Saturday, March 28, 2009


Two years ago it was said that you if had a direct line to the CIO of CalPERS, one of the nation's largest public pension funds, and specifically to its Alternative Investment Management group, you had it made. None of that Goldman Sachs partners being masters of the universe garbage - this was the real deal. Say you needed $100 million for fund XYZ - you simply dialed that one number in Sacramento, and if you made it past the secretary, you were golden. Of course, this worked best if your name started with Leon and ended with Black, but other managers were also sitting pretty. The reason for this is that unlike the public pension funds of New York State for example, where the bulk of the investments were in the public markets via an internal asset manager (who was pretty horrible at his job judging by the fund IRR), and only occasionally did NY invest in external private and public fund managers (which more often than not included a variety of kickbacks, bribes, and other illegal schemes as recently reported by NY's own Andrew Cuomo), CalPERS has the bulk of its assets invested in 3rd parties. While Thomson Banker gives the total amount of CalPERS public investments at $38 billion, an obscure site within the CalPERS website labyrinth presents the amount allocated and invested in various 3rd parties. And the amount is staggering: it seems that a vast number, maybe even a majority of U.S. private equity firms, owe their existence to CalPERS.

Here are the facts (as of September 30, 2008):

Number of unique investments: 290
Total Capital committed: $53.2 billion
Cash Invested: $30.8 billion
Cash Distributed: $17.4 billion
Cash Distributed Including "Residual" Value: $38.8 billion

It is that last number which we will focus on shortly...

But some more data first.

CalPERS had $173.6 billion in total assets at March 26, which represents a loss of 26.6% after costs between July 1, 2008 and January 31, 2009. The full January 31 CalPERS asset summary can be found here. Additionally, CalPERS seems to be suffering from the book-to-market marking syphilis that is pervasive throughout Wall Street: book value of CalPERS' assets was $194.9 billion at January 31, a non-trivial $21.3 billion overestimation of its market value. We would venture to guess which of these two numbers is used for pension actuarial purposes, but the answer is likely quite obvious. Interestingly, in the same report, the value of AIM investments had a $27.4 billion book value, and an even worse $23.9 billion market value. While I am not sure how this number compares to the $38.8 listed above as total investments plus cash outs, or the $21.4 billion of net (38.8-17.4) AIM value at September 30. However, if the superficial conclusion is that the market value of private equity investments between September 30 and January 31 increased by $2.5 billion, then we may have some very serious credibility issues on our hands.

Here is what CalPERS says about its Alternative Investment Management program:
Since inception in 1990 to September 30, 2008, the Alternative Investment Management (AIM) Program has generated $14.2 billion in profits for CalPERS. Given the young, weighted-average age of the portfolio (3.2 years) this amount will continue to grow as the portfolio matures.
CalPERS may need to adjust this mission statement once the December 31 number are out.

But continuing with the facts. Here are the asset managers that have benefited the most from CalPERS generosity, based on both total capital committed and actual cash invested (this is not an exhaustive list of CalPERS investments).

Apollo: $4.1 billion, $2.7 billion
Aurora: $650 million, $267 million
Avenue: $1.4 billion, $780 million
Blackstone: $1.4 billion, $1.2 billion
Candover: $643 million, $480 million
Carlyle: $4 billion, $2.1 billion
CVC: $2.3 billion, $1.3 billion
First Reserve Fund: $1.1 billion, $685 million
Leonard Green: $850 million, $455 million
Hellman & Friedman: $1.0 billion, $762 million
KKR: $1.6 billion, $880 million
Levine Leichtman: $450 million, $389 million
Lexington Capital: $400 million, $392 million
Madison Dearborn: $710 million, $634 million
MHR: $400 million, $218 million
New Mountain: $550 million, $165 million
Oak Hill: $375 million, $151 million
Pacific Corporate Group: $1.9 billion, $800 million
Permira: $573 million, $388 million
Providence: $525 million, $297 million
Silver Lake: $1.1 billion, $450 million
Tommy Lee: $640 million, $475 million
Tower Brook: $575 million, $220 million
TPG: $3.2 billion, $1.5 billion
Wayzata: $325 million, $218 million
Welsh Carson: $650 million, $601 million
WLR: $698 million, $405 million
Yucaipa: $764 million, $481 million

And many others... But you get the gist: Apollo, Carlyle, TPG, CVC, Silver Lake, Blackstone, and Avenue pretty much hold the fate of the majority of California's teachers and public workers in their hands... And that future is looking really, really ugly.

We dig in: Among the other data, presented on the CalPERS AIM page is the public IRR disclosed per fund. This is probably the best indication of how some of the more troubled private equity firms are gaming the system, and massively misrepresenting actual results.

We randomly picked as a case study the Apollo Investment Fund VI L.P., which CalPERS has committed $650 million to, actually invested $508 million into, withdrawn $10.9 million from and present the residual value (including the withdrawn amount) as $450 million, or a -10.7% IRR. Now we don't have reason to believe that CalPERS is fudging this number: after all it is reporting merely what Apollo is telling it.

