efficient way for a corporation to raise cash. However, today's commercial-paper market has recently been backed by collateralized debt obligations (CDOs) packaged in structured investment vehicles (SIVs). The CDOs have melted under the feet of the ABCP market, and the ABCP market has gone into freefall. This threatens many companies' ability to raise the capital necessary to finance daily operations.
For the banks most deeply involved in the structured finance industry – especially Citigroup and Merrill Lynch – it has been a disaster.
Citigroup, with the imprimatur of Treasury Secretary Hank Paulson, spent most of October desperately trying to patch together a banking cartel to throw money at SIVs until they stopped losing so much value. Unfortunately for Citigroup, the cartel never really got off the ground. The financial press wondered very loudly how a large, Citi-controlled bailout vehicle (from which Citi would extract handsome fees, of course) would enhance market efficiency. Hank Paulson and fellow Goldman alum Mario Draghi (chairman of the Bank of Italy) tried too hard to promote the super-SIV, saying that Fidelity (a gigantic fund of mutual funds) and PIMCO (the juggernaut of the fixed-income industry) were part of the MLEC, only to have PIMCO loudly and immediately repudiate the claim.
And then Merrill Lynch vomited bad debt all over the structured-finance punch bowl. And there was no rejoicing.
In the second half of October, Merrill Lynch took a massively higher-than-expected writedown on its bad CDO debts. The SEC began a preliminary investigation of Merrill. To make sure it was squared away with the regulators and to recapitalize itself in light of a much-larger-than-expected $8 billion writedown, Merrill dumped a lot of its less toxic debt onto the ABX and CMBX markets. Merrill's entire top management received the firing-squad treatment – and the collateralized securities markets, such as the one at left, which had apparently stabilized after retching their way through August, found themselves in their worst free-fall yet.
Then a Citigroup analyst named Meredith Whitney pointed out that Citigroup – as the most “SIV-positive” of all the flagship private banks – was a $30 billion crisis waiting to happen. Citigroup lost 7 percent of its value in one day. The johnny-come-latelies at the SEC began poking around Citigroup's off-balance-sheet vehicles. I say “johnny-come-latelies” because all this information was quite public as of one month ago, and public enough for me to take note of it in the October 8 newsletter:
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.”
[...]
The geniuses I'm talking about, of course, are Jeff Skilling and Andrew Fastow.
Once these off-balance-sheet vehicles begin proliferating for the express purpose of shunting liabilities away (to be realized in later quarters), in the midst of a broader economic slowdown, it's only a matter of time. Before Enron was obviously a bleeding whale, it could engage in a lot of off-balance-sheet vehicles without anybody really caring. It was only when Enron was suspected of using them for the express purpose of plugging holes in a terminally sick balance sheet, that broader confidence collapsed, and the regulators were shocked – shocked! - to find credit-derivatives shenanigans in that establishment. Of course, after the company had cracked up, and after a lot of overcredulous investors had lost their money, it was “so obvious” that Enron had been gaming the system. In an identical way, Merrill and Citi were obviously skating a murky edge of the law for years. Nobody cared as long as the punch bowl was full and everybody was “dancing,” in Chuck Prince's phrase that will live in infamy.
(Note: I am not arguing that Enron was “only as bad” as Merrill and Citi, or that Citi and Merrill are actually as evil as Enron was. I am stating for the record that this was visible from a long way off.)
Pretty soon, Stan O'Neal and others who, for better or for worse, played by the rules, will start wondering very loudly why Goldman Sachs, which has by far the most Level 3 ('mark to myth') assets as a percentage of capital of any bank, is not being roughed up by the SEC nearly as aggressively as the other firms. But that won't be until Hank Paulson's tenure at Treasury is almost over. I also expect Wachovia to get pounded in the next couple of quarters – they are still choking on their $25 billion acquisition of GoldenWest at the precise top of the real estate bubble (one year ago). GoldenWest's portfolio is 90% California mortgages, 90% of which are option ARMs. It's a $25 billion time bomb.
At any rate, after Merrill blinked, the CMBX markets also completely panicked. At left is one representative collateralized mortgage-backed securities index.
The oft-predicted (here) “second round” of the credit crunch is most assuredly happening. But it isn't having the same adverse impact on other markets that the first round did, in terms of volatility, evaporated stock-market valuations, or anything beyond the banking sector. Why is that?
