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Five Things You Need to Know: Oh No! Not a Return to Normalcy! Please No!; Moral Hazard; Redemption Day; Standoff!; The Big Payback


What you need to know (and what it means)!


Minyanville's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. Oh No! Not a Return to Normalcy! Please No!

European Central Bank President Jean-Claude Trichet called on investors to keep their composure today, according to Bloomberg, saying markets are returning to normal, which is ironic when you think about it because the last thing markets need is a return to normal. That would erase the nearly five years of abnormal risk-seeking behavior, irregular credit terms and excessively loose lending policies that brought us to this in the first place.

  • Please, please, oh please don't return to normal!!!
  • No worries. Here's Canada to the rescue.
  • Seventeen Canadian asset-backed commercial paper issues are seeking back-up financing from banks after failing to sell their short-term debt, the ratings company DBRS said.
  • According to Bloomberg, the sellers are unable to find buyers of their short-term debt as subprime mortgage woes in the U.S. have spread to new credit markets.
  • Coventree, a Canadian finance company that went public last November, failed to sell asset-backed commercial paper yesterday, and shares in the company plunged 35% as a result.
  • Coventree is one of the first companies to delay payments on asset-backed commercial paper in the U.S. and Canada in the 12 years since the debt was created, according to Bloomberg.
  • And what exactly is asset-backed commercial paper? (See link for a more detailed look.)
  • Asset-backed commercial paper (ABCP) is a form of senior secured, short-term borrowing.
  • While corporate commercial paper, senior unsecured short-term corporate debt, is widely used and available by most companies, asset-backed commercial
    paper programs offer low-cost financing to companies that could not otherwise directly borrow in the commercial paper markets.

2. Moral Hazard

Question: "If a fund, say the Goldman Sachs (GS) Global Equity Opportunities Fund, is leveraged 3.5 to 1 with $10B in positions and $2.86B in equity and suffers a 30% loss ($3B), don't they need a cash infusion just to stay solvent (rather than, the "assistance" of some "savvy" bargain hunters such as Eli Broad and Hank Greenberg?"

  • That's one way to look at it.
  • Another way to look at it is to see this as a move to protect Goldman's image in the marketplace and prevent a "run on the bank," if we may be so bold as to use an archaic metaphor from the late 1920s that could never again happen in a country with wealthy investors protected by both the Goldman Sachs' moral hazard clause and the Bernanke Put.
  • Wait, that's a bold statement. Who's suggesting this move by Goldman runs the risk of "moral hazard"?
  • Hohoho, you're right! That is a bold statement. What kind of weird, conspiracy-theory-spinning yokels would take such a kick at our Goldman Sachs? The weird, conspiracy-theory-spinning yokels Standard & Poor's credit rating agency, that's who.
  • "We are concerned that this action on the part of Goldman is also being taken to protect Goldman Sachs Asset Management's image in the market, pointing up moral hazard risks related to GSAM that go beyond what we had assumed in our analysis,'' wrote S&P analysts Scott Sprinzen and Diane Hinton in a report published yesterday, Bloomberg reported.
  • Of course, Goldman has a far different view.
  • According to Bloomberg, the firm said, "Current values that the market is assigning to the assets underlying various funds represent a discount that is not supported by the fundamentals."
  • Do you know what that means in English? It means that the fund doesn't like what the market has done to their asset prices, so they're going to wait for the "fundamentals" to reassert themselves.
  • Minyanville Professor Scott Reamer, writing on this morning's Buzz and Banter, noted "Robert Louis Stevenson once wrote that "sooner or later, everyone sits down to a banquet of consequences." Anyone that tells you that markets are misbehaving here is about to eat a lot of consequence. "
  • Which leads is to today's Number Three...

3. Redemption Day

But it's not just Goldman Sachs gearing up for a "run on the bank." Today and tomorrow will be critical for many hedge funds. Why?

