Wagging The Dog
by Brian Pretti CFA, Contrary Investor. April 11, 2008
Assessing what we know and what we don't know is the ever-present and ongoing psychological battle in investment management, now isn't it? Trying to make an assessment of the fundamental facts and then reconciling this view of life with the reality of very short term financial market outcomes can be quite the trying challenge psychologically, emotionally, and even physically, to be honest. If we accept the fact that the financial markets are theoretically always looking ahead and discounting in current price what they are seeing in the future provides the perfect backdrop for of the moment personal tension in trying to "guess" what the markets may be seeing ahead that we cannot amidst the day-to-day of current reality that presents itself to us in economic stats, corporate earnings reports, etc. Nothing like starting the discussion with a bit of personal philosophical meandering, now is there? But in this very special current environment, we need to broaden our thinking and "field of vision," if you will. Although traditional and time-tested financial market signposts are indeed quite important to monitor, the financial market environment of the moment has the capability to perhaps blur or bend our vision in a manner unlike anything we have lived through in many a moon, if ever. This is the topic of discussion.
Okay, here's what I think I "know" about the present. Until proven otherwise, we are in a macro bear market for equities. Detailed in a discussion on the CI subscriber site literally on the first day of this year was that collectively all of our favorite long-term equity market indicators have turned bearish. Not a few, not a lot of them, ALL of them. Trying to keep it simple, arguing with unanimity in longer-term market message is left to those willing to test their fortunes and their wills. In terms of the macro, it's a time for meaningful caution regarding equities. Secondly, the US economy is in recession right now. Although detailed in our commentaries many of the now current reasons why in discussions over the recent past, a standout anecdote is the fact that the LEI (leading economic indicators) report for February that hit the Street a few weeks back has now shown us a consistent five straight months of decline. LEI of the last half year is completely consistent with initial recessionary periods past. In essence, it's corroborating the fact that recession has already arrived, although "officially" that fact will be revealed some time in the future when its usefulness as a piece of factual investment information will be essentially useless. By the way, if the LEI deteriorates meaningfully further from here in the coming months ahead, it will be suggesting a severe or lengthy recession to come, as opposed to the mild recession the consensus is expecting (if any recession at all) and the LEI suggests for now.
Point blank, the evolutionary character of the credit markets is THE issue to focus upon, an issue that is clearly driving both broader financial market and real economic outcomes of the moment. It's my belief that a credit cycle of really generational proportion has now given way under its own weight to an elongated process of systemic deleveraging. A process that has really just begun. In question ahead will be the sustainability of the very props that built this credit cycle, such as the entire concept and faith in securitization, the integrity of and trust in the credit rating agencies, the trustworthiness of the brokers/investments banks, and faith in the regulatory oversight of the US financial system itself. Against this backdrop we also do indeed know that literally ALL guns are being brought to bear upon the continually unfolding credit market issues of the day by the Fed/Treasury/Administration.
In the past seven months, the Fed has cut the Funds rate 300 basis points (a near 60% decline) and the discount rate 375 bps. For the first time in the illustrious history of the Fed, these merry pranksters have truly flown over the cuckoo's nest and will now accept asset-backed commercial paper and mortgage-backed securities as collateral for borrowing at the discount window. The TAF (Treasury Auction Facility) has been set up along with the TSLF (Treasury Secured Lending Facility) to swap sows ears for silk purses, at least for a while. Moreover, the Fed has remodeled and essentially put in a larger discount "window" borrowing mechanism in place to now include the primary securities dealer participation (the first time in the history of the venerable Fed whereby they have acted to financially backstop the non-bank financial system). As you know, this has been termed the PDCF (primary dealer credit facility). More broadly, the government has kindly offered to drop tax rebates in $600 increments to various wealth demographics using the US mail as opposed to helicopters. And perhaps one of the largest "stimulus plans" of all has been to have the OFHEO (regulator of Fannie and Freddie) acquiesce in terms of lowering the capital requirements of the two mortgage credit market behemoths in allowing them to immediately expand their already questionable balance sheets. With the relaxing of these capital ratios, these two fun loving mortgage paper collectors and guarantors will be more highly levered than Bear prior to that company going on to its greater rewards. You get the picture. We're witnessing unprecedented action right before our very eyes.
