My Diary 429 --- The Weapons of Mass Destruction; The Power of D

My Diary 429 --- The Weapons of Mass Destruction; The Power of Deleveraging; The Questions to RTC V.2; The “Benefits” of Short-selling Restrictions; The Return to Ordinary Recession

September 21, 2008

Unprecedented Challenges, Unprecedented Response --- There are not many weeks like this past one. With intensification of the de-leveraging process sending VIX to the level above 40 (only 5 times ever), many would say --- this is almost unthinkable a week ago! Indeed, simply looking at the list of failed financial institutions -- BSC, FRE, FNM, LEH, MER, AIG, there is no doubt that all these will end up in the history book.

Let me do a quick slide show on what happened in the past 5 days, and here we go…Started with the nuclear bomb dropped by LEH bankruptcy, then the US government took 80% of AIG, followed by a record volume trading day in the NYSE. After that, gold had the single biggest day since 1981, and banks found that anything can be posted as collateral to Fed. The even bigger thing is the coordinated Fed, ECB and BoE response, witnessed by injections from the Fed coming $50bn per second. But it seems the market needs more as MMF become an inferno with every funding basis blowing out…Hey Yo, the Buck is broken, and we also saw Russia shuts the market to stop the selling. This is not the end of chapter…Short selling is banned in financials, 2yr UST dips to 65bp intraday discount to FFTR, then has the biggest single day rise in yields since 1982. So regulators have to step in and do more -- Fed to buy Fannie and Freddie debt from primary dealers; Fed to lend to banks for CP purchases; US Treasury to insure money markets and the $700bn RTC program is wheeled out …Wo, what a great show and now nothing seems ever happened…S&P is unchanged with last Friday's close, so do the HSI and STOXX.

My take-away is that investors did not place much credibility at all to the US regulatory abacus until they saw the synchronized moves taken by global central bankers. Fair to say here is that I do think the market have its own wisdom and the fates of the six firms are symptoms of financial market de-leveraging, rather than the root causes of the stress. Thus, I am wondering that while the government intervention in the past week may diminish panic and restore some confidence temporarily, it is essentially a band aid remedy, which will likely be followed renewed and potentially panic-ridden stresses, to the more widespread problems in the financial sector and economy. Having said so, I did watch the S&P (+8.3%) and ‘HSI (+9.6%) driven up mainly by short-covering, but I do not think there is big fundamental change in US and China, besides turning better sentiment. I think this si why both sides of the political parties are beginning to advocate a broad public sector response to the problem -- an RTC type solution, and FASB is considering lessening accounting rule --- allowing banks to book the bad assets on cost when markets are down and book on market price when asset are up…What!

In the rest of today’s diary, I am not going to cover each of the four asset classes as usual because under such a crisis moment, the correlations among them are equal to one. I will present a few of great readings, which I think could shed us some light where are we and what do we go from here. If history is anything to go by, this is only the beginning - there is still a lot more consolidation to come. Furthermore, I think a good understanding of derivatives, the deleveraging process, the implication of RTC and short-selling ban is the key to play our bets going forwards as it remain hard to know how and how fast things will unravel.

Having straight-lined my thought process, let us go though the weekly market performance. After tumbling 7.5% during Mon-Wed, global equities rebounded sharply to end the week down only about 0.5% as investors staged a late week rally. Stocks jumped roughly 4% in Japan & US and 8% in EU. However, Friday to Friday, stocks dipped 2.5% in Japan and 1.2% in EU; with US equity prices managed a 0.8% rise for the week...So bear seems not back to hibernate yet … Elsewhere, USTs fell smartly on Friday with 2yr and 10yr booming 48bp and 26bp, respectively, to 2.18% and 3.80%. 1M and 3M yields also corrected from their near 0% yields, rising 30bp and 86bp respectively. USD was relatively stable this week considering market events, falling 1.8% vs EUR to 1.448 and slipping 0.5% vs YEN to 107.4. Oil leaped +$3 this week to $104.55/bbl. Gold boomed this week (+17%) as investors fled to safety.

