Global Conspiracy of Fools
Also Stephen Roach - Tilt
Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his January newsletter.
A detailed account, superbly researched and documented, of the Enron debacle under the title “A Conspiracy of Fools” by Kurt Eichenwald, recently read, is the inspiration for the question above. There is, at least, a workable hypothesis that the Enron rise and collapse is a possible microcosm of the global bubble ongoing, stoked by massive credit emanation currently believed to be the New Wave of Economic Growth. In it’s time, Enron was believed to be the new model of corporate growth, expanding exponentially more rapidly than prosaic forebears, incorporating marketing and financial genius, transforming industries and economies and enriching vast constituencies. It was, in fact, a gigantic scam and sham able to deceive with aplomb virtually all areas of expertise in understanding and analyzing risk and reward. A combination of fraud, greed, obliviousness, unbridled ego, unquestioned belief in growth, and fascinated obsession with financial innovation catalogues the “E” debacle. Virtually all these elements are in plentiful supply in global financial markets and the players therein as the world “reflates” with a vengeance in every nook and cranny having a medium of exchange and the means to exchange it.
There is no question of the criminality of many of the players in the Houston company’s demise, however, there is also clear proof that the complexities of modern finance are beyond the comprehension and understanding of many extremely intelligent and supposedly well informed “leaders” of the mammoth organizations now proliferating at excessively rapid growth rates across the global economy. In the abbreviated mini-downturn of 2000-2002, abruptly terminated by plummeting Fed rate cuts and massive liquidity injections (First in the $ Trillions from the GSE’s and latterly in the $ Trillions from the Primary dealer, hedge fund and bank lending arenas), there were quite a few Enron-like disasters such as the two currently in the trial headlines, Worldcom and Tyco. Again, there is criminality aplenty but also plentiful further evidence of inability of supposedly astute “leaders” and observers to unravel what seemingly are relatively complex but not insuperably difficult frauds and misuses. More recently, the burgeoning AIG scandal, the shocking GM cash flow reversal and the ongoing flow of announcements from the Citi’s and BofA’s confirm the following thesis:
MARKET AND CORPORATE GROWTH HAVE EXPANDED BEYOND THE ABILITY OF THOSE IN CHARGE TO BE AWARE OF AND COMPREHEND THE INCREDIBLY RAPIDLY GROWING RISKS, BOTH BUSINESS AND ETHICAL/INTEGRITY, ASSUMED IN THIS GROWTH!
This growth, unprecedented during the 1990’s, although marred by episodic blow-ups easily quelled by Fed/Central Bank/GSE liquidity emanation, has expanded exponentially globally since the Greenspan demotion of interest rates below 0%, inflation adjusted, in 2002 and the maintenance at that level until succeeded by, in effect, a guaranteed “contract” between the Fed and the Brobdingnagian financial colossus labeled the “Leveraged Speculative Community” by Doug Noland, of a “measured” policy enabling ongoing profitable speculation. The “policy/contract” even produced a “conundrum” for the redoubted Sir Alan when long rates fell as he “measuredly” raised the short end.
Some rational observers have noticed that a “guaranteed” spread, even when shrinking, is just as possibly profitable with a concomitant increase in leverage!
In the “carry trade” a massive increase in leverage is a massive increase in demand creating part of the Fedheads conundrum. He has had to actually mutter the “bogeyman” word (inflation) to try to, belatedly, stem the onrush into longer dated instruments by the “carry traders” and the vitiation of spreads out along the risk curve. (The rest of Greenie’s conundrum, if he would bother to look at the Fed Z1 report, is from what Anatole Kaletsky calls the three brain dead zombie fixed income investors, Asian central banks, Western pension and insurance funds and, most importantly, Japanese private investors. John Mauldin included a piece entitled “Of Bonds and Zombies” by Kaletsky in one of his recent fascinating “Outside the Box” efforts and more detail on the underlying support for long fixed income exacerbated by the hedgies playing the carry can be found at GaveKal.com.) The aforementioned zombies have provided the unlikely “ceiling” for longer U.S. rates in a seeming anomaly, permitting the continued chase for performance fees by the burgeoning hedge fund community using the carry trade as a significant part of their strategy. Foreign holders of Treasuries have accumulated $1,385 Trillion!
