Martina Had It Right Print E-mail
Martina Had It Right
Martina Navratilova the Czech born tennis star is a woman of vast and varied experience. As a child she watched Russian tanks roll into her homeland and take away her nation’s independence. In 1975, she defected to the United States while competing as a teen in a tennis tournament. She left family and all she was familiar with a world away and forged a remarkable and controversial life in the land of opportunity. She said she knew in her heart that she was an “American”. Martina became a citizen of the U.S. in 1981. She thrived on fair, tough competition and liked knowing that she lived in a land where her amazing work ethic and talent could produce the rewards her native land could not under Soviet occupation. Martina thrilled fans of woman’s tennis. Her rivalry with Chris Everett was legendary. Martina dominated the world of tennis for nearly a decade. She set strength and conditioning standards that shocked viewers then but are the standard today. She won the Grand Slam of professional tennis, taking titles at Wimbledon, the US Open, the French Open and the Australia Open all in the same year. Her 9 Wimbledon titles is a record that stands to this day. In our world that celebrates champions and “winning at all costs” where we often separate character from accomplishment it is important to read Martina’s sage advice. “The moment of victory is much too short to live for that and nothing else.” Martina understood that the price for finishing first is dedication and sacrifice. She also knew there is more to excellence than just winning. As the cliché goes,” It’s the journey not the destination”. Certainly there is no doubt that an athlete of her caliber and success has a competitive drive that few can duplicate. Any who had the pleasure of watching her play observed palpable intensity and focus. Yet her focus included integrity as well as victory.
Where Have All The Good Guys Gone?
 I’m a sports junky. Even as a codger I love the thrill of honest competition.  Sports junky or not it is impossible to miss the GIANT LACK OF CHARACTER evident in the wide world of sports today. Our heroes put accomplishment ahead of character. Today’s road to success is filled with shortcuts. The next home run king probably used steroids to enhance his performance and may have perjured himself before a grand jury. The Tour de France may be won by the last racer standing- one who can pass a doping test. The Tour is loosing racers faster than Charles Barkley drops dough in Vegas. An NBA referee with mob ties is in the spotlight for gambling on games he officiated. An NFL star has been suspended while the league and authorities investigate allegations of disgusting animal cruelty. Unfortunately these character flaws are not 
confined to sport.
From The Wide World of Sports to Wall Street
In most sports we measure wins by who has the best times or most points. On the street “wins” are measured by who makes the most money. It is a rare individual who pursues a seat on a trading desk or a coveted investment banking position to do good for others. In the 1980’s classic “Wall Street” Gordon Gecko (Michael Douglas) proclaims that “Greed is good!”, while addressing the shareholders of a company targeted for a leveraged buy out. In the movie Gecko winds up in prison for insider trading but his sentiment did not go with him.  It is said that markets are driven by two things, greed and fear. When fear disappears greed takes the wheel and puts the pedal to the metal. Since fear has vanished from the markets the past few years it’s safe to assume that greed has been burning rubber. And greed unchecked by fear of loss or prosecution sorely tests integrity. As we all know, greed is not limited to Wall Street, nor is the absence of integrity.
Technology Levels the Playing Field
The revolution in technology has been great for many aspects of capitalist economies. Buyers have benefited from greater “transparency”. With a click of our mouse we can see pricing for any number of items we may wish to buy. We can get competitive bids or offers on-line for a multitude of goods and services. This has been a blessing for buyers and something less for sellers. For sellers technology, namely the internet, has turned highly valued items that fetched large profits into price sensitive commodities available from many vendors. Technology removed the buyers blindfold and lead to a grinding game of attrition for sellers.  Nowhere has this process been more evident than in the fixed income markets. The huge and highly profitable bond market had contributed to massive wealth on Wall Street. Buyers blind to markups paid tens of thousands of dollars in commissions a decade ago on transactions that today earn a very small fraction of that. Many a bond salesman has fled the market for other industries in search of a living wage. “Transparency” shed light on the bond market’s greatest weakness- its simplicity. A bond pays a set amount of interest determined by its coupon rate and the amount of investment to a set maturity date. It is like selling sand by the pound. Technology removed the mystery and the profit. Wall Street needed two things to restore profit margins in the bond market; a complex new product to bring back the mystery and a network of collaborators.