The Weapons of Mass Destruction

The following paragraphs are derived from the Berkshire’s 2002 Letter to Shareholders. The most impressive comment by Charlie Munger and Warren Buffet is --- In our view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. Both of them also view derivatives as time bombs, both for the parties that deal in them and the economic system.

There are a few interesting points and facts regarding the derivatives business I want to highlight here – 1) Very Hard to Unwind. “…But closing down a derivatives business is easier said than done. In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit…” 2) Mark to What.” … another commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. Those who trade derivatives are usually paid (in whole or part) on "earnings" calculated by mark-to-market accounting. But often there is no real market and "mark-to-model" is utilized. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth…I think this should classified as Level 4 or Level 5 assets…

But risks and headaches are beyond myths… 3) The Asymmetrical Error. “…marking errors in the derivatives business have not been symmetrical. This pile-on effect occurs because many derivatives contracts require immediately supply collateral to counterparties when a company suffering a credit downgrade. Such an unexpected and enormous demand for cash collateral can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown...Remember AIG case…4) A Big Systematic Risk. “… on a micro level, what they say is often true. Many people argue that derivatives reduce systemic problems, in that participants who can't bear certain risks are able to transfer them to stronger hands…However, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties… This seems familiar to us!… Some of these counterparties are linked in ways that could cause them to contemporaneously run into a problem because of a single event. Linkage, when it suddenly surfaces, can trigger serious systemic problem, e.g. LTCM in 1998.

Yes, we have a bigger problem then LTCM now, but 4) Do today’s Regulators Understand Derivatives better? …”LTCM used total-return swaps… Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is running… Good Job, Financial Engineers and Accounts…Sigh….

The Power of Deleveraging

The following piece is coming partially from “Financial Stocks' Vicious Circle”, an article published by Wall street Journal on 2008-9-1…As we all knew now, on Tuesday (21Sep) Fed added $70bn in temporary reserves, ECB offered 70bn EUR ($100bn) in a one-day refinancing operation, BoE injected 20bn pounds ($36bn), BoJ added Y2.5tn YEN ($24bn) and RBA injected A$1.85bn ($1.5bn)…So >$230bn was put into the system in a single day…that is big money, but hold on, how can all this happen ? And is all this too awful for the authorities to allow?

Here comes the great note written by Mr. David (I rewrite a few words) …“Financial stocks are caught in a vicious circle: Falling share prices make it tougher to raise capital, leading to ratings downgrades more likely. Downgrades can force firms to post more collateral with trading counterparties, putting them in a weaker state that raises the need for more capital and can lead to greater share-price falls. And so the cycle goes, sucking down weakened stocks such as Lehman”… “Securitization helped to mask the true amount of leverage in the global financial system. That makes it tough to know how far through the process we are…does it sound like what had Charlie and Buffet said!”…”Complicating matters is that markets have frozen for many of the assets banks and brokers would like to shed. Or they can only sell them at big discounts -- but management teams have balked at that as it would erode capital positions even further. That inaction has led to bigger losses, sparking a need for even bigger asset sales or capital raises”…I believe Dick Fuld has not read this piece carefully before LEH broken down…”Eventually, prices will fall so low that buyers re-emerge. That will stabilize markets and in turn financial stocks. But that day is a long way off…” Aha, a long way to go! I did agree with David as there were something missed over the super Friday Rally --- 1) Sept jobless claims increased 10k to 445k above mkt expectations; 2) Sept Philadelphia index for Prices paid fell to 31.5 from 57.5; and 3) Freddie Mac 30 yr mortgage rates dropped 75bp over the past month…But can anyone borrow?

