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July 27, 2007

The Big Crack

 Toxic Waste, How Wall Street Came to Love it

There are deep subterranean rumblings out there. Something very serious is looming and it may impact all of us, whether we are deep into the markets or mere bystanders going about our business.  The Cassandra's have had their eyes on it for a long time, ever since tens of millions among us were enticed, often by gimmickry, into a wallet full of plastic, investment schemes we couldn't fathom, houses we couldn't afford and home refinancing offers that drained the equity out of our homes.

What many investors and the public don't understand is that any crisis in the household finance market spills over into the broader financial markets in ways that are impossible to predict. It's very possible we are looking up at a coming avalanche that was triggered a few weeks ago when two hedge funds run by mortgage bond experts at Bear Stearns virtually collapsed creating as much as $20 billion in losses.  Bear Stearns has pledged over $3 billion to prop the funds but the reality is that the securities they hold, mainly on borrowed money, are virtually worthless should they be put to the test of an open market sale.

But these are, as we say, rumblings, treated by the mainstream press as background noise, the kind of arcane stuff that happens from time to time among the bankers with little chance for blowback. The reality couldn't be further from the truth. The Bear Stearns collapse is merely a canary in the mine or an important marker in a timeline.

What you do see reported these days is an unfolding disaster in the home building market.  Sales for new homes continue to decline; according to a July 26th New York Times article, "The Commerce Department reported that sales of new homes dropped 6.6 percent in June, and that sales in previous months were lower than first estimated. In the last year, new home sales have fallen 22 percent."

Along with falling sales come falling prices. In some parts of the country, Miami's just an extreme example, prices have dropped so fast that buyers are backing out of contracts, taking big hits in penalties rather than taking claim to properties that have lost a third of their value since the peak. All of this, painful as it might be to some, could merely be part of the customary ebb and flow of markets, thus limited to the home building sector and related parts of the economy.  It could, but it isn't, because of something that's come to be called toxic waste in the arcane world of investment-grade securities.

It was toxic waste that brought down the Bear Stearns funds last month and it is toxic waste that is now impacting on the sale of Daimler Chrysler and it is toxic waste that will weigh on the outcome of a long string of leveraged buyouts that have already been announced but that will require creative financing to close.

Toxic Waste has polluted the Entire Stream of Financing

On Wednesday July 25th there was yet another serious rumble and once again the stock markets took notice.  The nation's largest mortgage lender,  Countrywide Financial announced a 33% drop in quarterly earnings and 10% stock drop on Tuesday. What was particularly seismic however was this: "The culprit," the company said, "was a surprising jump in delinquencies by prime borrowers who had taken out home-equity loans". This was ominous news because it means that problems in the housing market had metastasized into what are considered, prime, or safer mortgages in addition to the sub-primes that were seen as the heart of the problem.  And here's where it starts to get tricky:

In today's world of hedge funds, easy money, high leverage, and derivatives (CDO's LDO's and RMBS's), new money can be manufactured out of anything, even the most risky housing loans.  This Wall Street magic, practiced by such bond stalwarts as Bear Stearns, Lehman Brothers, etc. works something like this:  a family buys a Mac mansion somewhere outside of Bakersville by taking out a teaser loan (for the first couple of years they do not pay any principle back only a small percentage of the real interest they have contracted for) that they could barely shoehorn into their budget (they didn't have to show any papers proving their income), and may have been told that by the time their real monthly payments kicked in two years down the road, the house they bought would have gone up in value so they would be able to refinance in a way that pulled out enough cash to keep up future payments. In other words, if everything goes perfectly, they might just be able to sneak in. Then Lehman Bros, say, buys this mortgage from the lender along with a number of other such and bundles them into bonds called Collateralized Debt Objects (CDO's) or Residential Mortgage-Backed Securities (RMBS's) that are sliced, diced and marketed on the basis of a risk calculation for the entire bundle.  The portion (tranche) of these securities that have the most sub-prime mortgages packaged together are called toxic waste by the industry. But even so-called investment-grade securities have a sub-prime component and it now appears that there has been collusion on the part of the bond rating firms (like Moody's and Standard & Poors) to make these securities compatible to large investors, like pension funds and university endowments that are restricted by charter from purchasing more risky bonds.

