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March 22, 2007

The Good, the Bad, and the Ugly
by Charles Zentay

When my good friend Michael Nystrom asked me to write an article for bullnotbull.com, I was first elated and then depressed. Elated at the opportunity, but then depressed at the challenge of living up to his invitation. How, after all, was I going to join together the massive amounts of information that the Internet and modern economy are supplying my aging brain? The result, for better or for worse, is what I have come to call "The Good, the Bad & the Ugly" but it doesn't follow in that order:

The Bad

Well, indeed, it's bad. Markets are down, and for the first time in a long time Wall Street denizens are beginning to rethink the goldilocks economy scenario that has been driving spreads tighter for years. Several multi-billion dollar subprime lenders are teetering on the edge of bankruptcy, Greenspan is warning that their could be contagion into other markets & that a recession is possible, and other pundits wonder if major banks such as Citibank and Goldman will be affected.

Yet, just several weeks ago, a friend, who is a derivatives trader at a major bank in New York, was telling me that everyone at his bank was afraid to be negative (short) because credit spreads have been doing so well for so long. "Anyone who has been short," he said, "has been a failure." In the Wall Street world where reputations and more importantly jobs are measured in quarters, it is much more lucrative to make a 2% gain, along with the rest of the market, and risk a 20% drop. After all, when the 20% drop occurs, you can just blame the fact that "no one saw it coming" and then lobby your friends at the Fed to rescue you from a financial crisis that threatens to subsume the global financial system (contagion is the word "they" always seem to use). ["One of the things to worry about is how much markets are worrying," says Andrew Tilton, senior U.S. economist at Goldman Sachs in New York. "A contagion in the credit markets based on fear is a possibility, though we don't think that's the most likelyscenario."] Remember, it's other peoples' money you're managing, but it's your bonus.

While pundits are running around trying to ascribe a reason or a series of reasons to what is causing the recent uncertainty, in my mind it is actually quite simple. The tide is going out. The monetary tide that is. After nearly two decades of generally decreasing interest rates, interest rates (on the short end of the yield curve) have been rising, and countries around the globe (China, Japan, Switzerland, the E.U., the U.S., to name a few) have been trying to drain liquidity from their financial systems.

So the trend is changing. But two decades of cheap money and an accommodating Fed can lead to strange happenings. After all, just weeks ago, someone who have trouble paying their credit card bills could easily receive a 100%-LTV loan (meaning 100% of the value of the house). The loan would have a barely-affordable monthly payment level, which would only get more expensive in a couple of years. But what a difference a few weeks make.

And guess what? The politicians and regulators are shocked that these practices have been going on (with the exception of Ron Paul, the lone, brave voice in Congress warning of the consequences of excess liquidity). Personally, I'm shocked that the politicians can maintain such plausible deniability in the face of the obvious. My personal favorite is Chris Dodd of Connecticut, who is appalled at what is happening and calling left and right for hearings on the matter. As Chairman of the Senate Banking Committee with all the resources at his disposal and his ability to ask any American to testify on the matter, how he did not know what was going on? After all, I'm just a small-time independent businessman with access to the Internet, and I was able to figure it out enough to make a lot of money shorting the subprime lenders. But maybe "independent" is the key word in the previous sentence. Because, while Senator Dodd is claiming that we need to bail out the poor, who are defaulting on these loans, few people are aware that the largest donors to the Honorable Christopher Dodd are the world's largest financial institutions, the ones who have been overlending to the poor in the first place to cause this crisis, and the ones who would suffer greatly if "contagion" were to spread.

But alas, in the list of the bad, the politicians are not at the top of my list. I've always believed it's the bankers (not the robbers) who should be the ones wearing the masks. My friend Flipper58 (whose wisdom you can see on the FAX board at investorvillage.com) describes what has transpired as follows:

"I guess what is so fascinating [about the subprime market collapse] is these [loans] all were structured probably by a few Wall Street financial engineers a half dozen years ago. When you think about the CDO (collateralized debt obligation) structure it is quite genius and simple. Take a bunch of lower grade, non-conforming loans and put them in a big pot. Break it into levels (tranches) by drawing 10- 15 lines thru the middle. Make it so the level 1 gets interest and principle first and if [there are] extra excesses it falls to the 2nd level and on down the line. Then get the levels rated and [you've made] a bunch of low grade loans now investment grade in essence making these type [of] loans marketable to any investing organization. This all of a sudden creates a MASSIVE new pool of buyers. Add interest rates swaps to manage maturities and duration, add default swaps on the low grade levels and you have an incredible amount of new money that can buy these mortgages that in the past had very limited funds allowed to them. Now selling some 99% LTV mortgage is easy because the CDO structure takes the risk of 1/2-3/4 of it away.

