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Sunday, 16 March 2008

The Weekly Report 16 March 2008

The Collection Agency - Weekly Report

16th March 2008

Welcome to the Weekly Report. Events are moving at an accelerated pace requiring further Central Bank intervention as Hedge funds and Investment Banks are hit by ever tighter credit conditions and a run on deposits. I make no apology for using the past weeks events as the central theme for the coming week. Without doubt we have entered a new phase in both the financial and monetary spheres of the Global economy.

First up is US Tsy Sec Hank Paulson who had some rather strange advice for Financial Institutions. He warned that the largest US banks should raise extra capital beyond the $70Bn already accumulated in order to prevent the credit crisis from worsening. He went on:

  • "We are encouraging financial institutions to continue to strengthen balance sheets by raising capital and revisiting dividend policies ,…… We need those institutions to continue to lend and facilitate economic growth."

I have some bad news for anyone relying on Mr Paulson to come up with a solution to the credit crisis. The statement shows a complete lack of understanding of what is currently happening. This is not a crisis, this is a full blown, unfolding before our eyes, collapse in confidence in the fiat monetary system.

The complete lack of innovation by Banks, Hedge Funds, Financial Institutions, Central Banks et al in response to the beginning and current situation is staggering. What have we seen so far?

Consumers will get some legislation (passed eventually) it will be too little, too late to save them.

Financial Institutions get instant, on demand, no books read bailouts from the Fed. If you are not a Primary Dealer and not entitled to access the Discount Windows, don't worry, the Federal Reserve will funnel the money through a PD, it saves a lot of regulatory hassle. It helps if your party and counterparty risks are huge, then you get classified as "too big to fail" as the domino effect would destroy the current credit system.

Within Paulson's comment we see the lack of understanding of what Financial Institutions (Large Banks and Primary Dealers) are already doing in an attempt to stave off the biggest financial disaster in 100 years. They are already raising capital by calling in loans, regardless of risk. It doesn't matter if you are a Hedge Fund using borrowed leverage to deal in AAA rated Municipal bonds, the FIs are calling in the loan, raising margin requirements or asking for more and higher rated collateral on any borrowings. This is no surprise, anyone who watched what happened with Asset Backed Commercial Paper (ABCP) last year could see this coming. The Financial Institutions are not recouping capital to re-invigorate lending, they are just hoarding cash to ensure they can meet their own capital requirements and hunker down to survive the approaching disaster.

Credit markets have not seized up due to a lack of capital per se, they seized up due to a lack of confidence in the ability of collateral to keep its worth and the rising risk that any Insurance used might not pay out. The "buck" didn't stop here, it stopped everywhere.

A fiat monetary system, built on the use of credit as a driver for economic growth, is utterly reliant on confidence. If action is taken that undermines that confidence then the system stops working.

This is not a new phenomena, the evidence is already on display. The rise in commodities, i.e "stuff" is not a function of inflation. It is a rise in the lack of confidence of fiat money. When the dollar, the current world trading benchmark, is debased you place your capital into assets that have a tangible worth. They cannot be eroded or re-valued by the actions of a Central Bank, they are worth something to someone. The dollar does not have the same worth. It functions only because of the confidence placed in the assets that underpin it.

Devalue the assets and you devalue the dollar. The Fed has decided to swap US Treasuries for so-called AAA rated debt backed bonds, not placed on "watch" by the credit rating agencies, currently on the books of Primary Dealers. The risk of default on the debt has not been reduced, it has been transferred from private Financial Institutions to the US Government and the tax payers. All of the Feds actions are just to allow the current credit lending mechanisms to continue.

Devalue the assets, devalue the dollar. The cure to all these ills that Paulson refers to is an illusion. The FIs have bought time, swapping their collateral to the highest standard, allowing them roll their own borrowings whilst calling in monies and assets owed to them. It helps when you have to go begging to Sovereign Wealth Funds (SWF) to raise more cash. Don't expect an increase in dividend payments on your banking shares either, in fact don't expect dividends from a number of Financial Institutions for some time. Hank said it is okay not to pay out. It's the patriotic thing to do.

How much capital do Financial Institutions need to reclaim?

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Here is the latest update, notice it does not include the increase in TAF. As I suspected, the TAF is being increased to keep total reserves stable.
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We know the situation has deteriorated with TAF limits now pushed out to $100Bn. Doing a simple calculation, it would appear that the update to the chart above (if total reserves are to be maintained at around $43Bn) will show non borrowed reserves are now at or headed for net minus $57Bn (TAF minus total reserves). When we drop into The Slosh Report (highly recommended for Fed watchers) we see that the total amount lent out by the Fed is currently $60Bn of which $44.8Bn is collateralised by Mortgage Back Securities (MBS).

The Financial Institutions are in the hole to the Fed for between $101.8Bn up to a possible $117Bn. Obviously this does not include any borrowings made with other Central Banks, Institutions or SWFs.

Let us make an assumption that the "Fed capital" is required to shore up FI borrowing positions and that they will have to repay it some time in the future. We will use the lower figure of $101.8Bn and a leverage of 5, which is probably very generous. FIs have a minimum of $509Bn in positions reliant on continued Fed lending. If the FIs have (want?) to cover then they need to reclaim $509Bn from the financial system. To do that they stop lending, call in margin, make margin cover and leverage more onerous and close credit lines and facilities.

