An Eternal Goldilocks

Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his newsletter.

THE GLOBAL OUTSOURCING OF CREDIT ORIGINATION ACCOMPANIED BY BUYER WEALTH/SOPHISTICATION PERMITTING OPACITY IN SALES

Over the last 25 years, an incredible juxtaposition of intertwining financial circumstances through-out the globe, has permitted the myth of “An Eternal Goldilocks” Economy to Emerge and Thrive. Even now, after having recently skated closer to the edge of a measureless Financial abyss than imaginable, the myth, far from shaken in the foundation of a belief in infinity of continuity, twirls merrily on with perceived enhanced immunity from destruction.

To illustrate, to some extent, the strength of belief in the longevity of what some call a “Recovery,” others a “Boom,” I will state that until recently, when asked how long the “brief” instability seizing global financial markets might last; my reply had been that we “were in the first out of the 2nd half of the 1st inning.” I will introduce at this time, Satyajit Das, author of “Trader, Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives” and someone better equipped to calculate the longevity of the ongoing Credit Crunch than this author. When asked the same question by an astute observer, “was the credit crisis was in what Americans would call the ‘third inning,” it evoked a gale of laughter. Brought back to the second or first inning (author’s initial choice), Das, who knows as much about global money flows as anyone in the world (there really is nobody because this assumes knowledge beyond the edge of the known universe), Das stopped chuckling long enough to suggest that we’re actually still in the middle of the national anthem before a game destined to go into extra innings, and it won’t end well for the global economy.

BACK IN YOUR GRANDFATHER’S DAY, BORROWERS (INDIVIDUALS,COMPANIES, GOVERNMENTS, INSTITUTIONS) IN NEED OF FUNDS WOULD GO A /SOME BANKERS/S AND WOULD AGREE TO BORROW, PAY INTEREST ON AND REPAY SOME MONEY. THOUGHTFUL OVERSEERS (OTHER BANKERS, GOVT’S, REGULATORS ETC.) WOULD MAKE SURE THE BANKERS HAD SOME SKIN IN THE GAME AS CAPITAL, AND REVERVES OR GOLD IN THE VAULT MAKING THE GAME SELF LIMITING AND THE GAME WAS ON

Humans would, as was/is their wont, try and beat the right way and some money would be lost often enough to keep the game straight but an eye, a tooth or a bunch of shekels lost pretty much made it all work. Those of us around long enough have seen the odd tooth scattered on the floor and taught some by loss. Ponzi and some folks close to the South Seas thing lost more, and a few lost all, but the lessons lasted awhile and things kept on. Even “The Pools” and the bankers they played with in the 1920’s got sufficiently hurt to correct.
HAD TO DO WITH LEVERAGE! COULD ONLY JUST GET SO MUCH OF IT.!

Might have found this out back in 1987 when Milken, Drexel, the Citi loans to Brazil, some nonsense called Canary Wharf and some more called Federated/Macy’s and RJR might have left a real large pile of teeth and a fair amount of skin out there. Fella called Greenspan (Up until then famous for certifying the soundness of a certain Arizona S&L) made Fedhead and stopped it all cold with the printing press! Worked like a charm. All the good loans had better margins, bunch of vulture guys got rich buying what the Govt had grabbed and we had the famous NON-EXISTENT Greenspan PUT (NOW BERNANKE PUT). By the way, he/BERNANKE is the author of the book told Greenspan how to do it!

