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In many respects, systemic stress from de-leveraging is more intense today than even during the LTCM fiasco.
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Throughout the system, risk models have broken down. They will now be functionally inoperable for some time to come. At the heart of the now unfolding systemic de-leveraging are some newfound realities. Leveraging, as Peloton Partners realized this week, has become a perilous endeavor...
...the Fed is today impotent with respect to the economy. It had best start paying attention to the stability of the currency markets, where it could have some impact."
No LTCMBy Doug Noland
February 29, 2008
SourceFebruary 29 – Economist: “After hubris comes nemesis. On January 24th more than 1,000 leading figures in the European hedge-fund industry gathered for a dinner at the swanky Grosvenor House hotel on London’s Park Lane to witness the EuroHedge awards for 2007. Out of the 20 awards, two—credit fund of the year and new fund of the year (for non-equity strategies)—were awarded to Peloton Partners, a credit manager set up by ex-Goldman Sachs employees in 2005.”
I’ll go out on a limb and suggest that this week provided another critical juncture for the unfolding Credit and economic crisis. Peloton Partners, commencing the year with about $3bn under management, is run by smart, seasoned investment managers. One of the fund’s founding managers was previously a co-head of macro proprietary trading at Goldman. They recognized and profited handsomely from last year’s subprime collapse, with their flagship “ABS” fund ending 2007 up 87%. By recent industry standards, their strategy was not particularly risky. To capitalize on the dislocated Credit market and depressed prices, the fund increased leveraged exposure to “AAA” securities. It was reported that a week ago Friday the fund had posted losses for the month of about 8%. Only a few days later funds had fallen into full crisis, forced to halt redemptions and seek liquidation. This evening the Wall Street Journal reported that some of its Wall Street lenders had moved to seize assets. Investors will suffer huge losses on “AAA”-rated securities bought at a discount.
The co-founders stated in a letter yesterday to investors: “Credit providers have been severely tightening terms without regard to the creditworthiness or track record of individual firms, which has compounded our difficulties and made it impossible to meet margin calls.” They are clearly not the only funds pounded abruptly by sinking asset values, illiquid markets, and increasingly distressed lenders. In the case of Peloton, leverage of four to five times was used commonly, with sinking prices on $9bn of assets quickly burning through equity. It’s convenient to blame an implosion on the margin clerk, although in this highly unstable environment, playing with leverage is playing with fire.
Also yesterday, Thornburg Mortgage – seasoned leveraged “AAA” MBS players that last year had aggressively retrenched, cut holdings to $37bn from $53bn, and had seemingly weathered the subprime storm – reported that they were once again hit with margin calls and forced liquidations on a portion of their mortgage holdings. The root of the problem was a 10% to 15% drop THIS MONTH in the valuation of “Alt-A” mortgages. With an estimated $950bn of “Alt-A” mortgages in the marketplace, such a dramatic price decline pelted scores of investors/speculators in these mortgages, mortgage-related CDOs, and myriad derivative instruments. Leveraged players, such as Peloton, were crushed. The troubled major banks and Wall Street firms have significant direct exposures in this area, as well as huge indirect risk on such collateral used by their leveraged clients. The impaired lender community today has no alternative than to manage risk very diligently, which means an aggressive approach to margin requirements and forced liquidations has become part of the new (Post-Bubble) marketplace reality. The “smart guys,” that had jumped in over the past months to capitalize on market tumult, have been humbled, chastened, and in some cases bludgeoned. Many are coming to recognize that the market backdrop has fundamentally changed.
Compounding systemic stress, this week also saw significant forced liquidations in the municipal bond market. This has been a hot area for sophisticated leveraged trading and derivatives strategies. Add this huge market to the list of Bubbles Burst. It is difficult to know the scope of the unfolding liquidation and resulting inventory of muni bonds overhanging the marketplace. It is easy analysis, however, to suggest that liquidity for this key market will be scarce for some time. The ramifications for municipal finances, state and local borrowings, and economic activity are disconcerting.
In many respects, systemic stress from de-leveraging is more intense today than even during the LTCM fiasco. Many have been eagerly anticipating a LTCM-style Federal Reserve-orchestrated “reliquefication.” It’s not forthcoming. I will again remind readers to think in terms of this being the first Post-Credit Bubble “reflation” attempt. The Fed’s influence on risk asset prices has been dramatically diminished. Unlike LTCM (or 2002 for that matter), it is simply no longer a case of the Fed lowering the cost of funds for the leveraged players and in the process enticing them to increase holdings of mortgages, MBS, junk bonds, stocks and derivatives (all on leverage). There are much greater financial and economic forces at work.