If the $509Bn is leveraged by a factor of 10 by the borrowers (Hedge Funds, Mutual Funds, Insts, Private Venture, Buy out vehicles, off balance sheet vehicles etc) then the drawdown on the financial economy to close out could amount to $5090Bn.

Any attempt to do this in a disorderly fashion would result in financial Armageddon. Thus we see the rationale behind the Feds actions. It is an attempt not to mitigate the pain but to drip feed it, a little at a time, so the markets only feel a series of pinches, not a right hook. The result however will be the same.

If I had any funds invested with Hedge Funds or leveraged accounts I would be looking for the door. It is more than feasible that the situation is worse than the current headlines.

I have been watching the actions and words coming from PIMCO, specifically Bill Gross and his call to reject the worries of moral hazard:

  • " And if Washington gets off its high "moral hazard" horse and moves to support housing prices, investors will return in a rush. PIMCO wants to sit at this more attractive return table - to provide an attractive return on your money (no matter what the asset class) as well as a return of your money. No Old Maids. No silicone AAA ratings. And ladies - no crotchety old bachelors either. The game, as well as the name of the game, is changing. It's no country for Old Maids anymore."(his emphasis)

At first glance its strange to see a bond maven calling for such a move, his job is to oversee investment to make returns on capital based on his projections for the future economy. Then I noticed this line in his March 2008 Investment Outlook letter:
"Old Maid now has a second life mimicking our financial markets, and at PIMCO we've played it frequently in our Investment Committee over the past several months. "Who's got the 'Old Maid'?" we ask over and over again - not to make us feel good that we don't - but to make sure we won't draw it when its holder tries to pass it on."

Mr Gross is saying, quite rightly, that his job is to avoid any potentially toxic assets leaking into his pond. Unfortunately sometimes a previously healthy asset already in the pool begins to decay, leaking toxins into the pond. In a small pond its easy to fish out the decaying matter, in a large lake, filled with cumbersome assets it can be much more difficult.

Has PIMCO found an Old Maid hidden in its hand?

Consider this, from Bloomberg :

  • "Ross, chairman of WL Ross & Co., and Gross, chief investment officer of Pacific Investment Management Co., said they jumped at the chance to buy $1 billion of municipals each. Their interest helped to drive last week's rally in fixed-rate debt. Investors remain concerned that a flood of new issues from borrowers refinancing auction-rate debt will overwhelm demand while hedge funds and banks pare their purchases, analysts at New York-based Citigroup Inc. said in a March 7 report."

Now this could be viewed as an attempt to capture some cheap assets with high yields. It could be viewed as an attempt to catch a falling knife. I don't think the reasoning behind such a move is either of these options. Mr Gross has no qualms about causing a moral hazard which in financial markets means intervention. I suspect the intervention, an attempt to restore confidence, has more to do with PIMCOs own position than it does with the Municipal Bond market.

A quick look at Allianz Global Investors site highlights PIMCO exposure to Municipal Bonds. The PIMCO California Intermediate Muni Bond Fund A (PCMBX) has total fund assets of $130.5m, PIMCO California Short Duration Municipal Income Fund A (PCDAX) $14.7m and PIMCO High Yield Municipal Bond Fund A (PYMAX) $167.5m.

However, the Fund that caught my attention was one that you might not expect to find, if your notion of PIMCO is as a safehaven:

  • PIMCO All Asset All Authority Fund A (PAUAX), total fund assets $772.3m, here is a description of the fund:

    Portfolio Construction

    "PIMCO All Asset All Authority Fund's portfolio invests in an expanded group of PIMCO mutual funds, rather than in individual securities, providing access to a variety of investments across both traditional and alternative asset classes. These underlying funds cover the full spectrum of traditional sectors of the stock and bond markets, as well as other asset classes, such as Treasury Inflation Protected Securities (TIPS), commodities, and real estate. Using a dynamic asset allocation strategy, as well as the potential use of leverage to attempt to enhance returns, the Fund's manager seeks to identify those asset classes and sectors that offer the most value at a particular point in the economic/market cycle. In keeping with PIMCO's dedication to risk management, the Fund contains internal guidelines to optimize risk controls, including:

    • No more than 50% invested in any single underlying PIMCO Fund.

    • No more than 20% invested in PIMCO StocksPLUS Short Strategy Fund.

    • No more than 50% invested in PIMCO Funds that track U.S. equity indexes.

    • No more than 331/3 % invested in PIMCO Funds that track non-U.S. equity indexes.

    • No more than 662/3 % invested in U.S. and non-U.S. equity funds combined.

    • No more than 75% invested in PIMCO Real Return Strategy Funds."

I have no doubt that Rob Arnott, the fund manager, is a sharp cookie and may well be rotating successfully between asset allocation models. What we don't know is the current composition of PIMCO mutual funds used within PAUAX and the amount of leverage currently employed. Maybe I am worrying too much, maybe things are fine and dandy at PIMCO. Then again, I have preserved a lot of capital by worrying.

That's it for this week, I have to finish this early today. Keep an eye on financials and Insurance (all types) as a measure of further market distress or intervention.

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