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The Missing Link: the Federal Home Loan Banks
There has been a massive surge in the liabilities of the Federal Home Loan Banks in the past month. This Depression-era agency, bigger and badder than Fannie Mae and Freddie Mac, has taken a ton of CDOs ($150bn or so) on its books in the third quarter (through September 30), and in all probability its liabilities increased even more rapidly in October. Taxpayers have already footed the bill for some of the CDO debacle through blatant depreciation of the dollar, but they will pay more when the government is faced with the price of insuring FHLB debt, which currently stands at approximately $1.15 trillion. According to the FHLB financials (see http://www.fhlb-of.com/specialinterest/financialframe.html), FHLB consolidated obligations have increased by 21 percent in the previous nine months. Even in the dog days of 2003-2004, FHLB obligations increased by a “mere” 12 percent year-on-year. Government-sponsored enterprises are notoriously lax when it comes to lending practices, but unless the FHLBs tend to significantly reduce liabilities in every fourth quarter – in other words, the only market in the United States to tighten its belt during the holiday season – this cost will be paid by taxpayers in the form of higher interest rates and a cheaper dollar, or higher taxes.
How do you solve a problem like Bernanke?
As readers know, I am of two minds regarding the Fed Chairman. The conventional wisdom of the gold bugs, commodity bulls, financials bears, and other people who have made a killing in this market is that Bernanke fundamentally gets almost all his information from private bankers. If you control most of the inputs into a black box (or a human being), you can estimate, with a high degree of confidence, what the output of the black box will be. Furthermore, Bernanke's academic background may suggest an overestimation of his own intellectual ability, and thus a bias in favor of central banking activism – i.e., an inflationary bias. As a huge gold bull myself, this has been a very rewarding sort of conventional wisdom ever since I first began buying gold stocks in early June, and again in September. Bernanke's every further move seems to further vindicate his worst detractors – namely, cutting interest rates by 25 basis points as the economy (supposedly) grew 3.9 percent in the third quarter, as well as a $41 billion repo injection into the banking system, the largest one-day injection since September 19, 2001.
However, there are very legitimate arguments in favor of a weaker dollar. All indications are that the easy-money/ artificially depreciated-yuan interests triumphed at the 17th Plenum of the Communist Party of China, meaning that, unless external pressure (in the form of a cheaper dollar) punishes them enough, an artificially cheap yuan will be de rigueur for the next several years.
If China will not allow the yuan to trade freely, then, the Fed could well have chosen to devalue the dollar instead. The dollar-yuan pair does not trade in an open market, so the Fed must counter-manipulate to compensate for Chinese yuan intransigence. That, at any rate, is the theory. Inflation is certainly rising in the United States, but it is rising still faster in the PRC, and if the Chinese want to keep playing chicken with their currency, they will be forced to blink first.
At any rate, whichever rationalization for Bernanke's behavior you prefer, competitive currency devaluation – higher inflation, more-expensive commodities, drastically more expensive gold – is the name of the game.
I looked back at Kitco's excellent data sets for historic gold prices. Gold's all-time high ($850/ounce in 1980 dollars, about $2,000/oz in current dollars) was extremely aberrational, but gold did trade at $550-700/oz ($1100-1500 in today's dollars) for over 12 months. Compared to that peak, we just aren't there yet.
According to people smarter than I, the most reliable leading inflation indicator is “money at zero maturity,” aka MZM (although there is a lag of several years). MZM has been somewhat schizophrenic of late, with a very perceptible downward kink very recently, but I suppose that Bernanke's recent $41 billion repo injection and gratuitous 25-basis point cut put an end to that.
The Bottom Line
Now that the sharks are circling both Merrill and Citigroup, with Wachovia, Lehman and Bear Stearns assuredly not far behind, the government-sponsored M-LEC is over. All of the aforementioned banks are in for some very rough riding, and Goldman will get its comeuppance a bit later.
With the caveat that things are not going to stay the same for very long, my predictions will be as shocking as they have been every other week. Short USD, GBP. Long EUR, gold, and cash. (I am not giving up on GBP. If you have followed my other predictions, your losses on GBP should pale in comparison to your gains, and the GBP will obey gravity sooner or later.)
Anyway, that's it for the week. Don't forget to e-mail me (alex.forshaw@gmail.com) if you have any questions!
--Alex Forshaw,
Editor in Chief
http://www.bestwaytoinvest.com
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