In a recent Credit Bubble Bulletin, Doug Noland summarized the credit sources available to the “Leveraged Speculators” just recently. The big 5 of Bear, Lehman, Goldman, Morgan Stanley and Merrill have expanded their borrowings 24% year over year to February and 44% over 2 years to a total of $2.60 Trillion. Bank credit is up $252 Billion so far in 2005 (a 19.4% annualized rate). In its infinite wisdom, the Fed Z1 report omits repos/reverse repos of $3.2 Trillion thereby vastly understating the blowout, in recent times, in credit available for speculation.
GROWTH RATES IN CREDIT IN THE HIGH TEENS/TWENTIES IN % OUTRUN BOTH CREDIT DETERIORATION AND THE ABILITY OF MANAGEMENT, NO MATTER HOW PRAISED AND SOPHISTICATED, TO COMPREHEND AND MASTER THE AFOREMENTIONED RISKS OF BOTH THE QUALITY OF THE BUSINESS BEING DONE AND THE ETHICS/INTEGRITY OF THOSE WRITING IT!
Layered on top of the “visible” credit expansion (balance sheet) and the aforementioned “repo” world of credit is a new game rapidly reaching prodigious proportions. CDS (Credit Default Swaps) is the fastest growing game in Speculation Town, the fastest growing gambling town in human financial history. A survey done by Fitch found the total under the purview of U.S. banking regulators at $3.1 Trillion by the end of 2004, having DOUBLED during the course of the preceding year. A recent look at the Bank for International Settlements year end derivatives numbers showed this category globally at $6.4Trillion and Bloomberg totals $8.4Trillion throughout all markets. By the way, the same annual compilation by the BIS showed total notional derivatives outstanding at the end of 2004 of $221 Trillion! The mind boggles.
Obviously, the bulk of this stuff is interest rate and foreign exchange, not to say that it is not potentially explosive in nature (Anybody remember Bankers Trust, Orange County, Gibson Greeting et al 1994?) and it is significantly obscure, given the willingness of the authorities to allow netting among the larger participants, but the credit default stuff is fuel for speculation and explosion where the notional category total in terms of “real” risk is not some computer derived tiny fraction but the actual amount at risk. “Financial Engineering, applauded by the eminent Alan, may disperse risk, thereby reducing it, or it may contain the seeds of greater risk an/or deals of questionable or even fraudulent provenance. Warren Buffett, of unquestioned integrity, is now caught up in the Greenberg/AIG deal, of which he knew. The fact that on March 29, Berkshire said in a statement repeated in the WSJ 3/30 that Mr. Buffett “WAS NOT BRIEFED ON HOW THE TRANSACTIONS WERE STRUCTURED OR ON ANY IMPROPER USE OR PURPOSE OF THE TRANSACTIONS.” Leaves two possibilities. 1) He is dissimilating or 2) the size of Berkshire and General Re, the complexity of financial engineering and some generalizations by a, presumably, trusted subordinate after a non-detail conversation with Greenberg previously, left Buffett feeling comfortable about a questionable transaction.
We are inclined towards 2 above and that makes the point of the thesis: The best, most honest, brightest of CEO’s cannot possibly stay on top of what goes on in these complicated financial megaliths. If the presumed honest, such as Buffett cannot, how can anybody believe that it is possible in the convoluted world of an AIG, driven by a CEO consumed by the company’s stock price (per statements by Wall St. analysts on the pressure from “Hank” for laudatory comments) and executives, motivated by excessive compensation for achievement of outlandish financial goals, that anyone within the company actually knows what is really going on. AIG is clearly out of control and only time will tell the order of magnitude. The question is how many other Financial Giants and BFB’s (Big Famous Banks) are in similar condition. The bonuses to the CEO’s are still given a la B of A where there is clear evidence the troops were out of control, based on a Board’s ridiculous excuses for “performance against goals” which obviously did not include having a spotless record in terms of regulatory, compliance or integrity to customers. Buffett himself has said that nobody can analyze entities such as Fannie Mae and he has likened derivatives to “financial weapons of mass destruction” but, nevertheless, finds himself beset within his own company. Jim Grant, of Grant’s Interest Rate Observer, an analyst truly worthy of respect, finds the FNM’s and JPM’s beyond analysis, as does this writer.
