I almost posted this yesterday, but I became too busy with work to finish. Here is something that I started writing in the past year about my experience on buy side in 2008. On a day like this, it might be helpful. In early March 2008, I got an email from our DB broker inviting me to a one day conference on the credit cycle. It was going to be and hosted by DB’s bank analyst Mike Mayo.
The pre-start gathering was reserved; almost somber. In some ways it felt like a wake. It was the morning of March 14, 2008. The hallway chatter was done in small knots of people who knew each other. There were about 250 people in attendance. Looking back on my notes, I remember all sorts of snip nits of conversations.
“Well you go to work end up 20% down, go home find out that your house is worth 20% less and go to bed thinking you will live 20% less too.”
“ Greenspan thinks the correction is 18 months long…the good news is the S&P told us we are half way home, only nine more months to go.”
“Remember the good old days when a recession would last 6 to 9 months and a bear market was 2 quarters – now it just goes on and on.”
“Does your calculator allow you to input 100 trillion?”
As people were still gathering and finding their seats, the conference host Mike Mayo, an outspoken bearish financial analyst made the introductory remarks. “We are in the capitulation stage now, fear has taken over and it will not be long until the full bottom is realized.” When most of the attendees were seated, the first speaker was introduced. Her name was Karen Weaver and she had built a reputation as a bearish analyst of scrutinized products at Deutsche Bank. She analyzed products like those that brought down the Bear-Stearns hedge funds nine months ago as well as Sowood Capital.
Her first slide set the mood for the day “Two big questions facing investors today: Where is the housing market going and who are clients 1-8?” The tension in the room was immediately cut in half. Everyone needed a laugh. She gave a salient overview of the mortgage issues. The Government is trying to stabilize home prices, keep people in homes and prevent mortgage losses. The problem is how do you get a six sigma move in a structured product that historically had very little historical volatility? In the near term we have $230 billion of debt to be funded, $138 billion is not syndicated, $32 billion that is syndicated is not closed and $60 billion is not funded.
What follows are my direct, but edited notes from that session. I am posting them because when I look back on the conclusions about the private sector, it shows that so many smart people got it wrong. When you turn on shows like CNBC and Bloomberg as well as the 5,000 investment web sites and 10,000 gold investment web sites, I think everyone should remember that smart people are often wrong, every person has an agenda and no one knows all the data to predict the future.
I do know that much of private sector debt has been transferred to the public sector some ~40 months later and the numbers are much, much larger. In mid-2008, Bank CEOs were out defending their companies and stock prices. In mid-2011, Prime Ministers and Central Bank Presidents are our defending their banking institutions and countries. When times are good, you never hear these people make a speech or give an interview tempering expectations. Only when times are bad do they grandstand to promote the positive. I highlighted some bullets. Remember, these raw notes are from March 14, 2008; BSC was still in business and for the non-investment professional reading these notes, they can be cryptic with a lot of assumed knowledge of financial products.
XXXX, Leveraged Lending
- How do you get a six sigma move in a structured product that has had very little historical volatility?
- $230B of debt to be funded…$138 funded not syndicated…$32 syndicated not closed and $60B funded not closed.