So the next question is, is this -10.7% IRR indicative of the investments in Apollo VI?

The names that constitute the $10.2 billion in committed capital Apollo VI are:
Realogy (on verge of bankruptcy)
Harrah's (on verge of bankruptcy)
Claires (on verge of bankruptcy)
The debacle that was the Huntsman LBO
Berry Plastics
Verso (bankrupt)
Jacuzzi brands

We highly doubt -10.7% is anything even remotely close to where CalPERS should consider its residual equity value in Apollo VI. And by fair estimates, this is merely the tip of the iceberg. Nonetheless, presenting public data that shows that the public pensions manager is disclosing over $14 billion in profits when it is hiding potentially much more than that in losses could be interpreted as borderline illegal. The question is, is this a responsibility of Apollo (to show the true sad state of affairs), or of CalPERS (to actually check these numbers and not to pull a Fairfield Greenwich "sorry, we had no clue what was really going on until it was too late").

Regardless, as CalPERS itself points out, the numbers were as of September 30. It is a fact, that the December 31 numbers are due any minutes and we are salivating at the prospect of feasting out eyes on these numbers, to see just how much disconnected from reality the column known as IRR as presented by CalPERS has become. And just as Apollo VI is merely the tip of the asset manager iceberg, so is CalPERS merely a blip in the Alternative Investment Management universe of all public pension managers. Combined together, and based on realistic performance, these two will result in an explosive deterioration in both fund IRRs and public pensioners' patience and empathy, once they realize their money has been mismanaged into oblivion. Sphere: Related Content

The Fundamentals Behind CRE - Part 1

Continuing the trend of disclosing the dirty laundry in Commercial Real Estate, I am presenting some raw data which the general readership should be made aware of before determining how fair (or not) any PIPP, TALF or other plan is to various beneficiaries.

Here is the summary:

In simple terms, the CRE fundamentals in Q1 are dramatically weaker across most markets and most property segments:
  • Price declines of 35-45% (or more) expected, exceeding those of early 1990s
  • Rent declines and vacancy rates may approach those of the early 1990s
  • Current downturn is demand shock induced versus over-supply induced downturn of early 1990s
The total delinquency rate is likely to exceed 3.5% by year end and 6% by 2010, and the biggest threat facing CMBS is maturity default risk: a large percentage of CMBS loans made in 2005-2008 will not qualify for refinancing without substantial equity injections due to:
  • Much tighter underwriting standards
  • Massive price declines
  • Declining cash flows
Enter TALF, with its inclusion of CMBS as applicable securities: government programs are critical to avoid hundreds of billions of dollars of distressed CRE hitting the market and perpetuating a vicious downward spiral in CRE prices which would exacerbate the damage to bank and insurance company portfolios, and impact other financial institutions.

The facts:

Aggregate delinquency rates are rising sharply, with 30- and 60-day delinquency rates up 300-400% in the past 6 months, and as noted earlier, aggregate delinquencies are expected to hit 6% by 2010.

Monthly total delinquency rates (TDR) are increasing at record pace: prior to September 2008, monthly increases in TDR were in the 0-3 bps range, and in September and October have accelerated to 10 bps. Since October, TDR have accelerated sharply to the 20-25 bps range, an unprecedented pace of deterioration.

As we pointed out yesterday, the deterioration is spilling over into seasoned vintages: all vintages are now demonstrating significant deterioration, however 2006, '07 and '08 vintages are by far the worst performers.

What is the impact by sector?

Hotel loan deterioration is in full take off mode, and expectations are that this will be one of the worst hit sectors during the downturn. As most independent hospitality firms are predicting 10-20% declines in NOI, the result would be TDR worse than the 2001-2003 downturn when cum default rates hit 25%.

The deterioration in the industrial sector is moderate by accelerating: declining production and the collapse in international trade (Long Beach harbor seeing cargo traffic down ~ 30%) implies trouble for industrial space demand.

The deterioration in Multifamily is by far the worst, with the current delinquency rate of 3.53% surpassing the previous 2.35% peak in October 2005.

Of particular note is the accelerating deterioration in recent CMBS vintages

Curiously, the Office deterioration to date is the least pronounced by likely the space where a lot of the pain will be concentrated shortly: it is likely that the recent 85 bps TDR will soon skyrocket.

Lastly, the degree of deterioration in retail is extraordinary. The Retail TDR of 1.66% has surpassed the previous peak in September 2002 and not likely to slow down any time soon. Curiously, the delinquency increases are not driven by single-tenant retail.

The Maturity Risk

As ZH pointed out, chronological series are performing sequentially worse, however, CMBX 4 is underperforming both CMBX 3 and 5.

In the Term market, floating-rate Loans are also beginning to deteriorate. While low LIBOR is a natural hedge, the second LIBOR increase picks up, the term market is poised for the double whammy of constrained lending and higher interest costs.

Additionally, loss severity rates also appear to be rising, although still nowhere near previous peaks of 2002 and 2004, implying there is much more room for deterioration.

