Thoughts from the Frontline Weekly Newsletter
Thoughts on the Continuing Crisis
by John Mauldin
March 21, 2008
In this issue:
Thoughts on the Continuing Crisis
Margin Clerks of the World, Unite!
Where Do We Find New Sources of Credit?
In Defense of Alan Greenspan
What Now for Gold, Oil, Etc?
Baseball, Mexico, and Travel Costs
My essay in Outside the Box last Monday seemed to ignite a lot of response in the blogosphere. My basic contention was that the Fed had to act to facilitate the sale of Bear to prevent a meltdown in the markets. Many agreed, but others said Bear should have been left to hang, pointing out that a thorough cleansing is what is needed. Others scoffed at the notion that allowing Bear to fail would have created a massive stock market sell-off. This week we will reexamine that concept, look at the drop in gold and commodities, come to the defense of Alan Greenspan (which should be food for a little more controversy), and think through to the end game of the economic crisis.
But first, a little housekeeping. There is now a Spanish version of www.johnmauldin.com. For those who care, you can click on the tab in the upper right. We hope to soon be able to offer the letter in Spanish, in addition to the current translation in Chinese.
Secondly, as we announced a few weeks ago, I am now working with my friend Steve Blumenthal and his team at CMG to offer a variety of investment managers who can work with investors with less than the $1.5 million needed to be classified as an accredited investor. I am proud of the managers we have on the platform. To see the managers and their returns, and how they are doing lately in this turmoil, just click on the following link and fill out the simple form. The minimum account size is $100,000. http://cmgfunds.net/public/mauldin_questionnaire.asp
Some have written that they filled out the form and have not been called by CMG. There was a rather large initial response. I suggest that you call after you fill out the form. They will get to you eventually, but a call will speed up the process. And of course, if you are an accredited investor you can go to www.accreditedinvestor.ws as always, and my partners will be glad to show you the world of commodity and hedge funds. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC. Member FINRA.) So, without further interruption, let’s get to this week’s letter.
First, let’s look at a few paragraphs from the Outside the Box last Monday. It was my reaction to the Bear Stearns sale facilitated by the Fed. It was short, and you can read the whole piece at http://www.investorsinsight.com/otb_va_print.aspx?EditionID=667 .
“If it was 2005, Bear would have been allowed to collapse, as the system back then could deal with it, as it did with REFCO. But it is not 2005. We are in a credit crisis, a perfect storm, which is of unprecedented proportions. If Bear had not been put into sound hands and provided solvency and liquidity, the credit markets would simply have frozen this morning. As in ground to a halt. Hit the wall. The end of the world, impossible to fathom how to get out of it type of event.
“The stock market would have crashed by 20% or more, maybe a lot more. It would have made Black Monday in 1987 look like a picnic. We would have seen tens of trillions of dollars wiped out in equity holdings all over the world.
“… Yes, taxpayers may eventually have to cover a few billion here or there on the Bear action. But the time to worry about moral hazard was two years ago when the various authorities allowed institutions to make subprime loans to people with no jobs and no income and no means to repay and then sold them to institutions all over the world as AAA assets. And we can worry in the near future when we will need to do a complete rewrite of the rules to prevent this from happening again.
“But for now, we need to bail the water out the boat and see if we can plug the leaks. Allowing the boat to sink is not an option. And get this. You are in the boat, whether you realize it or not. You and your friends and neighbors and families.
Whether you are in Europe or in Asia, you would have been hurt by a failure to act by the Fed. Everything is connected in a globalized world. Without the actions taken by the Fed, the soft depression that many have thought would be the eventual outcome of the huge build-up of debt would in fact become a reality. And more quickly than you could imagine.”
Margin Clerks of the World, Unite!
Let’s look at how a market crash would have actually happened. First, all credit to Bear would have been shut off. Immediately, anyone (hedge funds and banks) who needed Bear to provide loans, prime brokerage, leverage, etc. would have lost access to their cash.
And since other lenders and banks would not know who had exposure to Bear, banking and lending would have ground to a halt. If you don’t know what your capital position is, you cannot lend, and you certainly don’t lend to someone if you don’t know their position.
In all likelihood, Bear would have been forced to raise capital as rapidly as possible. This means margin calls to their client firms with basically solid credit, as they would have to reduce their credit exposure. But when the margin clerk calls, you don’t get to sell what you want. Sometimes you simply have to sell what you can. And since loans and credit assets would not be liquid, that means selling stocks and commodities.
But the margin clerks at other banks would look to see what exposure to Bear their customers had. Any exposure would mean that customer had to provide more margin capital immediately. If none was forthcoming, then the none-too-gentle hand of the margin clerk would start selling. You don’t want to be the last one in line to get your money.