Worked fine through the Mexican thing everybody remembers, worked good when the Siamese let the cat out of the bag. Even made Russia a democratic defaulter. Kept things going when the dotcom, telecom, bubble started to lose air long enough to let LOADS of Greenspan Put (RATE CUTS) and LIQUIDITY (Rubin printing press) get the better class of bubble going and this was a whole new kind of:

BANKING LIKE WE HAD NEVER SEEN BEFORE. NO NEED TO HAVE ANY SKIN IN THE GAME. NO NEED TO HAVE ANY WORRY ABOUT RISK OR DURATION. (Let guys like Das explain that kind of stuff.) WE HAD A BRAND NEW CENTRAL BANK . WHY WE DIDN’T EVEN HAVE TO PUT OUT THOSE SCARY NUMBERS CALLED MONEY SUPPLY USED TO CAUSE THOSE WALL ST TYPES FREEZE UP THEIR LIQUIDITY HOSES LIKE THEY GOT CAUGHT OUT IN THE COLD. WHY ALL YOU HAD TO DO WAS GET CONGRESS UP THE ANTE ON HOW HIGH FANNIE AND FREDDY COULD GO (DON’T FORGET THEM GOOD OLD FHLB’S!) AND THEY COULD PUSH ALL THE BONDS AND GUARANTEES YOU COULD NEED RIGHT OUT THE DOOR.!FED COULD JUST LET IT’S BALANCE SHEET GO TO SLEEP.

Didn’t take those geniuses down on Wall long to realize (particularly when they turned out to be a little tainted) that they didn’t need those GSE’s that much, just a bunch of PH’D’s. Seems like the big banks were still getting over the RJR’s, Canaries, Federated etc (And had a new crop from the Enron’s, Tycom’s etc. This Syndicated lending stuff wasn’t all it was cracked up to be. Nice fees but long tails. Why not go the way they and their PH”D’s had figured out to get rid of the pesky high credit score, low fee, doc-riddled mortgages. Do a bunch of M&A’s Buy-outs, Stock Buybacks etc. on the:

SAME WONDERFUL “TRANCHE” BASIS THAT WORKED WITH THE RMBS’S AND THE CDO’S AND CDO’s SQUARED IN THE MORTGAGE GAME! WHY, WHOOP De DOO, THE INDUSTRY COULD TRANCHE UP TRILLIONS WITH A NICE OPAQUE MIX OF SUB-PRIME (SHH, DON’T CALL IT THAT ANYMORE), ALT-A (ONLY A MORTGAGE BROKER KNOWS WHAT IT IS ANYWAY) STOCK BUYBACK’S (GIFT TO GET OURSELVES) M&A (Y’ALL EVER SEEN THE CHANGE OF CONTROL NUMBERS?) AND LEVERAGED PRIVATE EQUITY DEALS

So now we have got to the outsourcing of the Origination. Every peckerhead pumping gas can pump houses. Those who can’t can do the appraisals..

BETTER YET, ALL THOSE LENDERS CAN GO OUT AND ORIGINATE WITHOUT HAVING TO ANALYZE WHETHER THE DEAL PAYS. JUST MIX AND MATCH A FEW ALT-A AND SOME NICE CRE (WE HAVEN’T EVEN GOTTEN BACK TO THIS GOLDEN OLDIE FROM THE ‘80’S!) ALONG WITH SOME HEDGE FUND LEVERED BUY-OUTS, SLING THE WHOLE THING INTO A CDO (SQUARED< CUBED, what have you? And then GO SELL THE STUFF ANDS GET IT OFF THE BOOKS!

Then we hit the crème de la crème! Some of us can Remember when buyers of most things financial were individuals, then more and more mutual fund managers, a mix of “financial advisers” and other helpers named something like that. They did a few hundred, thousand, tens of thousands or maybe a couple million shares and bonds were sold ON A MARKET WHERE THE PRICES COULD NOW BE ASCERTAINED TO SOME DEGREE IN MILLIONS OR MODEST MULTIPLES THEREOF.

