This week we turn to Michael Lewitt of HCM Capital for a very insightful letter on the current credit crisis. As I wrote on Friday, it is important for anyone with any involvement in the financial world to pay attention to what is going on in the credit markets. I think it is going to have far more impact than most observers apparently believe.
Michael E. Lewitt is the Managing Member and President of HCM (Hegemony Capital Management). You can read his letter at www.hegcap.com.
I should note that readers will get a second Outside the Box tomorrow morning. We have never done this, but there are just two very good letters in my box demanding to be shared. I think readers will approve the extra material this one time. I am sure you will appreciate Michael's work.
John Mauldin, Editor
Outside the Box
The Wages of Financial Sin
"The western world has embarked on a speculative journey for which all the historical precedents are ominous."
Make no mistake about it - if the Federal Reserve is holding back on interest rate cuts because of near-term inflation fears, it will be fiddling while Rome burns. The collapse of the structured finance edifice must be understood as a highly deflationary event. The sell-off in the equity and credit markets signify a severe loss of confidence in the benchmarks of value established by market gatekeepers such as rating agencies, underwriters and market makers. A failure of the Federal Reserve to demonstrate that it recognizes the systemic threat posed by the collapse of structured finance and the subprime mortgage market could send the markets into a full-blown tailspin.
Fortunately, Federal Reserve Vice Chairman Kohn, in a November 28 speech, made it clear that the Fed is getting ready to act. He acknowledged that a change in market conditions had occurred that posed a threat to economic activity, and stated that uncertainties about the economic outlook were "unusually high." HCM expects a 50 basis point cut in both the Fed Funds rate and the Discount Rate at the December 11th meeting of the Federal Reserve's Open Market Committee accompanied by a statement confirming that the central bank will endeavor to remain ahead of the curve.
As for the risks of "moral hazard" that Philadelphia Fed President Charles Plosser and others have warned about if the Fed were to make such a move, HCM would echo Mr. Kohn's statement that there is "no need to hold the economy hostage to teach a very small minority of the population a lesson." That very small minority is hardly the one that would suffer serious pain were the Fed to take it upon itself to punish America for their sins. Having bailed out Wall Street in the past as a collateral effect of providing financial support to foreign nations (Mexico) or large hedge funds (Long Term Capital Management), the Fed shouldn't have to engage in any heavy intellectual or moral lifting to justify lowering rates today in order to enable more Americans to retain their homes and keep food on the table.
The Economic Outlook
While HCM still expects the U.S. to skirt a recession in 2008, it is an increasingly close call (despite an unexpectedly strong 3Q07 GDP report). The American economy is dangerously leveraged to a housing market that has further to fall, a consumer that is under increasing pressure, and a financial system that is smarting from excessive use of speculative finance. Goldman Sachs Group Inc. recently published a report arguing that one-third of the United States is already in recession, and certain industries would welcome a recession as an improvement from current conditions. The following data on the housing market, borrowed primarily from a report from the ever-lugubrious but unusually accurate forecasting and investment management firm Hoisington Investment Management Company, are worth a few moments of sober reflection.(ii)
Moreover, home prices remain near record highs and, as Hoisington puts it, "the unprecedented advance from 1999 through 2006 was directly tied to an equally unmatched growth in mortgage debt." From the 2006 peak, housing prices, in inflation-adjusted terms, have declined 3.4 percent thus far in 2007 according to the Shiller Real Housing Price Index. Real house prices therefore remain 58 percent above the previous cyclical high reached in 1989 and almost 94 percent above the average real price from 1890 through 2007. Adding to Hoisington's worries are the fact that housing starts and building permits remain well above prior cyclical lows (even after the housing market index compiled by the National Association of Home Builders declined 72 percent from its cyclical peak in June 2005); there is record inventory of unsold homes on the market; and nearly $800 billion of adjustable rate mortgages are due to reset between October 2007 and December 2008.
HCM would add a note of caution to these daunting figures. Some of these figures may not be as alarming as they sound - historical data, even data that is only two decades old, may not apply in the same way to today's United States, with its higher population, higher number of immigrants, and other demographic changes that require the data to be interpreted in the proper context. Furthermore, real estate remains a highly local phenomenon. California, for example, is far more likely to see a rerun of what occurred to house prices in the early 1990s than other areas of the country like the Midwest. Nonetheless, the key point being made by Hoisington - with which HCM concurs - is that housing is going to be a drag on the economy nationwide for the foreseeable future.
