Mark to Madness

March 2008 Malcolm Thomas

Since July of 2007 credit markets have been in an increasing state of disarray. While there were certainly warning bells in the early part of 2007, such as HSBC’s concerns over losses in the mortgage market voiced in February, and subsequent increased anxieties over smaller mortgage based companies going bust, the financial world was hit by a double salvo when Bear Stearns first announced the near demise of two of their hedge funds in late June of last year. These revelations, perhaps ignored at first, led to a full blown panic by mid August. Intervention by the US Central Bank, the Federal Reserve Board, by pulling down the discount rate and then subsequently the federal funds rate in September, led to a recovery which ran out of steam during mid October.

Since that time we have had newer losses and even more panic in mid January, leading to the now infamous decision by the Federal Reserve Board to cut interest rates on the morning of the 22nd of January. As this is being written in early March, the financial systems on a global basis seem to be in further danger. Successful attempts by some of the world’s leading banks, such as Citibank, Credit Suisse, and UBS, to name just three, to raise capital – most of it from sovereign wealth funds – has been well documented. Stocks, however, continue to go lower and the problems to financial markets continue to expand.

With the problem that began with mortgage originators and has since spread further, we are now in full blown crisis mode in the bond insurance business, the investment banks, not to mention home builders and many other groups that are now at the mercy of an increasingly reluctant consumer, not only in North America but also in Europe. Against this background, we are seeing recessionary conditions emerge now not only in Japan but also in Canada, Italy, Spain, the United Kingdom, Ireland and much of Eastern Europe. It should be emphasized that this is concurrent with what are certainly anemic conditions in almost all of the G10 countries. Financial institutions, investment banks, and an increasing number of hedge funds, are being hit by mark to market actions. This process simply means that an asset is revalued daily in order to set underlying values of a portfolio or of a more complex leveraged position. The problem, of course, has been how to mark to market some of the assets. As we have stated in these pages before, it is one thing to establish the closing price of a stock and quite another to establish the value of a mortgage portfolio against which oftentimes there is no readily available information. Even more complex is the information required to value a collateralized debt obligation (CDO) or an even more complex group of CDOs or CDOs square or CDOs cubed. Warren Buffett was recently quoted as saying that with CDOs squared you really had to try to read 750,000 pages of documents to somehow understand your exposure. Obviously not too many people have done that.

The meltdown has now affected all sorts of players in the industry as banks have also been raising collateral requirements for even the simplest trades. Once mighty investors, such as the Carlyle Group, have been subject to margin calls which have not been met. Indeed, quite a number of hedge funds have found themselves in a near impossible situation. Starting in the last week of February even routine transactions involving treasuries or agency debt have been under increased scrutiny. This has been due to a number of circumstances. The first of these is the now near disappearance of the so called auction market for quite a number of asset backed state or municipal bonds. It has since also spread to general obligation bonds. At the time of this writing the spreads between high quality tax free bonds are essentially even with treasuries of the same maturity, creating an almost unprecedented situation. Furthermore, the debt of government sponsored enterprises or GSEs such as Fannie Mae, Freddie Mac or even Sallie Mae are trading with more substantial premiums than have been seen at any time in the past. This is due in large part to the general market malaise we have already discussed, but more so to the very immediate difficulty now imposed by the banks on many hedge funds, i.e. a substantial increase in collateral requirements. If hedge fund “A”, for example, had purchased a portfolio of agency debt against the short position of treasuries, this trade has become quite unprofitable. In addition, the very sudden appearance of substantially higher margin requirements has oftentimes led to a forced unwinding or liquidation of such a position. This, in turn, has of course led to a further deterioration in the pricing of the underlying securities and thus an exacerbation of the entire situation. At some point in time, we expect central banks, both in North America and in particular in Europe, to respond to this problem in a much more meaningful way, but this may take another few weeks or a catastrophic event before anything can occur.

Our title, of course, comes from the now infamous words of Warren Buffett, who last autumn characterized some of the problems being seen in credit markets as “mark to myth”. Although we have used some degree of artistic license in order to come up with our title, we now seem to have arrived at mark to madness. The situation, unfortunately, reminds us of the events of the LTCM meltdown of 1998, or more importantly the famous portfolio insurance meltdown in the stock market of 1987. This latter point leads us to what is perhaps the most troubling element of the credit environment, which is the credit default swap (CDS) market . This market which now has a total outstanding notional value of approximately $50 Trillion (yes that is a “T”), that is roughly equivalent to one year’s global GDP. These instruments were invented as a way to insure a purchaser and presumably holder of a bond against possible default. The seller of the contract or swap agreement receives a premium much like an insurance company does in case of a problem. Should a default occur, the seller of credit default swaps would have to make whole to the bondholder. Although not discussed as much in the day-to-day press as has been the entire situation surrounding the sub-prime mortgage fiasco, it is this CDS market that is perhaps the most troubling and could lead to enormous systemic problems on a global scale.

Firstly, almost all the larger banks in the world seem to be involved, either having sold these or now of actively trading these instruments. Portfolio managers have also used them with the expectation that their higher yielding bond portfolios would then be immune from default risk. At the end of the day, however, such an instrument is only as good as its counterparty, which originally guaranteed the instrument, or what can be expected to come from a possible unwinding of this swap.

In recent weeks we have seen numerous counterparty problems and increasing doubts as to the credit worthiness of counterparties engaging in CDS activity. Indeed, analysts at firms such as JP Morgan and others have subjected the entire banking and investment banking industry to a succession of downgrades almost on a weekly basis. Over the past week “whisper numbers” regarding the total amount of write-downs in sub-prime, CDO and now CDS exposure for the global banking industry have exceeded $1 Trillion. This kind of number would have been almost unfathomable in August of 2007. What is remarkable is that in March of 2008 this number is being thrown about and few seem to be paying attention. What all of this may mean is that some of the global money center banks have much further to drop and that we will likely see some extremes in this area over the coming month or two.

Readers of this essay may wonder just what the central banks think they are doing. It is becoming clear that lowering interest rates alone will not solve the problems in the banking system. Indeed, several members of the Federal Reserve have been clear on this point. Federal Reserve Board governor Fred Mishkin and others, while dismissing inflationary concerns have wondered whether a more direct approach may be in order. In Europe, the ECB has been fixated on inflationary expectations while the economies in many countries under its dominion have weakened quite sharply. It will be worthwhile to watch what now happens in Japan, as within days we will hear about the government’s choice for the new head of the Bank of Japan, most likely Mr. Muto, the current deputy head. In time, it is our belief that both the Bank of Japan and the ECB will adopt much more aggressive stances in order to replenish the banking system with reserves and liquidity.

Our conclusion at the end of this process is that it is probably still too early to invest in most financials with a few exceptions. In the U.K. we are beginning to see some value, notably amongst one or two of the large clearing banks which were previously cautious about sub-prime and other excessive areas of lending activity. In this category, Lloyds Bank would probably be a clear winner. In addition, a company like Alliance & Leicester, also in the U.K., is probably another candidate for early accumulation, given its dividend, and its generally excellent internal financing and credit controls. In time we believe we will see more bargains emerge in other global banks but it is generally too early. Also, as in Japan in the 1990s, we will probably see a succession of low points followed by rallies and eventually even lower lows for the weaker and weaker components of major stock markets.

Patience will be a virtue.