Thoughts on the Continuing Crisis
There is so much that is happening each and every day as the Continuing Crisis moves slowly into month 8, so much news to follow, so many details that need to be followed up that it can get a little overwhelming. Where to begin? Maybe with a "minor" change of the rules on how we value assets, then a look at the proposed changes in regulations, some comments to my hedge fund friends, a quick look at the employment and ISM numbers which are clearly showing we are in a recession and then finish up with some thoughts as to what it all means. There is a lot of ground to cover, so we will jump right in without a "but first" today.
If the Rules are Inconvenient,
Change the Rules
Several times in the past few months I have reminded readers of the
problem that developed in 1980 when every major American bank was
technically bankrupt. They had made massive loans all over Latin
America because the loans were so profitable. And everyone knows that
governments pay their loans. Where was the risk? This stuff was rated
AAA. Except that the borrowers decided they could not afford to make
the payments and defaulted on the loans. Argentina, Brazil and all the
rest put the US banking system in jeopardy of grinding to a halt. The
amount of the loans exceeded the required capitalization of the US
Not all that different from today, expect the problem is defaulting
US homeowners. So what did they do then? The Fed allowed the banks to
carry the Latin American loans at face value rather than at market
value. Over the course of the next six years, the banks increased
their capital ratios by a combination of earnings and selling stock.
Then when they were adequately capitalized, one by one they wrote off
their Latin American loans, beginning with Citibank in 1986.
The change in the rule allowed the banks to buy time in order to
avoid a crisis. It did not change the nature of the collateral. They
still had to eventually take their losses, but the rule change allowed
both the banks and the system to survive. I have made the point that
the Fed and the regulators would do whatever it has to do to manage
All the major new multi-hundred billion dollar auctions at the Fed
where the Fed is taking asset backed paper as collateral for US
government bonds does not make the collateral any better, of course.
It just buys time for the institutions to raise capital and make
enough profits to eventually be able to write off the losses.
Thus it should not come as a surprise to you, gentle reader, that
the rules have been changed in much the same way as in 1980. In an
opinion letter posted on the SEC website last weekend clarifying how
banks are supposed to mark their assets to market prices is this
little gem (emphasis mine):
"Fair value assumes the exchange of assets or liabilities
in orderly transactions.
Under SFAS 157, it is appropriate for you to consider actual market
prices, or observable inputs, even when the market is less liquid than
historical market volumes, unless those
prices are the result of a forced liquidation or distress
sale. Only when actual market prices, or relevant
observable inputs, are not available is it appropriate for you to use
unobservable inputs which reflect your assumptions of what market
participants would use in pricing the asset or liability."
(The full letter is at http://www.sec.gov/divisions/corpfin/guidance/fairvalueltr0308.htm.)
So, now banks can simply say that the low market prices for assets
they hold on their books are actually due to a forced liquidation or
distress sale and don't reflect what we believe is the true value of
the asset. Therefore we are going to give it a better price based on
our models, experience, judgment or whatever. In today's Continuing
Crisis, nearly every type of debt and its price can be classified as a
forced liquidation or distressed sale.
Does this make the asset any better? Of course not. But it buys
time for the bank to raise capital or make enough profits to
eventually take whatever losses they must. And who knows, maybe they
will get lucky and the price actually rises?
There are two problems with this rule. First, it clearly creates a
lack of transparency. The whole reason to require banks to mark their
assets to market price rather than mark to model was to provide
shareholders and other lenders transparency as to the real capital
assets of a bank or company.
Second, can a forced liquidation or distress sale be from a margin
call? Obviousy the answer is yes. But as Barry Ritholtz points out,
this opens the door for some rather blatant potential manipulation. If
a bank makes a margin call to hedge funds or their clients to make the
last price of a similar derivative on their own books look like a
forced liquidation, do they then get to not have to value the paper at
its market price? Is this not an incentive to make margin calls? One
price for my customers and a different one for the shareholders? If a
hedge fund was forced to sell assets and then they find out that the
investment bank is valuing them differently on their books than the
price at which they were forced to sell, there will be some very upset
managers and investors. Cue the lawyers.