And it's against this set of "what we think we know" circumstances that we as investors try to assess and make sense of the day-to-day movement in financial asset prices. What we don't know is when what I believe to be a bear in equities and an economic recession stateside will end. Sooner? Later? Who knows? What we don't know is whether what has been brought to bear on the problem by the Fed/Treasury/Administration will be effective in turning the credit market, and by direct linkage real world broader economic health, anytime soon. Will broadened lending/investment/financial guarantee limits of Fannie and Freddie truncate and turn the physical housing price reconciliation cycle set against the truly powerful forces of debt deflation? Can all of these monetary policy and GSE balance sheet expansion/explosion efforts act as a spark to reaccelerate and return the now crippled US credit cycle to its former unfettered and "sky's the limit" glory? Will leveraged asset backed credit securities buyers who have not already been taken off the playing field on stretchers remerge from their newly dug bomb shelters, confident in the knowledge that the Fed/Treasury/Administration now really, really has their collective backs and will essentially monetize any and all losses? For the answer to some of these questions, we necessarily have to watch and listen to what the financial markets are telling us, all the time realizing that short-term investment performance is THE only concern of so many investment "professionals" in the modern era. Whoever said life was easy?
The Dream Team
Having said all of this, financial market events of the last month particularly paint quite the important and relatively large question mark. How about the largest one-day drop in the gold price in over a quarter century? Did that catch your attention? Or was it the intra-week doubling (from low to high) in stock prices of some of the financial sectors' finest such as Lehman, Fannie, Freddie, etc. that you might have seen out of the corner of your eye? Regular ho-hum everyday type of market events, no? Of course what accompanied these more than noticeable events, as well as many others, were cries from far and wide that the Fed has restored financial market confidence by its decisive actions (panic), the Fed is correct in its assessment that inflation will fall as witnessed by the commodity price bludgeoning late in the month, and maybe most importantly that THE bottom is in on the stock market given that the financials appear to have been saved and the fact that we never violated the January lows. Wow, from the end of the world to an all-new magnificent bull market and economic/credit cycle recovery in one short trading month. Imagine that. Are the Fed, Treasury and Administration official's miracle workers, or what? Once again, the dream team has saved the world!!!! Kinda makes you proud to be an American. Don'tcha wish every kid could be one?
The point of this discussion is to blatantly remind you that we need to think long and hard about what we are "seeing" as we monitor ongoing and short term financial market activity in our current circumstances. Again, incredibly important in the current environment. Specifically, intermarket cause and effect, intended and unintended consequences, and even direct cross asset class pricing fallout has been and will continue to shape equity and bond market outcomes in what remains a very important forward macro environment of credit cycle reconciliation and broad investment constituency deleveraging. Before rushing to judgment about new bull markets and new cycle credit market and economic expansions based on what we may have "seen" in short term financial market movement, we're going to need a little more corroboration if you ask me. Yes, call this conservative. Yes, call this skeptical. Extremely guilty as charged. Why? First have a peek at the following table.
|Asset Class/Investment Vehicle||Price Change From 9/18/07 to 3/14/08|
|XLF - Financials||(30.2)|
|XLY - Consumer Disco||(19.9)|
|XBD - Brokers||(33.8)|
|Philly Housing Index||(24.2)|
Now imagine for a second we could turn back the hands of time to the date of the first Fed rate cut in September of last year. Imagine further that you had suddenly and miraculously been blessed with omniscient financial market foresight that was set to expire, if you will, on Friday the 14th of March in this year. You are a hedge operator and need to structure a leveraged portfolio for this duration of time. As you already know by now, the absolute dream levered portfolio would have been long oil, gold, commodities in general, and short financials, discretionary stocks, the brokers, the GSE's and the housing related stocks. You would not have hit a home run with a portfolio like this, but rather would have been viewed on par with the second coming of the Messiah. Long the top four asset classes you see above and short the bottom five could have been close to a career maker for many an investor up until a few Friday's ago. Do you think what have been over time trends in these asset class prices escaped the notice of the levered speculating community? Do you believe those chasing short term performance would not have signed over their first born children to have participated heavily in these trends? Do you really think the ship was not meaningfully listing to one side by those who had collectively put this very trade on since the first Fed rate cut?