Speaking of Grant’s Interest Rate Observer (your writer is a “paid up subscriber” as Jim likes to refer to us and a member of a “small, perverse cult” as some commentators like to refer to such subscribers), in a recent issue, “deconvergence” was one of the articles. In it, a strategy is propounded. The concept is to use credit default swaps as a way to prosper if 1) credit analysis ever comes back into vogue and spreads go rational and 2) the euro gets into difficulty. Until reading this article, the writer was unaware of the current cost of obtaining credit protection on some of the various sovereign country European debt. Greece recently sold some 30 year paper at 4.45% or 26 basis points above the yield on German 30 year paper! As Jim says in the article: “Greece may be many things, but it is not 26 basis points removed from AAA quality.” We spent a couple of years lending to the country’s banks and we could not agree more. A Greek credit default swap for 10 years is available, according to the article and Bloomberg, at 14 basis points per year. The counterparty is not mentioned. The point is that if Greece were only to widen out by more than 14 bps, the deal goes into the money. Our point is that the counterparty is either some gigantic financial institution or a hedge fund. Likely, if a hedge fund, they are hedging the risk with a giant. Does anybody think Purcell, for instance, at Morgan Stanley, knows the details of the hundreds of billions of pieces of financial engineering being done. We happen to be a little more pro-euro than Grant but are still dubious on this bet. On the other hand, it is an example of the finest kind of credit default swap, a sovereign government which can actually print it’s way to payment. (They may elect to only print 30% a la Argentina) but at least the buyer of the swap won't get 100% probably of the face amount with 0% for the counterparty/swap seller. Citi managed to find $400 Million of sellers of CDS for Enron. Probably an example of the worst type of CDS back in 2002.
We wonder, in the halcyon days of of 4 ½ years of economic expansion, 2 ½ years of rising equity markets, falling unemployment and bad credit percentages and astronomically rising house prices, whether there may be some or a lot of deals being done in the CDS market which will provide the next “GREAT SURPRISE” for some CEO of one of these giants. In fact we like this bet as much as Grant’s bet against the CDS seller which we, not a GIANT institution, cannot participate in. It is about the only thing about CDS we like. Since all of this product is one-off, customized and “financially engineered,” our dim view of inherent risk and lack of understanding of such risk as it escalates continues to grow dimmer.
In a previous missive, we described the emergence of CDO SQUARED’S, debt obligations made up of synthetic CDO’s (CDS’s) leveraged into a higher yielding instrument. Now we have CDO CUBED’s, debt instruments leveraged another level filled with CDO SQUARED’s. We understand that at least one of the BFB’s is suffering significant problems with deterioration unexpected and premature in some of these. GM alone could cause such a problem, although we are unaware (as is virtually everybody) of the exact content of the CDO CUBED’s. As usual, total opacity in this over the counter, each issue unique world prevails. The March 31 WSJ has an article entitled “Amid Corporate-Bond Sell-Off, Risky Loan Market Chugs On. The presumption by the Journal is that this paper is favored over bonds because the loan “sits higher than bonds in a company’s capital structure” and mostly float in terms of interest rate. In passing, to this observer, if buying something for better bankruptcy protection, does it help to have rates cause an earlier possible bankruptcy? Leaving that aside, we posit that the real reason for the strength in this arena is the availability of such fodder for CDO’s and their combinations. Equally fascinating is the bailout of Krispy Kreme by CSFB and a hedge fund. Are we really to believe that this is a “relationship” deal or is the answer more fodder for a CDO. Anybody got a ready quote for a CDS on this one?