As pointed out maturity and refinancing risk is by far the highest threat to the CRE market. Key considerations in looking at maturity risk are: amount and timing of scheduled loan maturities, the current situation in maturity defaults and extensions, the quantifiation of default and extension risk, and whether the end result will be widespread maturity extensions or mass foreclosures and liquidations. The two main sources of maturity default risk are:

Risks that loans will not qualify to refinance due to:
  • tighter underwriting standards
  • massive price declines
  • weakening cash flows
  • a 2010-2012 time frame
The complete disruption of of capital markets, even for refi qualified loans:
  • CMBS market
  • Banks/thrifts
  • Life insurance companies
  • Pension funds
  • 2009 onward time frame
The 09/10 absolute maturities are moderate ($15 billion in 2009 and $30 billion in 2010) but rising precipitously afterward, mostly in 2011 and 2012 ( a high concentration of risky 5 year Interest Only loans from 2005-2007).

Intuitively, declining property prices pose a significant refi threat to loans over the next decade. Absent significant equity checks, and forgiving lenders, the carnage will be widespread. CRE prices peaked in October 2007 after appreciating 30% from 2005 and 90% from 2001! In the meantime Moody's CPPI is down 16.4% from its peak, implying there is much more room for price declines over the next several years.

As these indicators are lagging, it is interesting to see where hypothetical market tests would come out to generate comparable ROE as those seen during the 2007 bubble... And the results are scary: prices need to drop by 45% for comparable returns, assuming an 8.6% cap rate (35% assuming 7.4%) cap rates.

The continuing property price declines are at the heart of the problem: price declines that have already taken place pose significant problems for 2006 and 2007 loans that mature during 2011 and 2012, while inevitable further price declines will create significant problems for earlier vintages.

Cap rates will determine how far prices will fall (and also by implication how soon the death knell for REITs sounds). Cap rates increases to 7% imply a 14% price decline, 8% imply 25% price declines, 9% imply 33% decline and a 10% cap rate is equivalent to a 40% property price decline.

To be continued.

Thanks to TREPP, Intex, Deutsche Bank and others for primary data. Sphere: Related Content

March - the turnaround month?

As we've noted before, last month's housing numbers are far from being the basis for any bullish assumptions going forward. However some analysts seem to be using it as a springboard on finding other signs of hope; the boys over at Danske Bank have a bullish view and take the housing numbers in a much more positive light. Additionally, they're expecting the ISM numbers to really take off. Their model seems to be a bit bullish historically, but if the ISM numbers underperform by the historical margins it's still a huge gain. We hope they're right but are expecting them to be wrong.

An interesting piece on consumer demand; U.Michigan's consumer survey for March (57.3) basically shows a slight increase in demand (+1.0) but still below a trailing 6MMA (58.0). As with the housing piece, this is likely to be a temporary increase before the number returns to February levels or even lower. As a group, consumers seem positive about legislation's effect on the general economy but are mixed on it's effect on their personal financial situation. Additionally, consumers have not yet been seduced by the deeply discounted prices out there - savings are still a priority for most; this has to be disheartening news for the Treasury which has been battling deflation as a silent enemy.

The financial situation of consumers is dismal. “The fewest consumers in the history of the survey reported that their finances had improved during the past year, with an all-time record number mentioning that their incomes had declined in the past year,” Curtin said. Moreover, consumers anticipated the smallest annual income gains ever recorded—just 0.2%, down from 2.5% a year ago. Consumers favored saving a greater share of their incomes than they have in the past. “Higher savings intentions were reported by four-in-ten consumers, and half of all consumers reported that they intended to reduce their debt during the year ahead,” Curtin added.

With consumers expecting more unemployment and recession for at least the rest of 2009, ZH thinks this is a case where perception is going to become reality. Sphere: Related Content

OCC Issues Update On Bank Trading And Derivatives Activities

The Office of the Comptroller of the currency is out with their much anticipated quarterly report summarizing all the recent trends and losses (would say profits but not much here lately) in derivative trading at commercial banks.

Here is the report's summary.
  • The notional value of derivatives held by U.S. commercial banks increased $24.5 trillion in the fourth quarter, or 14%, to $200.4 trillion, due to the migration of investment bank derivatives business into the commercial banking system.
  • U.S. commercial banks lost $9.2 billion trading in cash and derivative instruments in the fourth quarter of 2008 and for the year they reported trading losses of $836 million. The poor results in 2008 reflect continued turmoil in financial markets, particularly for credit instruments.
  • Net current credit exposure increased 84% from the third quarter to a record $800 billion, and much of this is attributable to the sharp decline in interest rates in the fourth quarter.
  • Derivative contracts remain concentrated in interest rate products, which comprise 82% of total derivative notional values. The notional value of credit derivative contracts decreased by 2% during the quarter to $15.9 trillion. Credit default swaps are 98% of total credit derivatives.
Sphere: Related Content

