Ever imagine
getting your tie caught in a mechanical set of gears (sorry ladies - but I
will spare you). The results are nasty! Now you know what the Sultans of Swap
in the $695 Trillion global OTC derivatives market feel like. Every day the
slow moving gears of the world economies relentlessly grind, making it harder
and harder for the Sultans to wiggle loose or breath.
Financial Gearing is what we
non-accountants often refer to as simply 'Leverage'. Whichever your
preference, it has the Sultans of Swap tightly caught in a manner that has
greatly restricted their options and is now slowly squeezing the liquidity
life out of them.
As the economies of the world
adjust to the comatose shock of the Financial Crisis, the general public is
only now awakening to the fall-out and structural changes resulting from this
historic tremor. Some impacts are obvious; the most important are not - yet!
We hear the word
'de-leveraging' almost daily as a tag line whenever the word 'bank' is used.
We often hear it when people discuss the amount of debt the public took on
during the housing bubble and are now trying to get out from under. So we
think we know what there is to know about leverage. Whoa... are we
considering all the users and forms of leverage?
The near collapse of the
Shadow Banking mechanism and its exotic gearing instruments such as SIV, VIE,
and SPE working in conjunction with operatives such as highly leveraged hedge
& private equity funds, has left our highly credit reliant global
economies beached. These economies are presently attempting to swim once
again but with pre-crisis business models within a greatly diminished credit
creation infrastructure. We sense something isn't working like it did before,
but it is much too simplistic to say it is because credit is more difficult
to secure.
We have staggering numbers of
enterprises that have come into existence or grown to unsustainable sizes,
solely on the basis of the application of leverage. Like mortgage brokers,
appraisers, developers, listing agents, PMI insurers and a raft of other
occupations that exploded during the housing bubble, they have collapsed just
as quickly with de-leveraging. Economists call it mal-investment. The lay
person calls it 'unemployment'.
We need to understand more
fully the adjustments associated with de-leveraging or "Reverse
Gearing". As I mentioned, some might call it de-leveraging but that
distracts from the magnitude and scale of what we are presently experiencing.
I like the formal accounting terminology 'reverse gearing'; because it makes
it crystal clear the machinery is headed in a different direction.
FINANCIAL GEARING: Systemic Growth of Leverage
Financial Gearing is about any
entity increasing debt on its asset liability ledger relative to its
earnings, equity or capital base. By increasing debt it potentially allows
for greater profits or returns to be made. As in Housing, it is good to have
a small down payment and a large mortgage when housing values are increasing.
"Leverage" in this case is positive. However, when housing prices
fall OR interest rates increase, debt leverage levels can be crippling. A
virtuous rising cycle becomes a vicious death spiral.
When we use the terms interest
and asset prices as we just did, you can be assured that the next sentence
will have something to do with the Wall Street magicians plying their crafty
trade. They are insidious in unlocking the strategies that live in the world
of price, rate and time differentials. None are more shrewd nor pervasive
than the Sultans of Swap.
Let's have a quick
'look see' at how the post financial crisis looks to some key sectors and
where the Sultans of Swap with their portly derrieres have their ties caught.
A) NON FINANCIAL CORPORATIONS
The US is no longer primarily
a manufacturing economy nor a service economy. The US has been operating as a
Financial Economy since the Dot Com bubble. To survive and indeed prosper in
this Financial Economy, corporate America was forced to use its balance sheet
both as an engine of growth and as a corporate defense. Multi-national
conglomerates have aggressively practiced this for the last decade. Exactly
the same way the financial & banking industry is structured to "borrowing
short and lend long", American industry has steadily shortened its
lending duration to shorter and shorter, less costly, short-term financing.
The use of Commercial Paper, easily rolled over on monthly and quarterly
periods, was substantially cheaper than issuing longer term corporate notes
and bonds. Corporations like GM (GMAC), Ford (Ford Credit), GE (GE Capital)
had long ago stopped being industrial corporations. They were financial
corporation's leveraging their highly competitive credit ratings to borrow
extensively while 'leveraging-up' their balance sheets. Corporations were
quick to realize it gave them an unfair competitive advantage in the new
emerging world of financial engineering. The less sophisticated were forced
to follow or be 'gobbled up" by competitors with elevated stock
valuations.
