06-19-07
Bad loans are made in good times.
– Markus Brunnermeier, Princeton economist
BLOWUPS ARE RARELY AMUSING for the investors caught up in them. But for those watching from the sidelines, well... sometimes it's hard not to chuckle.
When a hedge fund called Amaranth blew up last year, wags noted that the fund's namesake—the amaranth plant—was commonly known as "pigweed." (Three cheers for truth in advertising.)
Just recently, another hedgie outfit with a funny name got crushed. No flora or fauna jokes this time; Wall Street's casualty du jour is known as the "High Grade Structured Credit Strategies Enhanced Leverage" fund.
What a mouthful! Sounds like something dreamed up by the Ministry of Silly Walks. The way things turned out, they might as well have dubbed it the "Pile of Dry Leaves under Magnifying Glass" fund, or perhaps the "Giving Us Your Money is a Really Bad Idea" fund.
It had already been a rough year for HGSCSEL (snicker) due to well-publicized troubles in subprime land. Nonetheless, the situation seemed to be improving as credit markets stabilized. There was light at the end of the tunnel... until Friday, June 15th, when Moody's Investors Service proved that light to be a train. In a single stroke, Moody's downgraded $3 billion worth of especially stinky bonds. Quiet panic ensued.
$3 billion is less than 1% of the total quantity of subprime-backed bonds issued in 2006, the WSJ reports. Nonetheless, the move counted as "the most aggressive action yet taken" by a ratings service thus far—putting the enhanced leverage boys into a tailspin. Nervous observers fear more ratings carnage; when large swathes of "high grade" suddenly wake up as "low grade," the result is never pretty.
Investment house Bear Sterns, the owner of the flailing hedge fund, had a rough weekend. With investors screaming and margin calls mounting, fellow investment house Merrill Lynch had the indecency to seize a large chunk of collateral ($400 million bucks worth) on money it had lent to the fund. As of that same ugly weekend, the WSJ reports, HGSCSEL had $600 million in invested capital and $6 billion worth of borrowed funds on the books. Enhanced leverage indeed!
These geniuses aren't much different than the garden-variety genius who mortgages the house, maxes out the credit cards, and bets the whole kit and caboodle on one dubious hunch. Except the average joe doesn't have $6 billion to lose, and doesn't get cut as much slack when he stumbles. The struggling fund's collateral holdings have not been liquidated as of this writing; as TheStreet.com reports, Merrill is giving the boys some "breathing room."
They say sharks don't bite lawyers out of professional courtesy. Investment houses, in contrast, are happy to feed on their fallen brethren. Yet, when the livelihood of the group is threatened, the bankers close ranks. Merrill's willingness to play ball (for now) is not an act of charity.
Subprime players aren't the only ones given too much rope. Another hot trend is something called "rescue financing," where companies in various stages of collapse are given cash to stave off bankruptcy. If a few hundred million can make the difference between Chapter 11 and a last-ditch turnaround, a sufficiently aggressive lender can make a huge score. With high-yield defaults and corporate bankruptcies at a 10 year low, what's not to like?
Like inflation, the phenomenon of "rescue financing" is born of too much money chasing too few investment opportunities. With more hedge funds than Taco Bells in the United States, liquidity at full strength, and investors desperately "reaching for yield," there are billions and billions just sloshing around, looking for a home. Greed is large and in charge. Fear is on holiday.
Another product of the times is the ‘covenant-lite' loan, in which safety clauses to protect the lender are gamely stripped out of the contract. Normally, when lending someone a large chunk of change, the one doing the lending wants a margin of safety. (A high rate of return means nothing if principal is lost.) This safety comes in the form of legal provisos, or covenants, spelling out what is supposed to happen if the borrower runs into trouble; certain actions the borrower can or cannot take; certain conditions that will trigger immediate repayment; and so on.
‘Covenant-lite' is the borrower's way of throwing that protection out the window, in effect saying, Look... we both know that cash is a huge drag on performance. You have to deploy that money somewhere, or else you can't raise more from your investors. So I tell you what. I'll borrow the cash... as a favor from me to you... but only if you forfeit your margin of safety, and suck up the risk of things going wrong. (Besides, what could go wrong?)
As if that weren't enough, there is a special brand of lunacy known as the "covenant-lite revolver." The covenant-lite revolver is essentially an emergency line of credit, stripped of safety provisions, for companies to tap into just when things start looking bad. "Revolver" is synonymous with "revolving," of course, but in this context it's hard not to think of Russian Roulette.
