Crisis Note 2008-0:  The Great Deleveraging is Only Just Starting


Unpublished and Incomplete

I just came across this draft from March of 2008. I as I read it today, I wish I had found the time to complete it, as my working notes had a lot of interesting trains of thoughts that would have helped my clients. However, I was insanely busy with work in the first part of 2008, and between hiring to build up my team and desk at MF Global, helping clients find liquidity, and client meetings in the evenings and nights, I literally had no time to do the required research.  SS 1/17/2016

Well, numerous people have been asking when the next ‘Crisis Note’ was going to come out.  Finally, here it is.

To be honest, I've not had much more commentary to add:  between the four Crisis Notes to date, especially Crisis 1 and 3, I think I've predicted and covered most of the things that have happened in the past 6 months. In addition, the press and academicians are beginning to catch on, and are starting to put out some interesting articles, especially in the editorials, some of which echo my views (thus making them interesting to me).

I’ll reiterate the core of my thesis, from Crisis Note 1, here:
-The global markets (debt and equity) over the past 10 or more years have been driven by leverage.
-This leverage came from numerous sources: initially yen-carry (hedge funds realizing they did not need to hedge the cheapest source of funding) driving up the US stock markets, which in turn created wealth, the LBO boom, private equity, levered loans, and CLOs (all equity derivatives).
-The post tech-bubble rate cuts made the US a funding currency (in addition to the yen), and stimulated a debt and real estate boom as US banks started lending out the cheap money, both directly (repo) and indirectly (SIVs, CP, etc)
-I consider subprime loans and other financial products that were created to feed the supply of cheap money, to be merely a symptom of the fundamental problem.
-The current problem in the market is one of over capacity due to deleveraging – too many assets and not enough balance sheet. It has nothing to do with the COST of money, something the Fed does not appear to understand.

If you've been positioning based on my predictions, stay the course - in spite of the staggering magnitude of recent events, there is more to come. In my opinion, the Great De-Leveraging is only just beginning, with more value destruction, especially in equities, housing and the dollar, yet to come.

My minimum prediction of losses to be taken by financials and hedge funds is at least $1 trillion.

And with that, I will proceed to pontificate.
The Impact of the Fed Cutting Rates

Everyone (with few exceptions, including myself) has been clamoring for yet more Fed rate cuts. It appears as if most people have forgotten Econ 101.

Firstly, as I’ve said over and over again, this crisis is different from past crises, and cutting rates will not have any real impact. The rate cutting is, however, having a superficial impact by propping (ok, maintaining confidence in) the equity markets, and tempting SWFs into too-early investing in the US. (The FT had a classic quite: “sources of dumb money” – I could not agree more!)

I’ve been crunching some numbers for the past few recessions - Fed cuts, money supply response, GDP data, etc - and my conclusions are that the current crisis is more like the early 90s recession, than either the 1970s or the 2000’s tech bubble.

Then, Alan Greenspan took the rates down from 8.25% to 3% in 18 cuts, over almost a 3 year period – in order to stimulate a banking system that was reeling from bad real estate lending in the 80s (S&L Crisis) and refusing to lend due to ‘tighter lending standards’. We ended up in a long recession, and even New York real estate declined by 25% (too many skyscrapers, coops, and condos). Check out this link for a recap of this period:

Most of Wall Street’s current inmates appear to have forgotten about this period, and expect a similar reaction to rate cuts as they experienced most recently, after the tech bubble bust – ie a quick resumption of leveraged consumption.

But, I will reiterate, they have not bothered to understand the nature of this crisis, which stems from an abundance of leverage, the withdrawal of which has destroyed financial balance sheets, and thus prevents standard monetary policy from having any impact. Most banks no longer have fungible reserves (my opinion). Thus they will not lend, and lowering rates will not be stimulative.

As an aside, the connection of money supply to inflation:

Now, money supply is linked to inflation by the velocity of money (the number of times a year it turns over in transactions for goods and services):

Velocity x Money Supply = real GDP x GDP deflator.

Thus if money supply grows faster than real GDP growth, inflation is likely to follow.

By observing that we have inflation (as the recent data has suggested), is the Fed concluding that it has increased money supply? I would hope that they are reading their own M1 and M2 data. Maybe they want to fake out the CNBC pundits, and keep the stock market rolling along.

But, just because we have inflation, does not mean that we have either an increase in velocity, money supply growth, increased demand for goods, or an increase in real GDP. Inflation can result from an increase in import prices (thanks to a declining dollar), which I believe to be the case now.

The only conclusion I can make is that we are headed for stagflation.

Trains of thought to elaborate on:

Walk away from houses
Tear down the house
Shame is the waste of natural resources, trees etc

TAF - comparison to RTC
TAF - reserve requirements
Issuance of bills
Impact on LIBOR - scary that its widened in spite of supply

Yen, Japanese earnings, carry trade
Flight to quality
Steepening of yield curve

I think we'll see a large hedge fund or 2 blow up this year from the yen side of  the carry trades..and that will get the ball rolling for a total stock market collapse..also, levered loans are a time bomb for dealers and banks. I'm hearing  they are not-trading at 85 now, and everyone still has them marked at 95. So more writedowns should be coming there. Monoline bailouts and stimulas packages wont do anything, if people are willing to walk from their debt obligations. If you can't stop the freight train, then the logical conclusion of the pieces is that the yield curve goes vertical:  stock mkt crashes, housing crashes, short end at 0, yen at 60, us keeps printing debt and lower rates trying to bail out financials, inflation goes thru the roof due to declining $ one is going to want to participate in UST refis..we'll only be able to roll maturing usts at absurd yields or through sales of military equipment..



Negative basis trades

Munis - auction rate notes

Tender Option bonds

     Feb. 14 (Bloomberg) -- Citigroup Inc., Merrill Lynch &
Co., and JPMorgan Chase & Co. may be hurt because they sponsor
entities that issue short-term debt to fund purchases of
student loans and municipal bonds, which are now coming under
strain, the Wall Street Journal said in its ``Heard on the
Street'' column.
     If the credit market worsens, these and other banks could
be forced to shift more assets on to their books, and they
will have to set aside capital to satisfy regulatory mandates,
the newspaper said.

Impact on level 3 and hedges

Buffett plan

UBS losses vs others
CLOs, levered loans

Pending buyouts vs market prices

     Bids for Alliance Data Systems Corp., BCE Inc., Clear
Channel Communications Inc., Huntsman Corp., Penn National
Gaming Inc. and Puget Energy Inc. exceeded their market prices
by an average of 28 percent as of yesterday's close, according
to data compiled by Bloomberg.

Stimulus plan - pie - tax increase/transfer of wealth - lead to slowdown and reduction in consumption

Of the things Bernanke has done so far, the only thing that has worked is the TAF - which has essentially allowed financial institutions to lower their required reserve requirements by borrowing the money back. This has helped lower LIBOR and gotten some of the brokers back into business trading in the secondary markets, especially in agencies. However, I don't think this has helped the majority of clients, as very few dealers are willing to show bids for position and provide liquidity. This is a very short term fix that has unclogged the markets for now, and I don't understand how the Fed is ever going to be able to get the principal back - I suspect we (the taxpayer) will eventually own the pledged collateral. This is not unlike the Thrift Bailout when we kept issuing T-bills till long after the Thrifts were no longer!

Samir Shah, 03/03/2008