- Mark to market is the issue…it can go lower…AAA related mortgage paper can go lower…80 yields 10-12%
XXXX, CMBS Research
- US commercial RE market is $3.2T
- CMBS is $800B of this market
- CMBS spreads have moved to levels never seen before…AAA spreads in 1998 LTCM crisis were +100bps….now 800 to 1500bps spread
- AAA 240, AJ 705, AA 895, A 1085, BBB 1965, BBB-1 2050….implied sum losses 35.6, 17, 12.5, 11.2, 10.2, 9.1….historical losses from the 1990s were 2.3 -3.2…today is 10X historical averages and 4x worse losses
- 1986 Life Insurance losses on commercial mortgage…in a 10-year span 32% defaulted…which led to a 10% loss…
- We are expecting to see significant price declines in commercial RE…10-15% declines
- We do not expect to see price declines leading to negative equity as is occurring in subprime
- We will see softening…but this is not the early 1990s in commercial RE
- No real deterioration on commercial mortgage loans
- Very little correlation between commercial mortgages and residential subprime
XXXX, Fundamental Credit Strategy
- Housing boom is going to take a long time to even out…
- Fed may let inflation sort the problem…which means a few years of pain
- Bearish macro, bearish property…but not credit markets because FOMC will be intervene
- Secular bear market for equities that has been propped up by earnings
- FOMC will not let credit market unwind leverage on their own…it would be a global crisis if let to unwind on their own
- Credit spreads at these levels is a perfect short, but FOMC is going to be interventionist so not a good short
XXXX, Global Markets
- How many more Carlyles? Answer…we do not know.
- Look for single strategy hedge funds that are leveraged, with fixed income strategy basis that are big enough to matter. The answer whether you go top down or bottom up is 24 to 50 funds.
- Why is this happening? Real simple answer…under calculation of the risk of default. It is always the under calculation of the risk of default: LTCM, Milken and now leveraged funds owning collateralized mortgages in which they under valued risk and did not have enough cash reserves to absorb margin calls because they were levered 20-30 to 1.
- We are now in a prisoner’s dilemma for these funds: 8 in a room with one guard…prisoners sprint for door…two make it and the rest are certain to die or be wounded.
- Two decision points are colliding: Hedge Fund managers need to decide if they want to sprint for the door…credit managers need to decide if they drop a margin call on under capitalized funds…it is all of game of risk assessment and who moves first…
- We are approaching terminal value…at some point price points attract long term money
- We are in a war between highly coupled systems with leverage and liquidity trying o find equilibrium…
- Timing the bottom only depends on your time horizon
- The question is: will portfolio managers take the risk of Bear Stearns? Why take the risk, you can go somewhere else.
XXXX, CEO and Fund Manager
- What we are doing in the market right now is losing a lot of money.
- These things happen every 2-5 years…
- NOW is the chance to make a lot of money if you have cash. 2 and 20 funds who send out statements every month cannot afford to lose money each month, that is why they avoid BSC, but the long term investor with cash to invest is going to make a fortune if they put money to work over the next few quarters.
- We have been ramping our positions in financials…I have been buying BSC since JAN and today they got their financing and it will work.
- Bear is not a fraud…Barings, Drexel, Refco…these were frauds…Bear is not a fraud. The FOMC will not let Bear fail.
- Very similar to 1989/1990…I have never seen such a similar market as now compared to 1989-90
- Wow….80% of the room are equities investors…only 5 are long financials
- USD concerns me the most…perfect correlation between commodity price increase and decline of USD…biggest negative in overall market
- Question from audience: BSC is down 16% today, are you still a buyer and long? XXXX…yes.
XXXX, Hedge Fund PM
- If you have a lot of capital, you are going to make a lot of money, but not in financials
- Banks in the US are under capitalized, no reserves, pace of credit problems are accelerating, they have not come to grips to with their problems and I would not own a single bank in Florida. The only good news is the banks in Europe are in worse shape.
- Capital market problems are worse. Rating agencies have no idea what they are doing.
- The buyers of structure mortgage products are structured mortgage people. It is Ponzi scheme.
- What is a SIV? It is 5% cash, 5% Treasuries and 90% asset backed paper, which is leveraged 20 to 1 based on ratings from the ratings agencies published in the paper…what a joke.
- We are going through the greatest de-levering in the history…there are a lot more Carlyles and Thornbergs…there is not a real solution but to take the pain over time
- Nothing is going to stop the de-levering process…
- If you have capital, you have no problems. The problem is products and funds were funded on minimal capital and high leverage. That is the problem.
- Even if banks stay solvent, the de-levering process is going to consume earnings.
