Investors who want the answers to these and other questions, and who want to understand just what the next phase of the financial crisis will look like, and where the “real” profit opportunities will be, should tune in on the Money Morning Web summit: “The Regime Change in Washington Triggers War on Wall Street.”

The Webinar was held last night (Thursday). However, due to the huge response, and for investors who may have missed the session, Money Morning has posted the link to program, which is free of charge for investors who wish to watch it. The video will only be available for a limited time.

The session featured Shah Gilani, a retired hedge fund manager and Wall Street insider who is now the editor of the “Trigger Event Strategist.”
“Wall Street doubletalk got us into this crisis; I hear more excuses than straight talk. Most of the dialogue is noise,” said Gilani, a respected expert on the credit crisis, and a commentator who is known for his deep connections inside the investment-banking world of Wall Street. “The truth may be difficult to swallow, but without hearing it, there’s not much hope for finding the right way out of the maze.”

During the half-hour Web summit, Gilani and host Mike Ward, the publisher of Money Morning and The Money Map Report, addressed such issues as:

• Why investors must still be in the stock market right now.
• Why banks aren’t lending.
• What low-priced stocks are worth looking at right now.
• Where the U.S. dollar is headed.
• If U.S. government bonds are a safe investment.
• And what markets around the world hold the most promise.

During the Webinar, Gilani shows investors how to interpret recent moves that U.S. lawmakers and their cronies have made to unlock the credit markets, and what’s really behind the recent machinations taking place in the power alleys of Wall Street and in the halls of government on Capitol Hill. He also details some of the challenges ahead for new U.S. President Barack Obama.

With these added insights, investors should be able to proactively strengthen their investing portfolios in the face of an escalating credit crisis and deteriorating financial markets – whose ripple effects are only now manifesting themselves in Europe, India and other markets abroad.

“The webinar [echoes] Obama’s message of ‘Change’ – what has changed, what will change and what the changes will mean for investors,” said Gilani, adding that “we will also examine how investors can tell whether changes will be good for them or not, and how to profit from change, whether the market goes up or down.”

Gilani’s distinguished investing career began immediately after college graduation, when he leveraged $10 million into $100 million while trading from his own seat on the Chicago Board Options Exchange. He followed up with an enormously successful stint on the trading desk at Lloyd’s Bank (LYG), where he designed hedging strategies for the bank’s capital investments. 

His experience includes trading billions of dollars in the bond and credit markets for old line Boston and New York investment banks and trading houses. He subsequently started his own hedge fund and retired at the young age of 52.

His investment analysis now provides the basis for the “Trigger Event Strategist,” an investment service focusing on how to profit from the “aftershocks” of the current financial crisis.  The same firm that publishes Money Morning, the global investing news service, and that publishes the monthly investment newsletter, The Money Map Report, operates the “Trigger Event Strategist”.

Investors should sign up early; those who do will be able to also submit questions in advance for Gilani’s consideration. Click here for more information on how to view the Webinar video.

Gilani on Monday published an open letter to President-elect Obama in which the credit-crisis expert gave the president-to-be a plan for overhauling the U.S. regulatory structure that governs the U.S. financial system. President Obama was inaugurated on Tuesday.

News and Related Story Links:

• Money Morning Deregulation Series:
  An Open Letter to President-Elect Barack Obama: How a Regulatory Makeover Can Fix the Financial Crisis.

The once booming business of private equity faces an uncertain future. What’s not uncertain, however, is that many private equity deals are imploding from the weight of leveraged debt and greed. Inevitable bankruptcies will result in higher unemployment and a deeper recession.

Private equity is an asset class consisting of equity securities in operating companies that are not publicly traded. The name “private equity”is the rechristened, kinder, and more gentle, label for what used to be known as leveraged buyouts, or LBOs. But make no mistake about it, while leverage may not be part of the name any more, it remains a big part of every private equity deal.

LBO firms, or “franchises”, as Henry Kravis, co-founder of Kohlberg Kravis Roberts & Co. (KKR), likes to call his shop, acquire publicly traded operating companies. Then they streamline management and operations to increase profitability and hope to cash out through a merger, an outright sale of the company, or by taking the company public again through an initial public offering, or IPO.

Private equity firms are the debutante sisters of hedge funds. They raise huge pools of capital from pension funds, endowment funds, sovereign wealth funds, institutional investors and wealthy entrepreneurs. But while hedge funds buy and sell the stocks of companies they hope to profit from, private equity shops buy whole companies.

Generally, once a target is identified, an offer is made to buy a majority, or all of the stock of the company. The trick of the deal is to pay for the target by using as little equity capital as possible, and raising the remainder by actually having the target company borrow the required funds. Except for the private equity firm’s initial equity investment, the target company is essentially buying itself.

And if that isn’t enough of a trick, very often when the target is privatized, their new masters have the company borrow even more money so they can then pay themselves a dividend as a bonus for the good job they did in leveraging the company to the hilt so they can streamline it.

The leveraged buyout business has been around for a long time and it has worked very well for investors and the private investment bankers who make an extravagant living with other people’s money. In fact, the business was so successful it eventually led to its now very problematic fork in the road. The problem facing private equity is that their leveraged deals were at one time in such great demand that it became too easy to borrow too much money.

The result was that they chased too many deals, paid too much for targets, paid themselves too many dividends and fees, and now their portfolio companies are straining and collapsing under the weight of too much debt.

Act I: The Two Big Mistakes that Made Leveraging Possible

There are two elements that made massive borrowing possible.

The first was a ready supply of capital courtesy of the U.S. Federal Reserve’s easy money policy and low interest rates. The second was the ability of banks that lend money to acquired companies to pool those loans into securities called collateralized loan obligations, or CLOs, and sell them off to investors. Banks and investors refer to this asset class as “leveraged loans.”

Since banks were able to sell off their leverage loans to investors they had plenty of recycled money to lend out again and again. Competition to lend out all that money put borrowers in an advantageous position, which they exploited.

Banks and non-bank lenders attach covenants to the loans they make. Typically, covenants dictate to borrowers what specific balance sheet requirements must be met and include debt-to-cash flow leverage ratios, limitations on the total amount of debt a company can carry, minimum equity provisions and other dictates that serve to secure collateral that is relied upon by lenders.

But, banks were so flush with money and so eager to lend that privately acquired companies, driven by their new private equity masters, proposed that the money they borrowed should not be encumbered by the protective covenants lenders are used to demanding. Hence the birth of “covenant-lite” loans.

Covenant-lite loans included insane “reverse covenants” that benefited the borrowers not the lenders.

Among other things, some borrowers demanded and got rights to:

• Increase debt-to-EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) levels to 10:1.
• Freely substitute collateral.
• Have collateral “released” outright.
• Issue unsecured debt equal to the total amount of existing debt (if they hedged or effected swaps.
• Employ PIK (payment-in-kind) options, where instead of paying interest in cash they could substitute more debt.
• Employ PIK toggles, sometimes called “extendibles.”

PIK toggles (think of a toggle switch which is used to turn something on or off) let the borrower can roll interest payments into principal and extend the maturity, instead of making twice yearly cash payments. If that sounds like an option ARM mortgage, where borrowers can choose whether to pay the interest due, some part of it, or none of it, and roll unpaid interest into principal, it’s because it is the exact same borrower covenant.

It’s like déjà vu all over again.

Act II: With No Leverage Private Equity Deals Fall Apart

Junk, junk and more junk. When the music stopped and the credit crisis began last August, money and credit evaporated. Only then did it bother leveraged loan investors that the private equity guys were leveraging their private companies to pay themselves huge dividends – enough in many cases to repay the entire initial cash equity investment used to underpin the leveraged buyout of their targets. And only then did they realize that all the debt heaped onto these companies was going to drag many of them into bankruptcy.

At that point, investors simply stopped buying leveraged loans. And the net result is that banks may be sitting on over $150 billion of junk leveraged loans that they can’t place. They are taking hits to their balance sheets as they have to mark down these loans which were securitized and subject to mark-to-market accounting. And they are terrified that the recession will drive more of these leveraged companies into bankruptcy.

Thomson Reuters recently reported that 40 private equity companies have sought bankruptcy this year. According to Standard & Poor’s, of 86 S&P rated companies that defaulted this year, 53 of them were private equity related transactions. Linens ‘n Things which was taken private by Apollo Group Inc. went bankrupt. Sharper Image, Wickes Furniture and catalogue company Lillian Vernon, were all taken private by Sun Capital Partners Inc., all of them are bankrupt. Mervyn’s which was taken private by Sun Capital and Cerberus Capital Management LP. is bankrupt.

Also in the clutches of the three-headed-dog from Hades, Cerberus, is Chrysler LLC; Chrysler Financial, GMAC LLC (General Motors Acceptance Corporation) (GMA) – 51% owned by Cerberus – and Residential Capital LLC, a GMAC company. By most accounting standards, all of these companies are, if not already, close to insolvent.

GateHouse Media Inc. (OTC: GHS), 40% owned by Fortress Investment Group LLC (FIG), is at risk of debt default and may likely be headed for bankruptcy. Former Lazard Ltd. (LAZ) deputy chairman and media honcho Steve Rattner’s Quadrangle Capital Partners may lose control of American Media Inc., publisher of The National Enquirer and Star magazine, as he battles with bondholders and may also lose portfolio company Alpha Media Group Inc., publisher of Maxim magazine. These few examples of failures are just the tip of the iceberg.

Then, of course, there’s the pure genius of PE firms coming to the rescue of troubled banks. But, TPG Capital (formerly Texas Pacific Group) doesn’t look so genius with its $7 billion investment in Washington Mutual Inc. (OTC: WAMUQ) which was wiped out in a matter of five months.

It’s understandable that bankrupt target companies are suing. Mervyn’s, for example, filed a 57 page suit against its lead dog master Cerberus, alleging fraud among other charges. But what is not as easily understandable is that some other lawsuits have the potential to turn the game viciously against the private equity firms and all the major bank lenders. I’m not talking about the deals that got done; I’m talking about the deals that didn’t get done because private equity firms walked away or otherwise tried to dissolve pending deals.

Apollo Management asked a Delaware Court of Chancery to kill a transaction it had entered into to have one of its portfolio companies, Hexion Specialty Chemicals Inc., buy NYSE listed Huntsman Corp.(HUN) for $6.5 billion. Huntsman sued and won. The judge issued a ruling that Hexion “knowingly and intentionally” breached parts of the merger agreement and ordered the company to complete the deal. Not only is Apollo being forced to go through with the deal, the ruling allows Huntsman to seek damages from Apollo. Apollo is now suing the banks it had lined up to provide debt financing for the deal.

There are hundreds of billions of dollars of abandoned deals that may now be re-visited in courts around the country. The implication for private equity firms and banks is potentially staggering.

Here are a few of the larger failed deals that resulted from a lack of debt investor interest:

• Cerberus’ failed deal for United Rentals Inc. (URI).
• The Blackstone Group LP’s (BX) failed deal for Alliance Data Systems Corp. (ADS).
• J.C. Flowers’ failed deal for SLM Corp. (SLM), also known as Sallie Mae.
• And Appaloosa Management in conjunction with Harbinger Capital Partners, Merrill Lynch & Co. Inc. (MER), Goldman Sachs Group Inc. (GS), and UBS Securities LLC’s failed financing of Delphi Corp. (OTC: DPHIQ) to take it out of bankruptcy, for which they are being sued for fraud and conspiracy to “derail” the bankruptcy plan; a serious situation because interfering with a bankruptcy is a federal crime.

The amount of leverage involved in private equity deals is a problem if banks aren’t eager, or able, to supply needed loans. But that alone isn’t scary. What is scary is the effort private equity firms are making to actually get into the banking business themselves.

Act III: Private Equity Seeks to Corrupt Banking System

There’s a lot of pressure on banks to raise capital and there’s a lot of pressure being exerted by the private equity guys to lean on the Fed and U.S. Treasury to bend the rules to let them play in that sandbox. Pushing hard from the private equity camp are Randall Quarles, Managing Director of Carlyle Group Ltd. and a former senior Treasury official and none other than the former Treasury Secretary himself, Chairman of Cerberus Capital Management, John Snow.