Recent earnings results have
showed us clearly that earnings are now being achieved by brutal cost cutting
efforts to offset revenue shrinkage. Existing "Lines of Credit"
have become more expensive and harder to obtain, especially with satisfactory
terms. "Covenant Lite" loans are now due. Roll-Over of funding
needs are more onerous.
Funding sources, terms and
availability have changed adversely and for the foreseeable future. Corporate
America is now strategizing, planning and reacting to this new reality. Pimco
call it the 'new normal' of smaller growth rates. It is called 'accelerated
unwinding' in corporate board rooms. Increasing corporate cash hoards are
your first signs. (1)
The reason this recession is
different is that it is a deleveraging recession. We borrowed too much (all
over the developed world) and now are forced to repair our balance sheets as
the assets we bought have fallen in value (housing, bonds, securities, etc.).
A new and very interesting (if somewhat long) study by the McKinsey Global
Institute found that periods of overleveraging are often followed by 6-7
years of slow growth as the deleveraging process plays out. No quick fixes.
Let's look at some of their
main conclusions (and they have a solid ten-page executive summary, worth
reading.) This analysis adds new details to the picture of how leverage grew
around the world before the crisis and how the process of reducing it could
unfold. Here is what McKinsey has to say and is listened to by global board
rooms:
- Leverage
levels are still very high in some sectors of several countries - and
this is a global problem, not just a US one.
- To assess
the sustainability of leverage, one must take a granular view using
multiple sector-specific metrics. The analysis has identified ten
sectors within five economies that have a high likelihood of
deleveraging.
- Empirically,
a long period of deleveraging nearly always follows a major financial crisis.
- Deleveraging
episodes are painful, lasting six to seven years on average and reducing
the ratio of debt to GDP by 25 percent. GDP typically contracts during
the first several years and then recovers.
- If
history is a guide, many years of debt reduction are expected in
specific sectors of some of the world's largest economies, and this
process will exert a significant drag on GDP growth.
- Coping
with pockets of deleveraging is also a challenge for business
executives. The process portends a prolonged period in which credit is
less available and more costly, altering the viability of some
business models and changing the attractiveness of different types of
investments. In historic episodes, private investment was often
quite low for the duration of deleveraging. Today, the household sectors
of several countries have a high likelihood of deleveraging. If this
happens, consumption growth will likely be slower than the pre-crisis
trend, and spending patterns will shift. Consumer-facing businesses have
already seen a shift in spending toward value-oriented goods and away
from luxury goods, and this new pattern may persist while households
repair their balance sheets. Business leaders will need flexibility to
respond to such shifts.
You can read the entire
report at their web site, including the ten-page summary.
http://www.mckinsey.com/mgi/publications/debt...aging/index.asp
B) PRIVATE EQUITY
Presently garnering little
media coverage is the historic levels of leveraged buyouts that have taken
place over the last decade using short term money, pre-financial crisis
'covenant lite' terms & extraordinarily geared balance sheets.
July 2007
Private Equity firms
"bought more than 3000 American corporations from 2000 to 2008,
employing close to 10 million people - nearly 1 of every 10 workers in the
private sector.
The formula was simple: buy a
target company with a small down payment and lots of other people's money.
Leverage it with huge loans using the acquired company - not the Private
Equity firm - as collateral. Cut short-term costs through radical layoffs.
Resell at a profit within 5 years, before the cuts & debt have totally
crippled the business.