Away from housing, Hoisington points out that a significant gap has developed between domestic U.S. demand and foreign demand. This is showing up in data on exports and imports. The real net exports deficit relative to GDP (which measures how much more we import than export) shrunk to 4.6 percent in the third quarter of 2007 from 5.0 percent in the second quarter and 5.9 percent at its peak in the fourth quarter of 2004. Hoisington writes that "(t)he reason for the trade improvement is that import growth has slowed sharply in response to weaker domestic demand. In the last twelve months, real U.S. imports of goods rose a miniscule 0.5%, down from the 8.5% growth rate in the twelve months ended August 2006, reflecting the slowdown in consumer spending. Concurrently, exports strengthened in response to growth in emerging economies and a lower dollar." Hoisington warns that "the improving U.S. trade account is a double-edge sword. While it serves to support U.S. GDP growth, it transmits the slower U.S. domestic demand to the rest of the world." The recent rally in Treasury bonds supports Hoisington's thesis that America is already starting to experience slower growth.
Structured Investment Vehicles (SIVs). Last month, HCM expressed its skepticism about the formation of a super-SIV (called, for some reason that still escapes us, M-LEC) that would hopefully provide some time for troubled SIVs to liquidate their assets. It now appears that Bank of America, Citicorp and J.P. Morgan Chase & Co. have reached agreement on a structure for this new entity and that Blackrock will be engaged to manage the assets. The engagement of Blackrock is the first hopeful sign that this plan may yield some productive results since the firm has the expertise and resources to bring value to the project. Upon first hearing about the concept of combining all of these SIVs into one big SIV, HCM must admit it couldn't help recalling the scene in the film Jurassic Park when the character played by the actor Jeff Goldblum (a chaos theoretician - boy, could we use him now!) walks up to an enormous pile of dinosaur dung and says, "Now that is one big pile of s*&^!"
On November 26, 2007, HSBC Holdings PLC, Europe's largest bank, announced that it was bailing out two SIVs by taking $45 billion of assets on its balance sheet to prevent a fire sale of the vehicles' assets. Investors in the two entities, Cullinan Finance Ltd. ("Cullinan") and Asscher Finance Ltd. ("Asscher") are being offered the opportunity to exchange their interests for debt issued by a new company backed by loans from HSBC. Moody's Investor Service ("Moody's") reported in early November that Cullinan's net asset value had declined to 69 percent of capital while Asscher's had dropped to 71 percent. HSBC said it does not expect any "material impact" on its earnings or capital strength from this transaction. A senior HSBC official tried to spin the bank's move as one that would "set a benchmark and restore a degree of confidence in the SIV sector." For anybody who is prepared to believe that palaver, HCM would only respond with the adage, "Fool me once, shame on you. Fool me twice, shame on me." There is no confidence to restore in the SIV sector because there is no viable SIV sector anymore. Cullinan and Asscher are a case in point since their assets are being removed from that very sector with this transaction! HSBC's SIVs have more than $34 billion of senior debt according to Moody's, making it the second largest bank sponsor of these ill-begotten vehicles after Citigroup (which is facing the prospect of adding about $40 billion of SIV assets back onto its balance sheet). Some observers viewed HSBC's move as a negative since it meant HSBC would not be participating in the Super-SIV, but HSBC would seem to be doing more than its part by assuming $45 billion of the estimated $300 billion problem.
HSBC's mortgage-related troubles may not be over, however. Goldman Sachs Group Inc. analyst Roy Ramos, wrote on November 24 that the bank may have to write down an additional $12 billion at its Household International Inc. unit. The bigger the banking institution, the bigger the clean up.