But collusion has been spread around, from the mortgage writers who have nothing to lose in getting the family into their dream home, as they pass the loan off to Wall Street, to the rating firms who claim they are not responsible for their ratings to the hedge funds that borrow against them to leverage their bets to the Feds who regulate the banking system and who have cast a blind eye on the pyramid.

Some will say, well, that's the market and these are sophisticated investors making choices, the markets are just working their magic.  If too many sub-primes default, some guys in Wall Street get hurt, big deal. Unfortunately, however, in today's gigantic money creation game, derivatives like CDO's don't only constitute the bottom of the spiral, in some cases they are way up on the chain.

In the Bear Stearns funds meltdown, for instance, less than a $1 billion in already risky paper was used to borrow another $20 billion! And the piper has not been paid, banks that are holding CDO's like these, have assigned a value to them on their books even though the CDO's are rarely brought to market.  But at some point they will have to revalue these holdings and potentially show major losses.  It is estimated that Wall Street has created $1.8 trillion in loans on top of just the sub-prime portion of the mortgage market and a further $10 billion on the primes, in the last few years. Put in perspective, $1.8 trillion equals about 1/7 of the entire US economy ($13+ billion) for a whole year.

As we've said, the other big holders of CBO's beyond the unregulated hedge funds and the banks, thanks to the credit raters like S&P and Moodys, are the major pension funds. That's important because while the banks might agree among themselves not to force a sale or mark to market their holdings for strategic reasons, the pension funds are by charter not allowed to hold anything less than "investment-grade" securities as determined by the credit rating agencies.  In other words, should the raters have to face reality and lower their ratings, the pension funds will have no choice but to put their holdings up for sale, and a fire sale it will be.  Once that happens the banks will have to recalculate the value of their holdings. This will not be pretty!

"......Downgrades by S&P, Moody's and Fitch would force hundreds of investors to sell holdings, roiling the $800 billion market for securities backed by sub-prime mortgages and $1 trillion of collateralized debt obligations, the fastest growing part of the financial markets." (Bloomberg)

Remember, failing mortgages cause foreclosures, foreclosures put more houses back into the market forcing prices down, making it impossible for mortgage holders who need to refinance to meet the obligations of the 2/28 (2 years at a teaser rate, 28 at market rates) loans they have that are about to come out of the teaser period .... in California, one of the nation's largest home markets, by 2005 nearly 1 out of every 4 loans issued was a 2/28 sub-prime. No wonder, investors took heed when Countrywide Financial announced the depth of its woes.

Another rumble came with the Daimler Chrysler deal; it too, is not insignificantly impacted by that family struggling to pay off its mortgage.  Wall Street has been powered by a rush of private equity buyout deals that rely on leveraging.  The deals happen because investors are willing to step in and buy derivatives based on the future potential of companies that are sometimes being purchased for twice their market caps. Like speculating in houses, these kinds of deals work when everything is going up and lenders are willing to take on risk at a small premium.  At one point in this cycle, the difference between the riskiest rates and the best was only 3%.  Customarily that gap is closer to 9%; in other words sell me your toxic waste but pay me amply for the extra risk, is fast becoming the new mantra as fear sweeps in. Once that happens, deals structured on cheap money, cave in.


Best of Times and Worst of Times

These have arguably been the best of times for the masters of the universe. They have (in their genius) managed to create an electronic  mountain of money that has, by its virtuality, defied up to now linkage to anything in the molecular universe. For many, Wall Street has, through the tricks of the hedge-fund filter, been made immune to the laws of economic gravity.