"If you look at any bubble in any market all you need to look for the NEW source of funds that caused it. IMHO, the NASDAQ bubble in 1999 was because massive number of online brokerage firms that allowed anyone to trade at will. IMHO, the CDO structure, now allowed a mass of new money.

"But now the punch bowl is being pulled. All those 100% option ARM's ain't going to happen and because the CDO structure PASSED the risk on...mortgage originators were volume focused, not quality focused...[To] see that REALLY nasty stuff went on by the mortgage brokers is not surprising. I know in my area Mortgage brokers sprouted up like grass."

For me, any bonus on and any regulation of a potential investment should be measured across the lifetime of the deal and should be returned or should become a liability if the deal turns out to be a loss maker over its lifetime! Can you imagine that? Imagine how differently bankers would behave? It's like asking politicians to send their children to war! It's funny how we ask human beings behave when we are managing other peoples' money or sending other peoples' children into harm's way.

Too often financial products are structured to provide short-term benefits and pile increasing risks out into the future. The tide of human emotions are what drive the business cycle because those making lots of money in the upswing become increasingly convinced that past performance does in fact indicate the unlikelihood of the increasing obvious (future losses), thereby explaining investors shock when they've realized they've been sold up the river.

But the obvious signs are all around. As a friend explained this weekend, when an ad for pure bread dogs offers financing, it just may be an indication of excess liquidity. Everyone in New York keeps telling me: "Don't worry, the risk of lending is so spread out so much that it's no longer a problem." Still, I don't believe it. Why?

In fact, I would warn that the exact opposite is true. The trading of short-term profit for increased future risk has been taking place on a massive scale, from the subprime mortgage originators all the way up to the Federal Reserve! I will write more on this subject in a future article, but for now one simple stat can demonstrate what I'm talking about: Since 1987 (when Greenspan became head of the Fed), Total Credit Market Debt has grown from $13 trillion to $40 trillion and now accounts for over 300% of GDP. Many argue (including Greenspan shockingly enough) that this debt growth is not a problem, because assets have grown more. But when too much money is available to lend, the borrowers can drive up prices (alla housing). It's only when the excess lending is taken away do we find out the real consequences, or as Warren Buffet likes to say, "It's only when the tide goes out that you find out who's swimming naked." With debt growing 50% faster than industrial production, I fear that the one who is swimming naked may be Uncle Sam, which is not a pretty picture.

My predicition: a lot of subprime lenders (and other lenders) are going bankrupt, the major banks are going to suffer losses, mortgage lending will slow down, housing prices will continue to decline, and the U.S. will slip into a recession sometime this year, if it has not already.

The Good

The good news is that the Fed can always just print more money (called the "Greenspan Put" because that's what he always did whenever things were going badly, thereby "saving" us from a recession). Although I've been listening to the Fed for a long time, and I've not bought the market's argument that the Fed will be forced to lower rates, I am now capitulating. I think the subprime shake-out will spread to the rest of the real estate market. The stock market will continue to be volatile and banks will suffer enough such that the Fed will be forced to lower rates this year, possibly to 4.5%, or possibly more.

Once the market realizes the Fed will almost certainly be lowering rates, there may be a rally. Until then, look for instability. As I always argue with my friends who fear deflation, it's just not going to happen. No way. The Fed can always just print more money. Plain and simple. Deflation cannot happen.