What the private equity guys want is the ability to buy into banks and control them. If they get their hands on the low cost deposit-based capital at commercial banks, they’ll be unstoppable. How about having the piggy-bank, backed by taxpayers to leverage at will?

The prospect is frightening.

Right now there’s a limitation imposed on investors in Federal Deposit Insurance Company insured commercial banks. Once an investment exceeds 9.9% there must be an agreement with regulators to not “control or influence” management. If an investment exceeds 24.9% the investing entity must register as a Bank Holding Company, and subject itself to all necessary transparencies called for by regulators and the Fed. In addition, the holding company is forced to serve as a “source of strength”, meaning its capital will be called upon to support its bank.

Private equity guys do not want any part of either of those restrictions. They don’t want their business looked through nor do they want their capital encumbered. The private equity firms are sitting on hundreds of billions of dollars of fresh money raised recently. While it may seem reasonable and expedient to allow private equity capital to be infused into ailing banks, any compromise of existing regulations would result in the creation of the mother of all moral hazard enablers.

There’s no doubt that if the recession is as deep and as long as feared,, the continuing failure and bankruptcy of leveraged private equity portfolio companies will result in far greater unemployment, and in and of itself, has the potential to deepen the recession on an inordinate scale.

There’s too much greed and far too much power in the form of private equity firms. Their greed has encumbered American banks with significant CLO and leveraged loan exposure and encumbered American companies with too much debt. Now, they threaten to undermine sound banking (wait a minute, that’s already been done by the banks themselves) by investing capital into them in order to control them.

Until concrete underpinnings replace the glue and duct tape that’s holding together the banking system, and until leverage is wrung out of companies, investment vehicles and households, banks and private equity firms will both be on a slippery slope.

News and Related Story Links:

• Money Morning:
  Hedge Funds Have Another $200 Billion to go to Complete Their “De-leveraging”

• Money Morning:
  The Five Financial Crisis “Aftershocks” Investors Can Play for Profit

• Money Morning:
  Paulson Amends TARP to Include Equity Stakes in Financial Firms and Assistance to Consumer Finance Companies

In the mid-80s, I ran a private partnership – call it a hedge fund – from the floor of the Chicago Board of Options Exchange Inc. (CBOE). I was an independent market maker, meaning I could walk into any trading pit on the floor and trade any options and any stocks.

I knew the stocks I traded very well. I knew my capital and leverage. I gauged the psychology of the crowd.

My plan was to cause the stock to drop, triggering the locals and others to panic out of their positions. They would sell their calls and if the price of calls fell too quickly, they would start buying puts to hedge themselves. As the stock fell and the price of puts rose higher and higher, guess who would be selling the locals puts?

Since I had bought a lot of puts and their price was rising, I would leave the crowd and have a broker in the pit sell my now-profitable put position to the eager crowd.

I am a trader. That’s my job. I trade to make money. That’s my job. That’s what everyone else does. But I succeeded much more often than most of the traders I competed against – because I followed these four basic rules of trading:

• I knew the instruments I was trading.
• I knew my capital and leverage limitations.
• I was able to gauge the psychology of the market.
• And I had a plan that I always followed.

Unfortunately, the story is much different for the U.S. Treasury Department, under the command of Treasury Secretary Henry M. “Hank” Paulson Jr., and the U.S. Federal Reserve, under the command of Chairman Ben S. Bernanke. Although these two top Bush Administration officials are the key architects of the bailout plan that’s being deployed even as you read this, they have violated all four of those basic trading rules. In short, neither of these two key officials:

• Has proven his grasp of the complexity of the instruments causing the credit crisis.
• Understands the extent of leverage used by the players who are central to this financial mess.
• Grasps the psychology of the markets.
• Or has a workable plan to fix the problem at hand.

The Genesis of a Global Financial Crisis

The Treasury and the Fed have several problems. First, they don’t understand the instruments that are at the root of this crisis. The complexity of collateralized mortgage-backed securities (CMBS) is beyond any simple explanation, though I offered one a few weeks ago. Second, and exponentially worse is that there is a “multiplier catalyst” in this devastating deleveraging and worldwide slaughter that isn’t understood, and isn’t regulated – by anyone.

I’m talking, of course, about credit default swaps.

Yes, collateralized mortgage-backed securities are at the bottom of the crisis. But, the frightening truth is that we can’t even get to them because they are covered so completely by what I’m calling the multiplier catalyst – credit default swaps. I also have offered a simple primer on credit default swaps.

These two instruments collided when traders wanted to either hedge their CMBS positions, or when they sought exposure to mortgage-backed securities, either by mimicking being long them or, in effect, shorting them. A credit default swap is a bilateral contract between, for example, you and me, under which we agree to a deal to insure a position you have because you own these dreaded CMBS. You agree to pay me a premium, up front and yearly, for the next five years. And I agree that if the CMBS you own defaults, I will pay you its full value. This is a good deal for you, right?

In fact it’s such a good deal that you ask me if I’ll insure you for the value of several different companies’ bonds and debts, in case they default. I agree. Pay me my premiums, please.

Your friend, who doesn’t own any CMBS, hears about the deal and asks me to insure them if the same CMBS securities default, even though they don’t own any themselves. I agree.

Pay me my premiums, please.

It didn’t matter to you that I’m not an insurance company. It didn’t matter to you that I never set aside any capital to pay you in the event that the instruments I was insuring you against actually did default. It’s a game – a trading game. Get it?

Unfortunately for the worldwide financial markets, I’m not the only one to play this game. Real insurance companies, investment banks, hedge funds, banks and lots of others have played this game. And, there’s a caveat. A big one.

All the bilateral contracts have a provision for margin to be posted; that is, collateral must be posted by me, or by American International Group Inc. (AIG), if they wrote these virtual-insurance-contracts and they start to go against us … which means that those instruments we insured actually might go into default.

AIG was bailed out to the tune of $80 billion, because it had margin calls on CDS contracts it wrote. Do you know why they now need an additional $38 billion in help? Because they are experiencing more margin calls on their credit default swaps. The Treasury and Fed never understood these instruments, let them run wild and now we are all paying the price.

That’s the story, but – as always – there’s also the story behind the story.

The leverage that was employed when CMBS and CDS contracts were bought and sold is not even known. How much did banks, investment banks, insurance companies, hedge funds and traders borrow to initiate their trades?  There are no accurate figures and not even any accurate estimates.

Now we come to the psychology of the market. No one – save my new idol, hedge-fund-manager extraordinaire and mega-billionaire John A. Paulson (who deserves every penny he made) – understood what “the crowd” was thinking. What they were thinking was that housing prices aren’t going to fall, companies aren’t going to default, and everything is under control because we’ve all calculated our Value at Risk and go merrily skipping along.

We’re not going to be okay because the plans that Treasury and the Fed have put forth weren’t plans to begin with. They are reacting, moment-by-moment to the markets.

With all due respect to Interim Assistant Secretary for Financial Stability, Neel Kashkari, he’s a “rocket scientist” and not a trader. And it was the rocket scientists who devised these securities for traders in the first place and neither group ever understood the instability and combustibility of the solid rocket fuel they were mixing. How is it possible for the talented Kashkari to gauge the markets and traders worldwide, when he’s never traded anything?

The global contagion is the direct result of margin calls that seeminglycrosses every security type (especially credit-default-swap positions), in very market, and seemingly in every country.

And the worst of it? As companies’ stock prices fall, as the value of their bonds fall and their debts mount, as they get closer and closer to actual default, the sellers of credit default swaps are getting bigger and bigger margin calls. Everyone is selling whatever they have to meet margin calls. It’s a worldwide de-leveraging – to an extent that we’ve never before conceived.

The Only Real ‘Exit Strategy’

Enough bad news. There is a way out: Shut down the CDS market. Net out all existing positions. Cancel contracts. Let CMBS holders keep their positions. And here’s why: There’s not enough money in the Treasury plan to buy them all up. Adjust the cost accounting basis on the books of holders so that they don’t have to mark those securities down. Give the Fed and Treasury unlimited transparency into every financial firm’s books on a strictly private basis and let them manage, merge and close down the insolvent “basket cases,” while guaranteeing every depositor in every bank and money-market fund.

And there’s more. Provide incentives for depositors and investors to stay with salvageable institutions by eliminating any capital gains on net new investments into these government-backstopped institutions.

Who are we kidding? Fannie Mae (FNM) and Freddie Mac (FRE) insure most of the troubled mortgages already. And that means the government. So allow all mortgages – after a certain date – to be refinanced by healthy banks whose cost of funds to make new loans should come directly from the Treasury at the Federal Funds rate. This will allow banks that write new loans to make them cheap and still have good profit margins. Make those homeowners pay back the favor by sharing the appreciation on those homes with the taxpayers who bailed them out, when they sell them.

Also absolutely necessary: Make key cuts. Cut taxes. And cut all wasteful government spending on all earmarked and pork barrel projects.

And last, but not least, put all the lobbyists in jail – especially the former legislators and their staffs who sold the American people short just to feed their own disgusting greed and avarice.

News and Related Story Links:

• Wikipedia:
  Federal Funds Rate.
• Money Morning Market Analysis:
  By Relaxing “Mark-to-Market” Rules, Has the U.S. Switched Off its Financial Crisis Early Warning System?
• AllExperts.com:
  Using Banks and Bank Accounts; Cost of Funds.
• Wikipedia:
  Mortgage-Backed Securities.
• Wikipedia:
  Commercial Paper.
• Reuters Financial Terms Glossary:
  Matched Book.
• Wikipedia:
  Discount Window.
• Wikipedia:
  Term Auction Facility.
• Wikipedia:
  Federal Deposit Insurance Corp.
• Money Morning News:
  Federal Reserve to Buy Commercial Paper to Free Up Frozen Market.
• Wikipedia:
  Federal Open Market Committee.
• McClatchy Newspapers:
  Fed’s half-point rate cut proves no match for Wall Street’s fear.
• About.com/Investing for Beginners:
  What is a Market Maker and How do Market Makers Make Money?

Back to Archive

In the mid-80s, I ran a private partnership – call it a hedge fund – from the floor of the Chicago Board of Options Exchange Inc. (CBOE). I was an independent market maker, meaning I could walk into any trading pit on the floor and trade any options and any stocks.

I knew the stocks I traded very well. I knew my capital and leverage. I gauged the psychology of the crowd.

My plan was to cause the stock to drop, triggering the locals and others to panic out of their positions. They would sell their calls and if the price of calls fell too quickly, they would start buying puts to hedge themselves. As the stock fell and the price of puts rose higher and higher, guess who would be selling the locals puts?

Since I had bought a lot of puts and their price was rising, I would leave the crowd and have a broker in the pit sell my now-profitable put position to the eager crowd.

I am a trader. That’s my job. I trade to make money. That’s my job. That’s what everyone else does. But I succeeded much more often than most of the traders I competed against – because I followed these four basic rules of trading:

• I knew the instruments I was trading.
• I knew my capital and leverage limitations.
• I was able to gauge the psychology of the market.
• And I had a plan that I always followed.

Unfortunately, the story is much different for the U.S. Treasury Department, under the command of Treasury Secretary Henry M. “Hank” Paulson Jr., and the U.S. Federal Reserve, under the command of Chairman Ben S. Bernanke. Although these two top Bush Administration officials are the key architects of the bailout plan that’s being deployed even as you read this, they have violated all four of those basic trading rules. In short, neither of these two key officials:

• Has proven his grasp of the complexity of the instruments causing the credit crisis.
• Understands the extent of leverage used by the players who are central to this financial mess.
• Grasps the psychology of the markets.
• Or has a workable plan to fix the problem at hand.

