January 25, 2008
What Does the Fed Know?
by John Mauldin
It had been my original intention to devote this week's letter to the view from Europe, as I have been here for the last week, but events have changed that goal. The Federal Reserve made a very rare inter-meeting rate cut of 75 basis points this week, after the worldwide markets were in turmoil. Many pundits suggest the Fed was responding to the worldwide collapse in stock prices. This week we examine that suggestion, and I will offer an alternative explanation. I am beginning this letter in a London subway train. Quickly, the consensus wherever I go seems to be that Europe and the United Kingdom are also headed into recession. There is a lot of interesting ground to cover, so let's get started.
But first, I want to make a quick correction from last week. I do know the difference between monocline (a set of rock layers that all slope downward from the horizontal in the same direction) and monoline (a business that focuses on operating in one specific financial area). However, Microsoft Word doesn't. I *think* I had it right in the original version of the letter, but when I sent it to my editor, the word monoline was "helpfully" changed automatically to monocline. As we will be mentioning the monoline companies again this week, let's hope we can get it right.
Fed's Folly: Fooled by Flawed Futures?
In The Financial Times today the inside headline is "Markets ask if the Fed was duped?" It seems that a rogue trader (interesting how a lone trader who loses a lot of bank money is always a rogue) lost Societe Generale $7.1 million (4.9 million euros). Seems he knew how to override the risk control systems, had other employees' passwords, and built up a massive long position which was down about $2.2 billion by the time SocGen management found out. He produced the losses in just a few weeks. SocGen started selling everything to cover the loss on Monday morning, and the markets moved away from them, growing the loss to the $7.1. That constitutes a bad day at the trading desk. (As an aside, I have worked with SocGen from time to time over the years, and have always been impressed.)
Some suggest that it was the very selling by SocGen, which was 10% of the market trades, which caused the downside volatility. It seems the European Central Bank knew early on about the problems at SocGen, but the Fed got caught by surprise. The Fed holds an emergency FOMC meeting ahead of the scheduled meeting this week, and makes a shock and awe 75-basis-point cut. I can tell you that shocked a lot of very sophisticated traders and managers that I talked with here in Europe.
Everywhere I went I was asked, "Why an inter-meeting cut?" The Financial Times wrote, "The question being asked now by some in the markets is: was the Fed duped into a clumsy and panicked move by the clean-up operation for Jerome Kerviel's [AKA rogue trader at SocGen] mammoth losses for the French bank?"
My very good friend Barry Ritholtz seems to agree with that position. He was on CNBC with Steve Lissman and Rick Santoli and they suggested that the Fed responded to the volatility in the stock markets with the rate cut and that the Fed is now responding to the traders in the S&P futures pit.
Let's read Barry's take when he finds out that the volatility may have been the result of our rogue trader, in a blog entitled "Fed's Folly: Fooled by Flawed Futures?":
"Was it a misunderstanding of their mandate, inexperience, or just plain hubris?
Regardless, it took only 2 days to learn just how ill-considered the Fed's emergency market rescue plan was: To wit, a fraudulent series of losses led to a major European bank unwinding a huge trade: Societe Generale Reports EU4.9 Billion Trading Loss.
SG's $7.1Billion dollar unwinding led to panicked futures selling on Monday and Tuesday.
"Hence, we quickly learn what sheer folly and utter irresponsibility it is for the Fed to use its limited ammunition to intervene in equity prices. Their panicky rate cut was not to insure the smooth functioning of the markets, but rather, to guarantee prices.
As we have been saying for the past two days, this is not the Fed's charge. They are supposed to be maintaining price stability (fighting inflation) and maximizing employment (supporting growth) -- NOT guaranteeing stock prices.
"I guess the European Central Bank has it easier: Their only charge is to fight inflation: 'maintain price stability, safeguarding the value of the euro.' Tuesday's panicked 75 basis cut will prove to be an historical embarrassment, a blot on the Fed for all its days. Failing to understand what their responsibilities are is bad enough; allowing themselves to be bossed around by futures traders is inexcusable.
And, having been rewarded for their past tantrums, the market will now be screaming for another 75 bps next week. As Rick Santelli appropriately observed, the Pavlonian training is now complete."
I don't agree with that assessment, and Barry is not so thin-skinned that he will worry about my having a different view. So, let me throw out another scenario.
First, for years one of my central premises has been that we have to remember that when a normal human being is elected to the board of the Fed, he is taken into a secret room where his DNA is altered. Certain characteristics are imprinted. Now, he does not like inflation and hates deflation even more. He sees his role as making sure the financial market functions smoothly. He does not care about stock prices when thinking about rate cuts.
Then what was the reason for the cut if not stock prices? Why an inter-meeting cut much larger than the market was expecting next week, just seven days later? What was so urgent that we needed a shock and awe rate cut a week early?
