THE NEXT FINANCIAL CRISIS
Sheila C. Bair, the head of the Federal Deposit Insurance Corp (FDIC), said that another wave of U.S. credit stress was coming, involving non-mortgage loans. She said delinquency rates on loans for construction, development, commercial and consumer debt were rising.
Here are some of the areas outside of residential mortgage loans:
1. Construction: Costs to developers have risen to the point where even new hotel construction is stopping. At the high costs of materials today, the economics just don't work out.
2. Commercial & Consumer debt: As business slows, profits decline and in many cases turn to losses. Remember, profits are the very top of the revenue pyramid. Just a small decline in sales can cause profits to vanish. Losses mean debt gets difficult to service. Many loans have been securitized, i.e., put into pools, in which pension plans and other investors could buy participations. It's much like the mortgage-related CDO's that blew up last year. Commercial and consumer debt will implode next year.
3. Development: Developers who are in the middle of construction can't stop. They have to finish the construction. They hope they'll be able to sell part of whatever they are building before completion, but that's hope, far removed from reality in today's environment.
The economists who talk about a “Goldilocks” economy, predicting good times ahead, are missing something important. Usually recessions occur when the consumer has exhausted his buying power, rising inflation causes the central bank (the Fed in the U.S.) to hike interest rates, retail sales decline and the entire economy contracts. This usually triggers problems in the financial sectors because of rising defaults. But this time, the situation is reversed, which is unusual. It's the implosion of the highly leveraged financial derivatives that is causing a gigantic deleveraging of the financial system. That means contraction of credit. You can't have a contraction in the credit markets without an economic contraction. And this the crucial point.
By the fall of this year, we will see the recessionary economy kick in and start doing its destructive work. We haven't even seen that part of the normal recession yet. That will accelerate the credit market contraction, and probably bring one, or several, crises. The person who is elected president will have a job similar to the captain of the Titanic.
Bert Dohmen
Bert Dohmen's WELLINGTON LETTER
THE DERIVATIVE BUBBLE: NEW REVELATIONS
The problems of last year are still festering. Earlier this year, we learned about Auction Rate Securities for the first time. When the Port Authority of New York suddenly had to pay 20% interest on its debt, versus just 4% the prior week, these instruments became more widely known.
Hundreds of firms had invested in these so-called "safe money market instruments." Now they are trying to get their money out, mostly unsuccessfully.
Companies invested their operating cash in these, and pension plans did the same, thinking they were as good or better than money market funds. And then they blew up. Currently there is no market for these securities. But there are $330 billion of them outstanding. So far, 15 lawsuits have been filed, and they are seeking "class action status." The brokers who sold these are also being sued. Investment banks are trying to refinance some of these, but the amounts are from $1 billion to $4 billion in many cases, much too small in relation to the size of the problem. An additional problem for the holders of these securities is accounting for the losses of these complicated instruments.
Another class of financial instruments that came to light late last year is SIV’s (Structured Investment Vehicles). These are off-balance sheet entities the major banks created to speculate, using high leverage, in mortgage-backed securities. They didn't want the shareholders to know, so these SIV's didn't appear on the financial statements. Until they blew up, only a few people knew they existed.
Now we hear of another derivative, previously unknown to us, and probably most professional investors, Constant Proportion Debt Obligations (CPDOs). Who thinks up these names? They are designed for institutional investors who want to make a bet on the credit-worthiness of debt of the largest corporations. Therefore, the ratings are crucial, and these ratings are issued by firms such as S&P, Moody's and Fitch.
Apparently, the bond rating firm of MOODY’s made another mistake in its ratings. The firm blames this one on a “computer glitch.” It resulted in billions of these strange derivatives having AAA- ratings, or 7 grades higher than they should have been. That's quite a glitch. Institutional investors reportedly lost billions of dollars as the value of these instruments plunged as much as 60%. A British newspaper that reviewed internal documents said that Moody’s senior staff was aware of the problem as early as the first part of 2007. However, the firm maintained the ratings, and adjusted some of the assumptions going into the ratings. In college, we used to call that working the problem backwards, or fudging.
Last year we also warned of the Credit Default Swaps, a huge problem that will produce some big waves later this year. There are $45 trillion of these derivatives, which are basically insurance speculations on mortgage derivatives. The amount is almost as large as the GDP of the entire world. With billions and trillions of dollars of derivatives imploding, the poor homeowner who can’t pay his mortgage is still being blamed for the financial crisis. He is a convenient scapegoat. He has little to do with the crisis. He was only the spark that started holders of all derivatives to question their value. After that, the gigantic global debt pyramid, designed primarily on Wall Street, started to crumble. Greed took over in many other sectors, even in corporate and governmental pensions. Everyone wanted to increase the “alpha,” i.e., out performance.