Saturday Spreads

  • Soros: Britain may have to seek IMF rescue (TimesOnline) [Who is rescuing the IMF?]
  • FSA Stress Test shows Barclays does not need more help... until it does (FT)
  • Obama desperate for bankers' help (Bloomberg)
  • Kenneth Lore: A lawyer's outlook on the PPIP (Bingham McCutchen)
  • Bank failure #21 for the year costs FDIC $320 million (FDIC)
  • Hungary in leadership vacuum as prime minister remains unfilled (Reuters)
  • Goldman Proxy reveals some shady dealings (FT)
  • Maguire Properties sells Irvine office complex to botox-maker Allergan (LATimes)[MPG has $260 million of debt maturing in 2009]
  • Americans go foraging as recession deepens (Reuters)
  • Bank of America bankers to see 70% increases in base pay (Bloomberg)
  • America's liberals lay into Obama (FT)
  • ... As Bank of America is named defendant in a lawsuit against Agape Capital ponzi (NYT)
  • China seeks G-20 currency debate over weakening dollar (Bloomberg)
  • James Saft: The world is stuck with the dollar (Reuters)
  • As the charade of the March 31 deadline approaches, automakers set to leech more taxpayer money (Reuters)
Sphere: Related Content

Friday, March 27, 2009

The "Real" Facts Behind Commercial Real Estate

Unlike the administration, which deals in hope and promises, Zero Hedge believes that facts and empirical evidence tend to have a more justifiable reflection in securities prices. As such, I present a snapshot of the factual deterioration across the entire securitized CRE landscape, and the sad conclusion that with each passing day the inherent cash generating capability of these "assets" is becoming worse and worse. I hope to make this into a recurring piece every week.

Furthermore, the horrendous remittance numbers in CMBX 4 and 3 are starting to spread to old vintages, which is probably the most troubling trend. Also note the dramatic shifts in loss-given-default (LGD) between estimated and actual realized defaults: the jump from 30% LGD to 80% effective loss would demolish any BS book marks if this pattern becomes prevalent from most properties.

Better get that PPIP up and running soon before people dig into the cash flow fundamentals and realize what a true scam the plan really is, and go Poject Mayhem on the HQ of PIMROCK for being a complicit aider-and-abettor to what ZH affectionately calls the scam of the millennium.

CMBX.1 Update

The overall non-performing rate for CMBX.1 rose 11bp, to 1.21%. This does not include loans that were transferred to special servicing. Notable loans include:
  • GMACC 06-C1: 35 properties all tenanted by Mervyn’s, which filed for bankruptcy in July, 2008, formed the collateral for the $106.3mn DDR/Macquarie Mervyn’s Portfolio loan (6.37% of deal, SS-Cur). This is one of the three A-notes making up the $258.5mn whole loan. Loss given default is estimated to be 50%.
  • GECMC 05-C4: As mentioned above, the $106.3mn DDR/Macquarie Mervyn’s Portfolio loan (4.54% of deal, SS-Cur) makes up one of the other A-notes in the whole loan mentioned and given default; the loss estimate is 50%.
  • CD 05-CD1: The $58.0mn Union Square Apartments (1.53% of deal, 30 days), backed by a 542-unit multifamily property in Palm Beach Gardens, Florida, became 30 days delinquent this month. The average value assigned is $100k per unit and 24 months of advancing to arrive at 30% expected loss given default.
  • BACM 05-5: The $28.1 Livingston Shopping Center loan (1.46% of deal, current) cured from 30 days delinquency. This is despite dark spaces totalling 61% of NRA due to the Linens ‘N Things and Circuit City liquidations.
CMBX.2 Update

The average non-performing rate of CMBX.2 continued its upward trend with a 25bp increase, to 2.17%. Compared with the other large loans that went delinquent or transferred to special servicing this month, the delinquent loans in this series tend to be relatively smaller.
  • BACM 06-5: The average non-performing rate for this deal worsened 268bp this month, due mainly to four DBSI-related loans and a hotel-backed loan. DBSI Inc declared bankruptcy and is the subject of a class action lawsuit from TIC investor. The four loans in question totaled $36.4mn (1.64% of deal, 30 days); all became 30 days delinquent this month. The other delinquent loan is the $23.8mn Crowne Plaza – Cherry Hill loan (1.07% of deal, 30 days) secured by a full service hotel in Cherry Hill, New Jersey.
  • MLMT 06-C2: The $20.7mn The Shops of Fairlawn loan (1.54% of deal, 30 days) backed by a retail property in Fairlawn, Ohio, entered 30 days delinquency this month. Last reported DSCR (at year-end 2008) came in at 0.85x. The property also has 38% of space up for lease renewal this month.
CMBX.3 Update