I am not sure if panic is the right word, but I think very deep concern is also a little understated. It has to be something serious for an inter-meeting cut. Looking around for problems I came up with the following thoughts that I shared with investors and managers while here in Europe.
What Does the Fed Really Know?
I believe the monoline insurance companies like Ambac and MBIA are in worse shape than most realize, the counter-party risk in the $45 trillion Credit Default Swap market is much worse than we realize, and the exposure by various banks to their problems is much larger than currently understood. The Fed understands this, and realizes that they have been behind the curve but need to catch up. Let's go back and look at this quote from my letter just last week:
"If you are a bank or regulated entity, and you have mortgage-backed securities that have been written by a AAA monocline company, you can carry that debt on your books as AAA. But as the companies get downgraded, you have to write down the potential loss. Quoting from a recent note from Michael Lewitt:
" 'MBIA's total exposure to bonds backed by mortgages and CDOs was disclosed to be $30.6 billion, including $8.14 billion of holdings of CDO-squareds (CDOs that own other CDOs, or mortgages piled on top of mortgages, or, to quote Jeff Goldblum's character in Jurassic Park again, 'a big pile of s&*^'). MBIA was being priced as a weak CCC-rated credit when it issued its bonds last week; it is now being priced for a bankruptcy. MBIA's stock, which traded just under $68 per share last October, dropped another $3.50 this morning to under $10.00 per share.
"'The bond insurers' business model is irreparably broken. In HCM's view, it will be all but impossible for these companies to raise capital at economic levels for the foreseeable future and certainly in enough time to work out of their current difficulties. The performance of MBIA's 14 percent bond issue will prove to have been the death knell for this business. The market needs to come to the realization that the so-called insurance that these companies were offering is not going to be there if it is needed. The fact that these companies were rated AAA in the first place will remain one of the great puzzles of modern finance for years to come.'
"You can bet that the $8 billion in CDO-squareds is gone. It is a matter of time. MBIA's market cap is about $1 billion [it is now at $1.74]. Current shareholders will be lucky if they only get diluted 75%."
Think this through. MBIA is still rated AAA. Ratings downgrades are just a matter of time. Banks that raised $72 billion to shore up capital depleted by subprime-related losses may require another $143 billion should credit rating firms downgrade bond insurers, according to analysts at Barclays Capital.
Banks will need at least $22 billion if bonds covered by insurers, led by MBIA Inc. and Ambac Assurance Corp., are cut one level from AAA, and six times more than that for downgrades by four steps to A, as Paul Fenner-Leitao wrote in a Barclays report published today. Barclays' estimates are based on banks holding as much as 75% of the $820 billion of structured securities guaranteed by bond insurers. (Source: Bloomberg)
The stocks of MBIA and Ambac have risen on speculation of take-overs or a rescue. But MBIA is going to have to cover that $8 billion of CDO squareds. With what cash? MBIA makes about $5 billion a year. It will take almost two years' earnings just to deal with the losses from CDO squareds. Not to mention the subprime mortgage exposure.
But what if the above-mentioned monolines are downgraded to junk, as was ACA when it could not raise capital? As the downgrades on various mortgage assets and the CDOs continue to increase, the ability of the monolines to deal with the problems is going to come under increasing question. The losses at major banks could be much worse than $122 billion if they are downgraded to the same junk level that ACA was.
And that is just the credit default swaps (CDSs) from the monolines. What about the trillions that are guaranteed by banks and hedge funds? There are a total of $45 trillion CDSs outstanding.
No one is really sure who owes what and to whom, and what is the risk that there may be no one to pay that CDS when it comes due? The entire mess is going to have to be unwound in the coming quarters. It may take a year or more.
I think the concern that there is the potential for a much worse credit crisis than we are currently experiencing is what is driving the Fed. They are looking at the problem from the inside, and realize that they simply have to engineer a much steeper yield curve to allow the banks to make enough profits so that they might be able to grow their way out of the crisis over time.
If I am wrong and the Fed was responding to the stock market, then we will likely not see a cut this next week. But if we get another 50-basis-point cut, as I think we will, then it means the Fed is responding to concerns about the credit crisis. And we will get another cut the next meeting and the next until we get down to 2% or below.
A 50-basis-point cut takes the rate to 3%. It they had cut the rate by 1.25% next week, the market would have collapsed. Better to do it in two leaps is what I think they are thinking. We will see. And it is not just the Fed that is concerned.
Brother, Can You Spare a Billion?
"The risk of a deeper capital shortfall may help explain why New York's Insurance Superintendent Eric Dinallo is trying to arrange a bank-led bailout of the bond insurers. Downgrades would cast doubt on the credit quality of $2.4 trillion of bonds the industry guarantees. Dinallo met with executives of banks and securities firms this week to ask them to extend capital to bond insurers and stave off credit rating reductions.
