In the early
fall of 1998, I remember being on a flight to Bermuda from New York. I was
upgraded and sat next to a very distinguished looking gentleman. He was going
to a conference about re-insurance and I was going to speak at a large hedge
fund conference. We hit it off, and began a very interesting conversation,
one that still burns in my mind today. It turns out that he was vice-chairman
of one of the largest insurance firms in the world, and was a real financial
insider, seemingly knowing every big name on Wall Street personally. After
he had a few drinks (he was clearly somewhat stressed), he began to talk about
the Long Term Capital Management fund and the problems in the markets. He
had had a ring side seat at the Fed-sponsored bailout proceedings.
to the edge of the abyss in the financial markets this week,' he told me,
"and then we looked over. The world does not understand how close we
came to a total meltdown of the markets."
This week we
look at the similarities and the differences between the credit crisis that
is going on today and what happened in 1998, take a quick look at the threat
from China to the dollar and see what exotic fish and exotic bonds have in
common. There is a lot of ground to cover, so let's jump right in.
China - Upping
the Rhetorical Ante
Early this week
the currency markets were roiled as not one but two senior Chinese officials
publicly advocated using China's large dollar reserves as a political weapon
should the US attempt sanctions on Chinese goods if the renminbi is not valued
higher against the dollar. The two were senior officials at Chinese think
tanks. Shifts in Chinese policy are often signaled through key think tanks
He Fan, an official
at the Chinese Academy of Social Sciences, used uncharacteristically strong
language, letting it be known that Beijing had the power to set off a dollar
collapse if it choose to do so.
has accumulated a large sum of US dollars. Such a big sum, of which a considerable
portion is in US treasury bonds, contributes a great deal to maintaining the
position of the dollar as a reserve currency. Russia, Switzerland, and several
other countries have reduced their dollar holdings.
is unlikely to follow suit as long as the Yuan's exchange rate is stable against
the dollar. The Chinese central bank will be forced to sell dollars once the
yuan appreciated dramatically, which might lead to a mass depreciation of
the dollar," he told China Daily. (London Telegraph)
This comes as
the US Congress will consider legislation that will implement tariffs on Chinese
goods if China does not revalue its currency. Given the level of rhetoric
from both political parties and presidential candidates, it is no wonder that
China is finally responding with a little rhetorical shot of its own. After
smiling at the editorial cartoon below, let's look at the likelihood of such
Cartoon from The Economist
China has an
estimated $900 billion in US dollar reserves. There is no doubt that if they
did decide to sell a few hundred billion here or there, they could push the
dollar down against all currencies and not just the renminbi. That would also
have the effect of increasing US interest rates on not just government bonds,
but mortgages, car loans and all sorts of consumer credit.
Given the current
state of the credit markets, that is not something that would be welcome.
But it is not likely for several reasons. First, it is not in their best interests
to do so. It would hurt the Chinese as much as the US, as it would devalue
their entire dollar portfolio and clearly do damage to their number one export
market - the US consumer.
is unlikely that the US will actually be able to get such legislation passed
into law. Even if such legislation passed Congress (an admitted possibility)
it would be vetoed by President Bush. That means that any real change would
not be possible until some time in the middle of 2009.
has already dropped almost 10% in the last two years since the Chinese started
their policy of a crawling peg. For reasons I outlined at length a few weeks
ago, it is likely that the Chinese are going to increase that pace over the
next two years, for their own internal reasons. A higher renminbi valuation
helps them slow their economy down from its way too fast pace of growth that
is evident today. (If you would like to see that analysis, click here.)
By the time
any real legislation could get passed, the renminbi will be very close to
the level where the China bashers in Congress want to see it, if it is not
already floating. Hardly enough to want to start a trade war at that time.
But let's look
at what the bi-partisan economic illiterates in Congress are actually advocating.
First, they whine about lost American jobs. But a 25% higher renminbi is not
going to bring any manufacturing jobs back. China is no longer the low cost
labor market. There are other Asian countries with lower labor costs. We just
will not be able to competitively manufacture products that have high unskilled
But we will
continue to manufacture high value added items in a host of industries where
skill and talent are required. Even though manufacturing as a percentage of
US GDP is down, our actual level of exports and manufactured products is up
by any measure. It is easy to write about the closing of a plant, and it makes
the headlines, but the fact is that free trade has created more jobs by far
than we have lost.
our cost of imports were to rise by 20-25%, that cannot be understood as anything
but inflationary. And it would not just be Chinese products, but the products
of all developing countries. Many Asian countries manage (manipulate) their
currencies to keep them competitive against each other and the Chinese. You
can bet that if the renminbi rises another 20%, there is the real prospect
that they all will.
