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Wednesday, 19 March 2008

A Reply to John Mauldin’s Outside The Box - Let’s Get Real About Bear

An Occasional Letter From The Collection Agency

A Reply to John Mauldin’s Outside The Box - Let’s Get Real About Bear

I have been, and still am, a long time fan of John Mauldin (JM). I enjoy his take on the bigger picture, even if there are areas I disagree with, from time to time. Generally my disagreements are more to do with the severity of a particular problem or the benefits of a highlight. For instance, JM might allude to a recession but think that it will be mild and happen over a certain time scale, fitting his “muddle through” model. I would agree with the talk of recession but not necessarily the depth, timing or effect. You get the point.

However the JM article “Let’s Get Real About Bear” has somewhat shocked me at a fundamental level and it deserves a reply. Let me say this from the beginning, I do not intend to start a war of words or change JMs thinking. Neither approach is constructive or conducive to open discussion of a truly fundamental part of the US and Global economy. This not a good vs. bad scenario, I have little or no doubt that JM is a well read, intelligent, honest and thoroughly nice bloke. I am a trader/blogger that very few have heard of or know, using the internet to foster thought. (As an aside, I asked JM to have a look at my writings and consider maybe using an article in the OTB edition. The answer is within his Bear article. Sometimes trying to be a “platform start up” has its knock backs. So no hidden agendas and yes, I fully expect to be viewed as the “Darkside”. Ahh the fun of blogging.)

Here is a link to the JM article at Investor Insight. Please read it before going further. I am not going to discuss the 2 other articles appended to JMs writing.

JM is an investor/advisor who looks to get real returns beyond the effect of inflation. He operates in the free markets, looking for advantages that return above the “norm”. He searches for new, innovative technology that may become the “next big thing”. He is a capitalist, using the capitalist mechanism. He knows the risks and tries to avoid being on the wrong side or if that fails to mitigate the risk to his capital. I do the same as do most investors and traders. It is the way of the financial world. There are upsides and downsides, we know the risks and rewards, and the rules of the game are simple.

Unless, that is, you decide that the rules can be bent to accommodate failures, to mitigate the downside. Such an approach leads to tyranny, it destabilises the system causing feedback loops, encourages excessive risk taking and allowing that risk to be ignored and causes confidence in the financial structure to erode.

This is big picture stuff. It is not about 17000 jobs at Bear Stearns; it is not about a loss on share portfolios suffered by employees. Protecting a company and its share price is never a reason for intervention and the introduction of moral hazard.

Bear and its employees would not be in their current circumstances if they had obeyed the rules and understood the game.

Bear Stearns went bust because of a lack of confidence in its collateral used to finance its lending. Customers and Lenders walked away because the risk of staying was perceived as too great. It was the risk that Bear Stearns took using its business model and allowing exposure to be greater than its ability to pay. The Capitalist System did its job; it rooted out a bad business model and laid it low. If you took losses, I am genuinely sorry for you but you knew the risks. We all take a loss sometime. If it wiped you out then you did the same as BS, you allowed exposure to a risk to grow well beyond acceptable limits.

Does this sound harsh, a bit heavy-handed? It probably does but it isn’t me saying it, it’s the free market shouting loud as it does every trading day.

JPM have stepped in and offered $2 a share for BS. We have seen such action before, a fast move to grab assets perceived as cheap. It happens in the capitalist marketplace. The risk is transferred to JPM equity holders, JPM write-down $6Bn to acknowledge that risk. The trouble is the whole JPM move was not a function of the free market. Without The Federal Reserve accepting who knows what BS assets as collateral on a $30Bn loan this deal would not have taken place. Even worse JPM get rewarded by asset grabbing at an extremely cheap price. (I suspect we have not heard the last of that either).

JM contradicts himself within the article as he attempts to align the adoption of allowing a moral hazard to exist within the market. I quote:

“And I can understand the sentiment, as it appears that tax-payer money may have been used to bail out a big Wall Street bank that acted recklessly in the subprime mortgage markets. But that is not what has happened. This is not a bailout.”

But just a few lines later he is forced to acknowledge the underlying fear his readers have emailed him about:

“Yes, tax-payers may eventually have to cover a few billion here or there on the Bear action. But the time to worry about moral hazard was two years ago when the various authorities allowed institutions to make subprime loans to people with no jobs and no income and no means to repay and then sold them to institutions all over the world as AAA assets. And we can worry in the near future when we will need to do a complete re-write of the rules to prevent this from happening again.”

