The Fed can act to control the overnight interest rate in two different ways. In one of them it buys or sells treasury bonds to establish its target for that rate on a "permanent" basis. The other way is to buy bonds on a "temporary" basis with repurchase agreement. This is done in case of transient dislocations, to bring the rate back to the target. This is precisely what the Fed is doing now. It is very important to distinguish the implications of one and another actions. With the first move, not only liquidity is pumped into the system, but it also improves solvence since troubled debtors will have a relief in their debt burden. The second helps liquidity only, preventing the credit crunch from killing the good guys.
Needless to say that the persons who are struggling to repay their mortgages will see no improvement in their situation, and so the problem will continue. There is no reason for the stock market to cheer the move. The crisis is indeed a matter of solvence. Wall Street is yelling at the Fed to lower the target rate, so that the party will go on. That's precisely why the Fed should not move. Otherwise the problem will simply snowball into the future. The cost of ending it later on will just increase.
It is worth noting that the ECB poured much more money into the European system than the Fed did in the US. Today the ECB injected 65 billion dollars in their system, against paltry 2 billion from the Fed. This might be an indication that the epicenter of the quake is in Europe...
8/13/07
8/12/07
What is being missed
There is (at least) one thing all the "pundits" touting the stock market to unconscious investors are not telling you: the recession that will come in the wake of the subprime snafu. Would you invest any penny in "subprime" securities? If your answer is "yes", please, drop your name and phone number for I will sell you the Brooklin Bridge. If there is one thing on which all the 300 million Americans have a full consensus now is that they will never put a penny in that market.
What is the consequence of this decision? The collapse of a model. Teasing mortgage applicants without creditworthiness with interest-only ARMs will not work anymore. This implies that those fellows will be out of the market. As a consequence the low-end of the real estate market will be in severe distress. But not only. The overwhelming majority of the persons who buy a house must sell theirs to buy the other one, in recent times, an upgrade more often than not. Needless to say that this will have a rippled effect percolating the entire housing market, cooling it down even further. The price depreciation will continue, leading to a renewed round of construction curtailing, thereby increasing unemployment. Considering that some 10 percent of the Americans work in fields related to housing, it is more than reasonable to assume that a fair share of those jobs will be gone. The economic activity will slow down considerably. Companies will have lower profits, which will lead to an obvious adjustment of the P/E ratio of their stocks.
Please, note that this analysis does not have anything to do with the credit snafu, panic selling, correction of the Bourses worldwide, repricing risk, BC interventions, etc, etc. These factors may only influence the negativity of the fundamentals, as detailed above. So beware of those economists and politicians who come out on the media telling you how solid the fundamentals of the economy are. For they are not.
What is the consequence of this decision? The collapse of a model. Teasing mortgage applicants without creditworthiness with interest-only ARMs will not work anymore. This implies that those fellows will be out of the market. As a consequence the low-end of the real estate market will be in severe distress. But not only. The overwhelming majority of the persons who buy a house must sell theirs to buy the other one, in recent times, an upgrade more often than not. Needless to say that this will have a rippled effect percolating the entire housing market, cooling it down even further. The price depreciation will continue, leading to a renewed round of construction curtailing, thereby increasing unemployment. Considering that some 10 percent of the Americans work in fields related to housing, it is more than reasonable to assume that a fair share of those jobs will be gone. The economic activity will slow down considerably. Companies will have lower profits, which will lead to an obvious adjustment of the P/E ratio of their stocks.
Please, note that this analysis does not have anything to do with the credit snafu, panic selling, correction of the Bourses worldwide, repricing risk, BC interventions, etc, etc. These factors may only influence the negativity of the fundamentals, as detailed above. So beware of those economists and politicians who come out on the media telling you how solid the fundamentals of the economy are. For they are not.
8/9/07
The juggernaut makes another step
The first post from this blog happened yesterday, after a 3-day rally of the insane bull run of the stock market. Therefore nobody can charge it as a go-with-the-herd movement. Today's precipituous decline was triggered by the French Paribas. With a very shabby excuse that they were closing three funds on the grounds that "with the currrent volatility they had no means to determine valuation", they prompted the intervention of the European Central Bank, which provided "unlimited" loans to the European banks at 4% interest rate. Not even after September 11th they made such a move!
The Fed doubled the reserve loans to overnight lending, from 12 to 24 billion dollars, a much more modest move. History will tell us whether the Fed was too timid, the Europeans were too bold, or if the latter had some other problems to address.