In ten years Private Equity
deals have generated more than $1 Trillion in new debt - which will come due
just when these businesses are least likely to be able to pay it off. As a
result it is forecasted that about half of all Private Equity owned companies
will likely collapse between now and 2015, throwing 2 million people out of
work" (2)
C) BANKS & FINANCIAL
INSTITUTIONS
The raison
d'être of banks is the gearing or leverage of their balance sheets. The
fractional reserve banking system allows the expansion of bank balance sheets
but limits it with reserve requirements. However loans can be increased with
more Capital infusions. The banks have over time, creatively found ways to
utilize debt instruments as capital thereby fulfilling bank regulatory
requirements. These debt instruments, which have been classified as Tier 1
Capital, are custom agreements typically not tradable that can only be valued
by the use of extremely complex proprietary non-auditable bank models. The
assumptions and variables used in these models make their 'mark to market'
valuations much closer to 'market to myth'. They are blatantly obscure and
totally non transparent to investors. The problem is these 'mystical assets'
have become such a large part of bank capital assets. This has fostered the
recent explosion in bank lending, that current reclassification attempts by
bank regulators and the implementation of the new International Basel Banking
definitions of Tier 1 Assets have led to significant conflicts and crippling
potential problems for the banks. The solution to date has been to simply
defer any changes until the credit crisis subsides. Since the investment
community is now aware of the problem but still cannot get enough
information, investment professionals are skeptical of investing in banks,
thereby allowing them to raise capital to allow for future 'adjustments'.
If Tier 1
Capital problem is not enough, the banks have also been employing practices
that simply kept alarming amounts of loans off their balance sheets
completely. There are a broad range of practices used but the largest was the
use of SIV's or Structured Investment Vehicles. Over the last decade SIV's
have been a major wheel in using low yielding public money market funds to
foster the procurement of the toxic assets that have become so well covered
by the media. Slowly the banks have had to pull these structures back on
their balance sheets but at a very 'measured' and glacially slow rate.
The government is presently
keeping the yield curve at a historically steep rate, for a protracted period
of time, to allow the banks time to attempt some sort of work-out.
Unfortunately delinquencies and foreclosures on existing loans have reached
such a level that the net result is barely any real resolution. Now
collapsing Commercial Real Estate values are adding another truly massive
problem to the mix. (3)
It is not only the major
banks, or the regional banks (which are being taken over by the FDIC at
approaching 3-5 per week - 140 since the crisis began) that have problems
because of excessive gearing. Throughout the financial services industry the
collapsing commercial real estate market is putting pressures on Insurance
companies, Real Estate Developers, REITs, Property Management Corporations
and a whole mix of financial services who are major holders of commercial
real estate assets. Their balance sheet assets are collapsing, placing their
solvency into question and minimally forcing a major contraction in any new
activities.
|
2010
|
2011
|
2012
|
2013
|
2014
|
TOTAL
|
|
COMMERCIAL
REAL ESTATE
|
552
|
560
|
537
|
480
|
459
|
2.7T
|
|
LEVERAGED
BUY-OUT DEBT
|
71
|
113
|
203
|
294
|
406
|
|
|
HIGH
YIELD DEBT
|
35
|
64
|
75
|
82
|
126
|
|
|
TOTAL
|
657
|
737
|
815
|
856
|
992
|
4.2T
|
SOURCE: Morgan
Stanley, Fixed Income Research & Economics (4)
The above chart from Morgan
Stanley, Fixed Income Research & Economics (4) indicates we will require
$4.2 TRILLION in new financing to accommodate loans of questionable
viability, existing lending terms or Loan to collateral value coming due.
D) SOVEREIGN
COUNTRIES
I have been very concerned
about all of the items mentioned above, but my biggest concern is the
staggering amounts of debt being increased almost daily - Sovereign Country
Debt. This is not just a USA problem but global, as countries have taken on
debt loads to be used for stimulus fiscal spending. This debt must be paid!
My recent article: " target="_blank";Eight Financial
Fault Lines Appear In The Euro Experiment!" lays out the undeniable
fractures that are occurring. The balance sheet gearing problem or rather
"game" in this instance is how this debt is presently being funded.
In the PIIGS there is large concern with how debt has been accounted for
going back to the inception of the EU and what sovereign governments did to
qualify and gain entry under the Maastricht Treaty.