The Genesis of a Global Financial Crisis

The Treasury and the Fed have several problems. First, they don’t understand the instruments that are at the root of this crisis. The complexity of collateralized mortgage-backed securities (CMBS) is beyond any simple explanation, though I offered one a few weeks ago. Second, and exponentially worse is that there is a “multiplier catalyst” in this devastating deleveraging and worldwide slaughter that isn’t understood, and isn’t regulated – by anyone.

I’m talking, of course, about credit default swaps.

Yes, collateralized mortgage-backed securities are at the bottom of the crisis. But, the frightening truth is that we can’t even get to them because they are covered so completely by what I’m calling the multiplier catalyst – credit default swaps. I also have offered a simple primer on credit default swaps.

These two instruments collided when traders wanted to either hedge their CMBS positions, or when they sought exposure to mortgage-backed securities, either by mimicking being long them or, in effect, shorting them. A credit default swap is a bilateral contract between, for example, you and me, under which we agree to a deal to insure a position you have because you own these dreaded CMBS. You agree to pay me a premium, up front and yearly, for the next five years. And I agree that if the CMBS you own defaults, I will pay you its full value. This is a good deal for you, right?

In fact it’s such a good deal that you ask me if I’ll insure you for the value of several different companies’ bonds and debts, in case they default. I agree. Pay me my premiums, please.

Your friend, who doesn’t own any CMBS, hears about the deal and asks me to insure them if the same CMBS securities default, even though they don’t own any themselves. I agree.

Pay me my premiums, please.

It didn’t matter to you that I’m not an insurance company. It didn’t matter to you that I never set aside any capital to pay you in the event that the instruments I was insuring you against actually did default. It’s a game – a trading game. Get it?

Unfortunately for the worldwide financial markets, I’m not the only one to play this game. Real insurance companies, investment banks, hedge funds, banks and lots of others have played this game. And, there’s a caveat. A big one.

All the bilateral contracts have a provision for margin to be posted; that is, collateral must be posted by me, or by American International Group Inc. (AIG), if they wrote these virtual-insurance-contracts and they start to go against us … which means that those instruments we insured actually might go into default.

AIG was bailed out to the tune of $80 billion, because it had margin calls on CDS contracts it wrote. Do you know why they now need an additional $38 billion in help? Because they are experiencing more margin calls on their credit default swaps. The Treasury and Fed never understood these instruments, let them run wild and now we are all paying the price.

That’s the story, but – as always – there’s also the story behind the story.

The leverage that was employed when CMBS and CDS contracts were bought and sold is not even known. How much did banks, investment banks, insurance companies, hedge funds and traders borrow to initiate their trades?  There are no accurate figures and not even any accurate estimates.

Now we come to the psychology of the market. No one – save my new idol, hedge-fund-manager extraordinaire and mega-billionaire John A. Paulson (who deserves every penny he made) – understood what “the crowd” was thinking. What they were thinking was that housing prices aren’t going to fall, companies aren’t going to default, and everything is under control because we’ve all calculated our Value at Risk and go merrily skipping along.

We’re not going to be okay because the plans that Treasury and the Fed have put forth weren’t plans to begin with. They are reacting, moment-by-moment to the markets.

With all due respect to Interim Assistant Secretary for Financial Stability, Neel Kashkari, he’s a “rocket scientist” and not a trader. And it was the rocket scientists who devised these securities for traders in the first place and neither group ever understood the instability and combustibility of the solid rocket fuel they were mixing. How is it possible for the talented Kashkari to gauge the markets and traders worldwide, when he’s never traded anything?

The global contagion is the direct result of margin calls that seeminglycrosses every security type (especially credit-default-swap positions), in very market, and seemingly in every country.

And the worst of it? As companies’ stock prices fall, as the value of their bonds fall and their debts mount, as they get closer and closer to actual default, the sellers of credit default swaps are getting bigger and bigger margin calls. Everyone is selling whatever they have to meet margin calls. It’s a worldwide de-leveraging – to an extent that we’ve never before conceived.

The Only Real ‘Exit Strategy’

Enough bad news. There is a way out: Shut down the CDS market. Net out all existing positions. Cancel contracts. Let CMBS holders keep their positions. And here’s why: There’s not enough money in the Treasury plan to buy them all up. Adjust the cost accounting basis on the books of holders so that they don’t have to mark those securities down. Give the Fed and Treasury unlimited transparency into every financial firm’s books on a strictly private basis and let them manage, merge and close down the insolvent “basket cases,” while guaranteeing every depositor in every bank and money-market fund.

And there’s more. Provide incentives for depositors and investors to stay with salvageable institutions by eliminating any capital gains on net new investments into these government-backstopped institutions.

Who are we kidding? Fannie Mae (FNM) and Freddie Mac (FRE) insure most of the troubled mortgages already. And that means the government. So allow all mortgages – after a certain date – to be refinanced by healthy banks whose cost of funds to make new loans should come directly from the Treasury at the Federal Funds rate. This will allow banks that write new loans to make them cheap and still have good profit margins. Make those homeowners pay back the favor by sharing the appreciation on those homes with the taxpayers who bailed them out, when they sell them.

Also absolutely necessary: Make key cuts. Cut taxes. And cut all wasteful government spending on all earmarked and pork barrel projects.

And last, but not least, put all the lobbyists in jail – especially the former legislators and their staffs who sold the American people short just to feed their own disgusting greed and avarice.

News and Related Story Links:

• Wikipedia:
  Federal Funds Rate.
• Money Morning Market Analysis:
  By Relaxing “Mark-to-Market” Rules, Has the U.S. Switched Off its Financial Crisis Early Warning System?
• AllExperts.com:
  Using Banks and Bank Accounts; Cost of Funds.
• Wikipedia:
  Mortgage-Backed Securities.
• Wikipedia:
  Commercial Paper.
• Reuters Financial Terms Glossary:
  Matched Book.
• Wikipedia:�
  Discount Window
• Wikipedia:
  Term Auction Facility.
• Wikipedia:
  Federal Deposit Insurance Corp.
• Money Morning News:
  Federal Reserve to Buy Commercial Paper to Free Up Frozen Market.
• Wikipedia:
  Federal Open Market Committee.
• McClatchy Newspapers:
  Fed’s half-point rate cut proves no match for Wall Street’s fear.
• Wikipedia:
  Mortgage-Backed Securities.
• Wikipedia:
  Credit Default Swaps.
• Wikipedia:
  Bilateral Contracts.
• Wikipedia:
  John A. Paulson.

Back to Archive

If there’s a proverb that captures the outlook for the U.S. economy in the New Year, it’s the one that says: “It’s always darkest before the dawn.”

Regardless of any formal announcement of whether or not the United States drops into an actual recession, the ongoing credit crisis guarantees a contraction of the American economy by virtually every measure we know. That period of darkness will be marked by a dramatic slowdown in economic activity, as well as by rising unemployment, additional declines in U.S. stock prices, and constant volatility. It could last as long as 12-18 months.

But when the dawn does come, it will be one to remember. If U.S. President-elect Barack Obama gets it right – and I have every reason to believe that he will – then investors will be presented with the greatest investment opportunity of our generation. At that point, shares of American companies will be at such low levels that wholesale buying by individuals, mutual funds, pension funds, institutional money managers, and foreign-controlled sovereign wealth funds, will generate gains that will not only make us whole, they will make us rich once again.

A Market Mandela

Creating an analysis of the U.S. economy’s outlook for the New Year is akin to creating a mandala, a geometric work of art whose pattern, symbolically or metaphysically, represents a microcosm of the universe from the human perspective. In some Buddhist temples, mandalas are made of tiny colored beads, painstakingly created by several monks as a form of meditation. In celebration of the ever-changing nature of the universe, the mandala is then joyously shaken by its creators, until it is once again nothing more than chaos embodied in a box of colored beads.

Regardless of the big picture, analysis of a mandala – or the economy – always starts at the center and emanates outward. With the U.S. economy, that centerpiece is credit. The credit crisis has shaken the complex mandala that is our economy and transformed the United States economy into chaos. It’s complex because this economic-forecast mandala derived its form from thousands of individual pieces – in the case of the economy, from scores of data points, many of which are currently dark and foreboding.

The credit crisis we are experiencing results from the contraction – or worse, the cessation – of lending. Under normal circumstances, institutions and markets freely facilitate capital movement between lenders and borrowers. But that’s not happening, now.

Because of a lack of transparency into the balance sheets of borrowers holding such complex and illiquid securities as collateralized debt obligations, credit-default swaps, and non-performing loans, and because of increasing recessionary fears affecting businesses and households, lenders don’t want to increase their loan exposure. Banks are holding onto the cash and liquid securities they control, using them as a cushion against their own potential losses. The U.S. Treasury Department’s direct-to-bank capital injections do not alter these banking realities. In fact, as a Money Morning investigative story recently demonstrated, instead of using these taxpayer-provided infusions to increase their lending, these banks are using the money to finance takeover deals.

The Recipe for a Recession

Whether or not the United States is technically in a recession ultimately will be divined by the National Bureau of Economic Research (NBER). The business-cycle dating committee of this privately run, nonprofit economic research group is right now studying five factors in an attempt to determine if the United States has entered a recession and, if so, when that downturn started, MarketWatch.com reported. Those five factors are:

• Gross Domestic Product (GDP).
• Industrial production.
• Employment
• Income.
• Retail sales.

Regardless of any formal announcement by the NBER of whether we’re in a recession, the credit crisis guarantees a general contraction of economic activity, by every measure.

“Any doubt that we’re officially in a recession can be put aside,” Anthony Karydakis, former chief U.S. economist for JPMorgan Asset Management (JPM) – and now a professor at New York University’s Stern School of Business – recently wrote in Fortune magazine. “The rapid deterioration of labor markets points to a sharp decline in hours worked and output in the fourth quarter. This is likely to lead to a decline in personal consumption to the tune of 5.0% or so for that period. Since [consumer spending] makes up about 70% of the economy, the stage has already been set for real GDP to shrink at a more than 4.0% rate in the fourth quarter.”

Confirmation of that belief is evident by looking at each of the NBER’s five key indicators.

• Gross Domestic Product (GDP): The U.S. Commerce Department estimated that the U.S. economy, as measured by GDP, rose 0.9% in the first quarter. In the second quarter, GDP advanced an estimated 2.8%. For the third quarter, GDP declined an estimated 0.3%. My own econometric models suggest that GDP actually contracted at a 1.5% pace in the third quarter and will decline another 2.75% in the fourth quarter. For the year, that would mean the U.S. economy actually fell 0.55%. The U.S. economy last posted a full year’s negative GDP in 1991, when it declined 0.2%. Verdict: Recession.
• Industrial Production: This measure of output by the nation’s factories and mines dropped 2.8% in September, and a very steep 6.0% in the third quarter. Verdict: Recession.
• Employment: The U.S. Bureau of Labor Statistics announced Friday that October’s unemployment rate was 6.5%, a jump of 0.4%, which was double what most economists expected, and also its highest level in 14 years. The economy has now lost a total of 1.2 million jobs since the beginning of the year, with nearly half of those losses occurring in the last three months alone, pointing to an acceleration in the pace of erosion in labor markets. Karydakis, the Stern School professor, wrote in
  Fortune : “By way of comparison, during the 2001 recession and in the sluggish growth that followed in 2002-03, the unemployment rate reached a peak of only 6.3%, in June 2003. We’ve already exceeded that mark and, given that we are still in the early phase of the current recession, the unemployment rate should be expected to push toward the 7.5% range – and possibly higher – during the next three months to six months.”
  Verdict: Recession.
• Income: Personal income increased $24.5 billion, or 0.2%, and disposable personal income (DPI) increased $25.7 billion, or 0.2%, in September. Personal consumption expenditures (PCE) decreased $33.6 billion, or 0.3%. Excluding the rebate payments made to U.S. taxpayers under the Economic Stimulus Act of 2008, DPI increased $30.3 billion, or 0.3%, in September, and increased $44.0 billion, or 0.4%, in August. Verdict: Too close to call.
• Retail Sales: October retail sales are coming in well below already-diminished expectations, and some reports have been downright depressing – including The Neiman Marcus Group Inc. -26.8%; The Gap Inc. (GPS) -16%; The Nordstrom Group (JWN) -15.7%; J.C. Penny Co. Inc. (JCP) -13%; Kohl’s Corp. (KSS) -9%;  Ltd. Brands Inc. (LTD) -9%; Target Corp. Inc. (TGT) -4.8%; and Wal-Mart Stores Inc. (WMT) +2.4%. In a report last week, Moody’s Investors Service (MCO) projected that the retail sector’s woes will continue into 2009 as consumers cut back on buying apparel, footwear and accessories “in order to save money for essentials.” The credit rating firm said in a separate report that holiday spending “will prove even weaker than expected,” amid October’s financial-market swoon. Verdict: Recession.

