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October 19, 2007

Collateral Damage
by Bill Laggner and George Karahalios

The Inevitable Unwinding of "Assets" and the Impending Governmental Intervention

To many it seemed preposterous to suggest that a credit crunch could prevail in a world flushed with liquidity. Thus, when the recent sub-prime loan fiasco materialized, authorities assured the masses that it was "contained" to a fraction of the overall mortgage market. As the contagion spread and claimed a few levered hedge funds, central bankers deemed this to be a necessary purging of weak hands which they welcomed. Finally, when a few of the "fringe" lenders responsible for the most risky of loans declared bankruptcy and the domestic equity markets held relatively firm, many believed that the worst of the crisis had passed. Instead, a global run on the banks ensued, not by depositors, rather by bankers themselves who no longer felt comfortable lending money to their peers at the discounted rate decreed by their respective governments. So in a world of allegedly ample credit, central banks were forced to infuse even more liquidity to maintain their already low short term interest rates and to prevent the imminent unwinding of the credit bubble. In a debt-laden U.S. economy dependent on asset price appreciation, even a government bureaucrat comprehends the importance of protecting the collateral by forestalling its liquidation.

In an unfettered society in which real interest rates are free to float to market, asset prices generally reflect their intrinsic value. In a world dominated by central banks intent on continually delivering yet lower and lower real rates with every passing crisis, asset prices reflect a premium to their real worth. When the Greenspan Fed ultimately lowered nominal short-term rates to 1% by 2003, real interest rates had fallen into negative territory, signaling to capitalists that a chance of a lifetime was at hand -- the chance to lever to the maximum and acquire all asset classes that had become grossly undervalued by employing a government-imposed discounted rate. Globalization bulls would dispute this contention on a number of grounds, instead asserting that high asset prices accurately reflect the favorable long-term global expansion, while ignoring the previous five years of unprecedented global credit creation. The only true way to settle this dispute is to allow the free market to determine interest rates, but it seems that whenever "risk" is re-priced by the marketplace, it is always deemed to be a crisis by these alternative theorists.

What has made this debt super-cycle unique is not just the extent of debt growth, but rather how the debt was originated and dispersed across the globe. In the old world of tighter credit (positive real interest rates) and less technological sophistication, home lenders and borrowers usually came into direct contact with each other, with the borrower submitting documentation to substantiate his ability to repay a loan. Not only did the lender scrutinize the borrower, but also the lender had extensive knowledge of the local marketplace and would determine a fair value for the underlying collateral. In contrast, today's "sophisticated" world is comprised mostly of originators who place loans that are sold to banks, where they are packaged into mortgage backed securities and collateralized debt obligations (CDOs), which are then peddled to investors, including hedge funds and large financial institutions around the globe, who have no direct knowledge of the collateral's real value. In an almost miraculous fashion, our just-in-time information age magically transforms debt into assets, which are then further leveraged by speculators looking to convert a presumably safe, low return on assets into a high return on equity. Of course this process could not transpire without the help of cooperative central bankers.

In the old world, cracks emerged when local lenders would restrict credit due to the deteriorating fundamentals of the collateral offered; prices would moderate, and the corrective process would prevent a significant over-supply of homes from being produced. In the new "sophisticated" information age, those who rate the value of collateral profited handsomely from debt creation without risking much of their own capital. Problems did not surface until the supply of debt became so abundant that an overproduction of assets soon followed. In other words, loan originators kept packaging debt--and the rating agencies continued approving it as long as disparate investors' insatiable appetite to purchase the securities continued--regardless of the deteriorating fundamentals developing in the market.

For example, those in the business believe that housing prices peaked in approximately June 2005, yet the expansion of sub-prime and Alt-A loans continued through most of 2006. In fact, in 2006 $1.1 trillion of these loans were originated, 12% higher than in 2005. Further, these loans now comprised an even bigger percentage of the CDO market, reaching 48% of the $375 billion of US CDOs created in 2006, up from 27% of the $194 billion of CDOs created in 2005. Apparently, the ultimate buyers of these loans accepted the "official" conclusion, produced by the National Association of Realtors and confirmed by the rating agencies, that housing prices were actually rising when indeed they were falling. Finally, the mounting evidence of declining home prices became so apparent that investors began to ignore the information provided by "biased" agencies and started selling off these assets to preserve their remaining capital. Leveraged investors in these instruments, including two prominent hedge funds, quickly became insolvent.