And much of
what China and the rest of Asia produces is bought by those on the lower economic
rungs of the US ladder. So, if Congress gets its way, they would be advocating
putting pressure on those least capable of paying higher prices. But no one
lobbies for the little guy. Congressional members can pander to their local
unions and businesses without having to answer for what would be higher prices.
And higher prices
means more inflation which means that interest rates have to be higher than
they should, which means higher mortgage rates, etc. Protectionism has a very
high cost. Free markets create more jobs everywhere.
should hope the Chinese continue to allow their currency to rise slow and
steady. Neither country needs the turmoil a rapid rise would induce. The world
needs a stable China. We are watching world credits markets freeze up because
things went very bad very quickly in the relatively small subprime world.
A 20% drop in the dollar in a few months would be even more catastrophic.
Senators Lindsey Graham and Chuck Schumer are competing to be this century's
Smoot and Hawley that creates a depression from trade wars where none should
The danger in
all this is that politicians who have little economic literacy create a hostile
environment with their rhetorical poison, with both sides feeling the need
to play to their "home crowd." That is a very dangerous environment.
It won't happen,
but I would like to see the following question asked in the presidential debates
to those (like Hillary Clinton, Obama and Dodd, etc.) who basically advocate
a weaker dollar.
you advocating a weak dollar policy? Why do you want American wage earners
to pay 25% more for the goods we buy from foreign countries? Do you really
think there is no connection between the value of the Chinese currency and
the rest of the currencies of the world? Do you think American consumers need
to send even more money overseas and get less for our dollars? Do you think
the American consumer is so well off they can afford to pay more and that
it will have no affect on the US economy? Do you realize that a 25% lower
dollar will mean a rise in world oil prices? Do you think there is no connection
between the value of the dollar and US prosperity?"
I won't hold
Back to 1998
Let's get in
the Wayback Machine and revisit 1998. (For reference for my foreign readers,
the "Wayback Machine" originally referred to a fictional machine
from a segment of the cartoon The Rocky and Bullwinkle Show used to transport
Mr. Peabody and Sherman back in time.)
was the Asian currency crisis and then Russia looked like it would default
on its debt, causing a crisis in the credit markets. A hedge fund called Long
Term Capital Management had leveraged their bond positions about 80 to 1 based
upon the relationship between certain types of bonds always, emphasize always,
converging upon a certain price. They diversified on bonds throughout the
world as an "extra" protection.
the markets in the fall of 1998 were not acting as they had in the past. The
relationships changed just a very small amount, but if you are leveraged 80
to 1, then small is enough to wipe you out. The Nobel Prize winners who designed
the system overlooked the possibility that the market could become irrational.
to 2007. Again, the credit markets are in turmoil, and the subprime mortgage
problems are spreading, as predicted here last January. Let's look at some
things that are similar to 1998.
relationships between certain types of bonds have been turned on their head.
For many companies who go into the credit markets, there are different types
of debt they sell. Certain types of bonds or loans are considered "senior"
because in the event of the company going bankrupt, they get paid first. Then
debt that is subordinated to the senior debt gets paid, and lastly the shareholders
get to split what is left over, if anything.
it stands to reason that senior debt is more valuable than subordinated debt.
Why would you pay more for the riskier debt? So, if you want to put on a hedge,
you can "go long" the senior debt and "go short" the subordinated
debt. And in the past, that works.
Except not this
time. There are a number of funds that are having real problems and are being
met with high redemptions because they are exposed to the subprime markets.
But no one is buying the subprime debt, so they have to sell what they can
to meet redemptions. And what sells? The quality senior debt. At a discount,
So, if you are
another fund holding that debt instrument that just traded down, you just
saw the value of your high quality loan or bond drop. But because the subordinated
debt you sold as a hedge is not trading, there is not a price for it, so you
can't show the profit there should be on the pair trade. Your fund is down
for the month. Bummer.
Now, if you
are not over-leveraged and forced to sell, you can wait a few weeks or a month
and the normal relationship will come back. And you may even benefit as quality
will rise even as the riskier instruments fall. But until there is a price
made on your hedges, you cannot just make up a price based upon normal rational
And if you are
in the lucky position of having cash, you can go in and buy very good debt
at a fire sale price today. There are a lot of debt instruments of very good
and profitable companies that is on the market for much less than what it
will be in a few months when things get back to normal. And if you are a company
with cash, you may be able to go back in and buy your debt at a discount.
The End of
the Quantitative World
I should first
note that the average hedge fund made money in July, and some did quite well.
There are a number of hedge fund strategies that have the potential to benefit
in this type of environment. That being said, if a fund has invested in the
subprime mortgage space (unless they are short), they are losing money. It
is easy to see the relationship between the subprime mess and the funds that
invested in it. But there are other funds which are losing money, and the
connection to the subprime markets is less clear.