After many years of licking their wounds after the real estate disasters of the late ‘80’s and early 90’s, the Banking industry has really returned to the game with a vengeance. In the 1st 10 weeks of 2005, the industry grew real estate loans on an annualized basis of 19%. Home equity loans did even better at 21% year over year in the last report. Musing about the constant good health of the housing industry from the National Association of Realtors stating that the supply of homes for sale stays at lows of months of sale, we stumbled upon our old friend the numerator/denominator equation. Given that the 1980’s saw 400-500 thousand new homes sold per annum, the 1990’s some 800-900 thousand and recently, an annualized rate approaching 1,400,000, we are not surprised that the month’s sales number from the “unbiased” NAR stays low! Having been through a few housing busts, we know that this market doesn’t slow, it freezes. Say we have 700,000 supply at the moment, how much supply is there in terms of “month’s sales” at an annual sales rate of the 1980’s?
Recently, we have become aware of some statistics on the front end of this “market on fire”. 1.) Homes for sale, not yet started, have accelerated from a 1998 low of some 30M to in excess of 80M, exceeding the previous bubble number in 1991 of 70M. The rate of change recently growing over 60% yr over yr. 2) Homes not sold, still under construction has shot up from the 1993 low of 130M to over 260M, way over the previous bubble of 1989 of 220M. 3) Total New Homes for sale are headed for half a MILLION in a spike blowout 50% higher than anything previously seen. Admittedly, the extreme points of heat in this “market on fire” are concentrated geographically but so was the previous housing debacle that extinguished the S&L industry. Remember also, that the previous era did not have 0% down 5 yr I/O “financial engineering” to help it along. It also did not have the Trillions of $ of “financially engineered” mortgage backed securities.
The April 4 WSJ has an article on the OFHEO (Those nasty regulators of Fannie who doubted their accounting) that these persecutors are now looking at the “TRUSTS” used by Fannie to offload their guaranteed mortgages. Need we repeat our obvious theme that these indentures, created with exquisite “financial engineering” are complex, nearly innumerable at this point, and examined, if at all, on ratios and legality. Subsequent review after issue, is at best, perfunctory. Covenants on substitution in some we have seen are generally permissive and provide opportunities for Enron-like manipulation. Admittedly a “perverse cult” cynic, I cannot help but have the suspicion that a lot of these indentures are, upon close examination have everything from flaws to frauds contained therein. When that great denominator of housing sales slackens or, Heaven help and forfend, declines, the numerator may worsen by orders of magnitude more viciousness than the pedants of real estate currently foresee. The aforementioned article briefly hints at the possibility that some of these trusts, if flawed, may not flow back onto Fannie’s books but onto the banks that did the origination.
BAD ENOUGH THAT THE CURRENTLY WOEFULLY UNDERCAPITALIZED FANNIE MAY HAVE TO SWALLOW SOME OF THIS BUT WHAT A SHOCK TO THE MARKETS OF ANY WHOLESALE REPATRIATION OF THE TRILLIONS OF BANK INVOLVED BUT “OFF THE BALANCE SHEET” MORTGAGE CREDIT WOULD BE! ALL OF THIS, WE ADMIT, FROM A SINGLE DATA POINT/ARTICLE BUT NOT TO BE SHRUGGED OFF GIVEN THE OPACITY OF THE PROCESS.
Just to be totally ridiculous, let’s hypothesize that some number of these trusts are deemed flawed by OFHEO. Instead of, theoretically, flowing back onto Fannie’s balance sheet, they are deemed to be the obligation of the originator bank. Would it not be quite an irony for that bank to also hold the security as an asset!? Possible? Yes! What strange webs we mortal spin. The forgoing absurd soliloquy in aid of further demonstration of how complex this whole financial enterprise mechanism has become and further demonstration of how unlikely the risks are truly known, dimensioned and prepared/reserved for.