You cannot expect market participants to accept such reasoning unless you believe intervention is right and proper. If you do think that way then your perception of risk has to be misplaced.

So, it is more than possible that Tax-payers will face a bill for this bailout. The moral hazard, as the UK Govt discovered after Northern Rock is that if you “cover one bet, you cover them all”. The extension of liability and assumed enlargement of risk becomes burdensome and affects the fundamentals underlying the national economic base.

Today in the UK, there are rumours, denied by the BofE and the bank in question, that a Bank may or has a requirement for emergency funding. Regardless of the truth or otherwise, this has directly affected Sterling vs., of all things, the dollar:

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The ellipses are the main points when rumour surfaced and re-surfaced. This is what acceptance of a moral hazard can do to a currency. I picked the $ as a comparison because it is weak, it shows the inherent weakness of Sterling under such circumstances. This is not a theory of mine, based around musings of economic facts and figures. This is market action telling us a story. Ignore the tale at your peril.

Should Bear have been allowed to go bust? Without doubt the answer is yes and to some extent JM agrees:

“If it was 2005, Bear would have been allowed to collapse, as the system back then could deal with it, as it did with REFCO. But it is not 2005. We are in a credit crisis, a perfect storm, which is of unprecedented proportions. If Bear had not been put into sounds hands and provided solvency and liquidity, the credit markets would simply have frozen this morning. As in ground to a halt. Hit the wall. The end of the world, impossible to fathom how to get out of it type of event.”

A very scary (and quite possible) scenario. JM is saying that current market conditions are not conducive to failure of a Financial Institution.

Well I’m sorry but these events happen because of the prevailing circumstances. Banks don’t go broke at the top of the cycle, failures occur when times are getting hard. It is the nature of the beast. To say the System cannot tolerate such an event is to deny the reality of capitalism. It encourages the acceptance of a safety net, a guarantee that regardless of the poor decisions and risk calculation taken there will be no failure.

This is truly a refutation of a capitalist, free market. No wonder CEOs take what seem to be enormous risk free assumptions about the future and the effects of their actions and decision upon the prospects of the company. They have nothing to fear. CEOs get their compensation, shareholders get a ride, and all is well. Until the cycle turns. The CEO has departed by then, either as part of a merger or retirement with an enormous compensation package. The shareholders are the weak hands, the strong hands sold at the top. Who cares what happens to the weak hands? Moral hazard isn’t just about tax payers.

JM quantifies what he thinks the damage to stock markets could be:

“The stock market would have crashed by 20% or more, maybe a lot more. It would have made Black Monday in 1987 look like a picnic. We would have seen tens of trillions of dollars wiped out in equity holdings all over the world.”

Again, I agree that losses of 20% or more could happen and still might. The reason it would have made Black Monday look like a picnic is because it was a picnic. In 1987 we didn’t have the massive expansion of innovative financial instruments, back then Futures and Options were complicated! If the free market decides it needs to provide a re-pricing then it should be allowed. After all, no one worries about the same mechanism working to the upside.

Would credit markets have closed, seizing up under the financial stresses? We don’t know. Let us assume that they would. So what? The weak debt would have been expunged, albeit on a massive scale. Would there be pain? Yes, massive amounts of pain would ripple through the global economy. Would it be the end of the world? No, it would not, prices would reset on the re-opening, risk would have been priced in - in full. Markets would continue to function, even if the players had changed or some disappeared. Eventually all this will happen and the outcome will be the same, we are living it right now. Delaying the inevitable whilst a transfer of liability occurs does nothing but risk the underlying fundamentals of the economy to further attacks and stress.

Does the acceptance of an enormous level of moral hazard have a justification? Again I quote JM:

“But for now, we need to bail the water out the boat and see if we can plug the leaks. Allowing the boat to sink is not an option. And get this. You are in the boat, whether you realize it or not. You and your friends and neighbors and families. Whether you are in Europe or in Asia, you would have been hurt by a failure to act by the Fed. Everything is connected in a globalized world. Without the actions taken by the Fed, the soft depression that many have thought would be the eventual outcome of the huge build-up of debt would in fact become a reality. And more quickly than you could imagine.