This week the California Association of Realtors reported that January home sales were down almost 30% from a year ago, with median prices sinking 21.9% y-o-y. Median prices dropped $46,010 during the month, putting the decline from June’s high at an astounding $163,900. These “averages” are being skewed by the lack of mortgage Credit – hence transactions – at the upper end. Inventory is up to almost 17 months supply and will likely growing rapidly as thousands of foreclosed properties hit the market in the coming months. Keep in mind that the California downturn is relatively recent – running about a year behind Florida, for example. Increasing recognition of the dimensions of the unfolding real estate collapse in California (and elsewhere) certainly is major factor for the sinking valuations of “Alt-A,” “jumbo” and MBS generally in the markets. And the resulting further tightening of lending standards by the mortgage companies, banks, GSEs, and mortgage insurers will only exacerbate the unfolding real estate bust.
This is No LTCM. The current financial and economic backdrop is altogether different. Speculators that would typically seek to capitalize on depressed securities prices now confront enormous uncertainties. How bad will things get in California, Florida, and elsewhere? How many will walk away from underwater mortgages – for starter homes and million dollar-plus California bungalows? How badly will the U.S. “services” economy be hit by housing and financial woes? How bad are the unfolding Credit problems in state and local finance? Will pinched consumers also turn their backs on Credit card, auto and student loans? How long will the seizing up of the securitization markets last? How will corporate Credits hold up in the event of prolonged Credit restraint and economic tumult? What are the ramifications if the “monolines,” GSEs, private-label MBS/ABS, the Credit derivatives marketplace, and Wall Street “structured finance” (more generally) don’t recover? None of these pertinent questions were even remotely contemplated in 1998.
The problem today remains a highly leveraged Credit system now confronting massive – and unquantifiable - Credit losses. And Moody’s and S&P can continue to claim that the major “monolines” are “AAA” – while the GSEs can pretend they are adequately capitalized. But the marketplace is not buying it. Sinking securities valuations are not a “technical” market issue that will be resolved when the margin calls are satisfied. Indeed, the Credit crisis and the economic downturn are gaining significant momentum.
Throughout the system, risk models have broken down. They will now be functionally inoperable for some time to come. At the heart of the now unfolding systemic de-leveraging are some newfound realities. Leveraging, as Peloton Partners realized this week, has become a perilous endeavor. The markets have become hopelessly illiquid, providing no escape route for even the perceived safest securities. Worse yet, the greatest leverage has accumulated in the perceived safest securities – creating atypical de-leveraging risk and Acute Systemic Fragility. Credit costs are now spiraling higher, and it’s today impossible to accurately forecast either the timing or scope of losses for securities from subprime to munis to agency debt and MBS. Meanwhile, Wall Street and the securities lending community are reeling and will over time impose only tighter standards (less leverage and more collateral).
Importantly, the nature of systemic liquidity and Credit risks has become a major risk factor working against leveraged speculating. Or, said differently, the Bubble in leveraged speculation has burst. Today’s reality is one of a Credit system severely impaired, with the ABS, junk, and CDO markets basically closed for business. Now the huge muni and investment-grade markets are badly faltering. This week also saw the Swiss franc and the Japanese yen as the best performing currencies, gaining 4.7% and 4.2% respectively. For those borrowing in these low-yielding currencies to finance leveraged speculations in higher-yielding U.S. (and other) securities, there is now recognition of acute currency risk. The stage is set for a panic out of the crowded leveraged trades.
This is No LTCM. And a very strong case can be made that Fed rates cuts have destabilized the Credit system. While the argument that Fed rate cuts worsen an already problematic inflation problem certainly has merit, there is a greater risk that goes unrecognized. During the Greenspan tenure, the Fed was keen to use the leveraged speculating community as its Key Monetary Reflationary Mechanism. This, over time, became an instrumental facet of the Credit Bubble; the Bubble in Wall Street structured finance; and the U.S. Bubble Economy.
Recent Fed desperate efforts to sustain both the Bubble in leveraged speculation and the deeply mal-adjusted U.S. economy are futile. As for the leveraged speculating community, it would be better for the long-term health of the system to let the bust run its course. Today’s reflationary efforts are clearly fueling further wild and destabilizing global speculation and excess, with major – and increasingly obvious - negative consequences here at home. As for the U.S. Bubble economy, throwing additional Credit at the Current Unsustainable (“services-based”) Economic Structure only ensures greater future Credit losses and financial sector upheaval, along with more problematic economic dislocation. Importantly, the Fed (Kohn and Bernanke) made another major mistake this week downplaying inflation and dollar risk – focusing instead on economic risk. Ironically, the Fed is today impotent with respect to the economy. It had best start paying attention to the stability of the currency markets, where it could have some impact.