Wall Street Gets Its Mojo Back
The global glut of liquidity set the stage for the street’s current debacle. Central banks around the world held rates low, enjoyed trade surpluses with the U.S. and rewarded our profligacy by buying our securities. America was awash in cash-well actually credit. The housing market soared and everyone wanted to get into the act. Heck you got paid to buy a house-literally! Ian Shepherdson of High Frequency Economics explains that at the height of the housing boom in 2005 the average fixed 30 year mortgage rate was a tax deductible 5.9% while home prices rose 10.7%. It made sense to borrow heavily to buy real estate. And everyone wanted a piece if the action. Even those with blemished credit histories could smell the money. With home prices rocketing higher lenders saw little risk in writing subprime mortgages. The worst case scenario left them with a profitable foreclosure. The mortgage market boomed and bubbled right along with the housing market. And the beauty of the subprime borrower was that he/she would have to pay up, sometimes by two or three hundred basis points for the privilege of home ownership. There was one obstacle to be overcome for lenders. Prices were rising so fast that subprimers couldn’t make the stretch for that new home without a little help. The solution was simple; teaser rate adjustable loans with a 2/28 structure. Lenders could make money available to subprimers with little or no money down and at rates as low as 1% for the first couple of years. Rates would rise in year three but optimism replaced common sense for buyers and lenders alike. Demand for adjustable teaser rate mortgages was nearly unrestrained. And where there is demand (and excess liquidity) there will be supply. The largely unregulated mortgage broker industry mushroomed. Mortgage lending, once the domain of stodgy and conservative bankers with significant skin in the game fell to commission driven brokers with little supervision or regulation and in most states no licensing requirements. It has become clear that integrity was also in short supply with lenders and their arms-length sales force. But what if the loans went bad? Someone would be left holding the bag, right? Enter Wall Street. Securitization of mortgages has a long history on the street. Ginnie Mae, Fannie Mae and Freddie Mac have long been conduits between lenders and investors interested in safety and a little higher yield. The agencies stood behind the mortgage investments with a bit of help from the Department of the Treasury. But this subprime thing was different. The new batch of loans, the subprimes, would be sliced and diced through Wall Street alchemy into incredibly complex and illiquid investments targeting “sophisticated” institutional investors and hedge funds.The new “derivatives” would package subprime loans and tons of leverage and funnel them to investors. The risks were moved away from  the brokers and the lenders and the street to the investors. In 2005 and 2006 the flood gates opened. Wall Street funded over a trillion dollars in subprimes for the opportunity to package the loans into Collateralized Debt Obligations (CDOs) and to collect billions in underwriting fees. Heck, fees greased the wheels of all the collaborators. Greed had the wheel.
Caveat Emptor
It was clear that there was an insatiable desire for real estate. The mortgage brokers could generate an enormous flood of applications- often with bogus income verification, job history and most other pertinent information. The lenders cared more about fees than loan quality as little if any of this subprime business would wind up on their balance sheets. And Wall Street is world renowned for its ability to package and sell designer garbage. But for it all to work the scheme needed buyers. The global glut of liquidity we mentioned above helped fuel investor demand. During 2005 and 2006 the benchmark 10 Year Treasury averaged a yield of just 4.53% and was losing value in the rising rate environment. Buyers were desperate for yield and ripe for the picking. There was one final piece to the puzzle. Most institutional buyers, excluding hedge funds are required to meet portfolio credit standards. Wall Street required help.
From Sow’s Ear to Silk Purse
There is a reason that referees are discouraged from having a stake in the outcome of games they officiate. Some are incapable of overcoming the conflict of interest. It’s the greed/fear and integrity dynamic again. One referee in the investment game is the rating agency. These referees are positioned to provide honest and unbiased advice about the level of credit or default risk associated with particular investments offered by our friends on Wall Street. They stand between buyers and sellers without prejudice to promote the greater good. But what if the referee is paid by one of the participants? Can the referee be expected to call a game without bias? What if a judge at a County Fair tells a contestant in a baking contest that to win a ribbon a pie should contain a measured percentage of boysenberries not strawberries? In the case of CDOs the rating agencies are compromised in these ways. They were paid fees by the street to evaluate and rate these very complex and illiquid investments. The rating agencies are also reported to have participated in the structuring of derivatives to assure the underwritings received the desired ratting of “AA”, or even “AAA”. In many cases these ratings were all that “sophisticated” investors had to rely upon as they stretched for increased portfolio returns. Don’t get me wrong, I have less sympathy than most for those investors afflicted with the three deadly sins of portfolio management: arrogance, avarice and ignorance 
but we all need someone to believe in. One must admit the contradictions here are striking. Pools of risky mortgage loans were somehow transformed from junk into pristine derivative securities with the same credit risk as a direct obligation of the United States Treasury.