Everybody's a player, the Fed's a player, the Comptroller of the Currency is a player, even the bond rating agencies have become players. The new Wall Street masters' alchemy is complex: with the sweep of a wand you turn bad debt (the new toxic waste) into investment grade "securities", you borrow against those securities to boost your bets; at the government level you bring the dollar to record lows thereby boosting, on paper (foreign profits in Euro's, say, translate into more dollars), multinational corporate profits, you flood the international financial system with the next round of newly generated money and voilá, like never before, all markets --bonds, stocks, commodities, derivatives, rise simultaneously.

Never mind the $12 billion a month being spent a month on the war --it's borrowed, anyway-- forget about the ballooning trade deficit --we'll just print some more dollars for that-- everybody wants dollars!

 Manufacturing, American Style

Having transcended the grimy steps, i.e.; workers (not counting a dozen or so million illegals at minimum wage to keep the rest of us waited upon and neat), unions, machines, factories, ERP, warehouses, shipping costs, the new business of America is to manufacture wealth directly in all number of packages, from consumer loans, to "teaser" mortgages,  to options, to derivatives, to CDO's to LDO's, to IPO's to... well, anything that supposedly spreads the risk, and more importantly, spreads the dollars to places like India and China where they will be taken, no questions asked. As the song says: "Nice work if you can get it."

Think of the Dollar as a century old brand name and that in our brave new world, most conveniently, the  Federal Reserve --the guys who are supposed to protect its value-- has licensed that brand to Wall Street, for nothing in return but the potential down the road for a Herculean hangover.

Bear Stearns, or the First Big Crack

Here's how the manufacturing process works: the base ingredient --yes, we exaggerated,  there is something sort of real underneath it all-- is a mountain of expanding debt at every level.  That's the beauty of it, if you happen to be an American working stiff, you get to borrow through your government, through Wal-Mart, through the plastic in your wallet, your house, if you have one, or through a specially tailored mortgage, that gets you into one.

The government gets to borrow like crazy too, and to spend money it doesn't have --nobody likes taxes-- for it's various enterprises, knowing you and your children will still be paying for these various enterprises far into the future. Wal-Mart and Nieman Marcus alike, take your plastic generated money and send it off to some exotic sweatshop where the prevailing wage is a dollar or so a day. The mega petroleum companies get another piece out of you as you drive back and forth to work --they know the real value of your dollar, even if you don't, and have adjusted accordingly-- the credit card companies take your interest payments and penalties, leaving the debt portion alone, and your mortgage company gets its interest-only payment for your house.  Who needs a raise in pay if all you've got to do is borrow some more! Didn't you just get another offer to consolidate all yours debts for 0%* (the asterisk explains what your real rate will be) from some other credit card company today?

If the motto of Wall Street many bubbles ago, was Gordon Gecko's rallying cry, "Greed is Good", today, for those masters the new motto has to be "Debt is Good".  The great revelation for the 21st Century is that people with little means make the best borrowers.  They pay more fees and penalties, and higher interest rates for longer times and that poor and rich alike around the world will take all the newly printed dollars we can make.

Billions and Billions of Dollars

Foreclosure filings in the U.S. jumped to 147,708 in April, up 62% from a year earlier, as sub-prime borrowers stopped making mortgage payments, according to data released by research company RealtyTrac Inc. on May 15. As foreclosures rise, the sub-prime-mortgage-backed securities in CDOs begin to crumble.

"How much could the losses be? It depends on who you ask, but estimates of $150 billion or more are quite common. Institutional Risk Analytics, a Hawthorne, California-based company that writes computer programs for accounting firms, says 25% of the face value of CDOs is in jeopardy, or $250 billion. But no one really knows. It is all guesswork, except that everyone seems to agree it will be large. " (Bloomberg Markets, "The Ratings Charade" by Richard Tomlinson and David Evans)

"More than a thousand U.S. companies were acquired in leveraged buyouts in 2006 -- a record $194 billion of deals, according to data provider Dealogic. More than $163 billion was borrowed to pay for those buyouts, according to S&P Leveraged Commentary & Data, more than total borrowings for the previous two years of buyouts combined. This year, through mid-June, $103 billion of debt was raised to fund buyouts. Over the next few months, more than $100 billion in loans will be sold to fund mammoth deals such as Cerberus Capital Management's acquisition of Chrysler Group and the privatization of SLM Corp., also known as Sallie Mae." (Wall Street Journal)

