Five Things You Need to Know: Durable Goods Orders; "Cone of Silence"; What Is Mark-to-Model?; Usage of "Well Contained" Spilling Over Into Other Areas; CIA Releases Secret Documents Revealing Broad Agency Abuse of Sharpie« Pen Powers
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. Durable Goods Orders
Demand for U.S. Durable Goods fell more than forecast in May, according to the Commerce Department, as consumers and businesses temporarily halted purchases in order to stand in line for Apple's new iPhone.
- Demand for Durable Goods (those goods meant to last for several years; but then, what goods do we not hope are meant to last for several years, other than toilet paper, Kleenex and raw meat?) fell 2.8%, the first drop in four months.
- The consensus prediction from economists surveyed by Bloomberg was for a decline of 1%, though the range was very wide - from -3.8% to as high as +2%.
- Only a month ago we were looking at Durable Goods Orders as good news, especially the Core Capital Goods Orders, which are Durable Goods Orders excluding Aircraft and Defense - things used by businesses to produce more goods.
- Core Capital Goods Orders declined 3.2% in May.
- This is important because the "Core" category provides a snapshot of business capital expenditures, what economists call "Capex" when they are trying to sound fancy and exclusionary to those on the outside looking in.
- Overall, the report breaks a string of three positive months and, what with the Federal Reserve Open Market Committee (FOMC) meeting today and tomorrow, weakens one of the economic growth support legs they've been using to justify current policy.
Click to Enlarge:
Core Capital Goods excl. Aircraft, Defense, yearly percentage change - Courtesy Bloomberg
2. "Cone of Silence"
On Monday we'll have a larger primer on subprime - explaining exactly what you need to know - but as it stands now, what is being characterized as a "cone of silence" created by Bear Stearns (with the help of other investment banks) is preventing all but the rhetoric of public relations from seeping out.
- Leave it to a UK media source - The Telegraph (UK)- to summarize what is happening even as many of the major U.S. media outlets continue to follow the Containment Propaganda Campaign - more on that in Number Four - or take turns allowing their sources to position them to their advantage in the emerging blame game.
- The Telegraph this morning quotes Charles Dumas, global strategist at Lombard Street Research summarizing the issue: "We don't know what the value of this debt is because the investment banks shut down the market in a cover-up so that nobody would know. There is $750bn of dubious paper out there in the form of CDOs held by banks that have a total capitalization of $850bn."
- Indeed, we simply don't know, which leads us to today's Number Three.
3. What Is Mark-to-Model?
As Minyanville Professor John Succo wondered back in May, why is it that financial markets were (are) so sanguine in the face of what all available data suggests are rapidly deteriorating collateral values in the mortgage market?
- Why aren't losses being seen? Even now, they aren't being seen.
- The answer, we now know, is mark-to-model.
- What does "mark-to-model" mean? Let's use something even we can understand - a sports card example.
- Suppose you and I are collectors (investors) in sports cards, but not baseball cards, the "prime" sports card market. No, we collect professional golfer cards - the
"subprime" sports card market.
- Why would we collect professional golfer cards? Simple, we're looking for an alpha edge - a fancy way of saying "excess return" - and with leverage, we believe we can buy these illiquid sports cards and sell them later to someone else for more money.
- Ok, ok, there are a couple of problems with this scheme you can see already.
- First, the market for professional golfer cards is far, far riskier and smaller (illiquid) than the market for professional baseball player cards.
- Second, since they so rarely trade, it's difficult to value the cards on a day-to-day (even week-to-week) basis.
- Ok, so back to the sports card market.
- Let's say that baseball cards are "highly liquid," meaning that, like stocks or U.S. Treasuries, they trade every day.
- These trades provide a way to instantaneously value our portfolio of baseball cards at any time.
- To value our baseball card portfolio, we simply look up the most recent trade of, say, our 2004 Derek Jeter card and record the value. This is called "Mark-to-Market."
- This "liquidity" is particularly helpful if we are using leverage (meaning, if we are using borrowed money to buy baseball cards with the hope that the borrowed money will increase our return when we decide to sell) since it allows us to closely monitor and track exposure and adjust the amount of leverage we are using accordingly.
- So how do we know, at any given time, what our leveraged portfolio of professional golfer cards are worth? They rarely trade, so we can't look up similar cards that have recently traded in the market.
- Well, unfortunately, in our professional golfer card portfolio we can't mark-to-market because these cards trade so infrequently.
- So how do we value our portfolio?
- Simple, we have some mathematicians build us a model that values the cards based on how each golfer performed last year, the tournaments in which they made the cut, their overall earnings and rankings among their peers, and a rating that a separate "professional golf card agency" that follows the golfers posts.
- Wait, did you say, "a model that values the cards based on how each golfer performed last year"? Yes.
- But what if a professional golfer's card in our portfolio is a guy who last year ranked fourth overall in earnings and won two tournaments, but suddenly gets injured this year, fails to finish a few tournaments, and slips down to 40th in overall earnings?
- Hmmm, good question. For that we would rely on that separate "professional golf card agency" we mentioned to "re-rate" this card. Then we would simply input that revised rating into our models and adjust the value accordingly.
- But what if the rating agency, for a variety of reasons, chooses not to re-rate the card?
- Then we have a situation where the value of the card that is being spit out by our model is in no way even close to the true market value of the card.