Indeed, As David pointed out, “…the factors causing the problem are beyond the control of the firms, the government and Federal Reserve. Among them: Real-estate prices continue to fall, dragging down the value of assets held by banks and brokers; global growth is slowing, leading to rising delinquencies on all kinds of borrowing; and financial firms have to reduce their reliance on leverage, or borrowed money, leading to a contraction of credit…That situation isn't about to change. Even if home-price falls ease, it will be some time before investors can confidently assess the value of bank and brokerage-firm balance sheets. Without sufficient credit, the global economy will struggle to expand. But credit expansion can't occur until deleveraging has run its course. That could take a year or two…”

The Questions to RTC V.2

Historically, banking crises can only be resolved with deflationary depression or with a big chunk of public sector money, like RTC, as the economic cost of other alternatives is infinitely higher. What an RTC does is that it will allow financial institution to sell impaired assets and then rule a clear line under their losses so that stronger financial institutions and credit markets can start functioning again. In other words, liquidity and solvency issues may become less of problem going forward, although buying bad debt is effectively not trading…So it is still a positive move, but certainly this will do nothing to help the US housing market directly… It is interesting to ask why such a proposal was not taken many months ago. Perhaps Henry Paulson needs more time to draft the proposal, or perhaps the Bernanke Fed has strong desire to distance itself from the Greenspan Fed. Maybe the authorities were hoping that they can continue to deal with troubled institutions on a case-by-case basis…

Until now, there are few details to be announced for this Version 2 of RTC—1) The size of govt fund (seems $700bn is the final amount) to buy illiquid assets from banks at a discount (should not as big as Merrill Deal); 2) The measures to help prevent an unwinding of MMFs; 3) The ban on short selling and 4) The likely provisions to provide new capital (most likely senior preferred stock)…Before we got the final answers from US congress, let us look at what has history taught us…The first RTC was established in 1989 - one year before US stock market bottomed, two years before US economy bottomed, and three years before housing market bottomed. In other countries, when FSA in Japan was unveiled in 1997 -- the stock market didn't bottom for another five years and it seemed that Japanese economy had not manages to stage a sustainable recovery. In the Swedish case of the early 1990s, even with an effective government solution, the process of extinguishing the bad debts via government intervention was painful -- the equity market incurred a 28-month long bear market that saw Sweden's major index decline 45% from peak to trough and the economy undergo a 20-month recession…So the first observation is that the creation of RTC does not equal to the end of pain…In fact, the 1989 RTC did not prevent a recession in 1990/91 and it took at least 2 years to clean up the Savings and Loan Industry.

Having said that, let us take a close look of S&P…When the RTC was formed on 14 Aug, 1989, S&P index was at 343. US stock markets initially rallied and traded at higher level for approximately a year before economic fundamentals eventually prevailed and the S&P bottomed at 294 ( 15% lower than Aug 14th). In addition, during S&L crisis S&P 500 did not bottom out until it was traded 11X PE (vs currently 16X) and a 8.8XPE (currently 11X) on financials…So perhaps the Thu-Fri rally is to be short-lived and Short Stocks/ Long UST is still the preferred trade going forward…

Furthermore, there is a doubt on whether the RTC type of solution can help the US to get rid of all the “bad assets”. During S&L crisis, the credit crunch was due to plain vanilla mortgages, not the various complex instruments we see today, with 20-30X leverage. In addition, during S&L crisis, real estate deflation occurred in only 40% of states in US vs. 85% now. More importantly, the first RTC worked was because the lenders were easy to identify...this time around, the ultimate holder of the mortgage or instrument is very hard to know…Recall the Charlie and Warrant’ comment on derivatives…A good example is that a federal judge in Ohio has already dismissed an array of foreclosure cases because he couldn’t identify who the ultimate owner of the properties were due to "the complex structure and disparate ownership of mortgage securities"… Sigh again…

The “Benefits” of Short-selling Restrictions

Including SEC, there are a few other regulators (Canada & Britain) are now confirming that it has ordered a halt to selling of financial stocks to protect investors and markets, with restrictions apply to banks, insurance co's and securities firms. Amidst discussion of short-selling restrictions in US and EU, the obvious question is what this will do to global markets in the short, medium and long term. Looking back over nearly 400 years of restrictions on short selling, it appears that any benefit will be short lived, while undue restrictions on short selling do little to end market downside and could actually prolong the pain and induce inaction over the real problems. (Note: The first regulations governing short selling were enacted in 1610 for the Amsterdam Exchange, just eight years into its existence.)