Even more unnerving than the exponential growth in sub-prime loans and collateralized debt obligations was the manner in which they were packaged and sold. By combining safe loans with risky loans, the rating agencies managed to achieve AAA ratings on packages of loans that included some of the worst debt through the use of quantitative "black-box" computer models -- models typically back-tested on data accumulated during the post 2000 era of excessive credit creation. Further, hedge funds levered up to increase their returns on this debt via the structured finance world whereby leverage of 15-1 became acceptable. Though much of the notional value of debt derivatives and credit swaps, estimated at nearly $400 trillion globally or seven times global GDP, were nothing more than levered bets that often expired worthless, some of these options were probably purchased as part of a greater portfolio strategy. As these derivative options became re-priced to reflect the higher cost of risk, many black-box hedge fund models imploded, further pressuring the value of the underlying collateral as the great unwind led to forced liquidation.

Some will argue that the size of the CDO market, which is approximately $2.5 trillion globally, is not significant enough to damage a world with a combined $47.5 trillion GDP. On the surface, that may seem true, but when some of the paper is levered seven to eight times by the community of professional speculators, it is also important to determine what future obligations may become at risk. Specifically, in a U.S. banking industry with $857 billion in equity, roughly $1.211 trillion dollars of "securitized real estate loans" exist, certainly not an insignificant number. The threat to the banking system might not present itself in the amount of questionable loans it currently holds, rather in the number of good loans that might later prove vulnerable as weak holders of loan obligations in other sectors of the economy liquidate these loans. Even in a highly leveraged society in which the risk is widely dispersed, the unwinding process can quickly escalate.

While nearly 50% of US corporate profits are generated by finance activities, optimists fail to recognize the importance of these earnings and their impact on the real economy. Securities firms collected nearly $27.4 billion last year in revenue from underwriting and trading asset-backed securities according to a JPMorgan analyst, while US bank revenue from trading derivatives jumped 24% to a record $7 billion in the first quarter of 2007. Before the liquidation process began, credit spreads had narrowed to extremely low levels as the Fed had removed risk from the marketplace with repeated liquidity injections. This permitted private equity firms to safely lever up and create their own liquidity by borrowing cheaply, buying up publicly traded companies, and chasing asset prices even higher. Further, public corporations, having no need to make large capital investments as production now transpired overseas, used their earnings and repatriated capital to repurchase their own shares. Asset classes have become so big that markets are able to create liquidity faster than the Fed itself! Eventually, though, risk became re-priced due to failures in the housing market that reverberated through the CDO market and virtually froze the private equity market.

The Fed finds itself on the horns of a dilemma: it must try to prevent the liquidation of assets at "fire-sale" prices without adding to inflation. There is the risk that foreigners will abandon their support of the dollar, and in particular of US treasuries, and that long-term interest rates will rise, inflation will soar, and the dollar will crash. Even if the Fed is able to temporarily achieve nirvana by slowing the liquidation process, the fact is that the housing market remains mired in extreme overcapacity. In inland areas of Northern California, some lots are being liquidated at pennies on the dollar, with prices plummeting from $50,000 per entitled lot just two year ago to just $5,000 each now. Even at today's bargain land prices, building homes is no longer a viable business model in areas where land is plentiful. There are just too many homes available for the market to absorb.

In the lending business not only is credit being restricted from formerly qualified borrowers, but also building activity has been curtailed. This deprives lenders of both new loans and re-finances. Global securitizations that were averaging $20 billion per week earlier this year now have declined to a paltry $3 billion. New paradigmers would have argued that this is not the beginning of something bigger (a systemic credit crunch) because the sub-prime problem was contained. With the recent implosion of the Alt-A lenders (such as American Home Mortgage), many prime lenders could soon be at risk. (Countrywide Financial verified this fact in its recent conference call by reporting difficulties in this area.) The new argument put forth by these true believers is that the problem has been restricted to "real estate only" and is not a broad credit crunch that might infect the overall economy. For this reason, they continue to pound their fists on the table, advocating the "buy the dip" approach to equity market corrections. Those advocating such methodology seem to dismiss the extent of the credit bubble and the damage done to the asset base - the collateral.