Is this a bad ruling? Of course. But is it maybe necessary? It just
might be. My first reaction was that this tells us things are much
worse than we think. The struggle to get the mark to market ruling
only to abrogate it in certain circumstances less than a year later
has to gall a lot of responsible parties. It seems like it is 1980 and
Latin America all over again. Let me repeat: The Fed and the Treasury
(who oversees the SEC) will do what it takes to keep the game and the
Let's Re-arrange the Deck Chairs
Treasury Secretary Hank Paulson put forth a number of "new" ideas
for changes in the regulatory structures. Nothing I saw will help all
that much in the current crisis. It's more like re-arranging the deck
chairs as the ship is going down. It seems like most of it is being
proposed to prevent another crisis like the one we are in from
occurring in the future. That simply insures that Wall Street will
have to invent whole new ways to create a crisis in the future. I am
sure they will be up to the task.
Most of the proposals are basically good ideas that have been
discussed for a long time, like merging the CFTC (Commodity Futures
Trading Commission) and the SEC. We are the only country with such a
bifurcated regulatory system. Good luck with getting that through
Congress, though. The Agricultural Committees in the Senate and the
House oversee the CFTC and futures trading, dating back to the 1930's
when all that was traded was agricultural products. Now the CFTC
oversees a vast derivatives market, which of course makes campaign
donations to members of those committees. Think those Congressman want
to see their major campaign donors go away? Of course, that means the
Finance Committees would get new donors. It will be amusing to watch
and see who "wins."
The really interesting item is the potential for the Fed to
regulate investment banks, which makes some sense if they are going to
loan them money at the discount window. Left unsaid and up for future
negotiation is whether that would mean investment banks would have to
reduce their leverage. Right now, investment banks utilize about twice
the leverage as commercial banks. That leverage is what makes them so
profitable. Take that away and they lose a lot of their profit
A great part of the continuing crisis can be laid at the feet of
too much leverage in too many places. The world is de-leveraging
fairly rapidly. In some circles, it looks more like an implosion. The
Fed and the SEC have made it very clear they want to have more
authority to oversee all sorts of funds and investment banks so they
can get a handle on the amount of leverage in the system. What you do
with that information is another thing, but they want it and will use
the Continuing Crisis to get that authority. My bet is that investment
banks are going to be forced to reduce their overall leverage "for the
good of protecting the system from itself" or some such twisted
So, let's sum it up. The problem is so severe with the financial
companies assets that the SEC is going to allow some of them to "cook
the books" so they can survive. That means there are going to be large
and continuing write-downs for many quarters to come. There is a
minimum of another $3-400 billion in write-downs (and maybe a lot
more) coming from mortgage related assets, not to mention credit cards
and other consumer related debt. And the investment banks may be
forced to reduce their leverage and thus their profitability?
Putting money in the major financial stocks is not investing. It is
gambling on a very uncertain future. There is simply no way to know
what the value of the franchise is. There are other places to put your
Regulations Coming to a Hedge
Fund Near You
The SEC pushed through rules last year to regulate hedge funds. The
courts ruled (properly, I think) that the SEC did not have
congressional authority to do so. The hedge fund industry fought tooth
and nail to avoid regulation and dodged the bullet.
I think the mood in Congress is going to be such that as the
authorization for many of Paulsen's proposed changes make their way
through Congress, some of them are going to allow the SEC the
authorization they need to regulate hedge funds. The Continuing Crisis
almost makes it a sure thing.
So, a quick note to my friends in the hedge fund industry. Forget
fighting regulation and start negotiating. Recognize that regulations
are coming and do what you can to make them as rational as possible.
Also, make sure you (we) get the rights of other regulated funds, like
the ability to advertise and not be so secretive, at a minimum. And
maybe a more reasonable interpretation of the research analyst rules,
which I note that many seem unaware of the implications on hedge funds
and private offerings of the research analyst rules.
I am regulated by FINRA (the former NASD) which is overseen by the
SEC, the NFA (the self-regulatory arm of the CFTC) and various state
financial authorities. It seems like we get a regulatory audit almost
every year from someone. My small firm survives, and so will hedge
funds. Does it cost a lot of money and time to be regulated? Sure. But
that is the price of doing business.
