It seems that the well-known philosophy of Dr Pangloss has been adopted as the mantra of the equity market bulls. Indeed, when looking at the domestic and international economies one could subscribe to this view, although the factors that the bulls cite to bolster (or rationalise) their case seem to be handpicked from a welter of conflicting evidence. Yes, the economic world, championed by rising equities markets, is fair to good, depending on one's point of view; and equities are priced for the best of all possible worlds.
The financial world is another matter; distended by enormous leverage and threatened by falling valuations and withdrawals from bond and hedge funds that may create heavy selling into an illiquid market. We believe the stock market to be a sideshow to the main event – the massively inflated credit markets, currently being led lower by plummeting structured mortgage-backed securities. And, while normally it is a slowing economy that initiates a bear market in financial instruments, this time it may be more the other way around.
Liquidity to an economy is like fertiliser to a plant – the right amount promotes growth, but too much is toxic. We have been living in a world of rapidly increasing financial liquidity for several years. Liquidity got a big boost when the Fed funds rate fell to 1%. It further expanded with the huge US trade deficits, abetted by most of America's trading partners selling their currencies to buy dollars in order to keep their exports to the US growing – currency interventions that are effectively competitive devaluations.
The banking system has done its share. The commercial banks have generated an ever-increasing number of easy loans, assisted by moderate interest rates and the ability to pass them on to issuers of structured debt, particularly asset-backed securities. Investment banks have issued or underwritten enormous amounts of such structured debt, in the process enabling the explosion of mortgage debt over the past few years. Through their creation of synthetic bonds by issuing credit default swaps (CDS) they have hugely expanded the amount of phantom corporate debt that overlays the cash (real) bonds. We have been unable to ascertain a satisfactory account of the amount of synthetic bonds outstanding but it may be much greater than the cash bonds. It is clear, however, that any customer with good credit, who might have bought $10 million of bonds a few years ago, can now purchase CDS representing $20 to $100 million of underlying bonds with only modest margin requirements. CDS are of course also created for hedging purposes, their original raison d'etre, but the market for them has exploded in size over the past few years as they have also become leveraged investment vehicles or outright gambling chips. So while we cannot state the size of the synthetic bond market that overlays the cash market, we can point to the case of Delphi Automotive bonds that went into default a couple of years ago when the company declared bankruptcy. In the aftermath it turned out that the $2 billion of defaulted bonds determined the price of approximately $20 billion of CDS. And the CDS market has grown substantially since then.
Another good example is the structured mortgage-backed securities market. In this area the issuers and underwriters of collateralised debt obligations (CDO's) backed mainly by sub-prime mortgages and aided by generous, if not complicit, bond rating agencies, tried to turn the classic sow's ear into a silk purse. Their concept was to bundle together the lower-rated, riskier tranches of residential mortgage-backed securities, which held sub-prime and other mortgages along with smaller amounts of other debt instruments, thereby creating a CDO.
They then layered the CDO's risk into tranches in the form of bonds with ratings from AAA down. On top of all of that an indeterminate amount of CDS, whose prices were linked to various CDO bonds, were issued. Some of the CDO's bought the lower rated bonds of other CDO's, piling leverage on leverage. In fact a CDS on a tranche of a mortgage-backed CDO is a derivative of a derivative of a derivative of an actual debt instrument, such as a mortgage. The only problem is that the mortgage market has turned out to be considerably less dependable than the rating agencies and the investment bankers thought. The prices of the various rated tranches of many of these CDO's, including some rated AAA, have fallen sharply over the past few months.
Our thesis is that all of this liquidity has distorted the credit markets, which look to us now like inverted pyramids, with enormous amounts of artificial, synthetic, highly leveraged debt, the pricing of which is often based on a relatively small amount of real live bonds, loans, mortgages, and installment debt. The prevailing Wall Street dogma is that, because credit risk has been spread out beyond the banking system, defaults would be less likely to cause serious problems.
We believe that the opposite pertains for several reasons: While a crisis within the banking system is more amenable to control by central bankers and, if necessary, government intervention, today debt instruments are held internationally and are largely beyond the control of domestic central bankers. The interests of various national governments and regulators may differ from each other, making coordinated actions in a financial crisis difficult to engineer. The number and type of debt instruments and the massive amount of leverage in the credit markets are many times greater just a decade ago. Many of the most popular debt instruments have limited liquidity and would be subject to severe price erosion, if selling pressures mount (as we are already seeing in mortgage-backed CDO's). Such price declines can precipitate a cascade of selling as owners are hit with successive waves of margin calls.
Wewant to address another issue affecting the US economy. Based on historical patterns, most analysts feel that consumption will continue to grow as long as unemployment remains low. We believe that a consumer slowdown has already begun for a different reason. Households in the lower two thirds of the economic ladder are stretched to the limit by debt payments, higher food and energy costs, increased prices for many imported items, declining home valuations, etc. Growing stresses on the financial system are causing lenders to reduce credit availability and increase demands for repayment of existing household debts. The post World War II American consumer miracle may finally be running out of gas.
The problem facing the Federal Reserve is becoming more apparent. Raising interest rates to defend the US Dollar and limit inflation could throw the economy into a recession. Lowering interest rates to boost the economy could engender a currency crisis and boost inflation. We continue to believe that the Fed will make no changes until a crisis develops.*
Balestra continues to invest in certain basic themes: Virtually all paper currencies are declining relative to hard assets and other stores of value. Historically narrow interest rate spreads between US Treasuries and most other debt instruments will widen to or beyond historically wide spreads as excess liquidity is reduced in the ruthlessly efficient manner typical of bear markets – by huge losses, particularly in structured credit instruments. The U.S. economy faces an increased risk of a recession and a bear market in equities.
*The above article was written in July 2007. The writer believes that the Fed cut the discount rate in September and subsequently the Fed funds rate because a financial crisis had developed – and that this crisis has not yet been resolved.
James A Melcher, who founded Balestra Capital Partners in 1999, runs a global macro hedge fund.