Um... Are We Forgetting Something Here?
by Brian Pretti CFA, Contrary Investor. September 26, 2008
It is clear that credit cycle reconciliation events are moving fast. Deleveraging, a theme I have been incessantly harping on almost all year, has clearly kicked into high gear. It’s thought in various circles that Paulson and friends helped engineer the near vertical decline in commodity prices sparked in mid-July. That spark clearly set off a firestorm of hedge liquidation that I believe continues to the present. Following closely behind the commodity price collapse was Fannie and Freddie returning to whom we always knew was their rightful owner – US taxpayers. But when Lehman was allowed to disappear into the night shortly thereafter by the head chefs at the Fed and Treasury, the scramble for liquidity and deleveraging began in earnest on a macro basis. What lay behind this acceleration phenomenon? In part the always hidden and always shrouded derivatives markets. What follows is a snippet from our subscriber site reminding us that amidst the sound, fury, emotion and hysteria of the moment regarding the current bank bailout proposal, there is yet another issue that has not been addressed.
We've been wondering when the fabled Bernanke helicopters would arrive on the scene, but we can wonder no more. The engines are warming up. Throughout this year we've been treated to the Treasury Auction Facility, the Treasury Secured Lending Facility, the Primary Dealer Credit Facility, a new facility for the FHLB, the FDIC, etc. A lot of asset swapping and short term lending. The Fed has even announced it will accept equities in terms of its liquidity enhancement efforts in swapping assets with financial institutions. Isn't that a low cost margin loan in sheep's clothing? If not, then what is it?
Anyway, it appears the choppers are now arriving, as per the AIG bailout and the Lehman "workout." After all, the Fed is simply running out of current balance sheet maneuvering room with which to "temporarily" pile on potentially troubled "assets" (and we use that term loosely) or lend in outright fashion.
As we’re sure you saw, in the middle of this month the Treasury Department announced the initiation of a temporary “Supplementary Financing Program” (SPF) at the request of the Federal Reserve. The SPF will provide cash for Fed “initiatives.” English translation? The Fed sure appears to have run out of balance sheet bullets.
In trying to gauge the rhythm of the so-called printing press, we usually look at the currency component of M1 and it's annual rate of change. Slowly but surely in the past few months, the absolute numbers are moving higher and the year over year rate of change has turned up. We need to keep an eye upon this as the presses are warming up. Not spinning at full tilt, mind you, but creating a low hum. Now that commodity and gold prices have been thoroughly stamped down, a much easier spot to begin to allowing the presses to warm up. At this point in the current cycle, we're not criticizing, per se. This was/is an inevitability. The key question for our investment activities directly ahead will become, just how will the financial markets price this in? And that necessarily points to the dollar, commodity prices in general, and the precious metals. Although time will tell, gold's mutli-decade one-day record liftoff last week may be quite the anticipatory signal.
It's absolutely clear at this point that absent an absent-minded buyer, Lehman was expendable. Unlike Bear, it had nowhere near the derivatives exposure. Merrill, we're not so sure. In part the BAC shotgun marriage sure appeared to be an attempt by fire marshal Paulson to cut a fire line around the perceptual Lehman forest fire. The viability of Merrill surely would have been in at least perceptual question left unattended. What we don't know, and neither does anyone else, is whether Merrill was a big derivatives counter party to BankAmerica, much as Bear had to be in terms of its derivative activities relationship with JP Morgan. But unlike Lehman, AIG was not expendable at all for one reason and one reason only - credit default swaps and assorted other derivatives "guarantees." An AIG failure would have surely caused panic and the reality of cross defaults. And we mean much more panic than we have already seen up to this point. But will the big time $85 billion effective bridge loan from the Fed to AIG really do anything to ameliorate much bigger picture credit cycle issues embodied in current derivatives contracts outstanding? We seriously doubt it. The Fed loan to AIG buys time for AIG to unload assets. And unload they will. But what about the CDS vehicles that continue to simmer on the books of the greater financial system and in hedge pockets from sea to shining sea, let alone globally? The Fed has provided AIG (and implicitly their myriad of counter parties) with operating liquidity, but what about those CDS contracts in the longer term time frame? Does forward risk associated with these simply fade away in the wind with a little Fed delivered fairy dust? The simple answer is no.
