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KISS
(Keep It Simple Stupid)
My wife Barb believes as did Shakespeare that true literary genius is reflected in brevity. The judicious use of concise word craft to express complex thoughts and emotions has presented a challenge to all who seek to enlighten and entertain. Few have met the challenge as successfully as “The Bard of Avon”.  These are complex times in the world of investments. Seemingly unrelated issues can and will affect the performance of the US Government bond market. We paid special attention to the Asset Backed Commercial Paper (ABCP) market in recent commentary entitled “SLY and ABCP”. Some clients were quick to remind us that ABCP was not on their list of approved investments. But the truth of the matter is that ABCP is found in many high yield money market funds and pools. The tell tale sign of above market rates has gone unappreciated and unquestioned by yield hungry investors. The credit crunch we are wading through today owes much to this esoteric, poorly understood and rapidly shrinking asset class. The global liquidity scare is behind the collapse of yields in the US Treasury market. Safety conscious investors shun risk and head for the safety and liquidity of Treasury securities as their attention is refocused from “return on principal” to “return of principal”. In an attempt to adhere to Barb’s wishes and the Bard’s guidelines I will take a stab at concise brevity in this quarter’s commentary.
Doubt and Certainty
During the Age of Enlightenment the philosopher Voltaire wrote “Doubt is not a pleasant condition, but certainty is absurd.” The inquisitive mind of Voltaire studied the work of his contemporary, the physicist Sir Isaac Newton because he wanted to understand the mechanics of the heavens and the world he lived in. All we strive for is an understanding of the mechanics of the investment world of our time. Lacking the intellectual gifts of either man we defer to none other than the “maestro”, the newly retired but incredibly busy Alan Greenspan. It seems that doubt has transplanted certainty in the former chairman’s mind regarding structured financial products such as Collateralized Debt Obligations (CDOs), Collateralized Loan Obligations (CLOs), and ABCP. Greenspan, formally an outspoken champion of financial innovation in the form of derivatives now calls for”some rethinking” of these murky and risky investments. The maestro admits miscalculating the risk to the housing market and the economy created by the combination of adjustable rate mortgages and subprime loans. The disastrous affects of gearing up this combustible combination in the form of leveraged derivatives has  altered the chairman’s perspective. “People always say it’s the subprime mortgage market that created this crisis,” Greenspan told Bloomberg LP. “It’s the subprime asset backed market” which did. The former head of the Federal Reserve Bank plants responsibility for the credit market turbulence squarely at the doorstep of Wall Street’s financial wizards. Quarterly earnings reports for the world’s largest banks are beginning to show the financial damage done by these derivatives. Citigroup, the largest U.S. bank reported a 60% drop in third quarter profits due to $5.9 billion of credit and trading losses on loans and mortgage backed securities. $1.3 billion was lost on subprime assets. UBS AG, Europe’s biggest bank took a hit on a $3.4 billion write down on fixed income securities. At the time of this writing we are awaiting earnings results from Bank of America Corp. and JPMorgan Chase & Co. Real world pricing is replacing the fantasy market values applied to these structured investments. As Mr. Greenspan astutely reminds us, “The pricing which in too many cases has been, by some model derivation four times removed from actual market prices just doesn’t work.” No wonder he goes on to say, “A lot of structured products are going to have short life expectancies.” Except for the poor rube left holding the bag. 
But I Don’t Own Derivatives…
The most injurious impact of the structured product meltdown has yet to play out. As the portfolio losses mount for banks they are forced to make greater contributions to loan loss reserves, money that otherwise could have been available for growth sustaining loans. At Citi loan loss reserve pulled $2.6 billion off the shelves of the commercial banking unit. This same scenario is playing out at banks across the country and the globe. It is also one of the forces driving short interest rates sharply lower. In the finance based global economy banking has a big impact on consumption, particularly if the “shadow banking system” locks up.
Shadow Banking System?