A large number of loans in CMBX.3 were transferred to special servicing or are delinquent. The average non-performing rate increased 38bp, to 2.20%. Of note are the following:
  • BACM 07-1: The largest loan to be transferred to special servicing this month is the $220.0mn Solana loan (7.09% of deal, SS-Cur) backed by a mixed use property in Westlake, Texas. This is an A-note of a $395.0mn whole loan. The other pieces are another A-note for $140.0mn, securitized in JPMCC 07-LDPX, and a $35.0mn mezzanine note. The reason for the transfer is an imminent default due to cash flow problems. The estimated loss given default is 40%, based on a stressed cap rate of 9.5%.
  • CSMC 07-C1: The Mansions Portfolio loan (4.77% of deal, SS-Cur) is a $160.0mn loan secured by a portfolio of four multifamily properties in Austin and Round Rock, Texas. There is also a $20.3mn mezzanine debt in place. The performance of the two properties in Austin had deteriorated drastically, with DSCR dropping to 0.76x and 0.45x, respectively, last reported in March 2008. The loss expectation of the two Austin properties is about 50%, while the other two performing properties have loss expectations of about 10%.
  • MSC 07-T25: The $59.7mn Village Square loan (3.89% of deal, 60 days) is backed by a 237k sf retail property in Las Vegas, Nevada. The borrower is GGP, a regional mall REIT that is struggling under significant debt maturities. The last reported financials in July 2008 came in at 1.0x for DSCR. The former housing bubble state of Nevada had seen an associated weakness in the retail sector, and vacant spaces were either not leased or leased at approximately 30% below the average rate as at issuance. The estimated loss given default of this loan is 40%.
  • JPMCC 07-LDPX: As mentioned above, the second A-note of the Solana whole loan (2.63% of deal, SS-Cur), for $140mn, is securitized in this deal. Also of note is the $47.0mn Lembi Multifamily Portfolio loan (0.88% of deal, 30 days) backed by eight multifamily properties in San Francisco, California, which is in 30 days delinquent status. There is an associated mezzanine-note for $10mn. The servicer reported that the borrower failed to replenish debt service reserve as required. The most recent DSCR reported in September 2008 is 1.18x. A loss of 30% is estimated given default.
  • CD 07-CD4: The $117.0mn Loews Lake Las Vegas loan (1.78% of deal, SS-Cur) was transferred to special servicer due to imminent default. The loan is secured by a full service hotel in Henderson, Nevada. The most recent DSCR, reported in June, 2008, came in at 0.37x. 40% loss is expected given default based on a 10% cap rate.
  • MLCFC 06-4: The performance of this deal continues to worsen this month with a 153bp increase in the 30+ day delinquent rate, due primarily to two office loans, the $50.3mn The Parkdales loan (1.12% of deal, 60 days) and the $18.4mn Pentagon Park loan (0.41% of deal, 60 days) both backed by office buildings in Minnesota. No servicer’s comments were provided for either loan. The most recent DSCR, reported in September 2008, came in at 1.32x and 0.96x, respectively.
CMBX.4 Update

CMBX.4 is the worst series in terms of the average non-performing rate, increasing 42bp, to 2.19%. Notable loans include:
  • JPMCC 07-LD11: Similar to the Lembi Multifamily Portfolio loan in JPMCC 07-LDPX, the $90.0mn Lembi Portfolio loan (1.67% of deal, 30 days) is backed by 16 properties in San Francisco, California. This is also part of a whole loan that includes a $25.0mn B-note and a $17.4mn mezzanine-note. The most recent reported DSCR in December 2008 is 1.24x. The servicer also reports a failure of borrower to replenish debt service reserve as required. A loss of 25% is estimated given default.
  • MLCFC 07-7: The $45.0mn Mervyn’s Corporate Headquarters loan (1.63% of deal, 30 day) backed by a single tenant office building in Hayward, California, entered 30 day delinquency. Mervyn’s filed for bankruptcy protection in July, 2008. Appraisal for the property came in at $17.6mn and factoring in advancing would result in an expected loss of 80%, versus original estimates of 30%.
  • JPMCC 07-CB19: The $36.5mn Bronx Apartment Portfolio loan (1.12% of deal, 30 days) is yet another pro forma multifamily portfolio loan that is deteriorating. The collateral is two properties comprising 490 multifamily units in the Bronx, New York. A 35% loss is expected given default.
CMBX.5 update

CMBX.5’s average non-performing rate worsened 21bp, to 2.44%. Of note:
  • JPMCC 08-C2: The $25.0mn Regency Portfolio loan (2.15% of deal, 30 days) is the A-note of the $26.6mn whole loan (with a $1.6mn B-note) backed by a portfolio of 20 properties of various types in Iowa and Nebraska. The most recent DSCR reported in September 2008 came in at 0.66x.
Sphere: Related Content

The Week That Was (Not As The Market And Media Will Have You Believe)

As the financial world is losing one of its best and brightest advisory brains through David Rosenberg's impending departure from Merrill, we believe in spreading his gospel as much as we can, as his vision and instincts have saved many people (at least those who have found the contrarian in them to listen and act on his advice) their life savings. David has the uncanny ability of calling it like it is and it is our duty as responsible citizens to disseminate his words.

The week that was according to Dave

1) Can you handle the truth?