Bond Guarantors. In the meantime, SIVs are not the only financial entities needing bail outs from bad subprime bets. The French bank Natixis SA's bond-insurance unit, CIFG-guaranty, is being taken over by the bank's controlling shareholders, Caisse Nationale des Caisses d'Epargne (CNCE) and Banque Federale des Banques Populaires (BFBP). The shareholders will infuse $1.5 billion into CIFG in order to maintain the bond insurer's AAA rating. CIFG had previously been identified by rating agencies as the most likely of the bond insurers to lose its AAA rating. Upon news of the bailout, Standard & Poor's placed Natixis' credit rating on negative watch, an action that strikes HCM as akin to closing the barn door after the horses have run away. Why didn't Standard & Poor's place Natixis on negative watch before the bailout, when its subsidiary was still at risk, instead of afterward, when the risk had been addressed?
In a well-researched report that is best read with a stiff drink, JP Morgan Chase & Co. structured credit analyst Christopher Flanagan writes that financial guarantors are facing a "market-implied" $29 billion of losses on so-called "super-senior" CDO tranches against which these institutions have taken few reserves.(iii) The stocks of several of these firms, such as Ambac Financial Group and MBIA, Inc., have been pasted over concerns that the may lose their AAA credit ratings once their losses come to light. Losses on the order of $30 billion should be sufficient to jeopardize these ratings and send these companies searching for additional equity capital.
Citigroup, Inc. While the Abu Dhabi Investment Authority may not have bailed out Citigroup with its $7.5 billion purchase of convertible preferred stock to bolster the bank's balance sheet, there is no doubt that "the Citi that never sleeps" is sleeping much better after this much-needed infusion of capital. While the 11 percent dividend rate seems expensive, the deal is more complex than portrayed in the media and offers Citigroup significant benefits. Comparing the transaction in which besieged Countrywide Financial Corp. paid a 7.25 percent dividend to Bank of America Corp. for what was clearly a lifeline financing in August may be tempting but is not particularly instructive. Countrywide's stock has dropped by more than 50 percent since that deal was cut as the subprime crisis has worsened. Citigroup's Chairman Robert Rubin had promised to preserve Citigroup's dividend despite subprime writedowns expected to exceed $10 billion in the fourth quarter, although HCM suspects there are reasons beyond preserving the dividend that led the former Treasury secretary to raise this kind of capital. Moreover, if market conditions continue to deteriorate, the bank's better than 7 percent dividend rate may increasingly seem unnecessarily generous to Citigroup's board of directors. In any event, the bank's management is talking about making significant cost cuts to lower its expenses. Significant layoffs are a certainty (and not only at Citi but across the canyons of Wall Street). As a (microscopically) small Citicorp shareholder, HCM can only hope that Mr. Rubin can get his hands around the challenges facing this giant institution sooner rather than later. We can certainly think of few individuals better qualified to tackle the task. The last time Citigroup sought capital from the Middle East in troubled times, a Saudi Prince made billions of dollars of profit on his investment. This time around, HCM expects the Abu Dhabi Investment Authority to fare extremely well from its well-timed decision to step up to the plate. Frankly, we wouldn't have been surprised to see Warren Buffett making this investment and would look for him to take advantage of the rich terms that other financial institutions in need of capital are going to be offering in the weeks and months ahead.
Missed By A Mile
When you are in the business of making your opinions public, sometimes you just wish you could take it back. And right now, the Moody's analyst who published a research piece this summer entitled "SIVs: An Oasis of Calm in the Sub-prime Maelstrom" (July 20, 2007) must really be wishing he could push the delete button. Now HCM doesn't mean to pick on Moody's, but just as we are prepared to stand behind the opinions and forecasts expressed in this publication, so should an institution of the importance of Moody's. The conclusion of the rating agency's July 2007 report will undoubtedly enter the annals of financial history alongside Irving Fisher's prediction prior to the Great Depression that stock prices had reached a permanent high plateau. Just four months ago, Moody's wrote the following about the investment vehicles that were funded with short-term commercial paper to purchase long-dated illiquid structured finance paper whose investment grade ratings have since been down-graded by Moody's itself to junk bond levels:
"SIVs and SIV-lites, like most market value based structured credit funds, invest in Aaa and Aa US RMBS and CDOs of ABS. Exposures to these asset classes are limited in SIVs owing to the inherent diversity of their portfolios. The strict pricing and reporting discipline observed by SIVs and SIV-lites ensures that NAVs are reflective of asset market values within the funds. Furthermore, the vehicles are not structured to forcibly liquidate assets in times of crisis. Even in the face of a rapid and dramatic deterioration in NAV that results in an ability to roll liabilities, SIVs and SIV-lites may, prior to liquidating the portfolio, draw down on committed liquidity, withdraw breakable deposits and extract asset-backed liquidity (e.g., through the sale of short-maturity prime Aaa credit card and auto loan ABS). This obviates the need to liquidate large buckets of assets at potentially the worst period in the life of the vehicle. Moody's therefore expects ratings in the SIV and hybrid SIV sectors to remain stable amid the current maelstrom surrounding the US sub-prime housing market."