IT WAS VITALLY NECESSARY TO CHANGE THE DISTRIBUTION MECHANISM IF ROE’S ON THE STREET WERE TO BE HIGH ENOUGH TO NOT ONLY MAKE BILLIONAIRES BUT REACH THE ULTIMATE CASH-OUT, SELL THE HEDGE FUND MANAGEMENT COMPANIES/PRIVATE EQUITY PLAYERS TO THE UNSUSPECTING PUBLIC! THE MASSIVE GROWTH IN HEDGE FUNDS, THEIR ASSOCIATED LEVERAGE AND THE PRIVATE EQUITY WORLD ASSOCIATED WITH FINANCIAL ENGINEERING, STRUCTURED FINANCE AND THE ALPHABET SOUP OF “ONE-0FF” DEALS, CDO’S CPPI’S, SYNTHETIC CDS’S PLAYED RIGHT INTO THE GAME. THE ONLY BUYERS OF THIS STUFF (BEFORE THE “FUND OF FUNDS GOT THE DOOR OPEN WIDER) WAS THE LOOPHOLE IN THE SECURITIES LAWS FOR THE “QUALIFIED INVESTOR”. THIS NEARLY COUNTLESS POOL OF CAPITAL SIGNED A SHEET OF PAPERTHAT CERTIFIED THEY HAD SO MUCH THAT THEY DIDN’T NEED TO KNOW ANYTHING; THEY ALREADY KNEW IT ALL?THE DISTRIBUTION SYSTEM WAS NOW A FLOOD CHANNEL. NATURALLY, SINCE THE POTENTIAL BUYERS KNEW EVERYTHING, THEY KNEW THAT THOSE, LIKE THEMSELVES, WHO ALSO KNEW EVERYTHING WOULD BID AGAINST THEM AND DEALS GOT DONE AT LOFTIER AND LOFTIER LEVELS.

Some office building owner had seen these types of cap rates before and dumped. Some tree grove owner thought trees didn’t grow to the sky but houses might and dumped. Mostly the smartest guys in the room tried to sneakily outbid each other. The distribution flood channel was wide and deep.

THE UNITED STATES COULD ISSUE ALL THE PAPER IT WANTED TO AND THE REST OF THE GLOBE GOT WELL OVER 5 TRILLION IN RESERVES AND COULD BUY ANYTHING THE U.S. CONGRESS DIDN’T THINK MIGHT BE RELATED TO THOSE NASTY FOLKS W HAD GONE TO WAR WITH.

Then those people who should never have been sold houses in the first place found out they couldn’t even afford the electricity. SUB-PRIME STRUCK!

With a PH’D or two more, we might have noticed that the marvelous distribution system took a while to get all the whatever through the pipes. In the meantime, before it became a “tranche” of a synthetic insured enhanced cdo squared, the Damn stuff had to be stuck somewhere. The Wall St. Machine had invented some short term wampum called Commercial Paper years ago. Companies such as the Dow 30 with real cash flow and solid balance sheets leading to real AA ratings issued it and Treasurers and Trustees etc. bought it. It yielded a couple bps more. Not content with the few hundred billion that this quality of company could come up with, “The Street” simultaneously solved the “parking problem” for the whatever in the pipeline, but also created lots more money called:

Behold:asset backed commercial paper!

A few trillion of this stuff greased the distribution flood channel and the fees and bonuses flowed and eventually the super cdo or whatever took the end product.

ONLY ONE PROBLEM; A FUND OR TWO (REMEMBER MANLY, AUSTRALIA) WOULD UP OWNING SOME OF THIS STUFF WITH (SHH?!?!) SUBPRIME IN IT. WORSE YET, NOBODY COULD BE CERTAIN WHICH FUNDS AND WHAT BUYERS WERE WITHOUT CHAIRS. PRIVATE EQUITY IS CALLED PRIVATE FOR A REASON AND HEDGE FUNDS DON’T HAVE TO TELL YOU ANYTHING EXCEPT 2 AND 20 AND THEY CAN, WITHOUT WARNING IN MANY CASES, SAY: OH, BY THE WAY THERE ARE NO REDEMPTIONS THIS MONTH, YEAR OR CENTURY

And so we arrive at the present with a trillion or so of central bank “liquidity” injected (Do they use a syringe, ouch!) into the system, 50bps of Panic from the helicopters piloted by a famous speaker and the landscape littered with a few discovered and, probably, a few more undiscovered, non-redeeming, liquidating and otherwise indisposed funds.

