Mon, Dec 17 2007
THE GUY WHO INVENTED THE TOXIC DERIVATIVES MESS SEZ WE'RE FUCKED
The Credit Crisis Could Be Just Beginning
By Jon D. Markman
Special to TheStreet.com
9/21/2007 6:40 AM EDT
Satyajit Das is laughing. It appears I have said something very funny, but I have no idea what it was. My only clue is that the laugh sounds somewhat pitying.
One of the world's leading experts on credit derivatives (financial instruments that transfer credit risk from one party to another), Das is the author of a 4,200-page reference work on the subject, among a half-dozen other tomes. As a developer and marketer of the exotic instruments himself over the past 30 years, he seemed like the ideal industry insider to help us get to the bottom of the recent debt crunch -- and I expected him to defend and explain the practice.
I started by asking the Calcutta-born Australian whether the credit crisis was in what Americans would call the "third inning." This was pretty amusing, it seemed, judging from the laughter. So I tried again. "Second inning?" More laughter. "First?" Still too optimistic.
Das, who knows as much about global money flows as anyone in the world, stopped chuckling long enough to suggest that we're actually still in the middle of the national anthem before a game destined to go into extra innings. And it won't end well for the global economy.
Ursa Major
Das is pretty droll for a math whiz, but his message is dead serious. He thinks we're on the verge of a bear market of epic proportions.
The cause: Massive levels of debt underlying the world economic system are about to unwind in a profound and persistent way.
He's not sure if it will play out like the 13-year decline of 90% in Japan from 1990 to 2003 that followed the bursting of a credit bubble there, or like the 15-year flat spot in the U.S. market from 1960 to 1975. But either way, he foresees hard times as an optimistic era of too much liquidity, too much leverage and too much financial engineering slowly and inevitably deflates.
Like an ex-mobster turning state's witness, Das has turned his back on his old pals in the derivatives biz to warn anyone who will listen -- mostly banks and hedge funds that pay him consulting fees -- that the jig is up.
Rather than joining the crowd that blames the mess on American slobs who took on more mortgage debt than they could afford and have endangered the world by stiffing lenders, he points a finger at three parties: regulators who stood by as U.S. banks developed ingenious but dangerous ways of shifting trillions of dollars of credit risk off their balance sheets and into the hands of unsophisticated foreign investors, hedge and pension fund managers who gorged on high-yield debt instruments they didn't understand and financial engineers who built towers of "securitized" debt with math models that were fundamentally flawed.
"Defaulting middle-class U.S. homeowners are blamed, but they are merely a pawn in the game," he says. "Those loans were invented so that hedge funds would have high-yield debt to buy."
The Liquidity Factory
Das' view sounds cynical, but it makes sense if you stop thinking about mortgages as a way for people to finance houses and think about them instead as a way for lenders to generate cash flow and to create collateral during an era of a flat interest rate curve.
Although subprime U.S. loans seem like small change in the context of the multitrillion-dollar debt market, it turns out that these high-yield instruments were an important part of the machine that Das calls the global "liquidity factory." Just like a small amount of gasoline can power an entire truck given the right combination of spark plugs, pistons and transmission, subprime loans became the fuel that underlies derivative securities that are many, many times their size.
Here's how it worked: In olden days, like 10 years ago, banks wrote and funded their own loans. In the new game, Das points out, banks "originate" loans, "warehouse" them on their balance sheets for a brief time, then "distribute" them to investors by packaging them into derivatives called collateralized debt obligations, or CDOs, and similar instruments. In this scheme, banks don't need to tie up as much capital, so they can put more money out on loan.
The more loans that were sold, the more they could use as collateral for more loans, so credit standards were lowered to get more paper out the door -- a task that was accelerated in recent years via fly-by-night brokers that are now accused of predatory lending practices.
Buyers of these credit risks in CDO form were insurance companies, pension funds and hedge-fund managers from Bonn to Beijing. Because money was readily available at low interest rates in Japan and the U.S., these managers leveraged up their bets by buying the CDOs with borrowed funds.
So if you follow the bouncing ball, borrowed money bought borrowed money. And then because they had the blessing of credit-ratings agencies relying on mathematical models suggesting that they would rarely default, these CDOs were in turn used as collateral to do more borrowing.
In this way, Das points out, credit risk moved from banks, where it was regulated and observable, to places where it was less regulated and difficult to identify.
Turning $1 Into $20
The liquidity factory was self-perpetuating and seemingly unstoppable. As assets bought with borrowed money rose in value, players could borrow more money against them, and it thus seemed logical to borrow even more to increase returns. Bankers figured out how to strip money out of existing assets to do so, much as a homeowner might strip equity from his house to buy another house.