If U.S. exports are taken out of the GDP calculations going back to January, it’s apparent that there has been very little domestic growth in the economy. And when revisions are finalized in the next few months, we’ll be looking back at the recession that we’re all but certain is upon us right now. Until the credit markets are freed up and borrowers are extended credit at reasonable rates, it’s unlikely that credit, the centerpiece of the economy, will be anything other than a major cog in the wheel.

There are some signs of a thaw, but not anytime soon. The U.S. Federal Reserve’s lowering of the Fed Funds target rate to 1.0%, and coordinated rate reductions by the Bank of England and the European Central Bank, as well as other major world-wide central banks, may start to ease the stranglehold gripping the worldwide credit markets. The London interbank offered rate (Libor), a critical interest rate against which trillions of dollars of mortgages, bank loans and derivatives are priced, dropped to 2.39% last week from a high of 4.82% on Oct. 10.

The prospect of President-elect Obama’s choosing a different means of attacking the credit crisis will be closely watched and, by itself, may create an air of confidence that perceptions will change. But changed perceptions will not be enough.

The truth about our economic outlook is that it is predicated on demonstrably better transparency. If U.S. banks follow the lead of their European counterparts, which have recently been freed from fair-value, mark-to-market accounting, and which may retroactively mark assets to “internal models” back to July, then balance-sheet clarity will continue to be cloaked in darkness. Lack of confidence in the banking system will persist, especially among the banks themselves. The first order of attack needs to be the creation of a fundamental leadership position that leads to an open, transparent and accountable measure of balance sheet assets and liabilities. As long as failing banks are being propped up, this cycle of credit contraction will persist.

The outlook for the economy is inextricably tied to the price of oil. The run-up of benchmark crude this summer to the record $145 a barrel level, and its subsequent fall to half that level, has wreaked havoc throughout the economy. Similarly, the run-up in commodity prices, and their subsequent fall, also has caused a lot of damage. Together, the dramatic rise and fall in the pricde of oil and other commodities is a harbinger of greater volatility in the future.

Follow the Money

Follow the money. Capital rapidly inflated the tech-stock bubble. When that bubble burst, capital flowed into and flooded the hard-asset world of real estate. When that bubble burst fast, speculative money dove into oil and commodities. When the U.S. and world economies looked weak, those bubbles burst. The looming threat of inflation this past summer instantly gave way after the drop of oil, gold, metals and agricultural commodities. And now, deflation is seen as the looming threat on the horizon.

Which threat should we worry about?

The answer is – both. The prospect for near-term deflation seems all too real. As raw material prices fall and finished good prices fall due to a lack of purchasing power resulting from lack of credit and world-wide recessionary fears, the U.S. consumer has fundamentally changed his or her collective psychology. Is U.S. consumerism, which is responsible for 70% of GDP, in full retreat? If it is, as all measures project, then it’s likely that government stimulus efforts will overshoot their intended mark.

Just look at what the United States has done already as it battles this financial crisis. It has:

• Handed out more than $150 billion in stimulus rebate checks.
• Floated a $700 billion financial bailout rescue plan – almost $160 billion of which has already been placed.
• Bailed out American International Group Inc. (AIG), to the tune of $125 billion.
• Covered JP Morgan Chase & Co.’s bet on taking over
  The Bear Stearns Cos. – to the tune of $29 billion.
• Looked to lend struggling automakers $25 billion.
• Agreed to guarantee depositors at all banks.
• Stepped in to buy commercial paper that no one else will buy.
• Guaranteed money-market-fund investors.
• And backstopped the Federal Deposit Insurance Corp. (FDIC), Fannie Mae (FNM) and Freddie Mac (FRE).

 And now we’re getting wind of another stimulus package and more help for everyone.

If, in six months to a year, the credit markets are facilitating borrowers again, the massive buildup of U.S. debt will result in a falling dollar and higher interest rates.

That spells inflation.

A massive re-inflation of the economy portends another flood of speculative money into oil and commodities. The cycles are increasingly condensed, more volatile and will be increasingly more disruptive.

Welcome to the brave new world of global finance and speculation.

The Federal Reserve’s balance sheet has ballooned from $900 billion to more than $1.8 trillion. That’s 13% of GDP. The Treasury Department has telegraphed its intention to float $550 billion of debt in the fourth quarter and estimates it will have to float another $368 billion in the first quarter of 2009. Our national debt will then be close to 49% of GDP.

If there is an easing of credit in the economy, and borrowers come to market with the pent-up demand that has not been met for the past year, the competition for funds will raise interest rates. Higher interest rates will counter any stimulus effect from government programs.

Who will buy U.S. Treasury debt if the world is less apprehensive about credit quality? Lenders will once again seek higher returns, potentially forcing the Treasury Department to increase its rates. The potential of this event may sink the dollar if investors perceive that the U.S. economy is stagnant and the world is awash in dollars. The yield curve – the spread between the Treasury’s two-year and the 10-year paper – has been steepening. A steepening yield curve, where short-term borrowing costs are low and long-term rates considerably higher, is good for banks that borrow short and lend long.

But if the perception of risk diminishes, and the perception of future inflation increases, the yield curve will invert and the threat of rising rates will cause a sell-off in the short end of the curve and a rush into longer-dated maturities. Any increase in short-term interest rates would be painful for struggling banks. An inverted yield curve would be devastating, and inevitably would lead to more bank failures.

Home on the Range …

At the core of the U.S. economy sits a desperately ailing piece of the mandala – the U.S. housing market. The once bright prospect of home ownership, which historically formed a beautiful economic picture, right now doesn’t exist. For most Americans, the family home constituted the bulk of their wealth. Or at least it did. And this family financial portrait will get worse before it gets better, since the real estate collapse is far from over. Goldman Sachs Group Inc. (GS), for instance, projects another 15% drop in housing prices.

I think that’s conservative. Mortgage rates are actually rising as Fannie and Freddie have to pay higher interest on their short-term notes and bonds. Thirty-year fixed-rate mortgage paper averaged 6.47% last week, up from its 52-week low of 5.36%. The 15-year fixed paper was trading at 6.18%, up from its 52-week low of 4.91% (based on Bankrate.com (RATE) rate surveys). This trend is definitely not our friend. As housing prices continue to fall, and inventories stagnate and grow in many areas, homeowners are increasingly underwater and are increasingly entertaining foreclosure as a viable economic alternative to indentured servitude.

The Hope for Homeowners Plan, which looks to lower interest rates and reduce principal on mortgages, and which makes homeowners pay a share of the appreciation on their home to their lender when they sell it, was initiated in October and was expected to garner some 400,000 takers. As of last week, according to The Wall Street Journal, there had been only 42 takers. That’s not a misprint – 42 – I even checked with The Journal.

In the real estate realm, the proverbial “other shoe” hasn’t dropped yet, but certainly is dangling – and that’s commercial real estate. As homeowners writhe in agony and stop spending, retailers will go out of business, businesses of all stripes will suffer and commercial real estate will implode. The leverage left over from just the private equity foray into commercial real estate in the acquisitive 2006-2007 period is staggering. Refinancing will be impossible. Banks are stuck with hundreds of billions of dollars of leveraged loans that they took on as bridge and mezzanine financing from the private-equity shops alone, at the time believing they would  be able to securitize those loans and sell them off to investors.

There’s no chance of that, now.

One deal in particular illustrates this entire mess.  Private equity behemoth The Blackstone Group LP (BX) took Hilton Hotels Corp. private for $26 billion. Blackstone put up $6 billion of its own money as equity and borrowed the other $20 billion from Bear Stearns, Bank of America Corp. (BAC), Deutsche Bank AG (DB), Goldman Sachs, Morgan Stanley (MS), Merrill Lynch & Co. Inc. (MER) and Lehman Brothers Holdings Inc. (OTC: LEHMQ).

Based on a current analysis of the deal at the multiple of seven times projected cash flow that the market currently puts on Starwood Hotels & Resorts Worldwide Inc. (HOT) -  Hilton’s nearest rival – if Blackstone values its property comparably, it will have to mark its Hilton holdings down 50%, because it paid 13 times projected cash flow. That wipes out all of Blackstone’s equity in the deal. What’s more, the $4 billion portion of the loan that Bear Stearns took on, courtesy of JP Morgan Chase casting off Bear’s orphaned liabilities, now sits on the Fed’s balance sheet – and isn’t likely to go anywhere anytime soon.

Until the real estate cycle completes its implosion and begins to stabilize, there’s nothing that will fundamentally alter the outlook for the economy. This is Ground Zero. President-elect Obama must resist creating only a political solution to the overwhelming economic problem of declining house prices and declining real estate prices in general. Any attempt to put a band aid on this economic plague will only delay the day of reckoning. I regret deeply the conclusion that the lake must be drained before we can realistically climb out of it. But there just aren’t enough ferrymen to get us all to shore.

Always a Silver Lining – My Forecast

The outlook for the economy is not rosy – and that’s an understatement. But there is a silver lining. Even in the near term, the stock market will present innumerable wealth-creation opportunities.

• First, there are plenty of shorting opportunities out there now, and more will present themselves in the future.
• Second, in due course – in perhaps 12-18 months – we will be presented with the investment opportunity of our generation. If President-elect Obama gets it right, and I believe he’s got the potential to bring us all together and get the country through this (and if you’re reading this Mr. President-elect, I’d like to put in my vote for [New York Fed President] Timothy Geithner as next U.S. treasury secretary), American companies will be able to be purchased so cheaply that fortunes will be made. The recovery will not only make us whole, it will make our people and our nation rich again.

I have absolutely no doubt that the United States will lead the world back into balance. The sea change that has arrived is the result of the conservative experiment having lost its true moorings, pushing the economy into disaster. Not that a wholesale swinging of the pendulum to the other side would be good. In fact, it would be disastrous. We have the potential to end up with a new, fair, transparent and judiciously regulated environment where capital formation can again spread its wings and the U.S. economy can fly.

There are new hands reaching into the colorful box of beads that comprise the American landscape and economy. From any human perspective, the United States is more than a microcosm of the universe; it is the center of the world as we know it. It will take time to construct the new mandala. We all need to meditate on the process to ensure that the design we embrace will ultimately be inclusive, forward-looking and – like all great art – an inspiration to all who view it.

News and Related Story Links:

• Fortune Magazine:
  Why the jobs report is so ominous.
• International Accounting Standards Board:
  Accounting standards: Commission welcomes IASB guidance on the application of fair value measurement when markets become inactive.
• Investopedia:
  Personal consumption expenditures.
• Money Morning Financial Analysis:
  Bailout Plan Forcing U.S. to Borrow $1.4 Trillion, Creating a $1 Trillion Deficit.
• Wikipedia:
  Economic Stimulus Act of 2008.
• MarketWatch.com:
  Recession arbiter is sifting GDP, jobs data.
• Wikipedia:
  Timothy Geithner.
• Wikipedia:
  Yield Curve.
• Investopedia:
  Inverted Yield Curve.

Back to Archive

If there’s a proverb that captures the outlook for the U.S. economy in the New Year, it’s the one that says: “It’s always darkest before the dawn.”