So, who is to blame? As con artists always say, you can’t con an honest person. Therefore, we shouldn’t feel sorry for the cons, nor for the holders of these securities. But in the end, the taxpayer, who had nothing to do with all this, and did not benefit, will be presented with the bill. Moral of the story: Never invest in something you don't understand. If the salesman (broker) can't explain it so you can understand it, forget about it.
Bert Dohmen
Bert Dohmen's WELLINGTON LETTER
BARGAIN HUNTERS—TOO EARLY
Construction starts on new U.S. homes rose by a big 8.2% in April and applications for new building permits rose for the first time in five months. Many observers consider this positive. My reaction was, do we really need more houses when there is already a glut of about 3.5 million unused homes on the market now?
The bargain hunters were buying the homebuilder stocks over the last 5 months, causing the sector to rally. Now the rally is over. New lows should be ahead. Prediction: There will be a bankruptcy, or bailout, of at least one major homebuilder this year, which will shake up investors in this sector.
Bargain hunters are also out in force in the residential home area. In Florida, prices dropped 29% but sales surged 41% over the same month last year. That's encouraging. It shows that during the bubble, prices soared too high, to levels that became unaffordable and uneconomical. Last year, I said that residential prices would eventually get back to 2003 levels, which is when the boom started. That's where demand can come in. In Florida, they must be approaching those levels.
But that doesn't resolve the nation’s problem of 3.5 million unoccupied homes. Two major homebuilders, TOL and HOV, just reported earnings. They were dismal. The CEO of Toll Brothers, Robert Toll, said: “Demand continues to be weak in most markets as our clients worry about selling their existing homes or entering the market before prices stabilize.”
According to Senator Christopher Dodd, there are about 12 million homes worth less than the mortgages. That means these homeowners have little to lose by just walking away.
Bert Dohmen
Bert Dohmen's WELLINGTON LETTER
BUYING
OPPORTUNITY FOR A TRADE
Excerpt
from the WELLINGTON LETTER, late April , 2008
........................... Bernanke recently commented on
the U.S. situation with that of Japan
in the 1990s, and even with the Great
Depression in the U.S., probably
because private sector analysts, such
as ourselves, had made such
comparisons. Of course, he says that
the current situation is much
different. What else can he say? He
says that in the 1930s the Fed let the
financial crisis infect the entire
economy. The Fed will not allow that
to happen now. But in early 2007, he
also said that the subprime mortgage
problem couldn’t possibly infect the
rest of the credit markets. Now it
has.
He rejected a comparison with Japan in the 1990s. He said
that Japan did not act to get bad
loans off the banks’ balance sheets,
which stopped lending. The Fed will
not make the same mistake. However,
that’s exactly the problem now. Only
U.S. banks are more proactive. They
are now busily raising new capital by
selling stock or convertible
securities. This dilutes the current
shareholders, who will take painful
hits. But at least the firms stay in
business, and eventually may start
lending again.
At least Ben finally seems to recognize the seriousness of
the situation; otherwise, he
wouldn’t make these comparisons. And
that’s the first step to finding a
solution. Then the question becomes,
is the problem solvable? He may know
the problems of the 1930s and of Japan
in the 1990s, but is he and his crew
astute enough to find the solutions?
There are so many rescue plans in the works, at the Fed, in
Congress, and in Europe, that it’s
hard to keep up with them. The IMF
(International Monetary Fund) is
floating a proposal to have the
governments, i.e., taxpayers, buy all
the unsalable paper (CDOs, Mortgage
Backed securities, etc.) from the
banks so that banks can start lending
again. The government would then hold
these until such a time that they can
be sold. I ask, if the taxpayers are
asked to take such a risk, will the
banks give us taxpayers some of the
profits they made over the last 5
years?
CONCLUSION
The (technical) signals for the U.S. market are positive
right now. No one can know how long a
rally will last. Instead of relying on
guesses, we prefer to let our
technical indicators tell us when the
end of a rally has been reached.
Last time we also wrote: “We will watch carefully over
the next week or two for a
confirmation of a tradable rally.
However, only experienced investors
should try to play such rallies.”
Well, it seems that we are there.
(Recommendations
are excerpted out of fairness to
subscribers)
A DECOMPRESSION RALLY
Excerpt
from the WELLINGTON LETTER, April 7, 2008
...................The FHFB authorized Federal Home Loan
Banks to increase their purchases of agency mortgage-backed
securities. This could provide more than $100 billion in additional
liquidity to the FNMA and Freddie Mac’s mortgage-backed
securities. Also, the reserve requirements of the latter two were
lowered, allowing them to add another $200 billion to the mortgages
they buy.
As you can see, money is pouring into the financial
markets. But will that allow the
average homeowner to qualify for a
mortgage under current conditions?
Will it prevent foreclosures? Will it
get the homebuyers to go out looking?
And will they be able to get a
mortgage when they want to buy?