These triple-borrowed assets were then in turn increasingly used as collateral for commercial paper -- the short-term borrowings of banks and corporations -- which was purchased by supposedly low-risk money market funds.
According to Das' figures, up to 53% of the $2.2 trillion of commercial paper in the U.S. market is now asset-backed, with about 50% of that in mortgages.
When you add it all up, according to Das' research, a single dollar of "real" capital supports $20 to $30 of loans. This spiral of borrowing on an increasingly thin base of real assets, writ large and in nearly infinite variety, ultimately created a world in which derivatives outstanding earlier this year stood at $485 trillion -- or eight times total global gross domestic product of $60 trillion.
Without a central governmental authority keeping tabs on these cross-border flows and ensuring a standard of record-keeping and quality, investors increasingly didn't know what they were buying or what any given security was really worth.
A Painful Unwinding
Here is where the U.S. mortgage holder shows up again. As subprime loan default rates doubled, in contravention of what the models forecast, the CDOs those mortgages backed began to collapse. Because these instruments were so hard to value, banks and funds started looking at all CDOs and other paper backed by mortgages with suspicion, and refused to accept them as collateral for the sort of short-term borrowing that underpins today's money markets.
Through late last month, according to Das, as much as $300 billion in leveraged finance loans had been "orphaned," which means that they can't be sold off or used as collateral.
One of the wonders of leverage is that it amplifies losses on the way down just as it amplifies gains on the way up. The more an asset that is bought with borrowed money falls in value, the more you have to sell other stuff to fulfill the loan-to-value covenants. It's a vicious cycle.
In this context, banks' objective was to prevent customers from selling their derivatives at a discount, because they would then have to mark down the value of all the other assets in the debt chain, an event that would lead to the need to make margin calls on customers who are already thin on cash.
Now it may seem hard to believe, but much of the past few years' advance in the stock market was underwritten by CDO-type instruments that go under the heading of "structured finance." I'm talking about private-equity takeovers, leveraged buyouts and corporate stock buybacks -- the works.
So the structured finance market is coming undone; not only will those pillars of strength for equities be knocked away, but many recent deals that were predicated on the easy availability of money will likely also go bust, Das says.
That is why he considers the current market volatility much more profound than a simple "correction" in prices. He sees it as a gigantic liquidity bubble unwinding -- a process that can take a long, long time.
While you might think that the U.S. Federal Reserve can help prevent disaster by lowering interest rates dramatically, as it did Wednesday, the evidence is not at all clear.
The problem, after all, is not the amount of money in the system but the fact that buyers are in the process of rejecting the entire new risk-transfer model and its associated leverage and counterparty risks.
Lower rates will not help that. "At best," Das says, "they help smooth the transition."Mon, Dec 17 2007
IT'S OFFICIAL - WE ARE TOTALLY FUCKED
The all-time best contrarian indicator is George W. Bush himself. Whatever that man says, the opposite is always the truth. Every single thing he has ever touched has turned into total shit. Everything.
So here's the truth:
- the economy is seriously seriously fucked
- stagflation is already here
- jobs are totally fucked
- taxes on the people are rising in the form of inflation
- there isn't jack the government or banks can do except try to manage the avalanche
- they don't have a plan are are dancing as fast as they can
- the budget is totally fucked, stick a fork in it
Bush says US economy is safe and sound
FREDERICKSBURG, Va. Associated Press - President Bush worked to reassure Americans on Monday about the economy but said "there's definitely some storm clouds and concern" because of the nation's credit crunch and mortgage problems.
"But the underpinning is good," Bush told business and community leaders at a gathering of Rotary Club members.
"We've had a pretty good economic run," the president said in a speech intended to show he is aware of the public's edgy mood these days. Consumer confidence has eroded as turmoil in the housing and credit market have battered the economy.
Bush tried to position himself as an advocate for working families by taking aim at his favorite target: the Democratic Congress.
"The Congress cannot take economic vitality for granted," Bush said.
"The most negative thing Congress can do in the face of economic uncertainty is to raise taxes on the American people," Bush said.
The audience of roughly 80 people listened to Bush with respectful silence. Yet a line that normally gets him applause — "I'll veto any tax increase" — drew no reaction at all.
Bush chose to highlight positive economic news, such as job growth. "People are working; productivity is high," Bush said.
He acknowledged the nation's major economic woes — mainly the housing and credit crunch — in the context of explaining what his administration is doing to help.
"We can mitigate some of the issues," Bush said.