Regardless of any formal announcement of whether or not the United States drops into an actual recession, the ongoing credit crisis guarantees a contraction of the American economy by virtually every measure we know. That period of darkness will be marked by a dramatic slowdown in economic activity, as well as by rising unemployment, additional declines in U.S. stock prices, and constant volatility. And it could last as long as 12-18 months.

But when the dawn does come, it will be one to remember. If U.S. President-elect Barack Obama gets it right – and I have every reason to believe that he will – then investors will be presented with the greatest investment opportunity of our generation. At that point, shares of American companies will be at such low levels that wholesale buying by individuals, mutual funds, pension funds, institutional money managers, and foreign-controlled sovereign wealth funds, will generate gains that will not only make us whole, they will make us rich once again.

A Market Mandela

Creating an analysis of the U.S. economy’s outlook for the New Year is akin to creating a mandala, a geometric work of art whose pattern, symbolically or metaphysically, represents a microcosm of the universe from the human perspective. In some Buddhist temples, mandalas are made of tiny colored beads, painstakingly created by several monks as a form of meditation. In celebration of the ever-changing nature of the universe, the mandala is then joyously shaken by its creators, until it is once again nothing more than chaos embodied in a box of colored beads.

Regardless of the big picture, analysis of a mandala – or the economy – always starts at the center and emanates outward. With the U.S. economy, that centerpiece is credit. The credit crisis has shaken the complex mandala that is our economy and transformed the United States economy into chaos. It’s complex because this economic-forecast mandala derived its form from thousands of individual pieces – in the case of the economy, from scores of data points, many of which are currently dark and foreboding.

The credit crisis we are experiencing results from the contraction – or worse, the cessation – of lending. Under normal circumstances, institutions and markets freely facilitate capital movement between lenders and borrowers. But that’s not happening, now.

Because of a lack of transparency into the balance sheets of borrowers holding such complex and illiquid securities as collateralized debt obligations, credit-default swaps, and non-performing loans, and because of increasing recessionary fears affecting businesses and households, lenders don’t want to increase their loan exposure. Banks are holding onto the cash and liquid securities they control, using them as a cushion against their own potential losses. The U.S. Treasury Department’s direct-to-bank capital injections do not alter these banking realities. In fact, as a Money Morning investigative story recently demonstrated, instead of using these taxpayer-provided infusions to increase their lending, these banks are using the money to finance takeover deals.

The Recipe for a Recession

The National Bureau of Economic Research (NBER) will ultimately determine whether or not the United States is technically in a recession. The business-cycle dating committee of this privately run, nonprofit economic research group is right now studying five factors in an attempt to determine if the United States has entered a recession and, if so, when that downturn started, MarketWatch.com reported. Those five factors are:

• Gross Domestic Product (GDP).
• Industrial production.
• Employment
• Income.
• Retail sales

Regardless of any formal announcement by the NBER of whether we’re in a recession, the credit crisis guarantees a general contraction of economic activity, by every measure.

“Any doubt that we’re officially in a recession can be put aside,” Anthony Karydakis, former chief U.S. economist for JPMorgan Asset Management – and now a professor at New York University’s Stern School of Business – recently wrote in Fortune magazine. “The rapid deterioration of labor markets points to a sharp decline in hours worked and output in the fourth quarter. This is likely to lead to a decline in personal consumption to the tune of 5.0% or so for that period. Since [consumer spending] makes up about 70% of the economy, the stage has already been set for real GDP to shrink at a more than 4.0% rate in the fourth quarter.”

Confirmation of that belief is evident by looking at each of the NBER’s five key indicators.

• Gross Domestic Product (GDP): The U.S. Commerce Department estimated that the U.S. economy, as measured by GDP, rose 0.9% in the first quarter. In the second quarter, GDP advanced an estimated 2.8%. For the third quarter, GDP declined an estimated 0.3%. My own econometric models suggest that GDP actually contracted at a 1.5% pace in the third quarter and will decline another 2.75% in the fourth quarter. For the year, that would mean the U.S. economy actually fell 0.55%. The U.S. economy last posted a full year’s negative GDP in 1991, when it declined 0.2%. Verdict: Recession.  

• Industrial Production: This measure of output by the nation’s factories and mines dropped 2.8% in September, and a very steep 6.0% in the third quarter. Verdict: Recession.

• Employment: The U.S. Bureau of Labor Statistics announced Friday that October’s unemployment rate was 6.5%, a jump of 0.4%, which was double what most economists expected, and also its highest level in 14 years. The economy has now lost a total of 1.2 million jobs since the beginning of the year, with nearly half of those losses occurring in the last three months alone, pointing to an acceleration in the pace of erosion in labor markets. Karydakis, the Stern School professor, wrote in Fortune: “By way of comparison, during the 2001 recession and in the sluggish growth that followed in 2002-03, the unemployment rate reached a peak of only 6.3%, in June 2003. We’ve already exceeded that mark and, given that we are still in the early phase of the current recession, the unemployment rate should be expected to push toward the 7.5% range – and possibly higher – during the next three months to six months.” Verdict: Recession. 

• Income: Personal income increased $24.5 billion, or 0.2%, and disposable personal income (DPI) increased $25.7 billion, or 0.2%, in September. Personal consumption expenditures (PCE) decreased $33.6 billion, or 0.3%. Excluding the rebate payments made to U.S. taxpayers under the Economic Stimulus Act of 2008, DPI increased $30.3 billion, or 0.3%, in September, and increased $44.0 billion, or 0.4%, in August. Verdict: Too close to call.

• Retail Sales: October retail sales are coming in well below already-diminished expectations, and some reports have been downright depressing – including The Neiman Marcus Group Inc. -26.8%; The Gap Inc. -16%; The Nordstrom Group -15.7%; J.C. Penny Co. Inc. -13%; Kohl’s Corp. -9%;  Ltd. Brands Inc. -9%; Target Corp. Inc. -4.8%; and Wal-Mart Stores Inc. +2.4%. In a report last week, Moody’s Investors Service projected that the retail sector’s woes will continue into 2009 as consumers cut back on buying apparel, footwear and accessories “in order to save money for essentials.” The credit rating firm said in a separate report that holiday spending “will prove even weaker than expected,” amid October’s financial-market swoon. Verdict: Recession.

If U.S. exports are taken out of the GDP calculations going back to January, it’s apparent that there has been very little domestic growth in the economy. And when revisions are finalized in the next few months, we’ll be looking back at the recession that we’re all but certain is upon us right now. Until the credit markets are freed up and borrowers are extended credit at reasonable rates, it’s unlikely that credit, the centerpiece of the economy, will be anything other than a major cog in the wheel.

There are some signs of a thaw, but not anytime soon. The U.S. Federal Reserve’s lowering of the Fed Funds target rate to 1.0%, and coordinated rate reductions by the Bank of England and the European Central Bank, as well as other major worldwide central banks, may start to ease the stranglehold gripping the worldwide credit markets.

The prospect of President-elect Obama’s choosing a different means of attacking the credit crisis will be closely watched and, by itself, may create an air of confidence that perceptions will change. But changed perceptions will not be enough.

The truth about our economic outlook is that it is predicated on demonstrably better transparency. If U.S. banks follow the lead of their European counterparts, which have recently been freed from fair-value, mark-to-market accounting, and which may retroactively mark assets to “internal models” back to July, then balance-sheet clarity will continue to be cloaked in darkness. Lack of confidence in the banking system will persist, especially among the banks themselves. The first order of attack needs to be the creation of a fundamental leadership position that leads to an open, transparent and accountable measure of balance sheet assets and liabilities. As long as failing banks are being propped up, this cycle of credit contraction will persist.

The outlook for the economy is inextricably tied to the price of oil. The run-up of benchmark crude this summer to the record $145 a barrel level, and its subsequent fall to half that level, has wreaked havoc throughout the economy. Similarly, the run-up in commodity prices, and their subsequent fall, also has caused a lot of damage. Together, the dramatic rise and fall in the price of oil and other commodities is a harbinger of greater volatility in the future.

Follow the Money

Follow the money. Capital rapidly inflated the tech-stock bubble. When that bubble burst, capital flowed into and flooded the hard-asset world of real estate. When that bubble burst fast, speculative money dove into oil and commodities. When the U.S. and world economies looked weak, those bubbles burst. The looming threat of inflation this past summer instantly gave way after the drop of oil, gold, metals and agricultural commodities. And now, deflation is seen as the looming threat on the horizon.

Which threat should we worry about?

The answer is – both. The prospect for near-term deflation seems all too real. As raw material prices fall and finished good prices fall due to a lack of purchasing power resulting from lack of credit and world-wide recessionary fears, the U.S. consumer has fundamentally changed his or her collective psychology. Is U.S. consumerism, which is responsible for 70% of GDP, in full retreat? If it is, as all measures project, then it’s likely that government stimulus efforts will overshoot their intended mark.

Just look at what the United States has done already as it battles this financial crisis. It has:

• Handed out more than $150 billion in stimulus rebate checks.
• Floated a $700 billion financial bailout rescue plan – almost $160 billion of which has already been placed.
• Bailed out American International Group Inc., to the tune of $125 billion.
• Covered JP Morgan Chase & Co.’s bet on taking over
  The Bear Stearns Cos. – to the tune of $29 billion.
• Looked to lend struggling automakers $25 billion.
• Agreed to guarantee depositors at all banks.
• Stepped in to buy commercial paper that no one else will buy.
• Guaranteed money-market-fund investors.
• And backstopped the Federal Deposit Insurance Corp. (FDIC), Fannie Mae and Freddie Mac.

And now we’re getting wind of another stimulus package and more help for everyone.

If, in six months to a year, the credit markets are facilitating borrowers again, the massive buildup of U.S. debt will result in a falling dollar and higher interest rates.

That spells inflation.

A massive re-inflation of the economy portends another flood of speculative money into oil and commodities. The cycles are increasingly condensed, more volatile and will be increasingly more disruptive.

Welcome to the brave new world of global finance and speculation.

The Federal Reserve’s balance sheet has ballooned from $900 billion to more than $1.8 trillion. That’s 13% of GDP. The Treasury Department has telegraphed its intention to float $550 billion of debt in the fourth quarter and estimates it will have to float another $368 billion in the first quarter of 2009. Our national debt will then be close to 49% of GDP.

If there is an easing of credit in the economy, and borrowers come to market with the pent-up demand that has not been met for the past year, the competition for funds will raise interest rates. Higher interest rates will counter any stimulus effect from government programs.

Who will buy U.S. Treasury debt if the world is less apprehensive about credit quality? Lenders will once again seek higher returns, potentially forcing the Treasury Department to increase its rates. The potential of this event may sink the dollar if investors perceive that the U.S. economy is stagnant and the world is awash in dollars. The yield curve – the spread between the Treasury’s two-year and the 10-year paper – has been steepening. A steepening yield curve, where short-term borrowing costs are low and long-term rates considerably higher, is good for banks that borrow short and lend long.

But if the perception of risk diminishes, and the perception of future inflation increases, the yield curve will invert and the threat of rising rates will cause a sell-off in the short end of the curve and a rush into longer-dated maturities. Any increase in short-term interest rates would be painful for struggling banks. An inverted yield curve would be devastating, and inevitably would lead to more bank failures.

Home on the Range …

At the core of the U.S. economy sits a desperately ailing piece of the mandala – the U.S. housing market. The once bright prospect of home ownership, which historically formed a beautiful economic picture, right now doesn’t exist. For most Americans, the family home constituted the bulk of their wealth. Or at least it did. And this family financial portrait will get worse before it gets better, since the real estate collapse is far from over. Goldman Sachs Group Inc., for instance, projects another 15% drop in housing prices.

I think that’s conservative. Mortgage rates are actually rising as Fannie and Freddie have to pay higher interest on their short-term notes and bonds. Thirty-year fixed-rate mortgage paper averaged 6.47% last week, up from its 52-week low of 5.36%. The 15-year fixed paper was trading at 6.18%, up from its 52-week low of 4.91% (based on Bankrate.com rate surveys). This trend is definitely not our friend. As housing prices continue to fall, and inventories stagnate and grow in many areas, homeowners are increasingly underwater and are increasingly entertaining foreclosure as a viable economic alternative to indentured servitude.