There are any
number of statistical relationships which have simply not functioned as they
have in the past. Large quantitative hedge funds that employ teams of mathematicians
and physicists to develop complex "black box" trading programs to
computer trade on these relationships are finding themselves losing money.
As Spencer Jakab writes:
hedge funds running 'black box' models are primarily market neutral, seeking
to exploit small inefficiencies in valuations and historical volatility between
similar securities. A period like the last few weeks would have typically
seen such funds outperform most of their peers in the hedge-fund community,
but they have instead shocked investors with steep losses.
risk managers were able to demonstrate that they were less risky, on paper
at least, they were allowed to use far more borrowed money than other leading
hedge fund strategies. Some are clearly overextended. 'The inherent leverage
is killing them,' said a broker at a major investment bank who deals with
Matthew Rothman of Lehman Brothers wrote that the models are working in exactly
the opposite way they should to protect a black box fund in an up or down
market. 'It is not just that most factors are not working but rather they
are working in a perverse manner,' wrote Rothman. 'The names that are short
are outperforming, often notably, while the names that are long are underperforming,
although less severely.'"
Alpha, which has been losing money for two years, is down 26% for the year
and down almost 40% since the end of July. It is not surprising they are being
hit with redemptions. And that forces them to sell. Many of the largest hedge
funds are the very quantitative funds that are being forced to sell, putting
pressure on the markets.
In 1998 problems
in Asia and Russia spread to the rest of the markets, affecting Norwegian
bonds and US stocks. It took a few months to sort out, and a lot of people
lost money. Today, problems in the subprime mortgage markets spread to other
credit markets and the affect is spilling over into stock markets.
But there is
a difference. Today, instead of one fund that was at the epicenter of the
problem, the problems are spread around the world among scores of funds and
permeate the largest institutional and pension funds. While that means the
losses are spread among thousands of investors, it also means that central
banks can't bring everyone to the table to "fix" the problem.
of the last two days was triggered by BNP Paribas telling investors in three
of their funds that they would not be allowed to redeem. This simply froze
the European markets. The European Central Bank has injected $211 billion
into their system. Central banks have put $339 billion into the world system
in the last 48 hours. And you should be very glad they did, by the way.
I heard on TV
that some are saying the Fed is bailing out banks. Not they way I read it.
They are simply taking short term "repo" paper for a few days to
inject liquidity. If you are going to have a central bank, then this is a
proper action. The fact that the excess liquidity which produced the bubbles
can be laid at the Greenspan Federal Reserve's feet is a topic for another
And while we
are on the topic, I think BNP Paribas probably did the right thing. They have
funds which have invested in all sorts of credit vehicles. Nothing is trading,
so if they tried to meet redemptions, they would have to sell assets at much
distressed prices, and then guess at what prices the other assets should be
valued at in the absence of a market price. If they guessed to little, then
those exiting would lose too much, notice their losses were too high and sue.
If they guessed too high, then those remaining would notice that they lost
more than they should have and then sue. BNP was in a no win situation. To
be fair to all investors, they have to wait until the market prices the assets
in their portfolio.
They have not
said what those assets are. If they are not US mortgage related it is likely
they will turn out ok. If there is subprime in the mix, they will take significant
a Long Time
And one last
difference between 1998 and today. Back then, the problems in the markets
became known and were priced into the markets in relatively short order. It
is going to be several years before we know the extent of the subprime losses.
Remember the table that I used last week which showed the bulk of subprime
mortgage interest rate resets was not until the first half of 2008. It is
going to take years for the markets to know what the losses on the subprime
will actually be.
And it is not
as if it should be a total surprise. Any investor can go to their Bloomberg
and pull up a listing of subprime Residential Mortgage Backed Securities.
There are 2,512 of them. If you sort by the ones with the most loans over
60 days past due, you find that the average RMBS has 12.39% of their mortgages
over 60 days, and 2.39% have already been repossessed (REO in the next table),
with almost 5% in foreclosure.
The table below
shows the RMBS with the highest level of 60 day past due (or worse) mortgages
in them. Yes, the worst two offenders are the 2006 vintage of RMBS. But notice
that a lot are from 2000, 2001, 2003 and earlier, well before the supposedly
lax standards of the past few years. The third listed RMBS, the INHEL 2001-B
is selling at 18 cents on the dollar (you can't see this from the table),
and has been dropping since 2003. Over 25% of the mortgages in that portfolio
have already been repossessed or are in foreclosure, with another 25% past
due for over 60 days. Can you say ugly?
But you can
also find paper from 2001 that is not doing badly. It should be clear to anybody
who did a little due diligence a few years ago that there were problems in
the subprime RMBS markets. There was a great deal of difference in the quality
of various offerings. So it paid you to do some homework. If you could not
get transparency, then you were taking a gamble.