Steven Rattner, an investment banker turned media mogul, has more than two decades of experience under his belt. He knows Wall Street from the inside out. In a recent op ed piece, Mr. Rattner made his feelings clear:
How curious that so many in the financial community should remain blissfully oblivious to live grenades scattered around the high-yield playing field. Amid all the asset bubbles that we've seen in recent years—emerging markets in 1997, Internet and telecoms stocks in 2000, perhaps emerging markets or commercial real estate again today—the current inflated pricing of high-yield loans will eventually earn quite an imposing tombstone in the graveyard of other great past manias.
...But we have little choice but to sit back and watch this car accident happen. It would have been a mistake to dispatch the Federal Reserve to deflate the dot-com mania or the housing bubble. And it would be a mistake now for the Fed to rescue imprudent high-yield lenders. They have to learn the hard way. Hopefully, not too many innocent bystanders will share their pain.
An even pithier summation comes from Steven Miller, a managing director at Standard & Poors. "It feels like Tony Soprano," Mr. Miller opines, "sitting in the ice-cream parlor with all this trouble brewing around him, and wondering where the bullet might come from."
Bada-bing.
Speaking of grand finales, remember the housing boom? California's debut of the 50-year mortgage?The issue of Fortune with REAL ESTATE GOLD RUSH on the cover? How about the perfect timing of condoflip.com, sporting its classic slogan "Bubbles are for Bathtubs?" (The website is still there, in chastened form; the slogan is not.)
All that euphoria went away when reality set in. Reality, in this case, meaning home foreclosures at their highest level in 37 years; nearly one out of five subprime loans headed for default; 17 million households coughing up half their income (or more) for the mortgage payment; U.S. homebuilder confidence at a 16-year low; and so on.
Wall Street and Main Street often seem like different worlds. Nevertheless, they are connected. If "no doc liar loans" were a bad idea for marginally qualified homebuyers, they will prove an equally bad idea for marginally qualified corporate borrowers. Reality just hasn't shown up yet.
This is a case of one wave following another. First the fed-induced liquidity wave rolled through the housing market... and then it rolled through Wall Street... and then it rolled through the corporate world. As with the housing boom gone bust, the corporate wave of reckoning will follow.
In Franz Kafka's 1915 short story, Metamorphosis, Gregor Samsa finds himself radically transformed overnight. In brief, Samsa goes to bed as his normal traveling-salesman self... and wakes up as a giant cockroach.At first, Samsa-the-cockroach still has the thoughts and feelings of Samsa-the-man. He cannot understand what has happened to him. His family is horrified; they beat him with a broom and lock him away. Poor Samsa is left to crawl the walls and ceilings of his bedroom, puzzling his fate as humanity fades. When the insect finally dies, the family feels a palpable sense of relief. It's as if a great burden has been lifted, and the sun can shine again.
There are many interpretations of Kafka's Metamorphosis; most of them focus on feelings of alienation and loneliness. Rarely is the tale applied to Wall Street.
When you think about it, though, the bursting of a credit bubble creates its own sort of metamorphosis in investors' minds. In a very small space of time—almost overnight—familiar and profitable markets suddenly become ugly, alien, grotesque. Gut-wrenching losses are beaten back, banished to a dark room, locked away. When the episode finally passes, everyone is relieved.
On the bright side, not every metamorphosis is grotesque. Sometimes, the ugly caterpillar turns into a beautiful butterfly.
Such may be the case with gold.
Gold has been locked in a descending channel for two months as of this writing, ever since it failed a second attempt to break the $700 barrier. As a result, many fans of the yellow metal have been vocally depressed. There are sad whispers that the "system" has won; that the manipulatory kinks have all been worked out; that gold will never again be allowed to have its day. It's time, the deflated enthusiasts say, to sell out of one's gold holdings, pick up the pieces, and move on.
To all that we say, Oh Please. Have patience! The butterfly is coming. The system hasn't won; things are progressing like clockwork. Resolutions take time is all. It's the same old game, down to the last jot and tittle. The premature instinct that says "throw in the towel on gold" is the same one that led the Economist to print its infamous "Drowning in Oil" cover in 1999. If anything, needless pessimism is a contrarian bullish sign.
The whole cockamamie fiasco we are living through… from housing bubble, to private equity bubble, to high yield bubble and so on… is based on a spigot of easy credit. That easy credit was first provided by Greenspan's Fed circa 2002, and then multiplied in spades by mercantilist financiers -- Asian exporters, oil sellers and the like selling their goods on credit, accepting paper dollars as payment, and recycling those paper dollars back into equities and treasury bonds.
Emerging market economies have staying power, but the euphoria we now witness does not. When the paper game ends—as it must, because there is nothing truly new here, nothing new in speculation under the sun—precious metals will be the beneficiary. More on that to come in future installments... until then, think of butterflies.