The Ugly

The ugly problem is rather the potential (and the political need) for inflation. Deflation cannot occur because the Fed can always inject more liquidity. However, inflation cannot always been contained, because the financial system as a whole has an incentive to make it happen. Just as the bankers can create products (certain derivatives contracts) that provide returns quickly and push risk out into the future, the Fed also attempts to reduce risk by adding liquidity (to avoid a recession). So what's wrong with that? After all, no one likes recession.

Unfortunately the problem is ugly. Really ugly. It's called moral hazard. Since Greenspan came into office, it has become increasingly clear that the Fed will pre-empt a recession. Don't worry. If you've overborrowed, people like Greenspan and Chris Dodd will come to your rescue. The moral hazard is that the smarter people in the economy have come to understand that this rescue will happen, and so they are even more inclined to overland! Why not be more aggressive than the guy sitting at the trading desk next to you? As so on, down the line, from the bank officer, to the mortgage broker, to the real estate investor. And don't forget that the leveraged buy-out guys figured this out a long time ago, as have the hedge funds.

Here's a simple way of looking at the complex topic I am bringing up. Say you manufacture pencils and your main cost in graphite. Let's say your job is to price the pencils, so that you make as much profit as possible but also sell as many as possible. If you price too high, you will not sell enough. If you price too low, you will not make enough profit. Simple right? Every business operates this way. Now, let's say you have connections in the graphite production world, and you've used those connections to figure out in advance that the price of graphite is going down. Then, you are ahead of your competitors, and you can order more pencils to be built and lower your prices before your competitors.

If you can understand the analogy above, you can understand what is going on in the financial markets. You just have to imagine that the pencils are loans, and graphite is interest rates (the cost of loans). Because you know that the government will be forced politically to lower the cost of interest rates (graphite), you make more loans (order more pencils to be built) at lower interest rates (lower prices).

The real sinister part is that the more bankers overlend, the more the government needs to decrease interest rates. It's what's called a positive feedback loop, although there is nothing positive about it.

The real, real ugly part (and this point may be controversial to some) is that there may be no one to blame. It is unlike the Iraq War, where it is crystal clear there were a handful of players pushing for war (ignoring some evidence and emphasizing other points, although "they" would like you to believe otherwise in retrospect, pinning blame on the CIA, superiors, or surprisingly "faulty intelligence."). Well, if we know the CIA has a history of producing faulty and politically-motivated intelligence, why the rock-hard conviction at the time that WMDs exist? Ah, the games people play. "I'm shocked to find gambling going on in this casino!"

In the case of the financial system, everyone can argue that they are doing their job. The politician is responding to the desires of the constituency. The Fed is responding to its dual mandate of balancing inflation and growth. Banks are just trying to stay ahead of their competitors. And lenders are just behaving according to market conditions offered to them by banks. Although there are some players who are ignoring some evidence and emphasizing other points (mostly, I would say the Fed), I did want to throw out the controversial thought that there may be something more dangerous than a conspiracy going on. In other words, maybe it's you and me that are causing the problem, behaving in our roles as they've been prescribed to us. As an analogy, global warming is easy to pin on "big oil," but it's really caused by you and me driving to work in the morning. The ugliest and scariest part about this idea is that one of the hardest things in life to do is change people. I can't even get my family members and friends to change the things that are most annoying about them! How then are we going to change the behavior of hundreds of millions of people?

So where does it end? Basically, as it's always ended. With a worthless U.S. dollar. Every banking system in history that is run by fiat (meaning not attached to an actual commodity or other asset) has ended up being worthless.

But do not lose faith. There are steps we can take. First, as individuals, we can invest in commodities and other investments that will benefit from a falling dollar and protect our families' networths. Second, in the next article, I will discuss what steps we can take as a society to create incentives to alter our behavior with a longer-term perspective in mind.

Until then...

"So we beat on, boats against the current, borne back ceaselessly into the past."

For those interested in talking more about this matter or offering new ideas, critiques, or suggestions, please feel free to contact me at czentay@yahoo.com. Please put NYSTROM in the subject line so I know it's not spam, or if it is spam, at least I know the source of its origination.

Charles Zentay
thinkinvest.blogspot.com

Charles Zentay is an independent business person who monitors the financial markets very closely.  Visit his blog at thinkinvest.blogspot.com.

Copyright © 2007 Charles Zentay

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