That being said,
many of the European and Asian institutions who bought this paper relied on
the credit rating agencies. They relied on the models built by the investment
banks that put this paper together. As I have written, they sold their AAA
rating but put legal language buried in the documents that basically said,
"OK, this is not what we mean by AAA in our other ratings." The
document for the RMBS mentioned above was 300 pages of fine print. I will
bet you that the vast majority of people buying this paper did not read it
or understand what they were reading if they did.
You can bet
lawyers all over the world will look at this same screen I show below. They
are then going to ask the bankers and credit agencies how they could put such
a high rating on the paper seeing the problems in these securities? "Really,
you didn't look at the lending standards?" It's all hindsight, of course.
But that's what lawyers do. And in front of a jury, it will be a tough day
for the banks and credit agencies.
And let's close
with a few paragraphs written by my friend and partner Jon Sundt of Altegris
Investments. I think this is one of the better pieces I have seen looking
at the complex environment we are in today. Most of the press tends to greatly
oversimplify and lump all funds, banks and bonds into one category, when the
truth is there is a lot of difference. Full disclosure, Jon and I and the
rest of my international partners are in the business of finding hedge funds
for clients, so we have both an inside view into what is going on, as well
as a clear bias. I am proud of the job that Jon and his team have done and
happy to be associated with them. That being said, let's read Jon's take on
if you look at the indices for different hedge fund strategies out there,
you will find a large dispersion of results for July, with some strategies
gaining money and some losing money. The differences between a long/short
US manager, a multi-strategy Asia manager, and a leveraged CDO manager are
too numerous to mention in this article, but the press would have you believe
that these managers are all bound together.
reinforce my point with a basic but very appropriate analogy. In Japan, there
is a distinctive puffer fish called the Fugu. It is served in special sushi
restaurants by master chefs. Fugu tingles in your mouth when you eat it. It
is supposed to be an exotic aphrodisiac in Japan, where diners spend hundreds
of dollars a serving to eat it. The problem is that eating Fugu can kill you.
There is an old saying in Japan, 'I want to eat Fugu, but I don't want to
die.' People have been known to literally drop dead in sushi bars from cardiac
arrest and pulmonary failure if the Fugu they ate wasn't prepared correctly.
You have to be a specially trained and licensed Fugu chef to prepare and serve
it. Personally, I would want to see the stats of the chef before eating Fugu...just
a simple 'number of customers killed' would work for me.
a family in your town called the Griswolds. (You may remember them from the
National Lampoon 'Vacation' films.) Suppose for their next trip, the Griswolds
decide to travel to Japan and pursue some gastronomical thrills and eat the
infamous Fugu. So they do some cursory research, march into a Tokyo Fugu restaurant,
plunk down $1,000 and order a huge plate of Fugu. And die on the spot.
morning as you sit at your breakfast table sipping coffee, you read the following
FAMILY DIES EATING EXOTIC POISONOUS FISH IN TOKYO"
to yourself, no problem... you continue sipping coffee... and maybe mutter...
'They should have known better.'
instead that you read the following headline:
FAMILY DIES IN FISH RESTAURANT"
may be very different. You are likely going to cancel your reservation at
the local sushi bar until you hear more. What if all fish are tainted? Or
is it just that restaurant? Or is it a specific type of fish? You'll have
lots of questions, and you might assume, until you know more, that no fish
are worth eating.
is that events like these and potential losses should not come as a surprise
to knowledgeable and well-educated investors, whether in Bear Stearns' funds
(the current focal point of media attention) or other funds. The name of one
of the Bear Stearns' funds was 'The High-Grade Structured Credit Strategies
Enhanced Leverage Fund.' If this name alone didn't suggest possible concentrations
in potentially high-risk investments, I don't know what would. According to
one Citibank report, the fund at one point was 80:1 leveraged! In March of
this year, the subprime story was all over the news. At a time when most news
sources were already talking about interest rate increases hurting subprime
borrowers, Bear Stearns appears to have been marketing a fund that invested
in illiquid/exotic mortgage credit instruments with high levels of leverage.
I don't personally know the full details behind the reasons Bear sponsored
this fund, it is clear in my mind that investors seem to have been taken by
surprise as to what they had invested in. As I see it, and to return to my
analogy, this fund may have been serving up large plates of Fugu to investors
clamoring for a bite. The 'diners' appear to have either been unaware of the
risks, or more likely, had not seriously considered what could, and in fact
did, go wrong.
CDOs have danger written all over them, but those backed by subprimes would,
with the benefit of hindsight, seem to have been quite clearly headed for
trouble. It is a very narrow and specialized breed of hedge fund that trades
in such a space. Like a sushi 'Fugu' bar, such investing is not typical of
all hedge funds. That doesn't mean there aren't billions of dollars exposed
to it... it just means it isn't your everyday long/short hedge fund."