  • August 15 is the day for redemptions for funds with a 45-day advance notice redemption window.
  • So if you have been sitting back as an accredited investor watching the goings on at Bear Stearns (BSC), Goldman, Renaissance, et al. and decide you want your money back ahead of the September 30 withdrawal date, you gotta get that letter in now, and the funds have to raise the case to meet your request.
  • But look, one in the industry might say, we are, after all, professionals here! This is not news to us. We'll meet those redemptions and carry on (perhaps literally).
  • If only it were that easy.
  • Equity markets, going back to July, have been market by weired gyrations that caused quantitative models of the kind used by the Goldman fund to misbehave and, in fact, perform opposite of expectations tested and predicated on 45+ years of returns.
  • Why?
  • According to a note last week from Lehman Brothers U.S. Equity Quantitative Strategist, it was likely due to a few large multi-strategy quantitative managers who experienced large losses in their credit portfolios (due to subprime) and in an attempt to lower their risk profile, coupled with being afraid to (or simply unable to) mark to market their credit portfolios, were forced to sell other more liquid assets (i.s., stocks) in order to raise cash and "de-lever."
  • Which leads us to today's Number Four...

4. Standoff!

The reason equities are selling off is that everyone is waiting for the "fundamentals" to come back "in line."

  • So what we have is a standoff.
  • No one wants to mark to market their illiquid "undervalued" securities that are illiquid and undervalued because no one wants them.
  • So they are doing what they can to hold onto them until the fundamentals come back " in line."
  • Join the crowd. That's what the last investors in, say, Etoys thought back in 2000.
  • The problem is there are now two conflicting and competing interests playing out on Wall Street.
  • On the one hand, firms such as Goldman Sachs are unhappy that certain illiquid assets they are carrying on their books are being assigned current values by what few bidders there are that in the firms' minds do not represent the fundamentals.
  • On the other hand, part and parcel with those very so-called "fundamentals" must be a demand for riskier assets.
  • If that demand dries up due to risk aversion, then the fundamentals have BY DEFINITION changed.
  • Risk is not a One Way street.
  • And this leads us to today's Number Five...

5. The Big Payback

Get ready for the Big Payback.

  • Last week's credit crunch (Wow, last week! Has it been so long already?) has set off a worldwide rush for dollars as banks and fund managers scramble to pay back loans used to buy risky mortgage securities, Bloomberg says.
  • After a five-year decline that saw the U.S. currency reach its lowest level in a decade, it has rallied 1.4% against the euro and 1.2% against the pound in the last three trading days, Bloomberg noted.
  • Now, isn't the economy in the U.S., led by housing, slowing? And aren't the Fed, and central banks around the world, injecting liquidity? So shouldn't that pressure the dollar?
  • Get ready for what the late James Brown referred to as the Big Payback.
  • "I may not know karate, but I know KA-RAZY!!! Yes we do," Brown stated.
  • There are a some things to keep in mind about the dollar under these circumstances.
  • First, increased risk aversion (that is, after all, what we are seeing: banks, lenders becoming risk averse, refusing to lend money under previous credit terms) actually creates incentives to save and postpone spending if those who have been borrowing to leverage assets believe those assets will be lower and purchasing power greater in the future.
  • This pattern can be self-reinforcing, which is what the Fed fears the most.
  • A deflationary credit unwind worsens repayment burdens for borrowers, precisely for the reasons Bloomberg's article noted, because the burden of repaying debt increases with deflation, and the dollar - because borrowers who want to repay their debts must accumulate more of them in order to do so - moves higher.
  • Debts remain fixed in dollar terms, if you borrow $3 billion, for example, you still owe $3 billion, but the cost of that $3 billion in dollar terms is now higher.
  • But can't the Fed cut rates? Well that's the problem.
  • As former Federal Reserve Chairman Alan Greenspan explained in a 2002 speech, the lower bound on interest rates - the Fed can only cut rates to zero - means that even if debtors are able to refinance loans at a zero nominal interest rate, real rates will likely be still rising (after all, that's exactly what happens when the dollar begins to appreciate due to risk aversion and the big payback) and this can cause their balance sheets to actually deteriorate further even as they are trying to pay back debt.
  • This cycle of risk aversion and decreased time preferences is already playing out in real time.
  • See, for example, Sallie Mae (SLM) facing the fact that investors have suddenly gotten cold feet about their $25.3 billion takeover.
  • Risk aversion, decreased time preferences.
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