The Hope for Homeowners Plan, which looks to lower interest rates and reduce principal on mortgages, and which makes homeowners pay a share of the appreciation on their home to their lender when they sell it, was initiated in October and was expected to garner some 400,000 takers. As of last week, according to The Wall Street Journal, there had been only 42 takers. That’s not a misprint – 42 – I even checked with The Journal.

In the real estate realm, the proverbial “other shoe” hasn’t dropped yet, but certainly is dangling – and that’s commercial real estate. As homeowners writhe in agony and stop spending, retailers will go out of business, businesses of all stripes will suffer and commercial real estate will implode. The leverage left over from just the private equity foray into commercial real estate in the acquisitive 2006-2007 period is staggering. Refinancing will be impossible. Banks are stuck with hundreds of billions of dollars of leveraged loans that they took on as bridge and mezzanine financing from the private-equity shops alone, at the time believing they would  be able to securitize those loans and sell them off to investors.

There’s no chance of that, now.

One deal in particular illustrates this entire mess.  Private equity behemoth The Blackstone Group LP took Hilton Hotels Corp. private for $26 billion. Blackstone put up $6 billion of its own money as equity and borrowed the other $20 billion from Bear Stearns, Bank of America Corp., Deutsche Bank AG, Goldman Sachs, Morgan Stanley, Merrill Lynch & Co. Inc. and Lehman Brothers Holdings Inc.

Based on a current analysis of the deal at the multiple of seven times projected cash flow that the market currently puts on Starwood Hotels & Resorts Worldwide Inc. - Hilton’s nearest rival – if Blackstone values its property comparably, it will have to mark its Hilton holdings down 50%, because it paid 13 times projected cash flow. That wipes out all of Blackstone’s equity in the deal. What’s more, the $4 billion portion of the loan that Bear Stearns took on, courtesy of JP Morgan Chase casting off Bear’s orphaned liabilities, now sits on the Fed’s balance sheet – and isn’t likely to go anywhere anytime soon.

Until the real estate cycle completes its implosion and begins to stabilize, there’s nothing that will fundamentally alter the outlook for the economy. This is Ground Zero. President-elect Obama must resist creating only a political solution to the overwhelming economic problem of declining house prices and declining real estate prices in general. Any attempt to put a Band-Aid on this economic plague will only delay the day of reckoning. I regret deeply the conclusion that the lake must be drained before we can realistically climb out of it. But there just aren’t enough ferrymen to get us all to shore.

Always a Silver Lining – My Forecast

The outlook for the economy is not rosy – and that’s an understatement. But there is a silver lining. Even in the near term, the stock market will present innumerable wealth-creation opportunities.

• First, there are plenty of shorting opportunities out there now, and more will present themselves in the future.
• Second, in due course – in perhaps 12-18 months – we will be presented with the investment opportunity of our generation. If President-elect Obama gets it right, and I believe he’s got the potential to bring us all together and get the country through this (and if you’re reading this Mr. President-elect, I’d like to put in my vote for [New York Fed President] Timothy Geithner as next U.S. treasury secretary), American companies will be able to be purchased so cheaply that fortunes will be made. The recovery will not only make us whole, it will make our people and our nation rich again.

I have absolutely no doubt that the United States will lead the world back into balance. The sea change that has arrived is the result of the conservative experiment having lost its true moorings, pushing the economy into disaster. Not that a wholesale swinging of the pendulum to the other side would be good. In fact, it would be disastrous. We have the potential to end up with a new, fair, transparent and judiciously regulated environment where capital formation can again spread its wings and the U.S. economy can fly.

There are new hands reaching into the colorful box of beads that comprise the American landscape and economy. From any human perspective, the United States is more than a microcosm of the universe; it is the center of the world as we know it. It will take time to construct the new mandala. We all need to meditate on the process to ensure that the design we embrace will ultimately be inclusive, forward-looking and – like all great art – an inspiration to all who view it.

My sister lives in a landmark building in Coral Gables, Fla. There was a fire in one apartment in the building. After that fire was brought under control, the fire department – for some unknown reason – dropped a hose in the burned apartment, and left the water running … for hours.

That inane maneuver destroyed many apartments, crippled the building’s infrastructure and resulted in the building being temporarily condemned. The entire building was closed down for many months. Every person who lived there had to relocate. My sister, fortunately, had the wherewithal to take up temporary residence in the world-famous Biltmore Hotel.

But others weren’t so lucky.

When the banking-system bailout plan – formally referred to as the “Emergency Economic Stabilization Act of 2008″ – was originally unveiled, the financial-crisis firefighters at the U.S. Treasury Department were essentially reprising the Florida firefighting strategy. And U.S. taxpayers can anticipate an outcome a lot like the one that afflicted the Coral Gables apartment dwellers.

Unfortunately for the U.S. taxpayer, there’s no Biltmore in which to seek temporary shelter. There’s only one U.S. economy, and we have to stay in it, whether it’s been condemned or not.

The Senate passed the bailout bill late Wednesday night (Oct. 1), followed by the House of Representatives Friday (Oct. 3). U.S. President George W. Bush signed the bill into law immediately after the House vote.

Treasury’s Eight-Point Plan – for Failure

In plain English, here’s what’s wrong with the newly passed “bailout” plan and what alternatives should have been included as part of any plan that had a hope for success.

The Treasury plan was originally predicated on buying $700 billion of collateralized residential mortgage-backed securities that banks could not unload. The idea was that the banks would get the money, which they could then turn around and lend to keep the credit markets open and credit flowing throughout the economy. In the meantime, the Treasury Department would sit on the securities until it is able to sell them, hopefully at a profit. The idea, from a theoretical standpoint,isn’t stupid. It is, however, impossible to implement to any degree that will result in its intended effect.

Here’s why:

1. There are more than $1 trillion worth of subprime collateralized mortgage-backed securities out there – and that’s just one type of problematic derivative security. The bottom line: $700 billion isn’t enough. Period.
2. The purchase plan is not limited to just residential mortgage-backed securities. Surprise! What else will Treasury buy?
3. Who’s going to fight off the lobbying groups out to influence the managers that the Treasury Department hires to direct money to their masters? Did we mention that $700 billion wasn’t enough?
4. The government plan is even more under-funded than people realize, for it doesn’t authorize the full $700 billion: Indeed, it starts with only $350 billion, leaving an even greater shortfall. Did we mention that $700 billion wasn’t enough?
5. Treasury is going to hire banking-industry managers to manage the process. Those managers are going to serve themselves – just as they served themselves to get us into the crisis.
6. There is no defined mechanism to determine what price the Treasury Department will pay for what it buys. For argument’s sake, even if Treasury were to only buy the problem securities its leadership speaks of in public – residential mortgage-backed securities – there are problems if it prices them too low: If that happens, some holders won’t sell them, taking the chance that if they hold them long enough they will be worth more than Treasury is willing to pay. How will those financial institutions regain liquidity if they won’t sell the securities needed to make this happen?
7. Since Treasury can’t buy all the problem securities, if it prices what it’s going to buy too low, all remaining holders will have to mark down their holdings and take more write-downs and losses. How will that create confidence and facilitate “liquidity”?
8. However, if the Treasury Department prices the securities too high, several problems quickly emerge: Hedge funds will rush to sell their current holdings, and may very well speculate by buying up more securities to sell them at a higher price (profit) to Treasury, meaning that the Treasury Department plan won’t necessarily be helping banks directly. What’s more, if those securities are priced too high, and the market for them continues to fall, taxpayers will eat the losses – a reality that likely will lead to an end to further program funding.

The “Heads I Win, Tails You Lose” Bargain

How are the Treasury Department and the U.S. Federal Reserve going to be able to conduct objective, responsible policy regarding fiscal matters and interest rate decisions when they will have to simultaneously “manage” the government’s portfolio of securities? There will be conflicts and there will be fallout for the U.S. dollar and fallout with regard to American interests vs. the rest of the world, with whom we trade and partner with in all manner of ways, not the least of which involves our own national security.

While the idea that taxpayers should get warrants and ownership in the entities that we buy securities from is theoretically a good idea, there are some issues. Let’s take a look at some of the biggest potential pitfalls:

• Foreign banks aren’t going to be thrilled about that; yes, they are included in the list of whom the Treasury will buy from.
• Are taxpayers going to be limited partners in hedge funds? What if those hedge funds implode?
• The U.S. Treasury Department could end up in control of our banks. Considering how well they run the government’s fiscal house, is that what we want?
• Who is going to decide when to sell any of government’s ownership interests, should they turn out to be profitable? Will we own these businesses forever?
• Is government going to control private enterprise? Is this a ruse? Are we heading into an era under the stewardship of a socialist government?
• There is no direct support for homeowners in the plan and no support mechanism for falling home prices. And yet, these twin evils are the root causes of what has happened.

After the House rejected the initial bill – and U.S. stock prices plummeted – the Senate rushed through its modified plan, which the House subsequently passed and the president signed. But that was just another hose from the same firefighting gang that can’t shoot straight; which will further douse the prospect of a directed approach.

Here are some of the additions that were made to the plan that the House originally rejected – meaning they are part of the plan that was signed into law. Ask yourself this question: What do they do to actually address the credit crisis?

• Extend unemployment benefits: That’s super – so when we’re all out of our houses, we’ll have enough unemployment to stay at the Biltmore for a day or two.
• A $1,000 tax deduction for homeowners who don’t itemize. Great, I can buy a cheap inflatable raft to float away on the red ink that flows out of my house.
• A reduction on the tax on dividends repatriated from foreign earnings. What?
• Economic stimulus measures – such as spending on transportation projects. That will actually help; if they build canals around my house, when I float away on my red-ink raft, at least I won’t end up in uncharted waters.
• Increase Federal Deposit Insurance Corp. (FDIC) deposit-insurance-coverage per bank account from $100,000 to $250,000. That will definitely calm nervous bank depositors, especially all those who have more than $100,000 in their many accounts. Personally, I wish I had that worry. Do you?

What is the common denominator to all these add-ons? They are meant to be added up so that Congress can say: “This is how much we’re going spend to help fix the problem that will benefit you, not just the $700 billion going to Wall Street.” Don’t buy into this.

However, my very favorite proposal is the push to do entirely away with fair-value – mark-to-market – accounting. This is being pushed by none other than the American Bankers Association and – guess whom else – the Securities and Exchange Commission (SEC). That’s the same SEC that presided over the demise of The Bear Stearns Cos. (now part of JP Morgan Chase & Co. (JPM)), Lehman Brothers Holdings Inc. (LEHMQ), and American International Group (AIG). It’s the same SEC that eliminated the up-tick rule. And it’s the same SEC that handed over to the exchanges the authority to decide who should be on the “do-not-short” list.

The truth that needs to be front-page news it that if there wasn’t Fair Value, mark-to-market accounting we would never have seen this crisis coming. Doing away with mark-to-market accounting does not change the value of problem securities. Period. Doing away with mark-to-market will only bury the bodies under the rubble. The stench will eventually suffocate us all…to death.

A Real Solution

On top of the list of solutions should be an immediate address of:

1. Regulation.
2. The nature and existence of problem securities.
3. A means of accurately and transparently pricing those problem securities.
4. A cleanup of attendant problem instruments (credit default swaps) that are massively contributing to the problem and – in and of themselves – are sinking the U.S. economy.
5. The need to facilitate an accounting aide – short of eliminating mark-to-market accounting – by directly addressing how banks can still hold these problem securities and not have to incur unrealistic write-downs and losses.
6. A means of allowing problem securities to be used as collateral when borrowing from the Fed.
7. A method of helping homeowners directly.
8. A strategy that will support the housing market with sensible tax and capital gains policies.

The problem right now is that we’re being force-fed a political solution in the immediate glare of an election, instead of a sound economic, market-based solution to a financial crisis.