By the time this report was written, the handwriting was not only on the wall, it was stamped on the foreheads of the market participants (including, front and center, the rating agencies) who were struggling to find someplace to hide from the colossal mess they had created. This report is emblematic of a degree of denial or something far more nefarious on the part of those responsible for the SIV debacle. While it is HCM's instinct to give people the benefit of the doubt, it seems almost unduly generous to attribute an error of this degree at such a late date simply to the madness of crowds.
But whatever was going on, the financial markets are facing a severe crisis of confidence that will not be easily repaired. Gregory Peters, an investment grade credit analyst at Morgan Stanley, spoke of working himself into "a full-fledged bearish lather" as he surveyed the "derailment of the securitization process." The bereft Mr. Peters argued that "the subprime disaster is the proverbial canary in the coal mine that has also broadly affected the psychology of risk taking, which in turn has reverberated across the entire lending spectrum." Mr. Peters laid the blame right at the feet of the rating agencies: "Central to our domino-toppling concern is the clear lack of confidence in the credit system due to skepticism on credit ratings. The 2006 AAA RMBS cohort has had a downgrade severity factor of 12 times relative to history, with all rating classes experiencing a severity factor almost 200% the historical norm. The agencies must somehow restore credibility before the market can begin to heal in earnest." (iv) HCM is loath to argue with anything Mr. Peters says.
The problem is that the rating agencies are not done downgrading CDOs. So far this year, Standard & Poor's has downgraded 381 tranches of residential mortgage-related CDOs, but it still has 709 tranches on a watch list for further downgrades. Moody's has downgraded 338 issues with 734 tranches still sitting on its downgrade watch list. Does anybody seriously expect these watch-list credits to improve in any reasonably foreseeable period of time? Is it fair to ask whether the rating agencies are still in denial or merely trying to further delay the day of reckoning to give the markets more time to absorb further selling by ratings sensitive investors who will have to sell once the next wave of downgrades comes? The longer the comeuppance is delayed, the worse it will ultimately be. Delay and denial are not going to help solve the problem.
Just as the markets panicked when investment grade corporate credits like Enron and WorldCom turned out to be nothing of the sort, they have been similarly traumatized by the disclosure that the AAA ratings of subprime mortgage paper were a complete fiction based on flawed financial models. The subprime debacle may not have involved the degree of outright fraud that Enron and WorldCom did (although there was plenty of fraud to go around in many areas of the subprime mortgage market), but the entire premise of the market (including the structured credit market built up around it) was a total fabulation. Even for markets that continue to amaze the jaundiced HCM with the brevity of their memories, it may take a considerable amount of time for confidence to be restored.
Finally, the financial press continues to find itself challenged when it comes to accurately writing about Collateralized Debt Obligations. The latest faux pas appeared in a breakingviews.com column in The Wall Street Journal on November 26, 2007 under the headline "The Nine Lives of CDOs." In trying to explain how the technology used successfully to securitize corporate bank loans was cloned into less successful vehicles like subprime mortgage CDOs, the columnist Antony Currie wrote: "To fund the purchase of the loans, the CLO issues debt, which offers higher returns than traditional bonds. That is usually because the combined face value of the loans it buys is greater than the face value of the debt is issues." These statements are misleading. The first sentence is essentially meaningless, since the term "traditional bonds" has no meaning of which we are aware. But the statement that face value of the CLO assets (i.e. the loans purchased) exceeds the face value of the CLO liabilities (the investment grade rated CLOs sell to finance themselves) is simply wrong. In a typical CLO structure, the face amount of the liabilities always exceeds the face amount of the assets by the amount of the fees incurred to put together the deal (generally between 1 and 2 percent). This means that the equity investor is generally under water on a liquidation basis on day one, although this has no practical effect because these are long-dated vehicles that produce more than sufficient cash flow over their lives to replenish the till and return the equity investor's original investment plus a double digit return. If the financial press can't get the basics of these structures right, what is going to happen when the politicians get their hands on these complex vehicles and try to legislate them in the wake of the massive losses incurred in the mortgage space?