The fact of the matter is that the additional liquidity did not calm the markets, that experienced a steep decline worldwide. It might have added insult to injury, unnerving the investors even further.
AIG, one of the top insures in the planet, came out of the closet to inform that they were experiencing non-subprime default rates above average. This was the coup-de-grace Wall Street needed for the day.
Beware of "pundits" and soothsayers with interests vested in the status quo telling you that the fundamentals are solid, for they are not. That the stock market is for the long-runners, for it is not. The companies whose shares you hold now may not be alive in the near future. They just want you to provide the cushion for their bail-out.
Goldman-Sachs also came out of the closet today, announcing steep losses in some of their hedge funds. Dozens of small players are already history, but they are not big enough to deserve headlines.
There is another (very) negative driving force to the markets now. The second brouhaha brought in by the excess liquidity created by the Fed, the Leveraged Buy-Outs, is fizzling. Or maybe not. But now they are acting in the opposite direction. How come?
Up until now, they took money from investors to fund 10/12ths of the purchase of any target company. The rest came from their own pocket. However this should match no more than the cash flow (EBITDA) of the acquired. So far so good, a naive reader could think, for they still have to make money for the T part of the EBITDA. Wrong. The just downloaded the debt onto the company balance sheet, whose service would be tax-free!!!! The tax-payers financing the party! This means that any tiny improvement in that cash flow would mean huge profits for the Equity Fund that acquired the company. And if the company goes under because of such a hefty debt? The suckers that held the vast majority of the debt would be wiped out. Who are those "suckers"? Hedge funds, so the hell with them. But not only. University endowments, pension funds, union funds, etc. have also been part of that group. What will happen to that investment as the economy undergoes a (mild) recession? The decrease in cash flow will turn those huge profits into huge losses. Is it why Blackstone just went public? Time will tell. Maybe shorter than expected.
How the force is turning from positive to negative? Obviously the current liquidity squeeze is generating an increase in private-lending interests. As much as three percent in recent weeks. So the equity funds are cornered with three options:
1- End the party. Ho, ho, ho.
2- Increase their exposure. Ho, ho, ho, ho, ho.
3- Drive the price of the stocks down. Bingo!
The third option just happened today with Home Depot. Slighly more than 5% decline in the day. Because their highly-touted LBO has just gone sour, and they received a lower second offer from the equity fund buying them out.
And, please, for your own sake, don't get too excited with dead-cat bounces.
The Fed doubled the reserve loans to overnight lending, from 12 to 24 billion dollars, a much more modest move. History will tell us whether the Fed was too timid, the Europeans were too bold, or if the latter had some other problems to address.
The fact of the matter is that the additional liquidity did not calm the markets, that experienced a steep decline worldwide. It might have added insult to injury, unnerving the investors even further.
AIG, one of the top insures in the planet, came out of the closet to inform that they were experiencing non-subprime default rates above average. This was the coup-de-grace Wall Street needed for the day.
Beware of "pundits" and soothsayers with interests vested in the status quo telling you that the fundamentals are solid, for they are not. That the stock market is for the long-runners, for it is not. The companies whose shares you hold now may not be alive in the near future. They just want you to provide the cushion for their bail-out.
Goldman-Sachs also came out of the closet today, announcing steep losses in some of their hedge funds. Dozens of small players are already history, but they are not big enough to deserve headlines.
There is another (very) negative driving force to the markets now. The second brouhaha brought in by the excess liquidity created by the Fed, the Leveraged Buy-Outs, is fizzling. Or maybe not. But now they are acting in the opposite direction. How come?
Up until now, they took money from investors to fund 10/12ths of the purchase of any target company. The rest came from their own pocket. However this should match no more than the cash flow (EBITDA) of the acquired. So far so good, a naive reader could think, for they still have to make money for the T part of the EBITDA. Wrong. The just downloaded the debt onto the company balance sheet, whose service would be tax-free!!!! The tax-payers financing the party! This means that any tiny improvement in that cash flow would mean huge profits for the Equity Fund that acquired the company. And if the company goes under because of such a hefty debt? The suckers that held the vast majority of the debt would be wiped out. Who are those "suckers"? Hedge funds, so the hell with them. But not only. University endowments, pension funds, union funds, etc. have also been part of that group. What will happen to that investment as the economy undergoes a (mild) recession? The decrease in cash flow will turn those huge profits into huge losses. Is it why Blackstone just went public? Time will tell. Maybe shorter than expected.