The 228 House Representatives who on Sept. 29 put aside political pressure to heroically vote against a flawed plan should have taken the lead in this firefight to offer up an alternative plan. It just so happens there was a really good one out there. The problem is that it wouldn’t serve the “Masters of the Universe,” the lobbyists, or the politicians who are paid off by both.

News and Related Story Links:

• CNNMoney.com:
  Bailout is law.
• MarketWatch.com:
  Bush signs historic rescue package.
• BBC News:
  Bailout bill: Still a bitter pill?
• Wikipedia:
  Mortgage-Backed Securities.
• Web Site:
  Biltmore Hotel.
• Wikipedia:
  Mark-to-Market Accounting.
• Journal of Accountancy:
  The Role of Fair Value Accounting in the Subprime Mortgage Meltdown.
• Wikipedia:
  Credit Default Swaps.
• Wikipedia:
  Bonfire of the Vanities.
• Money Morning News Analysis:
  Surprise Rejection of Bailout Deal Causes Record Decline in U.S. Stocks, Paves the Way for a Better Accord.
• Money Morning Market Analysis:
  Heads I Win, Tails You Lose: Why the Senate Bailout Bill Will Fail Taxpayers.
• Money Morning News:
  Bailout Bill Clears the Senate, Heads for (Another) House Vote. 

Back to Archive

While it’s clear from the current credit crisis that our financial system is at a critical juncture, it’s just as clear that there’s no agreement over how we should fix the problems we face. The reality is that neither the plan put forth by U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. – nor any of the addendums offered up by Congress or the lobbyists – will resolve this crisis.

The key culprits are the structured financial products that reside on the balance sheets of banks, dead investment banks, insurance companies, hedge funds and all manner of other duped and unsuspecting investor entities worldwide, as well as the proliferation of the unregulated $62 trillion credit default swaps (CDS) market.

Because all these securities, and in the case of credit default swaps, bilateral contracts, are impossible to value and impossible to guarantee, no one trusts them. As a result, everyone is afraid of these securities and contracts.

Banks are currently not lending to one another because they are afraid that the next round of write-downs and losses may imperil some of their trading partner banks to which they formerly lent billions and billions of dollars to every night. If the answer were really as simple as adding liquidity, the Federal Reserve would have lowered the Fed Funds target. But that won’t work. It’s a vicious cycle that’s eroding banks’ faith in one another, and worse, our faith in our banks.

Unfortunately, I don’t see the Treasury Department’s much-needed rescue plan being effective without actually addressing the pricing of – indeed, the very existence of – credit default swaps and collateralized debt obligations. As well intentioned as it is, the Treasury plan will create more problems than it solves and will eventually saddle taxpayers with so much debt that it will tank the dollar. It could even put the U.S. government’s AAA investment rating at risk. That would be calamitous.

I have a modest proposal that I’m calling the Money Morning Plan, because it potentially heralds a new dawn in the credit crisis, addressing the problems from the bottom up, and not from the top down. The bottom line is that my plan will end the credit crisis quickly with potentially little or no cost to taxpayers. And those are the two most important benefits of all. I present my plan as an open letter for public debate.

Contributing Editor and credit expert Shah Gilani outlines a bailout plan that could ease the banking crisis at a minimum cost for U.S. taxpayers. It’s a complicated issue, no doubt. Please take a look at the “Money Morning Plan” below. If you believe some (or all) of these points make sense, we urge to pass them along to your state’s representatives, as the Congressional dialogue is now in full force and time is of the essence. Just
click here to get a listing of your state’s representatives.

An open letter to U.S. Treasury Secretary Henry M. Paulson, Federal Reserve Chairman Ben S. Bernanke, Distinguished Members of Congress, and the American Taxpayers:

Dear Ladies and Gentlemen,

How we respond to the upheavals in our financial markets will define the American character at home and in the eyes of the world. With our cherished history of free markets and entrepreneurial spirit, we should guide ourselves as we always have, trusting our collective financial interests to our Constitution, which created a government by the people, for the people. Trying times are not a mandate to foreswear our personal, financial nor collective economic interests to any lobby or government other than one that protects all our rights, especially the right to not be taxed unfairly or unjustly.

The proposed Treasury Department rescue plan before Congress has not been presented without due consideration. There are, however, other proposals that merit our collective contemplation. As a taxpayer and investor, I am proposing an alternative plan for open discussion. We need to act quickly, but we need to act responsibly.

Respectfully;

Shah Gilani
Contributing Editor
Money Morning

www.moneymorning.com

The Money Morning Plan

1. Establish an empowered, not overpowering, regulatory apparatus to rein-in structured products and establish protocols for the creation and tradability of financial products based on real-world economics and hedging considerations. Products must be transparent, easily valued and rated on a universal ratings model.
2. Establish regulated standards to support the universal ratings model and allow free-market competition for providing rating services based on a “pooled-income revenue model,” whereby all issuers that either want to be rated, or that are required to be rated, pool funds on a per-volume, pro-rata basis and ratings providers are paid blindly for rating services.
3. Immediately stop the issuance of credit default swaps without mandatory reserve requirements and safeguards typical of what insurance regulations already require of legitimate insurers. Net out all existing credit default swaps to tighten counterparty risk and unwind positions that cannot be secured by issuers meeting adequate reserve requirements. Eliminate virtual insurers.
4. Only allow issuance of credit default swaps up to the actual outstanding dollar value of corporate debts and loans outstanding. This will ensure legitimate hedging and eliminate undue pressure on outstanding debt issuers.
5. Create a class of “eligible (mortgage-related only) securities” that constitutes problem securities. Leave all eligible securities on the books of existing holders.
6. Have eligible security holders identify to the U.S. Federal Reserve every eligible security by CUSIP and face amount. Only the Fed will have knowledge of institutional and investor positions. This will allow the Fed to correctly assess the risks at hedge funds and others with “significant operations” without exposing their positions to competitors.
7. Create a new accounting domain in-between “held-to-maturity” and “available-to-trade” where only eligible securities, as of a predetermined valuation date, can be accounted for at their value on the predetermined valuation date and not further subject to fair-value (marked-to-market) accounting, while held.
8. Mandate all holders of eligible securities mark-to-market inventories on a predetermined valuation date, preferably as soon as the Fed expects all eligible securities to be registered with it. Those who have recently marked their securities have already taken their write-downs; those who haven’t will have to. If the totality of the resolution represents a bona-fide solution, investors and speculators will bid up eligible securities to own them before the predetermined valuation date, because of newly ascribed accounting advantages of holding eligible securities.
9. Reduce the haircut on the reserve requirements for all eligible securities covered by this plan. Since valuations have already fallen precipitously, reducing reserve requirements on eligible securities would additionally enhance their value as balance-sheet assets with upside potential.
10. Have both the Fed and Treasury determine a liquidation or receivership outcome for holders suffering from insolvency as a result of accurately marking-to-market their holdings on the predetermined valuation date in the event bankruptcy would result in further systemic problems. This scenario would be cheaper and quicker to manage than what’s in store for us under the present Treasury draft, and it allows the two to assess the potential fallout of insolvent entities prior to their exposing the financial system to resulting disruptions. Hedge funds would not be saved.
11. The Fed must establish and manage a conservative, transparent pricing model for eligible securities based on actual underlying cash-flow measures, projections and model specific criteria. Absolutely no trading would be allowed over-the-counter or otherwise on any of the eligible-securities specific pricing models or indexes.
12. The Fed, with a firm handle on all eligible securities and a transparent-pricing methodology, would have to take in any and all eligible securities as collateral against Fed borrowings from the discount window or through its dealer facility.
13. “Servicers” managing underlying mortgages on behalf of trust entities, under which securitized pools are created, must be empowered to alter and modify terms and conditions of underlying mortgages in conjunction with originating banks or lending institutions.
14. To incentivize banks and lending institutions to modify existing mortgages and to incentivize homeowners to stay in homes with upside-down mortgage-to-appraised values, eliminate all capital gains on appreciation of newly appraised homes when they are sold by either homeowners, banks or lending institutions.
15. Create tax-advantaged scenarios for banks and homeowners partnering in the reduction of delinquent obligations whenever loans can be brought to a performing status.

News and Related Story Links:

• Wikipedia:
  Henry M. “Hank” Paulson Jr.
• Wikipedia:
  Credit Default Swaps.
• Investopedia:
  Credit Derivatives (Bilateral Contracts).
• Wikipedia:
  Structured Financial Product.
• Wikipedia:
  Haircut.
• Money Morning Market Commentary:
  Dear Ben: To Save the U.S. Economy, Here Are the Moves You Need to Make Now.
• Wikipedia:
  Securitization.
• Wikipedia:
  Asset-backed security.
• Money Morning Market Analysis Series:
  Inside Wall Street: Why Hocus-Pocus Accounting Will Perpetuate the Capital Markets Credit Crisis (Part I).
• Money Morning Market Analysis Series:
  Inside Wall Street: The Hocus-Pocus Accounting Tricks That Will Perpetuate the Capital Markets Credit Crisis.
• Wikipedia:
  Subprime Lending.
• ISO.com:
  Virtual Insurers Will Thrive in a Wired World, Says Futurist at ISO’s AISG INSTECH98 Conference.
• Wikipedia:
  Structured Finance.
• Wikipedia:
  Collateralized Debt Obligations.
• Money Morning Market Analysis:
  Why Mark-to-Market is Bad News for Shareholders.
• Wikipedia:
  Tranches.
• Wikipedia:
  Counterparty.
• Money Morning News Analysis:
  The Government’s Financial Crisis Fix-it Plan Sends Stocks Soaring, Though Some Argue There’s no Quick Fix for this Disaster.
• Wikipedia:
  Hi-Yield Debt (Junk Bond).
• Wikipedia:
  Mark to Market.
• Chest of Books:
  Eligible Security.
• Wikipedia:
  Mortgage-Backed Securities
• Money Morning Market Commentary:
  Sen. Dirksen: Allow Me to Introduce You to Standard & Poor’s.

Back to Archive

There’s nothing fundamentally wrong with the core insurance business units of American International Group Inc. (AIG). Nothing at all. What imploded the venerable insurance giant was an accumulation of misplaced bets on credit default swaps.

By the best estimates of the International Swaps and Derivatives Association and the Bank for International Settlements (BIS), often referred to as the central banks’ central bank, the notional value of credit default swaps out in the market place is some $62 trillion, or 35 trillion British Pounds at an exchange rate of $1.78.

A credit default swap (CDS) is akin to an insurance policy. It’s a financial derivative that a debt holder can use to hedge against the default by a debtor corporation of sovereign. But a CDS can also be used to speculate.

A subsidiary of AIG wrote insurance in the form of credit default swaps, meaning it offered buyers insurance protection against losses on debts and loans of borrowers, to the tune of $447 billion. But the mix was toxic. They also sold insurance on esoteric asset-backed security pools – securities like collateralized debt obligations (CDOs), pools of subprime mortgages, pools of Alt-A mortgages, prime mortgage pools and collateralized loan obligations. The subsidiary collected a lot of premium income and its earnings were robust.

When the housing market collapsed, imploding home prices resulted in precipitously rising foreclosures. The mortgage pools AIG insured began to fall in value. Additionally, the credit crisis began to take its toll on leveraged loans and it saw mounting losses on the loan pools it had insured. In 2007, the company was starting to feel serious heat.

From its humble beginnings in China in 1919 – through the 40-year tenure of CEO Maurice R. “Hank” Greenberg, which ended ignominiously for Greenberg in 2006 – AIG grew aggressively. Greenberg grew and diversified the insurance giant, ultimately amassing a trillion-dollar balance sheet.

But not everything was Kosher.

In an effort to assuage analysts and maintain leverage, the firm entered into sham transactions to affect the appearance on its balance sheet of $500 million of loan-loss reserves, which analysts had been questioning as formerly declining. The result was a 2006 Securities and Exchange Commission enforcement action, a $1.6 billion settlement and the removal of Greenberg. Greenberg is still fighting civil charges related to his actions at the firm.