The Fed is now committed to take $200 billion of
non-government debt-securities, AAA
rated, as collateral on loans it
makes. Many of these securities may be
downgraded to AA, which means they
would be selling for around 25 cents
on the dollar. Will the Fed still take
them? Even the AAA stuff is probably
not worth more than 75% of par.
Obviously, when the Fed is willing to
take such confetti as collateral, it
means there is a huge financial
crisis.
THE FED: WILL THEY RUN OUT OF MONEY?
So far the Fed has used 50% of its balance sheet in the
bailouts. That’s about $400 billion.
Is the remaining $400 billion
sufficient to prevent the collapse of
the CDS market? Should they even try?
Important questions.
People say that the Fed can “print” all the money they
want. Actually, it’s the Bureau of
Engraving that prints money. They have
the latest, high-speed Heidelberg
presses. I know, I saw them. These
presses obviously are from Germany,
which during the hyperinflation after
WWI found that the printing presses
were too slow to keep up with
inflation. That has been corrected.
Our Fed chairman, Helicopter Ben, may
eventually do what he suggested five
years ago, namely throw money out of
helicopters. We have some exciting
times ahead of us.
It’s obvious that a panic hit Wall Street and Washington,
and the Fed is now pushing the gas
pedal to the floorboard. Look at some
of the Federal Reserve charts.
The first chart is Money Supply MZM. From Jan. 21 to Mar.
24, which doesn’t even include the
Bear Stearns crisis, MZM is growing at
a huge 37% annual rate. That confirms
that the Fed is in crisis mode, and
doesn’t want a repeat of the 1930s.
This is extraordinary growth.
ASLEEP AT THE WHEEL
Excerpt
from the WELLINGTON LETTER, March 17,
2008.
.................Throughout 2007, Wall
Street analysts and money managers
told investors that the subprime
problem was too small to infect other
areas. We heard how “minute” the size
of that market was compared to the
entire debt market; they told us that
earnings were greater and would be
even greater in 2008. And every time
that the stock market plunged, they
insisted that “the market is wrong,”
and that “the only thing we have to
fear is fear itself.”
Well, all of that was garbage and a
prescription for ruin. We repeated
again and again that we are seeing an
implosion of the greatest credit
bubble the world had ever seen.
Therefore, earnings were irrelevant,
as they show the past. The driving
force in the markets is availability
of credit. When it expands, the
markets go up, and earnings follow.
When credit availability decelerates,
and then even contracts as it is doing
now, you always have a bear market and
recession. And the severity of these
events is directly proportionate to
the contraction.
Therefore, whenever you see an analyst
on TV talking about the “great future
earnings,” hit the mute button. He has
no idea about what’s going on. Until
one month ago, Intel was on everyone’s
“buy” list. In early March, it
announced disappointment. Sandisk, a
maker of flash memory chips, announced
that prices of its product would
decline by 50% because of a glut. What
a surprise! You can imagine what such
a decline means for profits. The CEO
of Cisco late last year proclaimed on
national TV that he had never seen
conditions this good. Just two months
later, he was talking about abrupt
weakness.
(This is only part of the lengthy
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RECOGNITION!
Excerpt
from the WELLINGTON LETTER, February
18, 2008.
...................Yes, historical
numbers are strong. But that’s
history. Just a few months ago, the
CEO of Cisco had a glowing report
about the firm and the economic
environment. I think he even said that
he had never seen conditions so good.
Well, his report on Feb. 6 was
downright gloomy. They reported
excellent results, (that’s the past)
but then said the future would be
worse than they had expected just
recently. The stock plunged over 10%
in after-hour trading.
The economy, especially the housing
sector, continues to worsen. Economist
Nouriel Roubini, who has been one of
the very few economists who saw the
current housing and credit crises
coming, just said that this year
20
million homes will see their values
decline to below the size of their
mortgages. That will cause
homeowners to just walk away from
their houses, and let the lenders
worry about selling the house.
On Feb. 13, Lehman Brothers said in a
report that sell-offs in leveraged
loans and CMBS (commercial mortgaged
backed securities) have recently
deepened. The firm believes that
defaults in these products could
spread to the “synthetic CDOs,”
potentially causing a more
“dramatic unwind.” I guess that could
earn a crash.
Lehman is concerned about exposure to
synthetic CDOs by broker-dealers—more
nuclear waste.
A few months ago, it was the SIVs,
i.e., off-balance sheet entities
formed by the largest banks to
speculate in the derivative markets.
It’s estimated that the problem is
bigger than $100 billion. Even
industry insiders have said they had
never heard of these entities before.
How can you hide a $100 billion
problem?
There are so many problems, which have
not yet been divulged. And each one
will cause a further contraction of
credit. Our long-time subscribers, who
have been with us for more than 20
years, know that
my
Theory of Liquidity, which has made it
possible for us to catch major turns
over the years, says that when credit
contracts, the investment markets and
the economy must decline. There is no
alternative.