The Fed and the Treasury are pulling out all the stops to bring mortgage rates down and it is not too hard at this point to see them falling to historic lows of 4.5% or perhaps even lower. Through the balance of the year, that rate relief should total $115 billion at an annual rate (even if we see the mortgage rate go down to 4.5% from around 5% right now, most of the decline from the 6.5% level that prevailed through most of last year is behind us). And starting April 1st, low- and middle-income households will start to see withholding taxes coming off their paychecks, which we estimate will total around $35 billion at an annual rate. So, we estimate the tailwinds from monetary and fiscal policy, as far as the consumer is concerned, are a hefty $150 billion at an annual rate. The savings rate is on a visible uptrend and, by year-end, when we estimate it will be closer to 7%, will likely have drained $175 billion out of spending. (Every one percentage point rise in the savings rate, it should be noted, as a static standalone development, is equivalent to 2.2 million jobs being lost in terms of GDP impact). On top of that, we have job losses totaling an estimated 2.2 million from now to the end of the year, and that comes at a cost of $110 billion to personal income (again, at an annual rate).

Based on our assumptions on asset values, we think the negative wealth effect could end up bosing a drag on spending to the tune of $400 billion at an annual rate through year-end. These headwinds amount to an estimated $685 billion. On net, the $535 billion drag on consumer spending is equivalent to a 5% contraction, though we anticipate that there will be more offsets in the form of further fiscal stimulus and expansion of the central bank’s balance sheet.

2) Are we seeing fiscal stimulus or … restraint?

The focus and headlines remain exclusively on what the Federal government is doing to boost the economy. But few write about what the state and local governments are doing to stay solvent – cutting back on spending at an unprecedented rate. Indeed, what seems to be forgotten is that after consumer spending, the lower level of government, with a 13% share of GDP, is the most important part of the economy – this is a sector that represents our teachers, law enforcement, fire prevention, and health and social assistance. The state and local government sector employs 20 million, or 15% of the total, compared with 13 million in manufacturing, 8 million in financial services, less than 7 million in construction and fewer than 3 million at the federal level. Fiscal gaps have now opened up in 42 states, and, when added to the shortfalls at the start of the year, they cumulate to a whopping $80bn; this offsets more than 60% of the fiscal tailwind. And, in 2010, the amount of fiscal tightening from the states/local governments is expected to total $85 billion, which bites into 30% of the stimulus we will see at the federal level.

3) Huge one-day rallies happen in bear markets

The S&P 500 surged 7.1% on Monday. Why, we haven’t had a day like that since … November 24th. And before that … November 21st! And before that … November 13th! And before that … who can forget October 28th (remember that 10.8% jump)? And before that … October 13th! And before that… September 30th. This is the 15th time in the past six decades that we have seen a 5%+ move in the S&P 500 and they all either occurred in a bear market (2007-09; 2001-02) or right after the stock market crash in Oct/87. In fact, two-thirds of those 5%+ rallies have occurred in this bear market!! And they have always, always happened on some major announcement or news item. But, to quote an oldie but goodie from Bob Farrell – the market inevitably makes the news, the news does not make the market. Look – we realize that there are many out there who are craving the opportunity to turn bullish. So are we. But we have seen this script too many times before. We just do not believe that a new bull market is going to be caused by Bernanke and Geithner, who have been at the helm through this vicious bear phase. The fundamentals, namely corporate earnings, are going to have to take over from hope to ensure that this rally has legs.

There have been seventy 5%+ sessions and twenty-nine 7%+ days back to 1920. The best 45 days in the market in recorded history actually occurred in the bear market of the early 1930s. Going back over the past 80 years, it is painfully obvious that spasms of this magnitude occur in the context of bear markets. This is NOT characteristic of a bull market. The last time we endured something like this was back when we bounced off the November lows – and 10 days into it, the market had surged 15% and every pundit and his mother were claiming that the wicked rally was dead. Caveat emptor.

4) New home sales higher but inventories bloated

New home sales surprised to the upside, rising 4.7% M/M in February to an annualized pace of 337K units. While upward revisions were made to both December and January sales, January and February levels remain the lowest on record. Activity in the South and West lifted the headline gain, while sales in the Northeast and Midwest fell.

Price concessions and lower mortgage rates were likely a factor over the month; indeed, median new home prices fell 2.9% M/M to stand at December 2003 levels and -18.1% versus year-ago levels (the worst YoY level on record). Relative to the existing stock of single-family homes, new homes remain nearly 20% higher, with a more striking disparity relative to distressed properties that are selling at an even steeper discount. In our view, an ongoing correction in new home prices will be necessary to stimulate demand over the next year.

Inventory levels remained problematic, with only a slight improvement in months supply, at 12.2 months in February versus a record high of 12.9 months in January. A figure closer to 6-7 months is consistent with a fundamentally balanced market, suggesting that ongoing cuts in homebuilding are in store. Since completion, new homes took a record 9.8 months to sell in February, reflecting both depressed demand and the need for ongoing price concessions.