PROBLEM SOLVED, RIGHT?

But that guy was saying we’re at “By the dawn’s early light” Whassup?

Let’s try and cut this credit thing up into chewable, if not digestible pieces and look at it from the most simple of angles.

DIGRESSING COMPLETELY AS THE WORD CHEW WAS USED IN THE PARAGRAPH ABOVE, I WILL PRATTLE ON ABOUT THE ADVICE ONCE GIVEN ME ABOUT A CERTAIN TYPE OF CREDIT: YOU ALL HAVE HAD A PIECE OR, IF NOT AND ARE UNDER AGE 25. WILL ONE DAY. MY MENTOR CALLED THIS GENRE OF CREDIT “MOOSEMEAT” WHEN QUERIED HOW ONE COULD TELL, HE REPLIED “THE MORE YOU CHEW, THE BIGGER IT GETS!”.

I could stop now and label the whole schmozzle moosemeat (technical term) but will press stupidly on.

Sub-prime is NOT the important part of the existing AND COMING Residential real estate crisis.

The Wall St. Journal finally seemed to half discover this in a Thursday, October 11 article where, amazingly enough, they still use the header “Sub-prime”! The problem is much more up-scale than the (forgive the word but it seemed so appropriate although may not yet have made the dictionary) “moniker” sub-prime. The WSJ, mixing and matching, interject the appellation “high-rate” occasionally in lieu of sub-prime. Since one of the areas they have listed under “The United States of Sub-prime” is Greater Miami with a mean price approaching the GSE minimum, they seem more than a little mixed up but, fortuitously, half discover, as mentioned above, that the real problem in total $ terms, in residential, is up the price road a piece and therefore much more humongous than the lowly subprime. The article and some better use of the research, although they DID go through 250 million mortgage records is the wanton failure in underwriting, as prolific in the McMansions as in the true sub-prime.

(Anecdote: an astute investor buys a run down (sub-prime) couple of shacks in Vidor, Texas (You find it-True story.) They pay less than 20M fix them up and sell one for 70M. Looks like a sale at 40 but maybe a rental at 300 per mo on the other. Loss, maybe but what’s the significance. You lose nationally $100 Billion on sub-prime. What is the significance. Most of the sub-prime origination chain loses more than the principal after Morgan Stanley and the like write off buying these things. Worst case, Congress or not, sooner or later, we slide most of it into the FHA, the GSE’s or your friendly home loan, maybe on a short sale, maybe a chapter buy.

NO, the worst is in the prime! There isn’t an acquaintance you have who didn’t go get a “second home” or two or three or did a cash-out refi and gone off and/or got into a specific performance suit on a condo that doesn’t flip. If it hasn’t happened where you live wait or admit home is in Flint, Michigan.- This brand of stuff, Alt A and Prime is in the million and way up level. At the bottom it is going to look, act and be worth subprime! One loss of a couple of million on a $3 million condo in the 60% range equals 30 subprimes and Congress will have a hard time getting Fannie and Freddie up to 4, 417,000! They are still building this stuff at a prodigious rate. Who are they going to sell to; each other?

We have genius Europeans in my small town buying like crazy. Miami at 40% off! When the $ drops another 30% as Gentle Ben takes rates to 2 or 1 and the Euro yields 4%, you think they won’t panic? The Venezuelans have the barrier beach and it looks like heaven at the moment. Last big buy here was when Castro sent all Cuba’s wealth to Brickell Avenue. One final question: who buys all the baby boomer’s 6/5’s on the shores of sunny Lake Michigan when they move to their retirement home. Pray for a continuing Chinese bubble! The new story in a lot of places is the short sale. No, this isn’t some bear pushing down a stock. It’s an about to be foreclosed homeowner finding a buyer 40% down from the mortgage owed and easily convincing the bank to take the cash and cancel the mortgage. Gets complicated if the seller gets a 1099 for the phantom gain but less so if he cash-out refie-ed high enough lately enough. Find a good attorney.