The term “shadow banking system” was coined by the guys at Pacific Investment Management Company (PIMCO). Until recently the shadow banking system has operated off radar (and off balance sheet) for all except the most in tune investors. PIMCO’s Bill Gross wrote “The modern financial complex has morphed into something unrecognizable to most astute market veterans and academics.” A simple analogy may clarify the shadow banking system. Think of the traditional banking system as the original power grid for our national economy. This “power grid” is fueled by federally insured deposits  The “juice” to keep the economic machine humming is amped up at the nation’s Federal Reserve Banks, to the tune of $4 or $5 for each $1 deposited and then distributed through local banks to credit-worthy borrowers. In the traditional banking system loans stayed on lenders balance sheets. Your banker knew how many kids you had and if you mowed your lawn on Saturday or Sunday. This system sufficed for the stodgy manufacturing based economy of the post  war boomer generation. In the 80’s and 90’s the economy would make a seismic shift from labor intensive manufacturing to technology, from production to services. We have often referred to this period as the Techno-Global Revolution. At the same time financial innovation was awakening and the concept of cash flow securitization was planting the seeds for the explosion of the derivatives markets of today. The flood gates of debt market hell opened when President Bill Clinton repealed the depression era Glass-Stegall Act that among other things prohibited banks from engaging in the underwriting and sales of investment securities. To continue the analogy, an alternative power grid formed shortly after the repeal. The alternative energy grid got its juice not from insured deposits leveraged modestly by the reserve banking system but through the securities markets. The post-Glass-Stegall banking system is able to lend money to and raise money in the securities markets, securitize loans, move liabilities off balance sheets and operate investment vehicles called conduits off the books. This new power grid created liquidity at a rate several times greater than the traditional banking system with little or no perceived risk to the lender. Entire sectors of the finance based economy became dependent upon the alternative power grid for their juice. The new grid offered outsized leverage of 10 or 20 to 1 so the amount of juice available for financing growth grew rapidly. Securitization multiplied liquidity and borrowing. Shadow banking was heralded as the more efficient low risk evolution of finance conceived and governed by the genius quant geeks of Wall Street. This borrowing machine supplanted savings as a prerequisite to buying. A levered up finance based service economy that outsourced manufacturing produced a massive trade imbalance and current account deficit. To an alarming degree the new economy was hinged on the alternate electrical grid- the shadow banking system. If the shadow banking system suffered a power outage portions of the economy such as housing, builders and their suppliers, mortgage lenders and retailers not to mention brokers and bankers could suffer financial blackouts.
Shadow Banking and Derivatives
The shadow banking system is fueled by and executed through the derivatives markets. The alphabet soup of CDO’s, CLO’s LBO’s and ABCP are interwoven. Each carries its own risk, generally the exact risks they were meant to ameliorate, particularly credit and liquidity risks. Nowhere is this risk more pronounced than with the funds raised in the ABCP market. Bank investments are conducted off balance sheet through special investment vehicles called conduits. Conduits arbitrage short term low risk investor money into long term higher risk investments while allowing the parent bank to duck full disclosure and capital reserve requirements. This dance partners opposing duration and liquidity interests to a tune of uncertainty. The music plays as long as ABCP rolls over and new financing can be found to fund the duration mismatches between investor expectations and investment realities. But the CP market is shrinking, down 17% or $369 billion since  peaking in July. If not for massive intervention by the Federal Reserve some dancers would have been left without partners as this market froze in August. When Conduits have exposure to failing investments they are moved onto the banks balance sheet. The shadow banking system becomes the burden of the parent bank and ultimately the Federal Reserve.
The Federal Reserve and the Shadow Banking System
Chairman Bernanke and his central bank counterparts around the globe wanted to distance themselves from the perception of bailing out hedge funds and other wild risk takers caught up in the unraveling debt bubble. It became painfully clear to the Bernanke Fed in August that the lock up in the shadow banking system was having a negative impact on the real economy. In August a $38 billion cash infusion failed to boost liquidity in the traditional banking system so Chairman Bernanke cut the Discount Rate by 50 basis points and signaled a cut in the Fed Funds Rate for September. About the same time a large portion of the Canadian Commercial paper market ceased to function when real banks declined to honor their shadow bank liquidity commitments. Incredibly, the banks denied the existence of any market disruptions and are refusing to provide liquidity to conduits to roll over maturing CP. The fire starter here is $35 billion in ABCP issued by Coventree Inc. Current solutions on the table include converting the short term CP to floating rate notes maturing in 5 to 10 years. As yet there is no solution to the Canadian CP mess and none is expected until year end. Adding to the pressure on the Bernanke Fed was England’s fifth largest mortgage lender, Northern Rock. It suffered an old fashioned “run on the bank” after depositors were granted a taxpayer backed guarantee for their deposits. Clutching “full refund slips” in hand the Brit depositors ran for the exits. With these credit panics fanning flames of financial uncertainty Bernanke chose to throw a hefty bucket load of cheap liquidity on the embers here in the U.S. and surprised investors with a 50 basis point cut and a promise to do “whatever it takes” to provide liquidity to the economy. In the end the leopard cannot change his spots.