5) Downward pressure on the housing market remains

We totally disagree with the views being espoused that the housing market is hitting bottom. To make that assessment in February of all months is a dangerous proposition. We shall wait to see what happens during the critical spring selling season. The key is that home prices continue to deflate, as they did in the new home sales report (median was -18% versus -11% in January), which indicates something very important: there remain more sellers than buyers. Indeed, at 12.2 months’ supply, the downward pressure on real estate valuation and bank capital is likely to prove resilient. We’ve said it once and we shall say again that it all comes down to housing, the quintessential leading indicator. In our opinion, there is simply no sustainable recovery in the economy, the stock market or the financial backdrop until we get some clarity on the outlook for residential real estate prices. And, in order to establish at least a tentative floor under home prices, we believe we would have to see the new unsold housing inventory recede to at least eight months’ supply. In fact, we went through the historical data on new housing inventory and found that when months’ supply is running below eight months, median prices are running +6.3% YoY on average. While inventories are currently above 12 months, median new home prices are running at an unprecedented -18% YoY pace (and a five-year low, in level terms).

6) Unprecedented plunge in corporate profits

The final report on GDP included the first estimate on 4Q corporate profits. Aftertax profits (ex IVA and CCA) plunged at an annual rate of 74% in 4Q, which was unprecedented, and by 36% on a YoY basis, which was also a record decline. The actual level of $930 billion was the lowest since the third quarter of 2004. However, relative to GDP (6.6%), profits are where they were in the summer of 1997. And, it wasn’t just financials this time, although sector profits did plunge at a record 97% annual rate (-67% YoY) and the level is back to where it was in 1994. Non-financial sector profits slid at a 36% annual rate in 4Q as well, and are down in five of the past six quarters.

7) Employment conditions are not stabilizing

There is also a view out there that employment conditions are on the precipice of stabilizing. That is hardly the case, in our view. Initial jobless claims edged up 8,000 in the week ending March 21 and the four-week moving average stayed near the 650,000 level – signaling that we can expect to see another substantial drop in nonfarm payrolls (ML call remains at -750,000 versus consensus of - 657,000 for the March report). Continuing claims for the March 14 week continued to surge, with 122,000 more displaced workers on unemployment insurance assistance, for a total of 5.56 million. Emergency unemployment compensation, which provides extended benefits for workers who have exhausted their normal 26 weeks of insurance, declined by 20,000 in the March 7 week, although 1.5 million remain on this assistance.

In sum, the numbers are suggesting that the unemployment rate will jump in March to a 26-year high of 8.6%. The unemployment rate looks poised to break to or through 10% by year-end, and those who just see this as a lagging economic indicator do not take into account the extremely close relationship it has with banking sector strains, such as credit card delinquency rates.

8) Durable goods rise with downward revisions

Large downward revision to durable goods in prior months = lower 1Q GDP: Durable goods orders unexpectedly rose 3.4% M/M in February for the first gain in seven months. This was notably higher than consensus (-2.5% M/M) and Bank of America Securities-Merrill Lynch expectations (-3.2% M/M), with gains in tech, machinery and electrical equipment and defense aircraft orders – the latter up 33% M/M. This report is notoriously volatile and importantly included a large downward revision to orders in the prior month; together with a larger than expected decline in inventories, ML is now tracking a 7.2% Q/Q annualized decline in 1Q real GDP (versus -6.5% Q/Q previously), with capex down 29% Q/Q (versus -23% Q/Q previously). Inventories were trimmed by 0.9% M/M, with increased efforts by manufacturers to cut back metals, machinery and electrical equipment stocks. Still, overall sales continued to fall, leaving the inventory-to-sales (I/S) ratio at a 17-year high of 1.88 months. This suggests that meaningful cutbacks in orders, production and jobs will be necessary over the near term to work down inventories.

9) Seasonal factors skewing the February data

To be sure, there have been several data releases in February that have lined up on the strong side of expectations. Caveat emptor on any February data point that is seasonally adjusted at a time of the year when winter weather typically forces most of the country into hibernation. This was no ordinary February. At an average of 37 degrees (F), the month was two degrees warmer than a year ago and four degrees balmier than two years ago. As ML said, almost everyone likes to talk about how the latest data have all of a sudden signaled a turn in the economy, with retail sales, home sales, and this week’s durable goods report. Everyone was so excited about a 3.4% increase in February orders, and it seems as though the headline was taken completely at face value. But again, like so many indicators, the seasonal adjustment factor was extremely aggressive in providing a record boost (in this case) to the top-line figure. ML calculates that if a typical February adjustment factor had been used, orders would have shown a 5% collapse last month. We are still in the process of trying to figure out why this happened – it could be due to the mild weather compared to the last two years. The YoY trend in the non-seasonally smoothed orders data shows that the pace is still testing unprecedented negative terrain (-29%); ditto for shipments (-20%). The durable goods inventory/shipments ratio at 1.88 is close to an all-time high. That spells more production cutbacks and deflation pressure as we move into the second quarter.

So, we do advise caution here because we have seen a very aggressive set of seasonal factors that made the raw data look extremely strong in February. The seasonal adjustment for new home sales, for example, was the strongest since 1982. For orders, it was the strongest since the data were first released in 1992. The retail sales number in February in non-seasonally adjusted terms was the worst, a 3% decline actually, on record, and yet again a strong seasonal adjustment factor made it look flat … or flattering, we should say. Beware of reading too much into the data in February when a 40,000 raw non-seasonally adjusted housing starts number suddenly becomes a headline seasonally adjusted figure of 583,000 at an annual rate.