Three very quick charts that are simply perspective on greater systemic credit default swap exposure. In our March 2008 open access monthly discussion, we dedicated almost the entire piece to CDS vehicles, suggesting that before long they would become front-page news. Just have a look at any newspaper at the local newsstand to see how this has worked out. As of the end of 1Q of this year, the US banking system had exposure to about $16.4 trillion in notional credit derivative vehicles. Although we're just guessing based on a Bank for International Settlements multiplier number, we'd say the cash value is approximately $550 billion. But remember, this type of cash value number assumes continuous and liquid markets at all points in time, all parties to CDS transactions having instantaneous access to liquidity at all points in time, and no out of the blue counter party blow-ups (as we've exactly seen this year in spades). Certainly those assumptions are open question marks at this point. It's clear looking at the graph below that the CDS market grew like wildfire over the last half decade, morphing into a trading marketplace well beyond the supposed insurance function it represented itself to be as a child. Who knew it would be a wildfire capable of jumping theoretical fire lines on almost all fronts of the US financial system? Certainly not the regulators or those firms participating in any healthy manner. Buffet's euphemistic financial WMD's on steroids? Yeah, something like that.
According to our friends at the Bank for International Settlements (BIS), global credit default swaps outstanding total close to $60 trillion in notional value as of the close of the last year. That number has been estimated to be closer to $70 trillion a few months back. Just yesterday, the ISDA (International Swaps and Derivatives Association) told us the volume of trades in the worldwide market for global CDS has fallen to $54.6 trillion due to contract offset activity in the wake of the demise of Bear, Lehman, etc. That’s comforting, right? The BIS estimate of CDS contract cash value as of 2007 YE was $2 trillion. Again, remember that in a potential default-triggering event, these supposed estimated cash values are pocket change relative to potential total cash liabilities created in a defined default. In a potential triggering event, a holder (buyer) of a credit derivative essentially wants all of their money back in terms of the credit that was insured, not the supposed ongoing cash value of a notional contract amount. Plain and simple, AIG could not have been allowed to default. Story over.
The final peek at the wonderful world of credit derivatives is really a question more than an observation. It's a question we've asked many times in terms of US banking system derivatives exposure, and one which never seems to find an answer. Have a quick look at the following chart.
Much like the character of total US banking system derivatives themselves, JPM accounts for almost one-half of total US banking system credit derivatives exposure. As you've probably deduced in remembering the BIS numbers from above, JPM also accounts for approximately 12% of total credit derivatives outstanding on planet Earth. As other financial giants quake at the thought of AIG blowing apart before our eyes, JPM never flinched. Up to the present, JPM always seems to make it through these little crises seemingly unscathed. The folks at JPM must literally be the smartest folks on Earth in terms of derivatives positioning and trading, always on the correct directional side of the trade at all points in time.
The bottom line here is that what has happened this year up until now with FRE/FNM being "conserved" by the US Government, BAC and Merrill teaming up, JPM as savior to Bear, and the bridge loan to AIG, simply keep the game going for a while and avoid large scale triggering of credit derivatives. But these contracts are still "out there." Fundamentally, we've done absolutely nothing to address the primary problem that is excessive leverage and risk inherent in these contracts. THAT has not gone away...for now. As we see it, market action in aggregate is suggesting that investors are starting to wake up to this fact and beginning to price this circumstance into financial asset prices.
As we move forward, we believe one of the key perceptions that will come into question is confidence in the Fed/Treasury/Administration, and by extension confidence in the global central banking community. Point blank, is the fallout from macro deleveraging simply too big for these folks to contain? Yes or no? Having a multiplicity of events such as FRE/FNM, Lehman, Merrill, AIG and the FHLB and FDIC backstops occur in a two-week time span certainly moves the investment community toward that very question in a big hurry. And at least so far, the vote has not been a resounding thumbs up.
These comments are being written prior to any type of final resolution on the bailout package. I have no idea what it will look like in final form. First, it will be important to gauge intermediate term financial market reaction once some type of bailout package is passed. But then the hard work begins. Let’s assume relatively illiquid bank assets are swapped for liquidity, the next question for the macro financial sector and the real economy then becomes, will we then have willing lenders and borrowers? Capital conservation and accumulation is the critical issue for the banks at the moment. Moreover, we now have a US consumer weathering higher energy and food costs, wage growth below the headline CPI growth rate, declining household asset values (residential real estate and equities), and now a growing personal tax obligation as per the bailout mechanism. Sounds like really fertile ground for acceleration in borrowing and lending activities, doesn’t it? As a final comment, keep your eye on the credit markets. Although it’s just my opinion, the financial markets, real economy and financial sector will not heal until the credit markets heal. After all, the global credit markets put a definable price on “confidence” each and every day.
© 2008 Brian Pretti