How the force is turning from positive to negative? Obviously the current liquidity squeeze is generating an increase in private-lending interests. As much as three percent in recent weeks. So the equity funds are cornered with three options:
1- End the party. Ho, ho, ho.
2- Increase their exposure. Ho, ho, ho, ho, ho.
3- Drive the price of the stocks down. Bingo!
The third option just happened today with Home Depot. Slighly more than 5% decline in the day. Because their highly-touted LBO has just gone sour, and they received a lower second offer from the equity fund buying them out.
And, please, for your own sake, don't get too excited with dead-cat bounces.
8/8/07
Subprime? Just a detail...
That's how the crash started. We are watching it in the making, slow motion, but inexorable as a juggernaut. The first body to come to surface was New Century. Then Bear Stearns, the kagaroo funds, and more recently, American Home Mortgage. Just to mention the ones that made the headlines. Let's always keep in mind that it all started with stupid lending, the most prolific historical recipe for financial turmoil. The Fed overreacted to the market correction of 2000/2001. Made the economy awash of money. The money migrated to real estate. Eventually everyone who could walk into a mortgage shop could buy a piece of the bubble, in a gigantic "Ponzi scheme".
Why the comparison to the scheme? Because it would be impossible to end without a crash for the late entrants. Why would one individual take an interest-only ARM loan? Because he could not afford the fixed-rate. What will he do when the rate resets? Well, if one can not afford lunch, he will not be able to afford dinner either, isn't that right? So that individual is left with only two options: to take a second-lien mortgage to continue to pay the debt - which is equivalent to eat his own arm for lunch - or to default. Considering that the first option only works as long as the real estate price goes up, when it comes down - as the situation is now, countrywide - the only option left is defaulting.
So far this year only 20% of the brouhaha was reset, around 200 billion dollars. The worst has yet to come. And it will come. In the following months during the second half of this year more than 300 billion dollars in subprime loans will reset. In February and March next year alone, almost 200 billion more will come to play. More than 80% of the real estate sold in California in recent months were interest-only loans. Hedge funds are already losing a phenomenal amount of money. They have CODs, which consist of packs of Mortgage Backed Securities, which in turn are packs of mortgage loans. CODs have their "value" determined by "analysts". Smells an awful lot like Michael Milken's rating of junk bonds.
Let's not forget that AHM did NOT operate in the subprime field. Filed for bankruptcy this week. The lenders cut it off. Big guys are coming to assuage the fears of the market. But the fact of the matter is the the snake's eggs have been laid already. There is no way out. The dam is going to burst. The outcry for the Fed's intervention resembles to the crushed hopes the same kind of speculators had in 1929. Someone with less scruples hinted that Fred Mac and Fannie Mae step in to bail them out. That is almost criminal: they profit handsomely from the mess and give the taxpayers the burden of sorting it out. The plain definition of (im)moral hazard.
Why the comparison to the scheme? Because it would be impossible to end without a crash for the late entrants. Why would one individual take an interest-only ARM loan? Because he could not afford the fixed-rate. What will he do when the rate resets? Well, if one can not afford lunch, he will not be able to afford dinner either, isn't that right? So that individual is left with only two options: to take a second-lien mortgage to continue to pay the debt - which is equivalent to eat his own arm for lunch - or to default. Considering that the first option only works as long as the real estate price goes up, when it comes down - as the situation is now, countrywide - the only option left is defaulting.
So far this year only 20% of the brouhaha was reset, around 200 billion dollars. The worst has yet to come. And it will come. In the following months during the second half of this year more than 300 billion dollars in subprime loans will reset. In February and March next year alone, almost 200 billion more will come to play. More than 80% of the real estate sold in California in recent months were interest-only loans. Hedge funds are already losing a phenomenal amount of money. They have CODs, which consist of packs of Mortgage Backed Securities, which in turn are packs of mortgage loans. CODs have their "value" determined by "analysts". Smells an awful lot like Michael Milken's rating of junk bonds.
Let's not forget that AHM did NOT operate in the subprime field. Filed for bankruptcy this week. The lenders cut it off. Big guys are coming to assuage the fears of the market. But the fact of the matter is the the snake's eggs have been laid already. There is no way out. The dam is going to burst. The outcry for the Fed's intervention resembles to the crushed hopes the same kind of speculators had in 1929. Someone with less scruples hinted that Fred Mac and Fannie Mae step in to bail them out. That is almost criminal: they profit handsomely from the mess and give the taxpayers the burden of sorting it out. The plain definition of (im)moral hazard.
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