Why? Because the other banks would have to protect their capital positions. If the Fed would allow Bear to go down, then it would only be a matter of time before others followed. So raise as much capital, call as many loans, and reduce leverage as quickly as you can.
The market would have opened down enough to trigger the so-called circuit breakers. That would not reduce panic, but simply give the margin clerks more time to make phone calls.
I can see that hand! The question is why wouldn’t people see great values and jump in? Because any astute trader would wait for the falling knife to hit the floor before deciding to pick it up. As long as there is massive forced selling, the price of anything is going to drop.
And absent of an orderly credit market, getting margin money to buy with would have been difficult. And as the market fell, more capital would have been demanded from hedge funds and other leveraged players, which would have meant even more forced selling. It would have been a vicious circle.
Now, if you were short going into Monday morning, you were not happy with the Fed, as they took money out of your pocket. But I can guarantee you that a forced sale that happened over 48 hours would not have come about unless the authorities were alarmed beyond what one can imagine.
The Fed had to make guarantees to get the deal done. JP Morgan had no time to do any sort of due diligence on the assets beyond agreeing to a $6 billion write-down, which was the true cost of Bear. Now, if there had been time for an orderly liquidation, Bear shareholders might have gotten more value. Maybe. But there was no time. The systemic risk to the global financial markets was deemed to be too great.
“The Fed risking a few billion here and there to keep the boat afloat is the best trade possible today. Their action saved trillions in losses for investors all over the world. It is a relatively small price. If you want to be outraged, think about the multiple billions in subsidies for ethanol and the hundreds of billions of so-called earmarks over the past few years to build bridges to nowhere. And think of the billions in lost tax revenue that would result from the ensuing crisis. I repeat, this was a good trade from almost any perspective, unless you are from the hair-shirt, cut-your-nose-off-to-spite-your-face camp of economics.”
The Fed simply bought time for an orderly liquidation. And it is going to take some time to get back to functioning debt markets and normal mortgage credit markets. The problem of bad mortgages being written off by a host of institutions is still with us. We will see hundreds of billions of dollars of write-offs more than we have seen so far. But just as with the Latin American defaults on bonds in the ’80s, time will eventually allow the banks to recapitalize.
And this brings up a point I have been making for quite awhile. We have vaporized 60% or more of the funds that bought debt in the last eight months. They are not coming back. We are going to have to create whole new ways of securitizing and funding debt of all types, but especially mortgages and consumer credits. While I have confidence that those intrepid bankers on Wall Street will figure out something, as their future bonuses depend on it, it is going to take time to replace a system that took decades to build.
Where Do We Find New Sources of Credit?
Average US consumers have seen their incomes rise very little in real terms over the past six years, for a variety of reasons. They maintained their spending patterns with debt of all types, and specifically mortgage equity withdrawals. That source is going away. Consumer spending is going to come under pressure, and with it the earnings of many corporations and businesses.
The problems that created the current crisis and the incipient recession cannot simply be solved with lower interest rates. It is going to take several years to work off the excess inventory in the housing markets. It will take at least as long to get the credit markets functioning smoothly.
As an investor or business, you need to plan for a rather long period of slack demand and slow growth, and think through how you will be affected. I have begun to think what the world will look like in a few years, and will write about that in future letters.
Clearly, we are going to have to create new ways to analyze credit. As Peter Bernstein points out in a recent letter, liquidity is partially a function of trust. If you believe something is AAA, you can buy it without a lot of research. The better the credit, the more liquid it is. But absent that trust, you have to do your own research. That takes time and money. And it slows the process down. And it means risk is priced differently and at a higher price.
I think we could see the formation of a lot of new credit funds (I don’t think they could properly be called hedge funds). It was only a few years ago that small public companies went to regional broker dealers to raise capital. Those days are gone. Now, if a small company wants to raise capital, they go to specialized hedge funds called PIPE funds, which stands for Private Investment in Public Equities. It is a lot more efficient and, aside from some problems from time to time, works quite well.
It used to be that to get a loan you sat down with your banker face to face, and they knew you. The problem with today’s credit markets is that credit was given to many people who clearly should not have been able to get loans. If it had been their personal money, any reasonable person would not have given a loan against 100% of a home without at least ascertaining if the person could actually make the payments.
But if you can get a nice juicy commission by lending someone else’s money to people you do not know and have no responsibility for, then greed kicks in and you get the subprime crisis.
Maybe we see the formation of funds that step in to do lending the old-fashioned way. They actually look at the quality of the credit. They put some skin in the game (their risk capital) in order to securitize the debt. And the rules of lending become very transparent. It is not clear what the actual form will take, but something like that is going to be what we see in a few years. More transparency and actual risk on the part of the agency/fund/group that makes the loan will be the order of the new day.