General Motors Corp. - Into the Abyss?
HCM has long maintained that General Motors will ultimately end up restructuring under the aegis of bankruptcy, and recent events continue to lend credence to that view. The most recent piece of evidence was the automaker's decision to write-off $38.6 billion of deferred taxes. Deferred taxes are an asset that companies carry on their balance sheet when they expect to be profitable in the future. They stem from past losses and are used to shelter a company's future income from taxes. For a company that is expected to return to profitability, deferred taxes are an extremely valuable asset since they effectively allow a company to retain 100 percent of its profits for as long as the deferred tax account lasts.
By writing off $38.6 billion of deferred taxes, General Motors is not merely removing that amount of value from its balance sheet. The company is also admitting that it does not expect profits to return to any significant extent in the foreseeable future because it is effectively saying that it will not have any profits to shelter with these deferred taxes. That is a remarkable admission, and one that must be contrasted with the optimistic statements made by management about the former auto giant's recovery efforts. In so many words, this is an admission by General Motors' management (driven by its financial staff and outside auditors, most likely) that the company's goose is cooked. With a stock price below $30 dollars per share (see Figure 1 below), the quarterly loss resulting from this writeoff was a whopping $68.85 per share. HCM is certain that many observers tried to seek comfort in the non-cash nature of this charge, but those that did missed the point.
The bad news does not stop there, however. For General Motors lost money in 2007's third quarter even before this gargantuan writedown. The bottom line is that the company's 2005 restructuring plan is not bearing fruit. While global automotive operations were profitable in the first half of 2007, declining industry sales in core North American and European markets outran cost cutting efforts in the third quarter. The company's restructuring plan was based on projected industrywide U.S. auto sales of 17.5 million units; actual sales are tracking closer to 16 million. (Who comes up with these projections? Is anybody paying attention to the housing and consumer economy up at GM's headquarters?) Even worse, the company has been unable to sell assets fast enough to replenish the cash it is consuming.
General Motors and Residential Capital LLC (or When It Rains, It Pours)
And GM's problems do not stop at the automobile business. The company reported a $757 million loss on its 49 percent interest in GMAC, the majority interest in which it sold to the buyout group Cerberus Capital Management LP ("Cerberus") last year. The previously profitable GMAC is being throttled by losses at Residential Capital LLC ("ResCap"), a home-mortgage business that was/is (surprise!) a big subprime mortgage player (reportedly the eighth largest home mortgage lender in the country).(vi) ResCap's bank debt price collapsed to the low-to-mid-80s in mid-November, while the company's bond prices collapsed to about 60 cents on the dollar, suggesting that markets are expecting a default sooner rather than later. This was further confirmed by the trading levels of the company's credit default swaps. By mid-November, the purchase of five-year default insurance on ResCap bonds cost more than 40 points up front and 500 basis points per year. In layman's terms, that meant that buying protection on $10 million of ResCap bonds cost more than $4 million up front plus $500,000 per year. This would entitle the purchaser of protection, in the event of default, to a payment equal to $10 million minus the fair market value of $10 million of ResCap bonds. So if ResCap bond traded down to 40 cents on the dollars (or $4 million for $10 million face amount) upon a bankruptcy filing, the buyer of protection is entitled to a payment of $6,000,000 from the seller of protection.
The reason for this panic on ResCap could be found in a November 15, 2007 article in The Wall Street Journal reporting that ResCap's net worth had declined to $6.2 billion at the end of the third quarter of 2007 (down $2.2 billion in a year), only $800 million above a covenant-busting $5.4 billion that must be met as of December 31, 2007 to avoid violating the company's unsecured debt agreements. Tripping those covenants would give ResCap's creditors the right to demand immediate repayment of $3.9 billion that the company doesn't have, although a more likely outcome is that lenders would give the company a waiver in exchange for a fee or collateral that would further cook the goose of the company's bondholders.