BUT THOSE IN RESIDENTIAL MAY BE IN THE SWEET SPOT. WHAT USED TO BE A GIANT TREE FARM IS NOW A LOT OF SUB-PRIMES. CONGRESS, THE GSE’S OR SOME MIXTURE MAY TAKE OUT SOME OF THE RESIDENTIAL BUT AT 4% CAP RATES WHERE DO WE FIND SAM ZELL; WAITING FOR THE 12% CAP RATE. WITH ALL THE HUNGRY BANKS NOW HAVING DIGESTIVE PROBLEMS OF THE ASSET BACKED COMMERCIAL PAPER VARIETY, WE NEED ANOTHER BERNANKE TRILLION OR AN FHA FOR THE COMERCIAL DEVELOPER.

Now remember all you good analysts, this is with a minuscule 4.7% unemployment rate. (Magnificent analyst Greg Weldon says the signs are malignant but we only seem to be hiring bureaucrats and those to take care of the sick bureaucrats when they find out what they have been hired to do.)

Interesting article in CFO magazine this issue. Of all things, they are talking about the “mythology” of the tallest building in the world; the idea that when a new highest or tallest is completed, it signals the end of an “up” economic era. Hell of an era. Shanghai will lose a lot of “face” as their World Financial Center was topped later by Taipei’s 101, well above the mainland city’s 1600 feet. The 1776 foot Freedom Tower at that height, if started, much less finished, might restore Manhattan’s luster but the winner will be the over 2000 foot Burj in Dubai. I remember opening a branch for what is now called Citi there in the early ‘60’s because we couldn’t get into Abu Dhabi where the oil was. The buildings (,ud) had central wind towers as air conditioning was yet to come and “industry” was syndicate smuggling ten tola bars of gold to Indian bride’s dowries. Great start for the world’s new possible greatest financial center. (Who knows, augur of new gold standard? Linking tallest building to idea of world’s Financial Center seems ludicrous in Dubai’s case but the Emirates may eventually make the case if NY drops the financial wrecking ball through its streets and the Chinese possible myth implodes. To quote the CFO: “So finance centers keep rising, popping up in new time zones like glittering trophies of financial nationalism. However, the substance behind such developments remains unclear. So has always been the stability of CRE lending and therefore the more normal “cap” rates than the current.

Running along, almost unseen in all the media glitterati and talking head noise about Peter Cooper/Stuyvesant Town and other ludicrous extensions of the value of a foot of dirt has been the ubiquitous accumulation of debt by otherwise seemingly sane corporations to “buyback shares,” There was a not too distant time when equity of a balance sheet was prized as proof of success rather than derided as proof of a CEO’s or Board’s inability to “Get it!” I challenge the financial asset community to come up with a net number for credit related to this phenomenon.

Yes, I know that an enormous amount of it is offset by the stock option exercise and concomitant increase in equity; but! How much of the stock so exercised winds up financed, not owned outright and represents credit extended on the collateral/worth of the company? With tax lawyers always one step ahead of the revenuers, it might be a big part of the jumps we see in the “Security” lending category.

In any event, casual and perfunctory as such analysis must be, the “buyback” game, as long as rates and accommodating banks were the wont, WAS AND STILL ON THE BOOKS< REALLY IS ONE HUMONGOUS PILE OF CREDIT> Now, extra credit question. How many of the lenders in these things did non-recourse because, in the long run, the market goes up? Probably our prudent lender corp would never think of such a thing!

WE HAVE SAVED THE BEST FOR LAST AS IT COMBINES THE VARIOUS ASPECTS OF WHAT HAS BECOME KNOWN AMONG SOME ASTUTE ANALYSTS WE KNOW AS THE “WALL ST THROUGH-PUT MACHINE!”