"I just want to let you know we've got a strategy. And Congress can help," the president said, citing a list of bills he's proposed to lawmakers.
Bush spoke at the Yak-A-Doo's restaurant inside a Holiday Inn.
The White House wanted to keep the flavor of the local Rotary meeting, so there was no banner or backdrop. Bush was not even introduced; he just showed up, drawing a round of applause. The Christmas music being piped was not cut off until someone pointed that out.
The president watched silently as club members offered a truncated version of their normal business routine, offering the Pledge of Allegiance and a prayer.
After months of bickering with Congress, Bush pronounced himself pleased with the shape of spending levels that Congress is expected to approve this week. He said any measure must include money for troops in Iraq and Afghanistan.
"We're making some pretty good progress toward coming up with a fiscally sound budget," Bush said. He said that the next couple of days "will be interesting to watch."Mon, Dec 17 2007
MR. PRACTICAL POINTS OUT ANOTHER ELEPHANT
Minyanville is an excellent finance site with a wealth of info and analysis. Cool econerds hang there, of which Mr. Practical is one of the better ones.
Current Global Economy Like Nothing Before
Mr Practical, Minyanville.com
U.S. investment abroad has all but collapsed, nose-diving from $42 bln to $4 bln.
The world's largest economies have really never been in this situation before. Last week I alluded to the fact that investors need to change their mindset. All the old "tells" don't work in a bear market. What you are witnessing is the most massive credit bubble in history first having trouble and next unwinding. We are seeing the beginning of the unwinding only.
Bulls are breathing a sigh of relief as the new TIC data shows foreign inflows into the U.S. picking up. What they fail to realize is that this is what is to be expected as the credit bubble starts to fizzle.
First, the real alarm should be sounding as U.S. investment abroad has all but collapsed, nose-diving from $42 bln to $4 bln. This illustrates the slowing economic activity as the result of credit unwinding. It is just starting.
Second, the increase in foreign inflows is mostly from the UK increasing its purchases of U.S. treasuries. Why? It is what we told Minyans to expect: as credit unwinds there will be demand for dollars. This is why the UK bought treasuries. Everyone wants treasuries. Debt is unwinding.
Don't mistake the old bull tells for positive news. Keep your eye on the ball. What is happening is the market is unwinding all these imbalances that central banks have fostered over the years.
It is just beginning. Risk is high.Mon, Dec 17 2007
TODAY'S RANT FROM GOLD YODA SINCLAIR, PLUS SOME BACKGROUND ON HIM FROM FORBES
Dear CIGAs,
THIS IS IT!
There is NO PRACTICAL SOLUTION to this problem outside of an immediate recovery in real estate conditions representing the average prices that existed in 2006. The chance of that is zero.
THIS IS IT! My vision for 2011 is ugly beyond your wildest imagination. Are your prepared?
1. Do you have paper certificates for your shares?
2. Are you still significantly in involved with Internet financial entities?
3. Are you in debt beyond your fully paid physical gold?
4. Are you in an ETF in precious metals where you cannot take delivery of paper certificates?
5. Do you have significant funds in time deposits at your local bank?
6. Do you have Federal T Bills in the non- dollar Cando and Swissy?
7. Have you seen to it that your family is in a strong position?
8. Have you protected your company treasury?
9. Have you, to the best of yours practical ability, eliminated agents between you and your assets?
10. Have you taken delivery of your coins from your coin dealer?
11. Have you withdrawn your cash balance from all banks and brokers? Do not forget Citi restrictions on the amounts of outgoing bank wire money transfers.
12. Are you charting your liquid net worth on a weekly basis?
13. Have you studied the simple TA I have offered you? When the world wallows in complexity the only defense you have is to return to simplicity.
14. Have you seen the DVD, "The Secret"? The greatest wealth you can have is self confidence, which is confidence in the SELF.
Last and most important, do you have insurance against the failure of the system to function? Gold is that insurance policy you pray you won’t have to collect on, but you will. Gold is going to $1050 and onward to $1650.
Regards,
Jim
------------------------------
Here's what Forbes Magazine was saying about Master Jimbo back in 2001:
Golden oldie
Forbes Magazine, 12.10.01
Having called the top of the gold market 22 years ago, a goldbug now thinks that he has found the bottom.
In 1977 James Sinclair boldly predicted that gold would rise from $150 per troy ounce to $900. Gold never reached that mark, but it came close on Jan. 21, 1980, peaking at $887.50. The next day, says Sinclair, he unloaded his entire gold position, personally netting $15 million. Pointing to the U.S. Federal Reserve's efforts to fight inflation, Sinclair then predicted at an annual gold conference that the metal would languish for the next 15 years. It did. On Friday, Jan. 20, 1995, it closed at $383.85.