Will making hedge funds register make them any safer? I doubt it.
Think of Enron and WorldCom. REFCO was registered and somehow hid a
$500 million dollar bogus loan from regulators, their investment
bankers and auditors. But it will make them more transparent. If we
are going to have to pay the costs of being regulated let's make sure
we get the benefits.
More Fun in the Unemployment
Payrolls tumbled by 80,000 today, more than forecast and the third
monthly decline, the Labor Department said today in Washington. The
unemployment rate rose to 5.1%, the highest level since September
2005, from 4.8%. The household survey shows the number of unemployed
people rose by 438,000. (That is not a typo!) In March, the number of
persons unemployed because they lost jobs increased by 300,000 to 4.2
million. Over the past 12 months, the number of unemployed job losers
has increased by 914,000.And of course, when you look into the numbers
it is worse than the headlines implies.
Prediction: we will see 6% unemployment before the end of the
There were negative revisions totaling 67,000 job losses for the
last two months, making those months even worse. This means that the
Bureau of Labor Statistics (BLS) is clearly over-estimating the number
of jobs in the first announcement. That is because they have to
extrapolate based on recent past data. And as I continually point out,
as the economy softens, they are going to continue to overestimate the
number of jobs. It's one of the problems of using past performance to
predict future results.
Job losses since December are now at 286,000 in the private sector
and 232,000 overall, counting for growth in government. What was up?
Health care (23,000) and bars and restaurants (23,000 also). Initial
unemployment claims are up by almost 25% for the last four weeks over
last year, and this week were over 400,000. Given the job losses, this
is not surprising.
This month the BLS hypothecates 142,000 jobs being created in their
birth/death model. You can guarantee this will be revised down. For
instance, they assume the creation of 28,000 new construction jobs as
the construction industry is imploding. Total construction spending
has fallen for the last four months in a row. Somehow they estimate
6,000 new jobs in the finance industries. Does anyone really think we
saw a rise in employment in mortgage and investment banks?
Buried in the data is a picture of a squeezed consumer. Inflation
is now running ahead of the growth in wages. As the chart below shows,
average hourly earnings were up just 3.6%, but inflation was 4.5%.
That means consumers must struggle to maintain their standard of
living. No wonder retail stores shed 12,000 jobs last month. Light
vehicle retail sales are down by 20% form last year. This all paints a
picture of a very challenged consumer.
A Muddle Through Recession
The business sector is clearly in recession. The ISM manufacturing
index came in at 48.6. Anything below 50 means manufacturing is in
decline. There was a sharp drop in new orders. New orders have been
below 50 for four months. Employment has been below 50 for four
months. Backlog of orders has been well below 50 for six months.
Yesterday the ISM service index was again below 50 for the month of
Given all the data, why then do I still think we will not see a
deep recession? Because corporate America is in much better shape than
in the beginning of past recessions. Lower inventories, better cash to
debt ratios, not as much as excess capacity, and so on. As Peter
Bernstein notes in his latest letter, nonfinancial corporate debt is
at its lowest level in 50 years, and four standard deviations below
the average from 1960 to 2000.
The recession we are now in is a consumer spending led recession
driven by a falling housing market which is infecting the entire
country. Can anyone still claim that the subprime problems would be
contained as many did just last summer? Consumer spending is going to
fall even more as credit becomes harder to get.
The situation is neatly summer up by Bernstein:
"The debate over whether we are or are not in a recession
continues. There is, however, no debate about resumption of rapid
economic growth in the near future. That's without question the most
unlikely outcome. Yes, there are some bright spots, such as exports in
the governmental largess that lies just ahead - and the likelihood of
additional government assistance in some form. The Federal Reserve is
also doing its part to lubricate the snarls in the financial
"But the household sector is in deep trouble and will remain in
trouble for an extended period of time. The combination of falling
home prices, the complex problems in the mortgage area, limited
financial resources and high debt levels, new constraints and higher
costs on consumer installment credit, and probably rising unemployment
already sluggish growth and jobs tend to restrain spending by the
largest and most important sector of the economy.