It doesn’t quite “through-put the whole magilla as evidenced by the high 20-30% growth in the balance sheets of the big or “bulge” bracket firms, and the still significant growth in others now including all kinds of foreign origin players as well as those multi-hundred billion or more what used to be called commercial banks.

All of the assets outlined above can (and have been) “financially engineered” into the end products spewing out of the “through-put” machine. (We will omit the quotation marks hereafter to save reader time.

THE REAL GAME FOR THE TRUE INSIDE PLAYERS, HOWEVER, HAS BEEN IN WHAT USED TO BE CALLED THE “LEVERAGED BUYOUT” May Drexel R.I.P. THE VERY RESPECTABLE TERM “PRIVATE EQUITY” AND/OR THE “IN CROWD” HEDGE FUNDS DON’T FLIP CONDO’S; THEY FLIP COMPANIES. RETURNS ARE MAGNIFICENT IN THE CREDIT ENVIRONEMENT WE HAVE HAD AND THE FEES EVEN MORE MUNIFICENT. TO QUOTE DOUG NOLAND OF PRUDNETBEAR, MOST FAMILIAR WITH THE PHENOMENOM,

THE ONLY PROBLEM IS THAT EACH SUCCEEDING YEAR REQUIRES MORE!!! CREDIT!!! OTHERWISE THE THROUGH-PUT MACHINE DELIVERS LESS PROFITS, ROE’S, “PERFORMANCE” AND THE “QUALIFIED INVESTORS” CALL THE INTERMEDIARIES THEY HIRE TO FIND THE “PLATFORMS” THAT PERFORM AND COMPLAIN THAT THEY DIDN’T!

THERE HAS BEEN A LOT OF KERFUFFLE (TECHNICAL TERM) ABOUT THE SUB-PRIME DISTURBANCE. WE DON’T PURPORT TO BE MORTGAGE/REAL ESTATE GUYS BUT COULD SEE IT COMING. THE MULTI-TRILLION ONE STILL WAITING IN THE WINGS IS THE PRIVATE EQUITY/HEDGE FUND GAME WHICH DIDN’T GET TO THE REQUISITE END GAME OF DUMPING ALL THIS STUFF BACK ON THE GENERAL PUBLIC IN A HOT MARKET AT A HIGH MULTIPLE! AS AN OLD COMMERCIAL LENDING GUY, WE WILL GO OUT ON A LIMB AND SAY THAT THE LEVERAGED DEALS WE SAW IN THE LAST FEW YEARS MADE MILKEN/DREXEL LOOK LIKE A MILQUETOAST. CASH FLOW AVAILABLE FOR DEBT SERVICE WAS RIDICULOUS, MUCH LESS THE CASH TO KEEP THE PLACE GOING AND SPRUCE IT UP FOR SALE TO THE HOI POLLOI (YOU FIGURE THIS ONE OUT)

WE WILL CLOSE WITH THE PROBLEM THAT THE PLAYERS HAVE BEEN DOING WHAT AN OLD GUY IN LONDON TOLD ME NOT TO TRY IN 1958-BORROW SHORT AND LEND LONG! THE SOURCES FOR MUCH OF THESE BALANCE SHEETS ARE OVERNIGHT OR NEAR OVERNIGHT LIABILITIES! THE WORLD HAS SEEN WHAT HAPPENS WITH A SMALL TAINT IN THE ASSET BACKED COMMERCIAL PAPER MARKET! DO WE HAVE ENOUGH DUMB HOLDERS FOR THEM NOT TO LOOK NOW!!! AT WHAT IS IN THEIR “MONEY MARKET MUTUAL FUNDS??? CAN BERNANKE MANUFACTURE A PUT FOR 3 TRILLION IN MUTUAL FUNDS. STAY TUNED IN FOR THE REST OF THE ANTHEM AND A PROTRACTED, FASCINATING GAME!