Short-selling restrictions will not help in the long run. Taking the US, for example, and looking at the various changes and restrictions from the 1930s, the immediate impact seems to be anything from short-term market uplift to nothing. Certainly the changes did nothing to remove the long-term downtrend in the market and didn't appear to solve any stock-specific problems. If there is anything to make a note, it is the occasion where the market spiked upwards simply allowed for greater volatility and later falls. The steady and stepwise progression of increased limits does not appear to have accomplished much other than to provide a perception of action. This market reaction to Short-sell ban had been well researched by Academics as well. As the Charoenrook-Daouk study (A study of Market-Wide Short-Selling Restrictions, January 2005) suggests --- “Restrictions actually increase volatility and reduce liquidity. Hence any undue willingness to tighten the rules could push markets further in the very direction people are trying to avoid.” The end result could well be to continue to limit liquidity, increase volatility, and limit full price disclosure for negative news…Thus, it seems to suggest that US regulators and pension boards should instead focus their energy on the causes of current market malaise and look for long-term solutions, not short-term, feel good “bang-bans”.

The Return to Ordinary Recession

Having discussed all the topics outlined above, we should realize that even if RTC could end the panic and restore market order, it will not prevent the economy weakening in the next few quarters and then picking up only slowly next year. Remember what happened to the real economy after S&L crisis and Dot-com bubble burst? Thus, I am not surprised to see another 20% drop in the stock market during the next 6-9 months.

Globally, the financial turmoil is raising the specter of widespread disruptions in markets and in the flow of credit to the economy. Tight credit will continue as banks will continue to work to improve their balance sheets by reducing risk and raising capital ratios. The Fed’s Senior Loan Officers’ Survey has shown a sharp tightening of lending standards. This is happening when the major economies already are experiencing a contraction in consumer demand and increased corporate retrenchment. Meanwhile exports, a mainstay of growth in recent months, will not grow as fast as the world economy slows down. This seems to me that, the post-RTC era is to return us to the profile of an “ordinary recession”. In fact, all the leading indicators, unemployment rate, retail sales and other data have suggested a recession may have began in the US over the summer

With household de-leveraging continuing to run its course in the developed countries, the recent global economic growth forecast for 2009 by UBS is 2.9%, a level barely above the 2.5% which the IMF defines as a global recession. Even under such a bearish scenario, coordinated monetary easing does not appear likely because central banks are not on the same page with respect to growth and inflation risks, nor do they share a common approach to risk management. However, one positive note is headline inflation is fading fast, given a sea changes of oil prices…Remember that agricultural prices also have declined, which will reinforce the decline in oil prices, especially in EMs…The August US CPI fell 0.1% mom after rising an average 0.8% mom in the previous three months. The EU CPI also fell 0.1% mom vs an average gain of 0.4% mom in the last three months… In addition, underlying inflation pressures will fall back with rising unemployment, falling capacity utilization and the world economic slowdown. Inflation expectations are falling back, whether measured by consumer expectations in the Michigan index or TIPs BE spreads. With respect to the outlook of US monetary policy, by leaving policy rate at 2% unchanged, the Fed sent a very clear message: enough is enough. Policy rate cuts will be dictated by the economic fundamentals alone and will not be a tool to address liquidity and credit market stresses. This implies that at least in the short run, the Fed will continue to rely on the current expanded liquidity management tools to address any further market dislocations.