Additionally,
Governments are using the "Duration" game to hide the loads.
Specifically they are lending on short term duration where interest expenses
are extremely low versus locking in the loan on longer term bonds. The latter
is the traditional manner governments employ to protect taxpayers from
increases in interest rates. New debt and roll-over debt is being funded on
less than 12-18 months terms. This is leaving accelerating balances of debt
which will need re-funding in a year's time. What happens if interest rates
move up from unprecedented historically low rates to even moderately higher
rates? Why would governments even consider such a strategy?
Credit Rating agencies are so
concerned about the current situation that they have already started warning
about sovereign credit rating downgrades and in some instances have
downgraded countries such Greece.
Downgrades immediately make
new debt issuances for a sovereign country more expensive. Poor credit
ratings and rising rates will quickly bankrupt any sovereign nation.
E) REVERSE GEARING
(DELEVERAGING) & ITS GLOBAL RAMIFICATIONS
The LEX column in the
Financial Times this week observes, concerning the report:
"It may be
economically and politically sensible for governments to spend money on
making life more palatable at the height of the crisis. But the longer
countries go on before paying down their debt, the more painful and drawn-out
the process is likely to be. Unless, of course, government bond investors
revolt and expedite the whole shebang."
And that is the crux of the
matter. We have to raise $1 trillion-plus in the US from domestic sources.
Great Britain has the GDP-equivalent task. So does much of Europe. Japan is
simply off the radar. Japan, as I have noted, is a bug in search of a
windshield.
Sometime in the coming few
years the bond markets of the world will be tested. Normally a deleveraging
cycle would be deflationary and lower interest rates would be the outcome.
But in the face of such large deficits, with no home-grown source to meet
them? That worked for Japan for 20 years, as their domestic markets bought
their debt. But that process is coming to an end.
James Carville once
famously remarked that when he died he wanted to come back as the bond
market, because that is where the real power is. And I think we will find out
all too soon what the bond vigilantes have to say.
And so we have uncertainty
all around us. What will our taxes look like in the US in just 12 months?
Health care? Who will finance the bonds, without a credible plan to reduce
the deficit? And any plan that has Nancy Pelosi as its guarantor is by
definition not credible.
The Fed
is going to stop the music in March. There will be a scramble for the chairs.
This is a huge experiment with no precedent. The entire developed world is
the test subject. Risk assets will be subject to uncertainty. And markets
hate uncertainty.
SULTANS OF SWAP
I know many of you are worried
about our Sultans of Swap with their ties caught in the gears. What does this
mean to them? More importantly you ask, what does it mean to us all?
Through the
magic mix of Credit Default Swaps, Dynamic Hedging and Interest Rate Swaps
the Sultans of Swaps have effectively been controlling interest rate spreads.
Through Regulatory Arbitrage they extorted tremendous political sway
globally. They have existed in the world of risk free spreads. To them low
interest rates simply attract more volume for their concoctions. But this has
changed. Individuals, Corporations, Financial Institutions and Sovereigns all
have more debt than they can handle. Is the global savings growth rate
sufficient to handle further debt growth plus debt associated with possible
compounding interest payments with unpaid balances and roll-overs? We are
very likely nearing a global supply & demand cusp with China's reserve
growth rate slowing, but without question we are seeing and will see
accelerated defaults from Commercial Real Estate (2) to Sovereign Debt. We
don't need to see defaults. How many Greek Sovereign credit downgrades would
it take to begin cascading collateral calls?
"If the US
administration's budgetary projections are correct, the national debt to GDP
ratio will climb from 40% in 2008 to 77.3% in 2020. Even if we are able to
curb future deficits, it is likely that this ratio will grow over the next
decade. As a result, rates on treasuries and other debt obligations are
likely to climb over the coming decade with profound implications for the
debt and stock markets." (5). It is not a matter of 'if' - it is a
matter of 'when'. With $3.7T in Gross Derivative Credit Exposure outstanding
we are talking some potentially very serious problems.