As I have repeatedly said, recessions are part of the business cycle. There is nothing we can do to prevent them. But depressions are caused by massive policy mistakes on the part of central banks and governments. And it would have been a massive failure indeed to let Bear collapse. I should note that this was not just a Fed action. Both President Bush and Secretary Paulson signed off on this.”

Quite simply (and JM touched upon this) intervention has exacerbated the conditions we live in. What was a normal business recession has been morphed into a possible depression. Not by capitalism or free markets but by centralist, socialistic interference.

Remember, last year when Bear closed down and re-capitalised the failed Hedge Funds? This was viewed as one of the problems that required action by the Fed. The intervention failed. All it achieved was a redistribution of risk to the Tax payer and JPM shareholders. The risk is not diminished; adding capital to a margin call does not make the position “safer” or profitable. It just risks more capital.

Trying to justify intervention by invoking fear may work at a human level but free markets ignore such reasoning’s. As far as the markets are concerned the game rules say you are responsible for your own risk management. If you fail to play the game well, you will lose or be given a disadvantage. Attempting to change the rules to favour one side breaks the game. The consequences of that are with us now.

JM defends his stance by pouring scorn on those who believe in free markets. It may also be the reason he didn’t like my writings. (This is fair enough, not every viewpoint that is contradictory to your own needs to be accepted).JM:

“I repeat, this was a good trade from almost any perspective, unless you are from the hair-shirt, cut-your-nose-off-to-spite-your-face camp of economics.”

I am a bear in the current climate, I have been a bull in the past and I trade both ways. In other words I am a realist, I may be bearish on macro-economic fundamentals but I can ride an uptrend when I see one. To use such an expression as JM has written to pooh-pooh those who believe in free markets shows a lack of argument. I have news for you all, regardless of your economic “bent”, unless you are prepared for events now you will all have your noses cut off.

Finally we look at the outcome of the current turmoil. Again JM is specific:

“It is precisely because the Fed is willing to take such actions that I am modestly optimistic that we will "only" go through a rather longish recession and slow recovery and not the soft depression that would happen otherwise.”

Does that qualify as “muddle through”? JM was looking for a muddle through scenario until very recently. I don’t think a longish recession and slow recovery qualifies. Muddle through to me was below average growth not contraction. There is no blame to attach here, it is just recognition that realism is useful and has a place in financial thinking. It is realistic to believe that if a moral hazard in the UK can affect the worth of that country’s currency, the same should be applied to any other government that accepts moral hazard can be introduced into the game rules. As we have already seen, intervention begets a further expansion of intervention.

JM makes a final point that the problem is so large and the effects on the “small guys” would be so great (i.e. small guys do not know about risk?) that a true re-pricing event would cause devastation. He also says that a lack of intervention caused the current turmoil. Other than a non-acceptance of capitalist free markets as a true reflection of worth, the blame appears to land at the door of the Government and the Fed. Boy they can’t win in this discussion.

Regulation is what JM is alluding too, or the lack of it. At what level though, the relaxation of credit lending standards? (Surely a bank decision). A lack of oversight in mortgages? (Greed from all parties overrode risk appraisal, including the consumer). A lack of transparency in credit markets? (Transparency is there, you just have to pay for it).

What exactly were the Fed and Govt agencies supposed to do? Regulate every transaction? Greed finds away around regulation, be it loopholes or flat out illegality. You can regulate for every function but it does not stop attempts to circumvent it.

If you want to correct an interventionist prone capitalist system then allow it to purge itself and reset the boundaries of its influence based on truth. If you want to get a rating on a debt package you wish to sell in the marketplace then tell the truth. Open the books, show the risk and accept the price that the market sets. You even save money on not paying a Ratings Agency.

Only this will restore confidence in the markets. If it means prices are lower (or higher for the good stuff) so be it. Its not the price that wipes you out, it’s the re-pricing when the truth comes out. Attempting to interfere and tinker will just cause greater imbalances and risks and lead to further opaqueness.

Maybe JM has forgotten how he worried about the costs of today being visited upon future generations. Intervention will ensure that such passing on of the debt will happen.

My thanks for your time if you have read this far, I appreciate it. Now, I may be inundated with emails after this article (or not!). Please don’t be offended if I fail to reply to them all. Please remember, I have written this letter not to ignite feelings but to open up an important debate. On Sunday I will be reading and enjoying JMs email, as usual.

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.