Throughout our experience, there have been two truly lagging indicators in the Financial Institution business 1.The Rating’s Agencies and 2 The Regulatory Agencies. Should we use Enron or AIG as the best example of the first category? How about the vintage 1983 Texas Commerce Bank, trumpeting itself in full page WSJ ads as one of two AAA banks not much before dropping a multi-hundred million clanger on the way to a distressed sale. “Nuff said.” Point is that the FDIC has just started to publish some cautionary commentary to it’s constituency and even the OCC seems to getting nerves/hives? The Fed doesn’t dare. All of this has been complicated by Sarbox and the SEC’s historic tendency to try and evaporate any “Unallocated” and therefore presumabllly “hidden earnings pocket” loan loss reserve just as the credit cycle turns. In the age of Enron, some financial institutions are not all that adverse to being “forced” to feed “excess” loan loss reserve into the earnings stream.
A reasonable observer of financial institutions might, at this point, have some reservations. One reasonable observer we are privileged to read, Charles Peabody of Portales Partners, the only “Street” analyst of Financial Institutions we respect, has lot’s of reservations. Cost of goods is going up, spreads are squeezed, there are lots of held to maturity assets which look to be in jeapoardy, branch expansion is rampant, competition on both price and credit standards is fierce and the economy just don’t seem to be hiring that many people. The Fed had to jigger the Z1 report in the last year by revaluing upward U.S. held “Non-Financial” assets(old bricks and mortar) by $900 billion to keep our net due foreigners below $5Trillion (It just exceeded that amount again)., and the current account deficit will accelerate as rates rise and what we have to pay accelerates. The domestic deficit is exploding and the consumer is sucking wind. If the market and/or the regulators slow the breakneck pace of credit creation previously detailed, the worst numerator (Bad Loans) is going to inexorably rise. Even if another $1.4-1.5 trillion in new mortgage credit plus corporations going berserk in capital spending were to be in the cards, there are ripplings of discontent in some of the zombie buyers in Asia. The Fed either has to keep raising rates or lose credibility and the famous “carry” will either require leverage even the prime brokers must be able to smell or will start to diminish. Two of the pillars of purchase of the four therefore look shaky. Three legged stools have a problem; two legged one’s collapse. When? Who knows? Whether-FOR CERTAIN.
The glorious days of burgeoning appraisals, magnificent cash-outs and “flipping” real estate for beginners are now turned over to home equity drawdown desperation, 0% down and no/low I/O mortgages, return to what is left of the credit card line and, finally, re-entry into lending on the most magnanimous basis by a banking system bereft of Fannie and Freddy.
The zombie buyers are not dead after all and are becoming restless. Brain death, if any is to be found, may be more domestic than foreign. All the Fed’s men and all the Fed’s horses (LIQUIDITY) have not resurrected Japan nor staved off EU recession. China and the U.S. are at the ends of their respective ropes.
CONCLUSION: OUR THESIS IS THAT THE GLOBAL FINANCIAL SYSTEM HAS UNWITTINGLY AND/OR GREEDILY GONE PAST ANY SAFE EXIT FROM A HUMONGOUS GLOBAL CREDIT BUBBLE. WHILE MALFEASANCE AND FRAUD WILL EMERGE IN THE AFTERMATH A LA LINCOLN SAVINGS AND PENN SQUARE; MUCH OF THE DAMAGE WILL HAVE BEEN DONE BY A CORPORATE/BANK/CENTRAL BANK LEADERSHIP OVERWHELMED BY A NEW, COMPLEX BREAKNECK, FINANCIALLY ENGINEERED CREDIT EXPLOSION A LA LTCM. HISTORY AND FORENSIC ACCOUNTING WILL JUDGE WHAT LEADERS WERE LARCENOUS, WHICH FRAUDULENT, WHOM WILLFULLY BLIND AND, FINALLY, THOSE OF THE EGO-DRIVEN OBLIVIOUS PERSUASION. THE COURTS AND PUBLIC OPINION WILL SORT THEM OUT!