So this is a guy to listen to. He's bullish again. Why? Because he believes, despite the whiff of deflation in the October producer price index, that the U.S. is headed for mild inflation. He thinks that the dollar is due for a fall. He is also impressed that mining companies, which routinely sell unmined metal forward at fixed prices to protect themselves against further price drops, have recently pulled back from placing these hedges, a move that should prompt gold prices to rise. If they do, Sinclair expects a squeeze on gold speculators, who have $36 billion in short positions. Sinclair figures that the shorts will cover their positions soon after gold hits $305, a move that could force the price to $350, even $430.
Persuaded? On the New York Mercantile Exchange you can buy an option to purchase 100 ounces of gold in six months with a strike price set at a slight premium to today's price. An option exercisable at $300 will cost you $9 an ounce. If gold hits $350 you pocket $4,100 in profits.
Sinclair is not buying just futures and options. Since 1996 he has invested $11 million to develop 5,600 square kilometers of barren land in central Tanzania that he's convinced hold vast gold deposits. Drilling on the property is still in the early stages, but Barrick Gold is already pulling metal from an adjacent site whose proven and probable reserves have nearly tripled to 10 million ounces in the past two and a half years.
It's a gamble not many investors would make, but Sinclair has always stood apart from the crowd. On the walls of his office hang six photographs of Shri Sathya Sai Baba, a guru in India whom Sinclair visits several times a year. Sinclair's love of carrot juice recently turned into a 25-kilo-a-week habit that was brought to a halt only when his doctor grew alarmed at the orange tint to his skin. A loner, Sinclair paid $3 million in 1983 to turn a 19th-century barn into a reception hall for his house but has held only three parties there.
After his 1970s career as a goldbug, Sinclair retreated to his Connecticut estate, where he played with his helicopters, show ponies and collection of Ferraris. He didn't stay idle long. He built cable systems at Cross Country Cable, a company he started with two friends, then made millions selling some of them to John Malone's TCI.
"Jimmy is different," says his onetime cable partner Vincent Tese, the former New York State banking commissioner and now a Bear Stearns director. "But in the trading business people don't care if you're purple, just as long as you're making money."
In 1989 Sinclair got back into metals after buying a small stake in a Vancouver, Canada, mining company called Sutton Resources. During a trip to Tanzania for the company that year to check out a potential nickel site, Sinclair became intrigued by a 140-square-kilometer patch of land called Bulyanhulu. It was studded with greenstones, volcanic rocks marked by long seams that are often rich in minerals. Some greenstone mines, such as those in Canada's Kirkland Lake Camp, have been yielding gold for a century and do so now at the relatively low cost of $200 an ounce.
"The opportunity stared at me as it did with cable and gold," he says. "The only way to make big money is to have the courage to put your eggs in one basket."
Sinclair helped Sutton buy rights to mine Bulyanhulu, then lobbied for it to do the same in adjacent lands. Sutton balked and eventually sold Bulyanhulu to Barrick. Sinclair decided to go it alone.
By the summer of 1999 he had invested $4 million in the lands near Bulyanhulu. He faced a sickening prospect. Gold had just hit a 21-year low of $246. Bears were predicting $150 soon, a price that could wipe out the profits from even the most efficient of Tanzania's mines.
"I felt a pit in my stomach, like hunger," Sinclair recalls. "When I was a young trader, I used to think that I was invincible. Now I feel the risk."
Simple logic mitigated his fears. It costs most companies $250 (including back-office support) to extract an ounce of gold. With gold trading below cost, it made no sense for mining companies to hedge against further price reductions. Recognizing that such hedges meant that an important force pulling gold down would soon disappear, he reasoned that the bottom was near.
Over the next nine months Sinclair spent $1.5 million on tests that measured magnetic pull to help locate seams in his greenstone. Soon after the tests ended, in February 2000, news broke that some big mining companies had indeed stopped placing new hedges. Sinclair reached into his pocket for $5 million to buy more mining rights in surrounding lands. Barrick expects that the $199 an ounce it is paying to mine gold at Bulyanhulu will drop to $130 over the next three years.
Sinclair hopes to sell his operation to a big mining company soon. To do that he'll need to prove that his gold can be as richly mined as it is in Bulyanhulu. And pray that bullion doesn't plummet again.
Sinclair's bullishness is catching on. One well-regarded bear, Andrew Smith of Mitsui, surprised the markets in September by announcing that he expects the metal to go to $340.All news articles and images provided under the Fair Use Notice.