As I outlined in " target="_blank";Sultans of Swap -
Explaining $605 Trillion in Derivatives" significant amounts of debt
today is hidden in the murky depths of "special" purpose
instruments - like SPE, SPV & SPC or "Structured" entities-
like SIV. This is done to keep debt off the balance sheet. Why would you not
want something on the balance sheet where investors and interested parties
could see what is happening? Obviously so you can camouflage them from what
is happening. The reason is fundamentally Credit Ratings. Keep your debts
low, your credit ratings high and the cost of money is cheap. The cheaper
money is, the more borrowing will occur. Everyone is happy except the
unwitting lender.
To the right
I illustrate the simplest of interest rate swaps. What you need to appreciate
is that everything is normally tied to LIBOR on the floating leg. LIBOR goes
up, one party gets hurt. If rates go up either party could suffer credit
rating downgrades. A credit rating downgrade can and often does trigger
collateral calls. One of the parties then gets hurt. So any significant moves
in interest rates and credit ratings and we have problems. With $3.7T in
Gross Derivative Credit Exposure outstanding we are talking some potentially
serious 'hurting'.
What we need to differentiate
is who exactly the Sultans of Swap are: Are they the Counterparties A & B
who hold the OTC contract? Are they the third party that administers the
ongoing payment exchanges? Are they the issuers or holders of CDS's to protect
against counterparty failure? Are they the magicians that put this OTC
contract together, took a quick fee and rapidly left the scene? Are they the
banks making almost obscene trading charges ($35B in 2009 trading fees
alone (6)) on brokering these swaps from parties desperate to re-align
contract bets since the financial tsunami arrived? Or is it all of them as
cumulative 'cohorts in crime'?
There is an old saying in
poker parlance: "when you look around the table and you can't tell who
the patsy is - it is you!" I will leave it to you, shrewd reader, to
determine who the patsy is and who the card shark is at this table! There is
only one person holding a risk free winning hand. They may all be Sultans of
Swap but there is only one Emir or Merlin here!
What is especially evident to
many of these Sultans is that they have their ties clearly caught. They now
foresee a rising LIBOR, likely Credit Rating downgrades, and probable
collateral calls as inevitable in the ongoing process of reverse gearing. The
gears just keep on turning.
Let me close with a point of
clarification. For those of you having troubles understanding any of the
above, let me relate a story. I was explaining swaps to a New Yorker who
appeared to have no financial background. When I finished my 'swaps in 100
words or less' dissertation he simply nodded his head without any questions.
He then looked me straight in the eye with a knowing expression and
explained. "In New York if I owe the Mob $100 dollars and I can't pay,
but my best friend Bob owes me $100 and hasn't paid me yet, then Bob owes the
mob $100. A swap, right? Well, when the mob collects the $100 from Bob, and
Bob now has a broken leg and refuses to ever talk to me again, I still owe
the mob $50 for collection fees plus the 'vig' on the original $100. The mob
is now up $150 and I desperately need more friends. A swap, right - yeh I
understand!"
SOURCES:
(1) 03-04-10 target="_blank" With
Fistfuls of Cash, Firms on Hunt Wall Street Journal
(2) "The Buyout of America" Josh Kosman, Penguin Group, 2009.
Quotation from front jacket flap.
(3) 03-02-10 target="_blank" Realpoint
Research Monthly Delinquency Report .pdf Realpoint
(4) Wall of debt a barrier to US recovery - 12-16-09 - The Sydney Morning
Herald, Malcolm Maiden
(5) 03-02-10 target="_blank" Obama's
Wake Up Call and What It Suggests for Future Interest Rates target="_blank" Stephen Shefler
(6) 03-01-10 target="_blank" Frank,
Peterson Vow to Eliminate Provision Keeping Swaps Opaque Bloomberg
McKinsey Global Institute target="_blank" http://www.mckinsey.com/mgi/publications/d...aging/index.asp
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