Below you will see just how pronounced the presidential cycle is in terms of fiscal and monetary stimulus. What concerns me the most is that if the punchbowl is removed from the leveraged mess that the American economy has become, the next downturn will likely sting.

DJIA and Monetary & Fiscal Policy Presidential Cycles

Click to enlarge

Just How Bad Could It Get?

Let me first state that I am not a bear at heart, nor do I wake up "praying for rain" like "dedicated short sellers." I simply review the facts, and try to decide if I'm being compensated for taking risk.

The key is to understand the concept of defined risk. In my firm's long only portfolios, we currently have no credit risk on the books (unless one considers Fannie Mae (FRE) and Freddie Mac (FRE) preferred stock to have credit risk) and do not anticipate taking credit risk for years to come. My firm is significantly underweight equities, having recently sold around May 1st when its proprietary sentiment and cycle indicators turned negative. In its hedged accounts and the Harbor Pilot Fund LP, my firm attempts to hedge itself to the point of expecting nearly everything we do to be wrong and still not lose money over the majority of rolling 12 month periods.

We have been tracking the ABX Markets (indices made up of dozens of sub-prime constituents) for the last year or so and have openly been expecting the BBB and BBB- tranches from 2006 and 2007 to go to zero, and they are well on their way, as you will see in the chart below (the chart was sent to me by a leading Wall Street brokerage firm a couple of days ago). When you see a price of 5-00, this means that the index is trading at 5 cents on the dollar. Yikes. Even the AA tranches from 2007 are "teenagers." This is the credit market’s way of telling us that the alchemy of Collateralized Debt Obligations that were full of sub-prime loans are not performing and that the real estate market, the credit market and the economy are in deep trouble.

ABX Markets as of May 7th, 2008

One of the ways that my firm positions itself is by evaluating the intersection between interest rates and volatility. For example, if volatility is high and interest rates are low (as was the case in the January-March period), it may choose to sell volatility to those that are willing to pay up for the chance to speculate. Conversely, when volatility drops as it has of late, and high coupon Ginnie Mae pools trade 250 basis points above Treasuries, my firm can simply spend the income on buying volatility (it can buy puts, calls, put spreads or call spreads) which defines its risk to premium spent. This is not a sexy way to invest, but it's comforting to be able to define how your portfolio will perform, even given a "black swan" event. I firmly believe that those that blissfully take risk and aren't getting properly compensated will wish they had been better positioned.

Just how bad will it get if the de-leveraging continues and the stimulus is removed from the economy and money supply growth slows?

Bad. Really bad. We have already seen one near bankruptcy in Bear Stearns with a bailout engineered by J.P. Morgan (JPM), the Federal Reserve and the Treasury Department. Over 250 mortgage originators are out of business, $300 billion of securities have been written down, 50,000 Wall Street personnel have been laid off, the U.S. is likely in a recession, and financial company after company come to market paying 8-9% for capital that they sorely need to stay afloat.

While these capital raising deals are getting done by the likes of Merrill (MER), AIG (AIG), Citigroup (C), J.P. Morgan, Morgan Stanley (MS), Fifth Third (FITB), National City (NCC), Regions Financial (RF), Fannie Mae and Freddie Mac, I openly wonder at what point we have a buyer’s strike. Having been around for a few credit cycles, I can tell you that this is not all that bad yet. What concerns me is when deals stop getting done, which is something I fully expect to occur as we approach 2009.

I've recently written about the amount of Level 2 Assets and Level 3 Assets in the system. The problem is that not only are the amount of Level 2 and Level 3 assets growing, the rate at which they are accelerating into these categories is staggering. Even companies like General Electric (GE) and AIG, heretofore thought of as the best risk managers, have been caught off guard in a matter of weeks and have had to write down tens of billions of dollars.

What could be a trigger for the next leg down? Insurance companies have "downgrade language" in their investment policies. This means that if they buy a security when it's "AAA" rated and then becomes "BBB" rated, they're forced to sell—no questions asked. If some of these assets are of the Level 2 and Level 3 variety, others that own the same assets and have them "marked to myth" will be forced to mark them down to the traded price as well, potentially impairing their balance sheets even further. This could force yet another round of capital raising. You can see how this could become an accelerating process. So while most feel the watershed event has occurred with the Bear Stearns near collapse, I think it's just the beginning of a series of similar, unpleasant events.

Who could be next? I have a list of a dozen or so financial companies that I think are already technically insolvent and doomed to fail. The credit window will likely shut on many companies in the next couple of years and I intend to position myself to take advantage via short equity and short credit positions as we approach 2009.

This is sobering material to be sure, but as Greenspan said, “History has not dealt kindly with the aftermath of protracted periods of low risk premiums.” When I'm asked repeatedly what historical event or events we should use to help us determine how all of this will play out, I say that "When we look back at this unwind 20 years from now, this will be history."

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