There Are No Shortcuts
In the short run many people have enriched themselves as the opportunity for a quick buck proved too much to resist. Lending regulations were too lax to curb the excesses and fraud. The costs are just beginning to mount. Over $100 billion in investment losses are expected from subprime CDOs. In the next two years $800 billion in subprime mortgages will reset to significantly higher interest rates. The problem is national in scope. The impact on the housing market will likely be felt for years. Default rates are ratcheting to historic levels in this sector of the housing market, reversing the inflated demand that drove housing prices to the crazy levels of 2005 and 2006. Inventories are growing, properties sit empty even as prices fall. Vacant homes trade draperies for plywood window coverings. Sales of new and existing homes are falling. Demand has crumbled and cannot absorb the recycled inventory spawned of foreclosures and forced sales. Now the question becomes, will the subprime meltdown spread to other markets?
What’s Next?
The most frightening aspect of the subprime mess is that it is greatly magnified by leverage. We witnessed the implosion of two Bear Sterns hedge funds in the past month. The Bear Sterns funds carried the catchy monikers of High Grade Structured Credit Strategies Fund and the High Grade Structured Credit Strategies Enhanced Leverage Fund. Bear Sterns sent a fateful “Dear Valued Client” letter in July, renaming the sibling funds worthless and nearly worthless, respectively. At ICM we have taken to calling them simply the BS Funds. The two BS Funds had combined leverage of $20 billion on $1.5 billion in capital.  Prices slumped in the funds with rising subprime defaults. Creditors demanded more collateral from the funds forcing increased asset sales. The result was a vicious cycle with the BS funds circling the drain. The most important lesson in our opinion from the BS fund debacle is this: from the blow up of Askin Capital and Orange County in 1994 to Long Term Capital Management in 1998 to today’s subprime mess the combination of illiquid investments and leverage = Financial Crisis. Are the BS Funds the end of the story or the tip of the iceberg? Time will tell. Experience suggests that more woes await the CDO market. The mess in subprimes has greatly affected other markets. Junk bonds have struggled with 
prices falling and borrowing cost rising sharply. This may lead to increased corporate defaults. The greatest impact could yet be seen in the equity markets. Stocks have been largely powered by takeovers funded by leverage. These Leveraged Buy Outs (LBOs) are funded by junk and Collateralized Loan Obligations (CLOs).  These markets have taken a sharp hit as investors move away from risky bets. Investment Bankers including Goldman Sachs, JPMorgan and Chase & Co. are stuck with $11 billion in loans and junk they can’t easily unload. The cost of tying up their own capital will damage earnings and slow the flood of LBOs which netted banks a tidy $8.4 billion in fees the past 6 months. Hamish Risk of the Royal Bank of Scotland notes that “at least 35 bond deals have been canceled or restructured in the past 5 weeks because of turmoil in the subprime market. Perhaps the highest profile LBO to veer off the road is the purchase of Chrysler by Cerberus, the private equity firm. Little wonder stocks are encountering a downdraft correction. “Hung deals” will crimp lender liquidity and could slow economic growth. As investors head for the exits in risk assets the flight to quality has pushed safe haven Treasury securities higher in price and lower in yield.
Economic Momentum
The economy rebounded from the very anemic .6% growth rate of the first quarter to come in at 3.4% for the second quarter. The final tally for Q 2 is still weeks away with several revisions to come. Fears are growing that housing, tighter credit, rising borrowing costs, $78/barrel oil and falling stocks could slow consumption and weigh on the economy in the second half of 2007. The consumer has proven bullet proof since 2002. The housing crisis is still filtering its way into consumption. June’s Consumer Spending report showed slowing with big ticket items like appliances and furniture declining sharply. Wealthy shoppers have supported retail sales as advancing stocks and big bonuses have contributed to the accumulation of wealth and booty. I must believe the well-heeled have saved a few shekels for rainy day shopping. It does rain on the rich doesn’t it? Gasoline and the inevitable winter heating costs will create more of a drag on consumption for the less well off among us. Employment has been strong so far in 2007 with adequate wage growth to support modest spending. The question remains, will consumers turn from spending to saving to rebuild debt loaded balance sheets? Most recent reports on Personal Income and Spending suggest exactly that. The very painful restructuring in the automotive industry appears to be paying dividends as Ford and GM both posted profits for the quarter. The methodology for this industrial genius is born out in the foreclosure rates in Detroit and surrounding environs. Ah, progress! 