"Imagine what would happen if all of these adverse forces struck a
business sector stuffed with inventories, busy installing a massive
amount of new productive capacity, with labor costs rising and
productivity falling, and an overload of new debt to service. A
difficult situation in the rest of the economy could be rapidly
converted into a deep recession. But the business sector has kept
inventory accumulation to a moderate pace, has limited in capacity
growth, and has been conservative in adding to debts outstanding. How
lucky can you get?
"Some observers are convinced that we are heading toward a deep
depression in any case. We are not so sure. We believe the likely
duration of these troubles is a greater concern than the depths the
system might reach. The condition of the business sector as pictured
above is the primary reason for this more hopeful outlook."
But a recession for at least two quarters and a Muddle Through
Economy for at least another 18 months is not going to be good for
consumer spending, job creation and most especially corporate profits.
I continue to predict more disappointment for corporations that are
tied to consumer spending and industries that are associated with
S&P analysts continue to project earnings to be up by 15% in
the third quarter of this year and by almost 100% for the fourth
quarter this year over last year. Yes, I know there are a lot of one
time charges and write-offs in the last two quarters of last year
which make comparisons difficult. But in a recession and a slow
recovery, how likely is it that we will not see even more "one-time"
write-offs. And as noted above, there are more than twice as much
subprime losses in our future as we have written off as of yet.
As I have written about at length in past issues, bear markets are
made by continued earnings disappointments. It typically takes at
least three difficult quarters to truly disappoint investors. We are
just in the early stages. The recent drop in the stock market has been
primarily caused by the Continuing Crisis in the credit markets, and
only modestly by disappointing earnings. We need a few more quarters
of disappointment to really get to a bottom in the stock market. It
could be a long summer.
How Much do we Borrow for a $1
growth in GDP?
Finally, I want to give you a chart from my old friend Ian McAvity
from his latest newsletter Deliberations, which he has been writing
for 36 years! Basically, it makes the point that the amount of new
debt in relationship to GDP is rising. We borrowed in one form or
another $5.70 for each $1 rise in GDP last year.
Debt in all forms rose $7.86 trillion for the previous 8 quarters
to $48.8 trillion dollars. Nominal GDP was only $14.1 trillion. This
is of course unsustainable. At some point, debt growth must slow
dramatically. As the world deleverages, decreasing debt and the
resultant slowing of consumer spending will become a head wind for GDP
London, Switzerland and South Africa
Next Wednesday I head out to California for my 5th
annual Strategic Investment Conference in La Jolla. It is completely
sold out for the first time. My partners in the conference, Altegris
Investments have been doing yeoman work to make it come off in high
fashion, and I thank them. I return and immediately head over to
London and then Switzerland. I will be speaking for Bank Sarasin at a
resort in Switzerland in the Interlaken area, and will stay on for a
few days to be tourist and take some needed R&R and fly back on
I will be in South Africa in Johannesburg from May 5 - 8 and in
Cape Town from May 12 - 14. If you are interested in attending my
presentations you should contact Prieur du Plessis. You can use the
contact button on his excellent blog: www.investmentpostcards.com.
I am going to try and play golf for the first time in at least a
year. I will be terrible, but I will be playing with good friend and
savvy commodity trader Greg Weldon and I look forward to it. Then in
the afternoon two of the best Science Fiction writers and futurists in
the world, Vernor Vinge and David Brin are going to join me, serious
technology maven Dr. Bart Stuck and financial guru and brilliant
thinker Rob Arnott for two hours of rambling conversations about the
future. My daughter Tiffani wants to record it, and if we do (and with
everyone's permission) we will post it on the net. Then 240 new and
old friends gather Friday and Saturday to hear some really interesting
speakers and enjoy each other's company. It looks to be a great
I hope you can enjoy your week as much as I will. And make it a
good one. Now if the Rangers can just win their home opener on
Tuesday, it will get even better.
Your amazed at how lucky I am analyst,
Copyright 2008 John Mauldin. All Rights Reserved
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