- Wouldn't that be a problem if we suddenly feared that all the ratings of our cards were too high? Wouldn't our model be insufficient? Might we not be over-leveraged in cards that have very little real market value? Yes, yes and yes.
- And that is precisely where we are right now with respect to CDOs.
- The credit ratings agencies' ratings are key in the mark-to-model values, and so far very few CDOs have been re-rated in a way that reflects the surging subprime default rates.
- There's an old investment saw that says "Paper losses don't exist until you sell."
- That old saw is being tested in real time, right now.
4. Usage of "Well Contained" Spilling Over Into Other Areas
Every day we fire up the Bloomberg to find yet another story about someone saying something is "well contained." Every day.
You might think this is an exaggeration, but it's not:
- Merrill Lynch & Co. Chief Executive Officer Stanley O'Neal said rising foreclosures on subprime mortgages in the U.S. aren't affecting other parts of the bond market.
"It's reasonably WELL CONTAINED," O'Neal said, according to Bloomberg.
- Things are looking good at the Caribou Hills wildfire near Ninilchik, where fire officials report the blaze that burned 88 cabins is roughly 43 percent CONTAINED. "Some of the most troublesome areas are pretty WELL CONTAINED now," Fire information officer Gary Lehnhausen said, according to KTUU.com.
- Every year, the Environment Agency spends thousands of pounds trying to eradicate the Japanese knotweed, one of the most invasive and unwanted species in the UK. But according to the latest copy of John Lewis's in-house magazine, Gazette, a partner has spotted the plant flourishing in the garden at Brownsea, the Telegraph (UK) says. The Brownsea gardener promises the plant is WELL CONTAINED by "heavy flagstone and cannot escape."
- Chicago Federal Reserve President Michael Moskow said on Friday that the Fed still sees inflation as the dominant risk to the U.S. economy, but that inflation expectations currently seem WELL CONTAINED, according to Reuters.
- Malaysia has CONTAINED the deadly bird flu virus and no new cases have been reported, Reuters reported. "Based on our monitoring of the surrounding areas and nationwide, there is no evidence of infection so far and we can say that it is WELL CONTAINED," Mohamad Isa, head of disease control at Malaysia's veterinary services department said.
And then there's:
- "Subprime mortgage market woes seen WELL CONTAINED" - Reuters
- Assistant Treasury Secretary Anthony Ryan told Reuters that subprime problems appear "fairly WELL CONTAINED." Reuters
- "For now though, the mess in the subprime market remains fairly WELL CONTAINED." - NPR
- "Still, with the impact of defaults on subprime mortgages "WELL CONTAINED,'' the (FOMC) minutes said that "downside risks were judged to have diminished slightly." - Bloomberg
- "So far, the real estate and construction slowdown seems to be fairly WELL CONTAINED to those industries." - The Bend, Oregon Bulletin
So, the usage of "well contained" seems to be the one thing that isn't "well contained" at all. Eh, one might say with a shrug, big deal. Well, actually it kind of is a big deal. It's almost as if there was a memo circulated last year instructing everyone commenting on subprime mortgages or real estate to use the phrase "well contained." Or, worse, we truly are governed by our most basic limbic system functions and herding instincts. Neither possibility is particularly comforting... especially when we're relying on models built by human beings to smooth out market risks.
Think about it like this. We're managing trillions of dollars in financial instruments and derivatives... while remaining deeply attached to and governed by structures in our brain that manage "fight or flight" chemicals? Those "fight or flight" chemicals were vital to our survival, indeed, dominated our behavior and response to stimuli, for...oh...only 99.9% of the time that human beings have existed. Fortunately, over the past couple of thousand years - that .1% of the 99.9% of time - we've apparently moved beyond reliance on the limbic system for decision-making and have successfully created models to improve financial decision-making.
5. CIA Releases Secret Documents Revealing Broad Agency Abuse of Sharpie® Pen Powers
Long-secret documents released Tuesday provide new details about how the Central Intelligence Agency abused Sharpie® pens in order to black out information the agency prefers to keep secret.
- Known inside the agency as the “family jewels,” at least according to the New York Times, the 702 pages of documents catalog domestic wiretapping operations, failed assassination plots, mind-control experiments and spying operations on journalists from the early years of the C.I.A., all of which has been carefully blacked out with a Sharpie® pen so as not to reveal the domestic wiretapping operations, failed assassination plots, mind-control experiments and spying operations on journalists from the early years of the C.I.A.
- In a note to agency employees, Gen. Michael V. Hayden, the C.I.A. director, said that Tuesday’s release of documents was part of the agency’s “social contract” with the American public, “to give those we serve a window into the complexities of intelligence”... a window that has been blacked out with a Sharpie® pen.
- General Hayden drew a contrast between the illegal activities of the past and current C.I.A. practices, the Times reported, then he carefully blacked out that line with a Sharpie® pen.
- Tom Blanton of the National Security Archive, the research group that filed the Freedom of Information request in 1992 that led to the documents’ becoming public, said he was initially underwhelmed by them, mostly because they were largely blacked out by a Sharpie® pen.
- Below, in the official debut of "Minyans on the Street," Minyanville surveyed some regular Minyans for their take on the newly released and then immediately blacked out by a Sharpie® pen C.I.A. documents.
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