[Appendix] --- BBG Story Headlines

I. Stock Market and Corporate Events

ü Lehman Brothers Files Biggest Bankruptcy in History: Full Legal Document

ü Bank of America Will Buy Merrill for $50 Billion as Credit Crisis Broadens

ü AIG Gets $85 Billion Fed Loan, Cedes Control to Avoid Collapse

ü Another nightmare on Wall Street: Dow down 450

ü Washington Mutual Tumbles on Concern Capital, Buyers Are in Short Supply

ü Morgan Stanley Said to Mull Deal; Wachovia Calls Mack

ü Goldman Profit Slumps 70%, Biggest Drop Since Company Went Public in 1999

ü Lloyds TSB Said to Reach Agreement to Acquire HBOS

ü Macquarie Leads Declines in Asia-Pacific Financials

ü Hong Kong Stock Index Set for Longest Losing Streak in 4 Years

ü China Stocks Update: CSI 300 Index Falls 66.07 to 2011.78

ü Asia Stocks Tumble to 3-Year Low on Bank Woes; Macquarie Slumps

ü Stocks in U.S. Post Biggest Two-Day Rally Since 1987 on Bank Rescue Plan

ü Stocks Soar Worldwide on Bank Bailout, Curb on Short Sales

ü Bush Seeks $700 Billion to Save Banks, Treasury Power Unchecked by Courts

II. Money Market and Credit Market

ü Fannie, Freddie Tell the Same Old Market Tale

ü Credit-Default Swaps Surge Most Ever as Lehman Threatens to Unravel Market

ü Chance of Fed Rate Cut Tomorrow Soars to 86%, Futures Show

ü Treasuries Jump, Stocks Fall, Dollar Tumbles Versus Yen on Lehman Collapse

ü AIG's Ratings Cut by S&P, Moody's, Threatening Fund Raising

ü Alt-A Mortgages Pose Next Risk for U.S. Housing Market After Subprime Rout

ü Money-Market Rate Jumps, TED Spread Soars on Squeeze

ü Is Your Money Market Fund the Next Subprime Mortgage Debacle?

ü Corporate Bond Risk Reaches Records on Bank Collapse Concerns

ü U.S. Bill Rate Near Lowest Since World War II as Stocks Plunge

ü Treasuries Fall as Paulson, Bernanke Seek Solution to Crisis

ü Gold Climbs the Most in Nine Years as Investors Seek Haven From Turmoil

ü Dollar Rises Most Against Yen Since April on U.S. Bailout Plan

ü Asian Currencies: Won, Peso Gain on U.S. Plans to Calm Markets

III. Regulator Reactions

ü Greenspan Says Sale of Lehman Should Be Resolved Without Government Help

ü Hong Kong 's Yam Says Next Few Days Crucial for Financial Crisis

ü Roubini Says Fed Is Desperate, `Running Out of Bullets': Chart of the Day

ü SEC Forces Hedge Funds to Swear Oath in Probe of Manipulation

ü Short Sellers Under Fire in U.S., U.K. After Lehman, AIG Fall

ü Short Selling of Bank Stocks Stopped by Canadian Regulators

ü Central Banks May Seek More Global `Bang' for the Buck as Markets Seize Up

ü Federal Reserve Adds $50 Billion to Money Market, Sending Funds Rate Lower

ü ECB, Bank of England Join Federal Reserve in Calming Markets After Lehman

ü Taiwan Government Funds to Support Market After Slump

ü China Reduces Interest Rates for First Time in Six Years as Economy Cools

ü China , Thai Central Bankers Signal Asia Coping With U.S. Crisis

ü Paulson, Bernanke Push New Proposal to Cleanse Balance Sheets

ü Democrats Seek to Add Subprime Relief to Paulson's Rescue Plan

[The next shoe to drop] --- The FDIC has less than 1% in operating reserves (US$45.2bn) (US Treasuries and GSE paper) covering US5.4 trillion in insured deposits. The failure of Indy Mac (US$32bn in assets) in July cost the FDIC US$8.9bn. The FDIC Chairwoman has not ruled out the possibility of a short term loan from the Treasury. A Washington Mutual (US$309.73bn) failure would dwarf the largest bank collapse in US History - Continental Illinois National Bank in 1984 with US$33.6bn in assets.

Good night, my dear friends!