Not everybody, however, is negative on the credit. Lehman Brothers, Inc. issued a research report on November 19 upgrading ResCap's 6.125s of November 2008 to "Overweight." At a price of $64.50 and a 59 percent yield, Lehman believes that the "potential return is more than enough compensation for the high default risk, especially considering the downside is limited by the recovery rate, which we (Lehman) project(s) would be above 60%." HCM would only cite in response the old investment adage about there being a difference between the return on one's money and the return of one's money. If a bond is trading at a 59 percent yield, it should be avoided except by those investors with a pathological compulsion to take risk. Right before Thanksgiving, obviously feeling the pressure to take some action to stop the freefall in ResCap's debt, Cerberus announced that it was considering repurchasing some ResCap debt at a discount, which would prop up the company's net worth and delay a covenant violation. While a clever financial engineering solution, a debt repurchase would do little to solve the underlying business problem, which is the infirmity of the subprime mortgage business. Moreover, the company is facing large debt maturities in 2008 that would only be marginally impacted by the debt buyback scheme.
In 2008, ResCap has $4.5 billion of debt coming due as follows: $250 million in May; $1.25 billion in June; $1.75 billion in July; and another $1.75 billion in November. Unless Cerberus is going to write the checks (HCM views the chance of that happening as very small), ResCap is not going to be able to refinance these debts and would have to use all of its remaining cash on hand to repay them. The only other scenario is a sudden turnaround in the subprime mortgage market, and the odds of that happening are about the same as Cerberus simply writing a $4.5 billion check. If Cerberus were to step up with additional financing, the terms would be very onerous for existing lenders based on the private equity firm's reputation as tough-minded negotiators. A ResCap restructuring in 2008 is a near-certainty.
ResCap is not the only mortgage company at risk of disappearing into the abyss. Figure 2 on the next page shows the stock of Freddie Mac dive-bombing on November 20 after the shrinking mortgage giant announced a larger-than-expected third quarter loss of $2.03 billion that lowered its capital base to dangerously low levels. This news shattered the confidence of the markets in financial stocks (for all of about a week before stocks rallied off their lows on statements by Federal Reserve Vice Chairman Kohn and Chairman Ben Bernanke that the central bank was waking up to the problem).
In fact, the loss reduced Freddie's core capital by two-thirds to a mere $600 million above regulatory requirements. Standard & Poor's immediately confirmed the company's AAA senior debt rating based on the longstanding assumption that the U.S. government would rescue Freddie in a crisis, but changed its outlook from stable to negative on its AA- rating of the risk that Freddie poses to government coffers (i.e. taxpayers), as well as on its subordinated debt and preferred stock. The real issue, which has been written about by Christopher Wood for a couple of years, is that Freddie and the larger Fannie Mae have been aggressively supporting the expansion of the mortgage market for the past several years and will now be pulling in their horns. Shrinkage of these entities' balance sheets - even a slowdown in their growth - will contribute to the withdrawal of capital from the economy that the subprime mortgage meltdown is causing. America's debt-driven economy is rapidly being deprived of its lifeblood. About a week after announcing this loss, Freddie Mac has announced that it will seek $6 billion in additional equity and halve its dividend to atone for its sins. Unlike Citigroup, however, Freddie will seek its capital in the public markets rather than trying to work a deal with a single deep-pocketed investor.
(i) Peter Warburton, Debt and Delusion Central Bank Follies That Threaten Economic Disaster (London: Penguin Books, Ltd., 1999), p. 1.
(ii) Hoisington Investment Management Company, Quarterly Review and Outlook, Third Quarter 2007.
(iii)Christopher Flanagan, JP Morgan Chase, US Fixed Income Markets 2008 Outlook, November 23, 2007.
(iv) Gregory Peters, Primary Analyst, Morgan Stanley, Investment Grade Credit, "Standing on the Razor's Edge," November 9, 2007.
(v) UBS Investment Research, Mortgage Strategist, November 27, 2007, pp. 27-28.
(vi) Why is it that large enterprises can't limit themselves to one money-losing business but always manage to get involved in all of the worst businesses at the same time? It's like they have a nose for trouble.
I trust you enjoyed this as much as I did. Have a great week.
Your very concerned about the credit crunch analyst,