As 2007 progressed, so did the losses on AIG’s books and credit default swaps. Once again, it appears that AIG tried to “manage” the problem through accounting maneuvers. Last February, for instance, AIG said that “its auditor had found a material weakness in its accounting.” It had not been properly valuing its CDO liabilities and swap-related write-downs. The losses were revealed to be in excess of $20 billion through this year’s first quarter. The SEC is once again investigating, as are criminal prosecutors at the U.S. Justice Department and the U.S. Attorney’s Office in Brooklyn.

After writing down assets against gains elsewhere, AIG posted cumulative losses of $18 billion over the last three quarters. In February, AIG posted $5.3 billion in collateral against credit default swap contracts it had written. In April, AIG had to post an additional $4.4 billion in collateral. When rating agencies Standard & Poor’s, Moody’s Investors Service (MCO) and Fitch Ratings Inc., lowered the firm’s ratings last Monday evening, it triggered an additional $14 billion collateral call as margin against AIG’s credit default swaps.

The company didn’t have the cash.

Indeed, the dire need for cash collateral on top of mounting losses on warehoused CDO “assets” on the company’s balance sheet necessitated a massive infusion of capital. That’s what happened to AIG.

But once again, there’s the story – and there’s the story behind the story.

There’s a problem – an inherently systemic problem – and it has to do with how structured investments like tranched collateralized debt obligations (CDOs), residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and credit default swaps on them and on corporate debts and loans are actually valued.

Individually, CDOs are hard to value. Suffice it to say, legend has it that constructing the cash flow payments on the first theoretical 3-tranche CDO (the simplest type of CDO) took a Cray Inc. (CRAY) supercomputer 48 hours. Now try and value credit default swaps on them!

Because there are so many different individual CDO securities, and because there are so many credit default swaps on so many of these CDOs, and so many swaps on individually referenced entity debts and loans, the only way to value them in a portfolio is by indexing.

That’s right, there are indexes, and guess what? You can trade the indexes! Markit Group Ltd., of London, constructs and manages the CDX, ABX, CMBX and LCDX family of credit-default-swap indexes. Investopedia has a decent little tutorial.

Here’s the problem: If you own a portfolio of CDOs, and the only way to value them (or, at least, to develop a valuation that others are reasonably certain to respect), is by looking at them through the prism of an index of credit default swaps on them, you’re at the mercy of the index. Your portfolio, your securities may not be so bad, but you may not really know based on mortgage-duration analysis and foreclosure events that you can’t calculate. So you value, or mark-to-market, against the closest index.

Here’s the rub. What if other speculators are selling short – that is, betting in anticipation of that index going down? What if large portfolio-hedgers are selling short the index to hedge the portfolio they can’t sell because no one will buy it – because no one knows what it’s worth?

It’s crazy. And it gets worse.

What if you’re running a profitable company that needs to borrow money, but credit default swaps (bets against your ability to pay back your debt) are expensive by virtue of speculators fear and greed, such that if any bank looks at where the CDS pricing on your paper is trading, they tell you: “Sorry, but we can’t lend you money because the market for credit default swaps thinks you’re a bad bet.”

You don’t get the loan. You can’t build your factory; you can’t produce and have nothing to sell. The upshot: Now you actually are going out of business. Is this self-fulfilling?

Ponder this: Last Monday, as AIG was initially seeking $20 billion in capital and actually had it in hand (by virtue of a deal with New York insurance regulators), traders were bidding up credit default swaps on AIG’s debt and loans so furiously that based on the insurance premiums traders were actually paying for default insurance on AIG… the company was already dead. Self-fulfilling?

Credit default swaps are creating a downward spiral in the capital markets, driving up the cost of capital, and squeezing out all manner of borrowers. And these speculative bets run amok are undermining all U.S. Federal Reserve and U.S. Treasury Department efforts to “liquefy” the system. If this keeps up, the credit default market could sink the U.S. economy into a recession/depression that will make the Great Depression look like a day at the beach.

Anyone got a towel?

News and Related Story Links:

• BIS.org:
  Bank for International Settlements.
• Wikipedia:
  Credit Default Swaps (CDS).
• Money Morning News:
  JPMorgan Raises Bear Stearns Bid.
• Wikipedia:
  Over-the-Counter.
• Money Morning News Analysis:
  Fed Steps in and Bails Out AIG to the Tune of $85 Billion in Taxpayer Funds.
• Wikipedia:
  Mortgage-Backed Securities.
• Web Site:
  International Swaps and Derivatives Association.
• SEC Press Release:
  SEC Charges AIG with Securities Fraud.
• Wikipedia:
  Maurice R. “Hank” Greenberg.
• Money Morning Market Analysis:
  Credit Default Swaps: A $50 Trillion Problem.
• Wikipedia:
  Subprime Lending.
• Money Morning Market Analysis:
  Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout.
• Wikipedia:
  London Interbank Offered Rate (LIBOR).
• Wikipedia:
  Collateralized Debt Obligations.
• Wikipedia:
  Alt-A mortgages.
• The Business Spectator:
  Rio Tinto to Sell 3-Tranche Dollar Bonds: Source.

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Are you shell-shocked? Are you wondering what’s really going on in the market? The truth is probably more frightening than even your worst fears. And yet, you won’t hear about it anywhere else because “they” can’t tell you. “They” are the U.S. Federal Reserve and the U.S. Treasury Department, and they can’t tell you what’s really going on because there’s nothing they can do about it, except what they’ve been trying to do – add liquidity.

At the exchange rate yesterday (Wednesday), 35 trillion British Pounds was equivalent to U.S. $62 trillion (hence, the 35 trillion Pound gorilla). According to the International Swaps and Derivatives Association, $62 trillion is the notional value of credit default swaps (CDS) out there, somewhere, in the market.

This isn’t the first time Money Morning has warned readers about the dangers of credit default swaps. And it won’t be the last.

The Genesis of a Derivative Boom

In the mid-1980s, upon arriving in New York from Chicago with an extensive background trading options and futures (the original derivatives), I was offered a job at what was then Citicorp [today's Citigroup Inc. (C)]. The offer was for an entry-level post in the bank’s brand new OTC (over-the-counter, meaning not exchange traded) swaps and derivatives group. When I asked what the economic purpose of swaps was, the answer came back: “To make money for the bank.”

I declined the position.

It used to be that regulators and legislators demanded theoretical, empirical, and quantitative measures of the efficacy of new tradable instruments being proposed by exchanges. What is their purpose? How will they benefit the capital markets and the economy? And, what safeguards will accompany their introduction?

Not any more. In the early 1990s, in order to hedge their loan risks, J. P. Morgan & Co. [now JPMorgan Chase & Co. (JPM)] bankers devised credit default swaps.

A credit default swap is, essentially, an insurance contract between a protection buyer and a protection seller covering a corporation’s, or sovereign’s (the “referenced entity”), specific bond or loan. A protection buyer pays an upfront amount and yearly premiums to the protection seller to cover any loss on the face amount of the referenced bond or loan.

Typically, the insurance is for five years.

Credit default swaps are bilateral contracts, meaning they are private contracts between two parties. CDSs are subject only to the collateral and margin agreed to by contract. They are traded over-the-counter, usually by telephone. They are subject to re-sale to another party willing to enter into another contract. Most frighteningly, credit default swaps are subject to “counterparty risk.”

If the party providing the insurance protection – once it has collected its upfront payment and premiums – doesn’t have the money to pay the insured buyer in the case of a default event affecting the referenced bond or loan (think hedge funds), or if the “insurer” goes bankrupt (Bear Stearns was almost there, and American International Group Inc. (AIG) was almost there) the buyer is not covered – period. The premium payments are gone, as is the insurance against default.

Credit default swaps are not standardized instruments. In fact, they technically aren’t true securities in the classic sense of the word in that they’re not transparent, aren’t traded on any exchange, aren’t subject to present securities laws, and aren’t regulated. They are, however, at risk – all $62 trillion (the best guess by the ISDA) of them.

Fundamentally, this kind of derivative serves a real purpose – as a hedging device. The actual holders, or creditors, of outstanding corporate or sovereign loans and bonds might seek insurance to guarantee that the debts they are owed are repaid. That’s the economic purpose of insurance.

What happened, however, is that risk speculators who wanted exposure to certain asset classes, various bonds and loans, or security pools such as residential and commercial mortgage-backed securities (yes, those same subprime mortgage-backed securities that you’ve been reading about), but didn’t actually own the underlying credits, now had a means by which to speculate on them.

If you think XYZ Corp. is in trouble, and won’t be able to pay back its bondholders, you can speculate by buying, and paying premiums for, credit default swaps on their bonds, which will pay you the full face amount of the bonds if they do actually default. If, on the other hand, you think that XYZ Corp. is doing just fine, and its bonds are as good as gold, you can offer insurance to a fellow speculator, who holds the opinion opposite yours. That means you’d essentially be speculating that the bonds would not default. You’re hoping that you’ll collect, and keep, all the premiums, and never have to pay off on the insurance. It’s pure speculation.

Credit default swaps are not unlike me being able to insure your house, not with you, but with someone else entirely not connected to your house, so that if your house is washed away in the next hurricane I get paid its value. I’m speculating on an event. I’m making a bet.

The bad news is that there are even worse bets out there. There are credit default swaps written on subprime mortgage securities. It’s bad enough that these subprime mortgage pools that banks, investment banks, insurance companies, hedge funds and others bought were over-rated and ended up falling precipitously in value as foreclosures mounted on the underlying mortgages in the pools.

What’s even worse, however, is that speculators sold and bought trillions of dollars of insurance that these pools would, or wouldn’t, default! The sellers of this insurance (AIG is one example) are getting killed as defaults continue to rise with no end in sight.

And this is only where the story begins.

The Ticking Time Bomb

What is happening in both the stock and credit markets is a direct result of what’s playing out in the CDS market. The Fed could not let Bear Stearns enter bankruptcy because – and only because – the trillions of dollars of credit default swaps on its books would be wiped out. All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions and billions of dollars in losses that they’ve been carrying at higher values because they could say that they were insured for those losses.

The counterparty risk that all Bear’s trading partners were exposed to was so far and wide, and so deep, that if Bear was to enter bankruptcy it would take years to sort out the risk and losses. That was an untenable option.

The Fed had to bail out Bear Stearns.

The same thing has just happened to AIG. Make no mistake about it, there’s nothing wrong with AIG’s insurance subsidiaries – absolutely nothing. In fact, the Fed just made the best trade in its history by bailing AIG out and getting equity, warrants and charging the insurance giant seven points over the benchmark London Interbank Offered Rate (LIBOR) on that $85 billion loan!

What happened to AIG is simple: AIG got greedy. AIG, as of June 30, had written $441 billion worth of swaps on corporate bonds, and worse, mortgage-backed securities. As the value of these insured-referenced entities fell, AIG had massive write-downs and additionally had to post more collateral. And when its ratings were downgraded on Monday evening, the company had to post even more collateral, which it didn’t have.

In short, what happened in one small AIG corporate subsidiary blew apart the largest insurance company in the world.

But there’s more – a lot more. These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. Knowing what all this means for hedge funds, the credit markets and the stock market is the key to understanding where this might end and how.

The rest of the story will be illuminated in the next two installments. Next up: An examination of the AIG collapse, followed by a look at how bad things could get, and what we can do to fix the problem at hand. So stay tuned.

News and Related Story Links:

• Wikipedia:
  Credit Default Swaps (CDS).
• Money Morning News:
  JPMorgan Raises Bear Stearns Bid.
• Wikipedia:
  Over-the-Counter.
• Money Morning News Analysis:
  Fed Steps in and Bails Out AIG to the Tune of $85 Billion in Taxpayer Funds.
• Wikipedia:
  Mortgage-Backed Securities.
• Web Site:
  International Swaps and Derivatives Association.
• Money Morning Market Analysis:
  Credit Default Swaps: A $50 Trillion Problem.
• Money Morning Market Analysis:
  Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout.
• Wikipedia:
  London Interbank Offered Rate (LIBOR).

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