XXXX, Former Fed person and a CEO of Bank
- In the summer 2007 we had a meeting with the Fed and head of the major banks to discuss “what could go wrong” and we all focused on geo-political issues, maybe risk is miss priced and there is a lot of leverage in the system, but it seemed all was under control. A few weeks later it all fell apart. Two funds in August keyed the collapse, then a fund at a major bank collapsed and the crisis was afoot. There is clear lack of confidence in the system. Two or three incidents in August of 2007 created the awareness of risk.
- August 2007 was an accident waiting to happen. Subprime just kicked it off.
- The complexity of models are still too simple to capture human nature. That is the problem.
- We have never been able to capture the shift from euphoria to fear…that is why we cannot forecast recessions
- When the total system is collapsed it is net long…when fear takes hold, it is far more devastating than a rise market because downward moves utilize achieve a force multiplier effect
- Market stabilization may require coordinated effort by major central banks
- It is getting very dangerous if the marking down process does not stop
- If US home prices stabilize, the market turns. Home equity withdrawals will be a key indicator. When home prices stabilize, then prices can be marked to market and market turns. The market is pricing in what seems to be extreme worse case scenario for home prices, which is why if prices stabilize we remove the contagion in the system.
- We are in the “fear mode” of the cycle, which is greater than the actual results when market stabilizes. All this is going to take is for one market to stabilize.
- Look at the Resolution Trust Corporation (RTC)…when the Fed auctioned the collateral, the vulture funds made a killing before Wall Street woke up. We dumped all our junk far faster than anyone thought we would in an inventory liquidation process. Today, the process is under way. We are still some months away, but inventory liquidation of properties is an important indicator.
- During the euphoria bankers would tell me they were under pricing risk, but they were forced to play the game. Was that a BOD level problem? Why were bankers forced to play the game and under price risk in the market like the others?
- We play a complicated game, if we do not take the risk people do not get compensated, shareholders do not see price appreciation. If you avoid all the risk, soon you will have no risk to avoid. It all goes back to compensation because we are paying cash in compensation for mark to market gains. We had 95% of people make gains and 5% make losses. Should the 95% take less bonus because of 5% of the people? It is a very philosophical question.
- 20 years ago it seemed that banks were very cautious on how they booked reserves. The mathematicians took over and said your reserves are wasting money and today it seems the banks are low on reserves. Part of this accounting issue, some of this is a philosophical style. Earnings and profitability pressures to mark to market have caused more problems than have capital reserves.
- It is so difficult to compare bank balance sheets that investors do not know what they are looking at.
- Q…can you discuss the weak USD? The recent weakness in the USD is the result of a gradual migration from USD to EUROs…this is really a merging diversification that people expected to happen quickly, really took years. I do not think intervention will make much of a difference. Intervention does not work because the balance sheets of the central banks are too small to make a difference. There are 100 trillion arbitrageable (currency) units in circulation and if central banks take an interventionist strategy they create an inflationary effect on their balance sheets.
- A few years ago if you would have said oil at $100 and Euro/USD at $1.50, people would have said that this was unsustainable and Europe would collapse. Now that we are here, no one is complaining. What we do see is some inflationary pressures and the ECB are holding rates steady, but they would actually like to raise rates. I see no willingness on behalf of European central banks to cut rates. The only reason they did not raise rates was to calm the turmoil.
- Q…what is the FOMC’s ability to influence the 10-Year note? I am arguing that treasuries are losing the ability to control currencies five years out. Central banks cannot control long term rates. I would say the rate of the ten year note is a global question. Short term I think the ten year goes lower, long term it goes higher, but who knows.
- Q…could a credit derivative market collapse cause a global recession? It is more than just counter party risk, in some cases with Fannie and Freddie it was a question if they even had counter parties on the other side to create a hedge. It is conceivable that these guys were trying to create transactions in which they could not find enough counterparties to hedge the risk.