In Defense of Alan Greenspan
Alan Greenspan is routinely blamed in many circles for creating the housing bubble. It was his keeping rates too low, we are assured, that was responsible for the run-up in home prices. Now, he probably did keep rates too low for too long, but I am not certain that we can lay the blame at his feet. He had a lot of help.
First, a point made by Peter Bernstein. Housing prices rose by almost 50% from 1998 to 2001, before Greenspan started on his rate-cutting binge. 50% in three years when the Fed funds rate was over 6% is not exactly encouragement from the Fed to buy homes. It seems people were ready to do it without low rates. So, a good part of the bubble was not due to lower rates.
And home prices continued to rise rather sharply, even as the Fed began to raise rates in 2005-6. We built 3.5 million more homes over the last ten years than the trend growth suggested we needed. They were not all built during the period of low interest rates.
While low rates did help, the bubble was aided and abetted by sloppy lending practices. It now looks like some two million people took out loans they are going to have difficulty repaying, and are likely headed for foreclosure. Rating agencies labeled these loans as AAA credits. Mortgage and investment bankers sold them to all manner of institutions.
All these culprits took advantage of the low rates, but that was not the cause of the bubble. If proper lending practices had been followed, there would have been far fewer buyers and less building, less speculation, and so on.
Greenspan, in hindsight, should have raised rates sooner, which I said at the time. And lower rates did make homes more affordable. No question about that. But to lay the blame for the housing bubble at his feet is not entirely fair. He had a lot of helpers who did the really heavy lifting.
What Now for Gold, Oil, Etc?
Just a few quick thoughts about the drop in commodity prices we saw this week. First, it was about time. Gold and other commodities went too far, too fast in a largely speculative frenzy. A correction was overdue. Gold saw the largest one-day drop in 28 years, since the bubble days of the ’80s. When everyone is on the same side of the boat, the boat is likely to tip over. Gold still probably has some room to fall before it catches support. But I seriously doubt that we have seen the highs for gold against a whole host of paper currencies.
A few weeks ago, I sent you an article by David Galland on why the gold stocks have not kept up with gold. For those of you who want to put some of your assets into gold, I would use this pullback to get positioned. If you have not yet read it, click on the following link and see why David thinks gold stocks are getting ready to rise.
But we could continue to see pull-backs in other commodities. China is getting serious about curbing inflation, and that means they need to slow down their economy, raise rates, and allow the yuan to rise. They increased the requirements for bank margins this week. Along with a slowing US consumer and generally slower US economy, which will be felt worldwide, we could see commodity prices come under pressure before a growing world increases demand.
Part of the reason is that the dollar is no longer a one-way play. A falling dollar may no longer lead inevitably to higher oil and commodity prices.
And Greg Weldon makes a strong case that oil prices are set to come down from their lofty highs. Demand is softening and supplies are rising. Gasoline supplies are at a multi-decade high, and the number of days of supply is rising as well. This is quite bearish for oil.
It also means that the inflation caused by food and energy might actually subside, giving the Fed cover to lower rates again at their next meeting, which I think they will do.
Falling demand is what you should expect in a recession, especially with prices as high as they are.
Baseball, Mexico and Travel Costs
It’s time to hit the send button. It’s a Friday night. I am working a little late, but I have to admit there is a distraction. They are letting some of the local high school teams play in the Texas Ranger baseball park, and it is nice to hear the sound of a bat on a ball, even if it is a metal bat. Spring has officially arrived.
Given that the Dallas Mavericks have not beaten a team with a winning record since the Jason Kidd trade, it is probably good that baseball is just around the corner. It does not look like we will go very deep into the play-offs.
Speaking of inflation, is it just me or have airfares gone crazy? American Airlines wanted $2,000 for a round trip from Dallas to Orlando two weeks before departure. I am used to paying a few hundred for that flight. I flew Southwest, but they still wanted $500. Cancun is normally a few hundred. To get the flights I needed, it was $1100. The cheapest we could find was about $600, if you wanted to get up at 4 AM in Cancun. Ugh. I will pass.
I don’t even want to talk about the fares to Europe and South Africa. Yes, I do fly business class over the pond, but the cost is way up. I wonder how the Commerce Department figures out the cost of travel in the inflation numbers. Their numbers don’t square with my costs.
Let me wish everyone a very happy Easter. This is a time to be with family and friends and reflect on our lives and realize the grace that is given to us.
Your wondering when Jason Kidd is going to kick-start the Mavs analyst,
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