Before answering these questions, have a look at the next table.
|Asset Class/Investment Vehicle||Price Change From 3/14/08 to 3/20/08|
|XLF - Financials||10.6|
|XLY - Consumer Disco||4.2|
|XBD - Brokers||3.7|
|Philly Housing Index||9.2|
What occurred in the week after the Bear Stearns debacle was simply the dream levered hedge portfolio of the last six plus months being turned completely on its head. And what it clearly suggests as one potentially very meaningful driver of performance during that week was levered speculating community leverage unwinding. A leverage unwind that is not finished. As you already know, if indeed you were a levered fund either choosing or being forced to unwind a portfolio perhaps due to the heavily increased margin/collateral capital calls from the prime broker community in the wake of Bear's sudden submergence, the influence of collective levered portfolio unwinding (raising liquidity) might have looked exactly as is detailed in the table above. To delever you would have sold what you were long and bought what you were short. So although the CNBC fan club may indeed have tried to celebrate the big bear market bottom for the financial markets, what we may have indeed experienced is simply more significant major macro credit cycle reconciliation - levered investment position unwinding (the hedge and levered speculating community). Seems relatively logical, no?
And this is the very reason why I suggest meaningful reluctance in proclaiming an all healed and ready to head higher credit cycle that has all of a sudden been reborn due to the fact that a few financial stocks jumped off of their collective death beds. Although the Fed members have apparently been re-anointed as miracle workers, have they really addressed and/or ameliorated THE real problem of the moment, which is financial sector balance sheets still loaded with problem credits? Balance sheets now problem long and capital short. Quite unfortunately, a one week change in stock prices does not change balance sheet asset values, especially those values tied to real world residential real estate prices and increasingly commercial real estate values. So for now, despite the emotional and financial price roller coaster ride of recent weeks, I reserve judgment on the true character of fundamental credit market, financial market and real economic change that has taken place. We watch and learn.
"Bear"ied Below The Headlines?
I want to briefly take these comments just one step further in light of a number of financial sector acquisitions we have witnessed this year that would most clearly have had an influential outcome in a good number of credit default swap positions. Further, why the credit default swap market may indeed be influencing financial market outcomes well beyond the singular world of derivatives. Last month CI devoted an entire discussion to credit default swaps, the leverage that had been built up inside of these contracts, and the potential for risk and unintended consequences therein. We showed you US banking system derivatives exposure numbers through the third quarter of 2007, as well as what has been the growth in this segment of the broader derivatives world globally. Please remember, this derivatives neck of the woods has moved well beyond simply acting as a form of insurance against long oriented bond or credit market positions held by investors to a world of growth in credit default contracts outstanding dedicated to nothing more than the trading of these vehicles themselves. Using GM as an example, the credit default vehicles written against real world outstanding company bonds is probably near three times the volume of actual bonds outstanding. Like many derivatives vehicles, these derivatives products have become an end in and of themselves as opposed to the purity of use of these vehicles to simply insure or hedge against adverse outcomes protecting larger financial asset positions actually held. Simple translation? The credit default swaps world has taken on a life of its own.
Alright, fine, so how does the credit default swap market relate to equity market sector volatility of the moment? It is absolutely clear that the "acquisition" of Bear avoided triggering Bear Stearns related credit default swaps and swaps against CDO, SIV, etc. positions they may have held (assuming a potential Bear BK would have forced a mark to market event), which would indeed have happened had Bear formally entered bankruptcy and their bonds/debt became potentially very meaningfully impaired. There is simply no question whatsoever that this was the key reason a theoretical acquisition of Bear HAD to happen. Remember the details. JPM took out Bear for a couple of hundred million at the headline $2 per share initial offer level, but concurrently announced it was going to need to charge off about $6 billion as a result of the so-called acquisition. Even at the ultimate $10 level (which is basically shut up money offered to help prevent litigation, which might also have led to asset price discovery) JPM was "telling" us Bear was worth far less than zero by the charge-off number alone. Of course the truth simply had to be that if Bear had filed bankruptcy and the credit default swaps written against their bonds/debt/asset positions had been triggered, the credit default swap liabilities in the market would have been well north of a $6 billion hit to whomever had written those Bear specific CDS contracts. Well north. And that simply could not have been allowed to happen. By the way, just as an item of curiosity, JP Morgan has exposure to over 55% of the total banking system credit default swaps outstanding. Connecting the dots clearly enough for you?