Margin debt in the stock market has
always been a great indicator of bull
and bear markets. When traders
increase their margin debt, you are in
a bull market, and when it contracts,
you are in a bear market. Well, margin
debt is now down about $60 billion
(end of December) from the peak of
$381 billion in July last year. That’s
an indication of a bear market.
BEWARE! THE SHORT TO INTERMEDIATE TERM
...................Complacency is
still very high. Just watch financial
TV and see all the Wall Street guys,
who have been telling you to bargain
hunting during the entire decline.
They are still talking about the
“bargains.” Of course, the bargains
are getting cheaper and cheaper. You
won’t see a good bottom until there is
actual fear and these people advise to
just “hold but do no new buying.”
Human nature never changes. Emotions
and fundamentals are usually wrong.
You have to look ahead, not at what
earnings and other fundamentals were
in the past year.
The rally so far is weak. That’s a
problem. Conditions are worsening. We
are just a few weeks into the
“recognition phase” of the bear market
and the recession. The bulls are all
hoping for a rally, so they
can raise cash. But “hope” is a very
poor investment tool. In fact, when
you start hoping, it’s the best sell
signal you can get. And that’s what
the majority of money managers will
soon learn.
Bloomberg reports that Goldman Sachs
Group Inc. had its first-quarter
profit estimate cut a hefty 51% by
Fox-Pitt Kelton Cochran Caronia
Waller. The analysts wrote that GS
faces “continued challenges in credit
markets” and may report a $1.7 billion
writedown from leveraged loans. GS
stock is down from 250 in October of
last year to 175 on Feb. 15. That’s
30% in just four months. So much for
being a long-term investor. GS won’t
see that high again for many years.
You can put that forecast in your
trade journal.
Leading U.S. electronics retailer Best
Buy Co. cut its full-year earnings
forecast Friday, citing
weaker-than-expected revenue growth in
January.
Yet, analysts in the media tell us the
“the market is cheap.” But is it?
Actually, it’s far overvalued, as we
have been saying. These analysts are
still using profit forecasts from last
year. But things change. As our
colleague John Mauldin points out, in
January 2007, the earnings forecast
for the S&P 500 index was $89.10 per
share. As we know now, the actual
number for the year was $71.56, a miss
by 20%.
In March of last year, the S&P
earnings forecast was for $92.30 for
2008. At the end of last year, this
forecast was reduced to $83.98. And
now, they are projecting only $71.20.
But for the four quarters ending in
June this year, they are forecasting
only $65.15. We can see that the
expected decline is now running about
35%. And the P/E ratio would be 21.
That’s hardly “cheap.” In fact, it’s
close to what we saw at the bull
market top in the year 2000.
And remember, these are just
forecasts. Everything is deteriorating
much faster than the greater majority
had expected. If the 35% earnings
decline turns into a 50% decline, we
should expect a market decline of a
similar amplitude. Of course, that’s
for the big cap stocks. The small caps
will be decimated. Why? In a
recession, they can’t get bank
loans—and go out of business.
Excerpt from January 7, 2008
Wellington Letter
Bear Market Confirmed!
........
In the meantime, the large financial
firms are rushing to the Middle East
and Asia trying to find capital for
their firms so that the firms don’t
fall below required capital ratios,
which would threaten their very
existence. Much bigger write-downs of
assets held by these firms will occur
in 2008, meaning they need to get even
larger capital infusions than have
been announced.
The world’s greatest credit bubble in
history is imploding. At the same
time, our central bankers, especially
in the U.S., are totally unprepared to
handle it. They have repeatedly shown
over the past 12 months that they do
not even recognize the severity of the
problem, much less come up with a
solution.
And that’s how a financial crisis
evolves and naïve investors are used
to taking stocks off of the hands of
the professionals who don’t want them.
A survey of the biggest money managers
was conducted by CNBC. As you will
see, they don’t share my bearish
opinion.
Only 2% thought the chance of
recession is over 50%.
More than 50% of managers believe the
S&P 500 will finish up at least at 8%
in the coming year,
while financials will be the strongest
sector and materials will be the
weakest. Out of these, 33% said the
index would gain 8%, while 23% expect
a gain of more than 10%.
Well, we shall see. However, history
shows that the majority is usually
wrong.
An old Wall Street rule is that if
January is down, the rest of the year
is down, and if the first week of
January is down, then the entire month
will be down. Furthermore, if the
first day of the year is down, then
chances are high that the week will be
down. So far, it looks like it will be
a down year, according to these rules.
Of course, based on our analysis, we
are very confident that the year will
be down, probably hard.
The market was down in December. If
it’s down in January, it would be the
first time
since
1943 that the market has
been down in both months.
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