The two charts below tell the story without needing much of a description.

KBW Bank Index (in logarithmic terms)

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(Copyright 2008 Bloomberg L.P.)

Amex Broker/Dealer Index (in logarithmic terms)

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(Copyright 2008 Bloomberg L.P.)

The credit bubble that was created by financial institutions, as a result of the bad loans with rising delinquency rates, now resides on the balance sheets of the banks and brokers. Additionally, much of the "nuclear waste" that was created also resides on their balance sheets, much of which is unpriceable, untradeable and in some cases several times more than the shareholders equity on their books.

According to Bloomberg, there are now over 668 publicly traded companies with Level 3 Assets on their books, which is 133 more than just last month. What I find highly interesting is that the companies aren’t limited to just banks and brokers. We are increasingly seeing them on the balance sheets of insurance companies like AIG, Metropolitan, Hartford, etc.

This leads to a very interesting possible scenario that could get Stage 2 of the credit crisis rolling. Insurance companies are usually forbidden to buy junk bonds and most of them have ‘downgrade language’ in their charters. Downgrade language is language that can force an insurance company to sell bonds if they are downgraded from say, AAA to BBB. Level 3 Assets have three magical words in their definition: "no observable inputs."

What would happen if insurance companies slowly had their holdings downgraded and they were forced to sell? A couple of notable possibilities come to mind. First, other holders of similar securities would likely be required to mark their bonds to market, possible wiping out shareholder equity in the meantime.

Secondly, it could force other holders to sell as well, or at a minimum, raise more assets to cover their write-downs/write-offs. And while the market has been open for those willing to raise money in the capital markets, it is open at stubbornly high rates. National City raised money at 9 7/8% and then 12% before it was forced to sell a huge amount of shares at a multi-decade low of $5 per share that effectively diluted existing shareholders by 50%. Key Bank, which operates in almost identical markets as National City as does Fifth Third Bancorp, has had to pay nearly 9%. Merrill sold a $2 billion preferred deal at 8 5/8%, J.P. Morgan at 8.1%, Fannie Mae and Freddie Mac at 8 ¼%, Citigroup at 8 1/2%, Regions Bank at 9%.

To drive home the point, below is a chart of bond yields dating back to the 1920’s. Note that in the 1930’s Treasury Bill yields plotted, just as they have today, except that BBB rated bonds actually spiked simultaneously as the Fed eased to 1%. Does that have a particularly familiar ring to what is happening now? It sure does to me. See the Level 3 Assets in this table of Level 1, 2, 3 Assets (ranked by Level 3 in descending order). Ouch. 

The table is not shown for shock value. I present it because it slowly undresses all of the emperors. There are only two companies that have over 3:1 Level 3 to capital and both of those are being acquired (Bear Stearns (BSC) by JPMorgan) and Countrywide Financial (CFC) by Bank of America. Others that are high on the list are Merrill Lynch (MER), Morgan Stanley (MS), Goldman Sachs (GS), Fannie Mae (FNM) and Lehman Brothers (LEH). Earnings season ought to be rather interesting. There are conflicting stories out in the Street—some say folks like Goldman put lowball prices on their Level 3 Assets and then sell them at higher prices, passing this on as "earnings". Others, like AIG and Citi, haven’t been nearly as lucky. The worrisome part, though, continues to be how rapidly bonds are being downgraded, less are able to be priced, less have an observable market and their business models are hopelessly flawed.

This explains our caution. In a normal market, one that had relatively normal liquidity, I could liquidate the Harbor Pilot Fund’s holdings in a day. I may not love every price I could get, but we would be able to sell relatively quickly. If someone yelled, "SELL, (fill in the blank for your favorite investment bank)," I highly doubt they would be solvent, hence creating the nasty chain reaction the Fed was so frightened about with the BSC bailout.

Historical Yield Perspective

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And these were not small deals-rather; they were deals approaching $5 billion each. I have to admit that, in a vacuum, the deal seemed cheap, but my hunch that they are value traps and most now trade below issue price. You may be asking yourself why these companies had to pay up so much for capital. The simple answer is that "They needed the capital desperately and sold while they could." My belief is that while these issues are awful from an earnings point of view, they still allow them to function-not necessarily normally, but at least they can remain open for business.

My belief is that at some point in the next six to twelve months, the financing window will shut, and shut hard. When these companies can no longer fund themselves, it could be curtains for many of them, and there will likely be many forced marriages. When one thinks about it, the JPM/Bear deal was a shotgun marriage with the Fed and Treasury Department acting as matchmakers. This is how many of the brightest folks I know feel the next wave will look like—the Fed will simply try to retard the speed of the crisis by innovatively creating new financing facilities and have more "good bank/bad bank" marriages. In truth, I really don’t know of many banks that are truly "good" in the pure sense of the word, so you may say they may be "not-so-great/bad bank" marriages with a shotgun at the altar.

Where It All Begins

When I think of all the bad loans and low quality securities floating around, the question that should come to mind is "Where on Earth did all of this originate?" The key word in that simple question is "originate." The bad loans are a function of banks and mortgage brokers making low quality loans—whether this was the mistake on the part of the borrower or predatory lending on the part of the lender is moot at this time. Suffice to say that the loans aren’t performing for reasons other than the fact they were made on over-priced real estate at rates that benefitted the lender. Throw on top of that a slow economy, rising unemployment and soaring gasoline prices, and one gets a sense of why there are nearly 3 million homes vacant in this country and 2-3 million more to be foreclosed on this year. Just take a look at the chart below of West Texas intermediate Crude on an inflation adjusted basis over the past 25 years.

A picture, indeed, tells a thousand words. Gasoline consumption is slumping precipitously now and we can now be sure that gasoline isn’t completely inelastic anymore. Anecdotally, all the signs are there. I see people dropping out of country clubs, travel being curtailed, and budgets being cut.

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