Sorry, back to the issue at hand. So Bear avoids formally blowing up and the credit default swaps written against their liabilities/investment positions, etc. now become a moot point as JP Morgan (or for the true problem credits, should we say the Fed) is the new creditor, and market based asset price discovery is avoided. Hurrah for those folks who had written these default swap contracts. They dodged a massive bullet that was heading one hundred miles per hour directly to a certain spot between their eyes. But what about those "investors" who had purchased the CDS contracts/insurance against a potential Bear default? Whether they did this against existing credit market investment positions for insurance reasons or were simply holding them as a trading position is immaterial. Those CDS contracts purchased which probably had been very profitable, and zoomed straight up in value as Bear was in the process of disintegrating, became worth massively less with the stroke of a pen (and a $6 billion write down to come).
Now put yourself in the position of a meaningfully levered hedge fund who had purchased CDS contracts against Bear credit vehicles. You had levered up against what was continually becoming very profitable CDS positions or credits as Bear was heading nose first into the tarmac. Who knows, you might have even increased the position prior to the weekend based on info your fellow good buddy hedgies were feeding you about Bear's imminent demise. When those long CDS contracts against Bear credits/positions dropped like a lead balloon virtually the Monday after the JPM acquisition announcement, all you were left with was massively deflated CDS asset values relative to the prior Friday and still in place leverage. So what do you do when you get up in the morning on Monday after the Bear acquisition announcement (assuming you slept Sunday night, that is)? You start delevering. You start unwinding in place inflation themed trade positions to raise liquidity. You sell what assets you can (gold, oil, commod's, etc.) and get less short those sectors you have heavily shorted (financials, brokers, consumer, etc.) to raise liquidity and decrease total leverage against a now immediately diminished asset base. Who knows, maybe this was exacerbated if your already freaked out prime broker sponsor put in a call or two demanding more margin now that your assets had deflated post the Bear related CDS contracts nose diving.
And it was not just Bear credit default swaps that plummeted. As you know, with the Bear deal the Fed put in place the primary dealer credit facility, minutes before both Lehman and Goldman showed up at the window with hands held straight out. Unquestionably CDS values related to Lehman, Merrill, Goldman, etc. evaporated for many a levered investor long those contracts. And wouldn't ya know it, it was only one week later, after their earnings were reported, that S&P revised its "outlook" for both Lehman and Goldman to negative from stable. And that, folks, is how it works. Without question, the fallout from cascading CDS values for Bear and the other assorted brokers could easily have caused liquidation of meaningfully levered equity positions, both short and long, causing the very movement in sector prices we saw in the latter weeks of last month.
In the current environment it is nothing short of critical to understand and keep in mind these very important intra market relationships. We need to understand how what we see in one sector of the financial market can have meaningful implications for asset price movement in many other parts of the very same broader financial market. What we see in the headlines on TV is shallow, and what we "hear" on CNBC is almost meaningless. It is the actions and unintended consequences underneath the headlines that are crucial to "see" and understand. Can the CDS and other derivative markets influence equity market outcomes? The derivatives tail is indeed wagging the greater financial market dog. And it is understanding this that is the key to both risk management and successful investment outcomes as the process of credit cycle deleveraging and reconciliation is sure to continue to play out ahead. Be surprised at nothing. Do not let short term financial asset price movements that appear illogical throw you off emotionally from remaining focused on the greater credit cycle reconciliation and deleveraging environment that now reigns the day.
© 2008 Brian Pretti