The trouble goes way beyond Bear Stearns and right to the heart of the way hedge fund managers get paid and hedge fund sponsors, like Bear Stearns, make their money.  CDO's, CLO's and their children are highly exotic mixes of different kinds of loans, some more risky than others.  They don't trade in any markets, like stocks and bonds, so it's anybody's guess what they really are worth until they get "marked to market".

Hedge fund managers get a hefty piece of the profits, around 20% in many cases.  They have every incentive to value their CDO and CLO holdings as high as possible and little incentive to mark them down as, in this case, mortgage failures start to crop up in major markets where housing prices are falling.

Against a background of higher interest rates, Fed tightening and Wall Street skittishness, sub-prime lenders have stopped pushing their wares with the same abandon.  Median house prices have been falling around the country and in some of the once hottest areas, prices have dropped dramatically.  To make matters worse, many of the sub-prime loan holders were directly involved in a house building industry that is cutting back. With fewer jobs, lower home values and rising payments, loan holders have no choice but to walk away from their properties. This tragic, perfect storm for the individuals could fuel a perfect storm in the financial markets that have fanned the boom.

An Air of Unreality

There is always an air of unreality on Wall Street.  The Bear Stearns crack was no exception. Had the funds been allowed to collapse a potential correction might have been put into motion.  Instead, what observers got was a charade, a game of chicken between two Wall Street powerhouses. When Merrill Lynch threatened the leaders at Bear Stearns that they would  bring the "collateral" (the CDO's Bear put up against their loans) to market, all eyes fixated.

Of course, in the end even Bear Stearns, a company not known for its cooperative spirit --they were the only big Wall Street firm to stay out of the multibillion dollar Long Term Capital Fund bailout when that fund collapsed in the '90's-- had to cave. In the end, they had agreed to put in $3.2 billion to bail out the less leveraged of the two funds. The first chapter in the sub- prime meltdown had closed with nothing more than a haircut for some punters, and the bruising of some very large egos.

One of the most anticipated stock market moves of the year took place a couple of weeks ago.  A major player in the leveraged buyout game, the wildly profitable private investment firm, Blackstone, with the Chinese government kicking in, launched what looked to be an IPO hearkening back to the Tech Stock years.  Public market investors in BX, were, as of this week down over 10% on the stock. Could it be that investors are aware that rather than getting in on the ground floor, they were getting to throw good money into a CLO-driven game that may have already played out? The BX guys were just cashing out.


Back in the late 1980's, the pioneering Wall Street leveraged buyout firm, KKR, had the temerity to attempt to buy out one of the pillars of the Dow Jones Industrial Average, the great American conglomerate Nabisco, a food company that also happened to own one of the major tobacco companies, Philip Morris.  KKR reckoned that given Nabisco's stock price, the total assets of all its various components along with the cash flow generated by Philip Morris,  far outweighed the company's market cap. They had generated the numbers to prove it, along with a plan to sell off some of the companies in the Nabisco  portfolio and a path to paying back the money they would have to borrow to make the deal.  They offered, for the time, a stunning $25 billion for Nabisco, an offer well above the per share price; the stockholders couldn't resist.  The only problem was that in order to swing the deal, KKR, a small private equity firm made up by a small group of money men, had to go into the banks and amass enough in loans (over $13 billion) to make the deal stick.  The landmark deal was so big for the time, that in order to pull it off, the US banks had to let in a number of foreign banks into the deal, and even then KKR had to find another $2 billion from smaller players to finally seal the deal.