"Barclays Capital has come up with a very big and very scary number," said Donald Light, an insurance analyst at Boston-based consulting firm Celent. "It indicates that the cost of a bailout of the bond insurers is a lot less than the cost of shoring up these banks' mark-to-market losses."
You can bet that the various investment banks being asked to shore up the capital of the monoline companies are not going to do it as a donation. They are going to get the equity and debt of the company. I don't often make bets about the stock prices of individual companies, but I think those who think a "rescue" of MBIA and AMBAC and others will be good for shareholders are going to be in for a rude awakening. It will not be pretty.
The Barclays report said that Financial Guaranty Insurance Company is likely to be downgraded. They have insured just $315 billion in bonds.
The Financial Times reports that several groups are looking into setting up new monoline insurance companies. Once Warren Buffett announced that he planned to do just that, several other groups decided to follow. "The plans by TPG, Mr. Ross and others have not been finalized and could come to nothing, but any attempt to bring fresh competition to the market would complicate the capital raising hopes of Ambac, MBIA and others." That is a mild understatement.
$5 Billion a Quarter
Here is how I think the next few quarters are going to play out. Each new downgrade triggers more losses at financial institutions. You don't write down a bond insured by MBIA as AAA until there is actually a write-down. And then you do, and announce it at the end of the quarter. Along with the rest of the losses caused by new downgrades. We are going to see massive write-offs every quarter by the same financial institutions that have already written off $100 billion. We are only in the beginning innings.
There are very serious suggestions that several extremely large banks (and not just in the US), of the "too big to be allowed to fail" size, technically have negative equity. With each announcement of a new massive write-off, we will see yet another large capital investment announced as well.
And every time it happens, the market is going to be disappointed. And continuing disappointment is what keeps a bear market intact. Couple that with earnings disappointments from companies with exposure to consumer spending, and you have a recipe for a bear market that could linger for awhile.
I think there is very serious risk that taxpayer money is going to have to be spent on shoring up some of the financial players that are at risk. There will be much screaming and wailing and gnashing of teeth before that happens, but it is quite possible.
As I am closing this letter (as I have yet another meeting tonight), I take special note that Bank Credit Analyst has changed their forecast. They now are forecasting a recession, but they see one that is worse than I am predicting. They think the recession will last a year and that GDP will be around a -2% for that time period. I will call Martin Barnes when I am back in Texas next week and get an update for you. Martin is one of the best economic minds I know, and I value his opinion highly.
Next week I will review my thoughts from this whirlwind trip to Europe. Let me say that at least the people I met with were generally more bearish than I am. That is a little disconcerting. A few think I am quite the Pollyanna. And now that Martin is bearish, maybe I should enjoy being the "optimist" in the crowd.
Planes, Trains, and Santa Barbara
And Charlie Wilson's War
I fly back tomorrow on a 777, and am still waiting to hear what caused both engines in a 777 to simply fail at the same time at Heathrow last week. Speaking of deep concern.
Then Tiffani (my daughter and the person who runs the business) and I fly to Santa Barbara to meet with Jon Sundt and his team from Altegris for two days of planning at Jon's ranch. It has been a few years since we have been there, and I really enjoy the views of the ocean from his mountain retreat. Not to mention the food, as we all take turns trying to out-do the last cook. Jon is actually quite good.
The train ride from Geneva to Zurich is one of my favorites. It is such a lovely country. This was my first time to Zug; and I can see the attraction, as one hedge fund after another is moving there as the canton offers serious tax advantages. I like to see competition between various governments as to who can offer the best tax advantages. I wish the US would consider such a move.
I like the proliferation of cheap airlines in Europe. But if you can, I would suggest avoiding Clickair. In addition to cheap fares, they offer the most cramped seating of any plane I have ever been on.
One final suggestion. Go see the movie Charlie Wilson's War. Besides being one of Tom Hanks' roles (he should get an Oscar), it offers a different view of Afghanistan and the anti-communist movement in the '80s. I suggest that before you go you should read Chip Wood's essay called "It wasn't just Charlie Wilson's War" at http://list.soundpub.com/subscribe/arch ... nsWar.html
While there is much to enjoy about the movie, they did stretch a point. The role played by Julia Roberts was fictional. The real hero was a man many of us know and respect, called Jack Wheeler. Read Chip's well-written and fascinating essay for the rest of the story. It is worth the time.
Enjoy your week. I am off to dinner with Tom Fischer from Jyske Bank, who has come from Copenhagen to meet with me. It is always a pleasant time with him. It has been a good week for making new friends and meeting old ones. My time with my partners at Absolute Return Partners here in London has been especially enjoyable. And for whatever reason, jet lag did not seem to bother me this week. I usually struggle for a few days with it when I come to Europe. More on the view from Europe next week. Enjoy your week, and keep those hedges on.
Your ready to get back home and watch the Mavs analyst,