- Q…what is the affect of willingness not to lend on the US economy? Are the credit markets anticipating this state? AG…the decline in long term rates has enabled corporations to fund short term and given rise to earnings and created the rise in buy backs. Stock buy backs is still rising. The real problem that is occurring is the tightening of credit on markets that corporate market serves. That is the problem that this impasse is creating. If it prolongs itself, we will get profit margins easing off as they have already started. It is still too early to tell if the economy makes it through this period with little or great affect.
XXXX, CEO of a bank
- Just flew in from Saudi Arabia this morning, I was begging for money from SWFs. They all wanted to talk about the credit crisis for ten minutes and then spend the rest of the time talking about Client #9
- Capital markets have grown exponentially faster than global GDP because of leverage…leverage is the problem.
- We are going to see most of that leverage wiped out over the next few years…capital will be king, long only fund managers with capital will be most powerful. Why do you think people are fleeing to sovereign funds? They have capital.
- Organizations that rely on yield curves and financing to make earnings are dead
- I am not calling the bottom, but we are clearly in the capitulation stage. It will feel really bad until capitulations end.
- Now is a great long term buying opportunity.
- I am not calling a bottom in the credit markets.
- I see no reason to own treasuries…that will be the next bubble to pop.
- Clients have given us $100B in our liquidity funds…we are seeing huge pools of capital flowing into liquidity funds and when fear eases, this money will flow into equities and start to work
- We are seeing a remarkable model change…there are going to be massive head count reductions (think 20-25% percent) and if you are not leveraged and not building complex transactions, you need less people.
- If a bank like Bear goes under, that is a bottom signal
- My story is so different from ten months ago, I am telling people to forget the fear. We know who is dead and start looking for opportunities. I like the whole MSFT/YHOO deal. MSFT is doing a cash deal and now the PE guys are dead. We are back to basics. Large cap CEOs are giddy, because they see the best M&A opportunity in ten years. This reminds me so much of 1994.
- One thing is clear the industrial sector is doing well. EMEA will be affected and they cannot be competitive with $1.50 exchange.
- Credit crisis is real, going to have a few failures and we are going to have some mergers. If we did not have sovereign wealth funds, a couple of institutions would be gone already.
- 3 firms (financial) announcing earnings next week, if losses are as severe as anticipated, the SWF may not be there to help because they are upset with Sen. Schumer and Congress does not understand how much treasuries SWF’s own
- The problem we have is this is a viscous cycle…Wall Street and banks are refusing credit, raising margin requirements and this is causing institutions to sell…the cycle has not broken, I do not know when it will break. FOMC has an $800B balance sheet and they are willing to put $200B in mortgages for 28 days. It should allow institutions to repo to the Fed. It really did not happen this week, maybe it happens next week. The objective was to allow banks to offer better terms to leveraged players.
- I do believe that the majority of the credit crisis is over, but it is not done yet. Over a 2-5 year cycle, the opportunities for investors who have capital are amazing.
- My checks in the Middle East this past week tell me that the big oil companies think oil should be $78 a barrel and the $110 price is driven by hedge fund speculators. The firms I met with are already seeing demand reduction, which should moderate price over time. They are not increasing production.
- Fin services consolidation? I think there will be fewer security firms and several will end up with banks that have capital reserves. The failure of the Citi model is they do not have a deep and broad deposit base.
- Capital is going to be King! People who have capital will rule the future. We are going back to basics wherein capital is king with certain liability bases. BoA will be a big winner because they have 10% of the deposit base in America. HSBC world wide looks similar.
- Worldwide customers are not interested in treasuries at these spreads
- I see much greater interest in diversifying away from dollar based assets
- The next bubble will be Treasuries
- I do not want to speak badly about Carlyle’s hedge fund, but come on 30 to 1 leverage? The last time lenders let this happen was LTCM in 1998. Ten years ago.
- We are not going to go back to a robust securitization market…what will happen is there will be more equity to cushion shocks. Every country I have gone too feels they were burned, lied to, screwed by the securitization of real estate assets. They are not coming back.
The reality is it is all about the economy stupid.
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