Why Is Ben Sweating?
The Bernanke Fed continues to name inflation enemy number one despite its recent downward trend. Inflation is garnering more of our attention too. And not because of energy costs alone. Production costs are rising overseas. Globalization has meant the integration of disparate economies and the results are difficult to predict without precedent to guide perspective. One thing is clear. Developed nations have transferred inflation risks to underdeveloped nations, those with slack in their human and hard capital resources. This slack appears to be dissipating and import inflation is on the rise. The colossal Asian infrastructure build out has sent commodity prices ever higher. $80 per barrel oil is a blink away. Have you wondered where oil prices might settle if and when the U.S. withdraws from Iraq?
Not Made In China
Why are production costs and import prices destined to go higher? Because China is a mess! Globalization thrust modern capitalism upon a largely agrarian, fundamentally corrupt, communist behemoth. The price advantage provided by Chinese factories over American production can be traced to non-existent environmental controls, unsafe working conditions, government subsidy, stolen technology, meager but rising wages and few if any benefits. Think you have OPEB problems? The July 23rd issue of BusinessWeek reports that in the 1980’s China began to dismantle the “iron rice bowl” of cradle to grave benefits delegating the responsibility and costs of social programs to local governments. Health care costs alone are estimated at $40 billion. China’s aging population will require pensions as well. Lax regulatory enforcement has led to ecological nightmares. Consider Lake Taihu which supplies drinking water to Wuxi a city of over 2 million. Industrial pollution has caused the water to glow an iridescent green. And if you haven’t noticed it is worth your life to eat food imported from China, be you man or pet. The same is true of pharmaceuticals. Check the tires on your fleet vehicles. Were they imported by New Jersey based Foreign Tire Sales, Inc. or produced by Chinese company Hangzhou Zhongce Rubber Company. The tires are the subject of several lawsuits involving roadway failures and fatalities. Chinese tire imports have a 10%   U.S. market share. There will be costs to pay to clean up China. From its agriculture to industry to waterways and the air billions breathe, pollution is becoming an environmental factor hard to ignore. China’s poorly educated rural workforce requires costly training. Many industries are already migrating to other Asian markets to save money. Those already skilled are learning the power of wage negotiations. Costs will rise in the not to distant future. Won’t it be a crying shame if the 
deflationary influences of globalization are short lived? Could it be that much of what has been gained through out sourcing American jobs is transitory? It has long been our contention that the “Techno-Global Revolution” would prove to be a great leveler of global wages, particularly for labor. It seems we may have traded jobs, product quality and safety for “every day low prices”.
The Markets
 As I write stocks finished another down day loosing more than 140 DOW points. Treasury yields are falling in a flight to quality and talk of a Fed policy easing is amplifying. Because of the shenanigans of those looking for a shortcut to the winner’s circle $billions will be lost. Homes will be lost. Some form of financial disruption and bailout becomes more likely. Subprime woes are sure to grow. It’s a shame more participants in this sham weren’t in tune with the wisdom of one great tennis player. If sport isn’t your thing perhaps the words of Honest Abe might be the ticket. He noted, “You can’t escape the responsibility of tomorrow by evading it today.”
Bringing It Home To You
ICM clients will never buy a subprime mortgage pool or any other derivative if we have our say. This debacle will affect our clients none the less. Tighter credit will cause higher borrowing costs for capital projects. Falling home values and rising delinquencies can affect tax revenues. Foreclosure rates are up 58% in the first half of 2007. The collapsing housing market will deflate many seemingly unrelated industries from rail roads to insurance companies to tourism. Consumption tax revenue may slide. If the flight to quality continues to depress government bond yields investment earnings will decline. In a side note higher energy costs are most likely here to stay. Keeping your service vehicles on the road and heating and cooling your buildings will require more money. We strongly suggest that each client review their tax base for potential weakness that may affect revenue. Cash flow analysis and long term planning will be more important than ever.