Because loans have been dispersed throughout the economy and are carried as assets by many global entities including hedge funds, insurance companies, investment and commercial banks, governments and various other institutions, the re-pricing of risk can weaken the entire global financial system. However, in a world of excessive idle liquidity, the corrective process can be frequently slowed by well known "bargain hunters" who might purchase some of the distressed assets. Also fierce stock market rallies might occur which are exacerbated by short players who fear that perhaps the ultimate credit crunch has been postponed once again. This perpetuates the illusion that the liquidation process has been staved off or halted, when in fact this is a necessary step to eventually purge the system of its excess liquidity.

Unless greater amounts of new liquidity are repeatedly injected, the cracks in the global financial system will reappear somewhere in the world as asset prices continue to decline. New paradigmers will define this gradual, global systemic failure as "the efficient dispersion of risk." The reality is that a systemic rot is infecting the entire global financial system, and it is being concealed continually by the excess liquidity that has either been dormant on the sidelines or is being newly created by governments to combat the crises. The result can be either a very quick unwinding of the debt if markets are allowed to freely adjust without intervention, or instead, if the government moves to protect the bad debt and stabilize asset prices, the result can be a gradual erosion of the efficient allocation of capital, as society must continually designate good resources to prevent the failure of its bad investments. Of course, some economies with stronger balance sheets and better economic fundamentals may be better able to cope with the dilemma than others.

Given that the US Fed is the originator of the excess global liquidity that has created the great credit bubble, and that it has delayed the free-market resolution of purging this bad debt, it's appropriate to consider the views of front-running US politicians as to how they might intervene in the credit crisis. Earlier this year politicians from both side of the aisle proposed various types of forbearance relief. In particular, Senator Clinton proposed a "foreclosure timeout" to allow distressed homeowners to work out their differences with lenders. In a recent CNBC interview, she acknowledged that the "lenders have taken advantage of what is a very tough economic circumstance for many Americans" and that "(Americans) are in an interdependent global economy" which she hopes to help make work to the advantage of a broad scope of Americans, not just the rich. She elaborated on the fact that so much of the paper (debt) is being held by foreign governments that are guided by motives other than true market forces. She also added that our government must extend credit through Fannie Mae and Freddie Mac to help us through this period of transition. By these comments she has implied that the US's bad policies have greatly damaged the middle class, and that to save "capitalism" in America from the foreign forces that have exploited it, perhaps a time-out is in order to favor some form of "temporary" socialism. This is not to say that the Fed's policy of money printing has not been a form of socialism, as indeed it is -- a socialism for the rich who have greatly benefited at the expense of the middle and lower classes -- rather that a new order of socialism will be instituted that will greatly benefit the non-rich.

Investors must realize that this impeded corrective process can endure over a prolonged time period. Should the Fed initially misgauge the extent of the credit crunch and react only intermittently or belatedly, short positions should be increased on all investments related to the financial economy - homebuilders, investment and commercial banks, mortgage insurers, credit card companies, and government sponsored entities (all the contents of the Bearing Credit Bubble Index). Initially, small cap companies may suffer the most as they are more dependant on growth and less able to borrow than their large cap competitors. As the credit contraction gains momentum, the Fed most probably will react by aggressively flooding the money supply and monetizing various forms of bad debt, causing inflation to soar and the precious metals to follow suit. Depending on the severity of any potential US recession, foreign equity markets and base metals could also suffer for the intermediate term, but eventually their respective markets should prosper as strong growth re-emerges in a world that will no longer rely on extraordinary US debt creation. In the US, tax rates on capital gains will likely increase to help finance expenditures necessary to shore up the country's failing infrastructure. Workers involved in the build-out will likely be rewarded with high wages by a US government that tries to appease the suffering lower classes. Just as the Eastern world moves closer to capitalism, America and the West appear to be abandoning it.

Ben Bernanke has suggested that central bankers have learned from the Great Depression and that history could have been re-written had the Fed acted promptly. Paradoxically, the Fed's policies, when combined with those of US politicians, might only work to reverse the sequence of events that occurred by creating a rolling, soft depression that is at first buffered by a growing socialism. Perhaps, though, in the end capital markets will remain open and the Great Depression will be avoided by allowing foreigners to purchase our assets since they will be among the few who can rightly afford them. This would make working Americans extremely dependent on their foreign owners. Such is the collateral damage done to a society hell-bent on preventing the unwinding of a credit bubble in order to maintain high asset prices.

Bill Laggner and George Karahalios
Bearing Asset Management, LLC

Copyright © 2007 Bearing Asset Management, LLC

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