Will the Fed Succeed?
We have long feared that the Fed would receive diminished returns for its monetary efforts in an economy so reliant upon the shadow banking system. Leverage is one concern and “velocity” is another. The traditional banking grid of insured deposits and corresponding reserve system that produces $4 or $5 to a $1 deposit may require two to four times the stimulus to counteract the drag created by the unwinding of 10 or 20 to one leverage. The multiplier affect is bound by the realities of simple mathematics. Second, velocity is the great unknown. The Fed can add liquidity and reduce the cost of money but in order to stimulate growth the money must turn over at a rate sufficient to produce growth in production, employment and consumption. One must only look to Japan for that lesson. As fixed income investors we must also recognize that foreign investors, our creditors, have an enormous impact on the amount and cost of liquidity in the U.S. The laws of supply and demand transfer considerable power to affect bond yields and credit availability to interests outside the U.S. If the Shadow banking system falters further the traditional banking system and the Federal Reserve will be left to clean up the mess.  Make no mistake, the rate cut of September and any that may follow are aimed at bolstering the real banking system in anticipation of the shadows returning to the balance sheets. One more detail of the shadow banking system the Fed will likely try to offset is the debt hangover from the LBO binge. Banks and brokerages float bridge loans to finance leveraged buy outs until the junk bonds intended to finance takeovers can be sold to investors. Some $300+ billion in junk sits on the balance sheets of financial institutions with few takers. Prices will drop further before the vultures swoop to cherry pick the best of the junk. The financial institutions will take losses on the sales and will probably be stuck with the least desirable of the bonds. Reserves will again be ratcheted higher removing more capital from the lending markets.  This means the Fed will continue to push monetary policy until it achieves a positively sloped and moderately steep yield curve.
What Are the Risks?
The most immediate risk of the Fed’s latest bailout is to the Dollar. The world’s reserve currency in floundering at all time record lows against other major currencies. The results of this sharp devaluation will likely be higher import prices, in a word, inflation. Our trading partners and creditors, who are one in the same, will eventually tire of receiving a falling currency in exchange for goods and more importantly debt service payments. $80 oil, $750 gold and rising commodity prices are all symptoms of the falling buck. So far interest rates have followed the Fed’s script tracking the funds rate lower. Foreign investors who lend us trillions each year may soon demand higher returns on Treasury securities to counter the falling value of the Dollar. The forces of inflation and foreign exchange rates will produce dramatic counter pressures against the Fed’s efforts to stimulate economic growth with lower borrowing costs. Another significant peril associated with this Fed bailout is that of continuing the moral hazard that promotes excessive risk. The market discipline that punishes unwise speculation and greed has once again been put on holiday by the Central Bank. In the universe of quantitative analysis that drives today’s black box investing recessions have been relegated to the “tails” of the bell curve. Recessions of the recent past have been infrequent and shallow, low profile speed bumps flattened with a whisk of the Fed’s magic interest rate wand.
Where are Rates Headed?
This brings us full circle, returning to Voltaire. Operating with doubt is unpleasant but any great level of certainty is folly. The curve will most probably steepen with lower short rates and sticky long rates. The September fifty basis point move was a bold initial step that implies serious concern for the health of the real economy not just the well heeled whiners of Wall Street. More cuts are a high probability. If past is prologue then the Funds Rate will come to rest about 2% above the rate of inflation, 4% would seem a comfortable perch. 
Investment Strategy
The need to cut rates to soften the blow of the credit crunch must be weighed against the threat of inflation and the falling dollar. ICM will blend callable agency notes with bullets. We will stick with quality and avoid temptation to chase yields. We will continue to avoid FNMA. Some in congress look for the Government Sponsored Corporation to absorb a greater portion of the adjustable rate subprime market burden before we are sure we have seen the light at the end of this long dark tunnel and continue to wait in vane for audited financials.
Beauty in Brevity
The Quarterly Commentary is nearly 30% shorter than past writings. I trust my efforts will please Barb and the “Bard”. We hope you are provoked to thought about the rapidly evolving banking system where so much public money is warehoused. Most importantly we hope you feel a sense of satisfaction in knowing safety continues to be ICM’s main focus.