KKR showed the way. And by today's standards, all that is as primitive as the gold standard, when paper money could only be printed if a deposit of gold stood behind it. Because of the system-wide debt orgy we've been on, now there're floods of  dollars out there looking for a home. Investors hungry to earn more than they can get from ultra-safe Treasuries, have been willing to accept all manner of CDO's  for a very small premium. It's this willingness, that's driving the leveraged buyout boom. Today, the spread between lower credit bonds and US Treasuries is at a historical lows.  This lack of a risk premium makes it easy for buy-out companies to raise money. In the remaining months of this year, they have been expecting to float another record amount of over $200 billion for buyouts that have already been announced.

"In late April, a Bank of England report noted parallels between the markets for sub-prime mortgages and for poorly rated corporate credit, heightening concern about the CLO market. CLO's are a form of collateralized debt obligation, or CDO. Besides corporate loans, CDO's often hold mortgage bonds and junk bonds." (WSJ)

"CLO's, as they're called, are giant pools of bank loans bundled together by Wall Street and sold off to investors in slices. They aim to spread default risk an inch deep and a mile wide. Last year, more than half of the loans behind the record wave of buyouts were parceled out to investors as CLO's, bankers say."

."CLO's are the equivalent of the savings and loans in this cycle," says Kenneth Buckfire of Miller, Buckfire & Co., a restructuring advisory firm. Savings-and-loan institutions gobbled up a mountain of junk bonds issued to fund the 1980s buyout boom. A spike in corporate defaults during the recession of the early 1990s, coupled with a sharp downturn in real-estate markets, caused many S&Ls to fail." (WSJ)

What's all the more amazing is that this latest bubble has occurred under the watchful eye of Allan Greenspan --a former disciple of Ayn Rand and supporter of the "hard money" gold standard-- and now his hand-picked successor, Ben Bernanke.

Maxxing Out

Debt, of course, is endemic, like the massive trade deficit that the US has run up mainly with China, Japan and Saudi Arabia. This deficit is now climbing upwards towards $1 trillion dollars a year.  As a direct result China, alone, now holds over a trillion dollars in US dollar reserves, money that is recycled back into the pool.  To further fuel the need to borrow, the US government also runs a domestic deficit that is somewhere close to $400 million per year. Individuals are no slackers either:  In recent years Americans have taken out cash from their home equity by floating new mortgages.  In addition,  Wall Street has made credit card borrowing as easy as sub-prime borrowing by flooding customers with offers for new cards that consolidate the debt already run up on other cards. As a result the average household in the US owes an astounding  $28,000 in plastic debt.

The Federal Reserve, once viewed as the bank of last resort, in place to guard against a meltdown, has in recent years become the great not so invisible hand that guides the markets.  When the Fed sees an economic situation it doesn't like, it has the power to move interest rates up and down.  What the Fed saw after the great tech bubble burst, the ensuing corporate scandals at companies like Enron, and at the investment banks that manipulated the stock market in the late 90's, and then 9/11, it launched a highly aggressive policy that produced some of the lowest interest rates in history.  Not only did the Fed open the gates of money with these low rates but it also lowered the standards in which it controlled the terms banks could lend money.

Perhaps there are several hundred million people out there in the world still ready to take any dollars that might come their way and perhaps someone will come up with a machine even more powerful than the Chinese government to create a way.  If so, the party will continue, if not, we fear there will be plenty of blood on the floor before this is all over.

In this wash of borrowed money, an important component has been the Iraq War, that has been financed on credit.  Bush has never asked any taxpayer to open his wallet in this struggle that he has determined, as late as just this week, as an existential fight for our country's survival.  Rather, he has chosen to lower taxes for the duration! No pain has worked pretty much so far but Americans are fighting for schools, healthcare, highways, the environment, pensions, wages in costs that look silly next to the $12 billion a month the war is now costing, even before we start adding in the price of supporting the displaced persons, the permanently disabled,  the Iraqi militaries, infrastructure in Iraq, etc. that is sure to weigh on the next phase. As the economy does a Hindenburg, more and more Americans are going to be looking at the cost of the Iraq enterprise, the rumbles are already clear.


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Posted by dymaxion at 04:40 PM

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