10) Second derivative on GDP growth is not improving

Many pundits believe that the second derivative on GDP growth is improving; this is not the case. Real GDP contracted at a 6.3% annual revised rate in 4Q08, and chances are high that there will be an even steeper decline for 1Q09 (-7.2%), in our view. But, the market does not trade off of the second derivative. If it did, then the S&P 500 would have peaked in the first quarter of 2006 as opposed to the third quarter of 2007; and would have bottomed in the fourth quarter of 2001 instead of the fourth quarter of 2002. However, we cannot stop people from believing what they want to believe, and there is incredibly strong belief now that this is a fundamentally based equity market rally. We are trying to keep an open mind, but are not convinced. Sphere: Related Content

Ken Lewis: fan of investment bank?

After BoA's IB tanked in Q3, '07 Ken uttered the infamous "I never say never, but I've had all the fun I can stand in investment banking at the moment." Quite a turnaround then...

If I was a shareholder, I would view the IB as a deadweight to the cash cows of the commercial operation. Even if we say "what's done is done", on a going forward basis the outlook is still pretty grim as deals are not happening, very few IPOs coming to market, trading flow is at all time lows and prop trading is a complete ghost town. Lewis gave an implicit backing of the combined IB/CB model with the ML purchase but since then has done a shitty job of communicating his vision for why or his plan for how. Sphere: Related Content

Commentary on Japanese demand

Through this whole crisis, the conventional wisdom has been that the yen was somewhat more insulated to the crisis than other currencies, due to the inherently low levels of leverage in the Japanese economy (courtesy of the 90s). Much of the price movement since then has been attributed to ex-Japan macro factors; the "safe haven" theory, Japanese repatriation due to fiscal year end, open market actions by BoJ, etc. There was some discussion of pain due to lower demand for exports but it hasn't been really explored in any great detail and typically been viewed as secondary to other factors, given the relative nature of FX.

It's important to look at the raw demand numbers to get a sense for what is really going on. BoJ released the industrial activity numbers last week for Jan 09. If we use the industrial activity numbers as a proxy for lagging demand indicators, the picture is much grimmer.

Below is the raw data for all industry activity (ex. agriculture, forestry and fisheries) and the three largest individual components for the all industry index. As expected, government services has been relatively stable, while industrial production has fallen off a cliff. Tertiary industry services has also moderately declined; while it is the largest individual component, it is frustratingly also not defined so it's up to our best guess. Industrial production is presumably driven by exports and domestic demand; to put it in perspective, the last point of comparison is the 2000/2001 bubble burst. The current crisis has killed demand by ~3x of the last recession in about a 1/3 of the time.

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What We, Uh, Really Meant Was...

...That the plane is back to crashing into the mountain. After vociferous pledges that business has never been more stellar, the big 3 banks are starting to hit retraction mode. Enter Jamie Dimon, who in a interview with the lovely Erin Burnett stated sheepishly and under his breath that "March was a little tougher." Talk about read between the lines understatements! If the pillar of stable banks that is JPM is saying things are back to normal, read horrendous, we can't wait to see Vikram tell people he was really drunk or high or both when he said that the January-February trend was his friend (only exception if copious amounts of roofies were involved). Sphere: Related Content

Deep Thoughts From Howard Marks: March Edition

The man behind the Oak demonstrates that even despite his sage investor advice, he is also mortal.

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Obamanomics: The Bud Selig View

What the U.S. economy will look like in 10 years is anyone's guess, however, it is fair to say that if Obama, in addition to being president, also moonlighted as commissioner of the MLB, then Jose Canseco, Barry Bonds, Mark McGwire and A-Rod would not only be swinging all day, but also juicing up on their bathroom breaks and twice on Sunday. Obama's fascination with the steroidal rejuvenation of the U.S. economy is astounding, however supply and demand is a little different than swinging a corked baseball bat. The example Obama is setting for the young generation is that it is ok to overspend on everything (especially if some pork barrels can be snuck along), so spend away, max out your credit cards, and whatever will be will be (if you are lucky you may just borrow enough to become too big to fail).

Where do we stand?

In past recessions, the corporate sector, the consumer and the economy were given the benefit of low real interest rates, some accelerated depreciation tax credits for capital equipment, on occasion some personal tax cuts, but that's about it. The economy was left to respond to these incentives, and when you saw things like consumer spending, housing and inventories start to move, you knew the recession was ending. It was time to get back to investing, since the economy was functioning on its own again. As seen in the chart, most recessions get the benefit of 300-450 bps of Fed easing (size of bubble), but the expansion in the monetary base is modest (10%-20%, y axis), and the fiscal expansion (x axis) is not that much, or even zero.

But this time, public sector stimulus to combat the recession is off the charts (literally). You get the same Fed easing, but its combined with an expansion in the monetary base of over 200% and a 20% increase in the US treasury debt/GDP ratio (this is a conservative estimate that will probably go much higher). This is something we have not seen in the last 70 years. Of course growth, spending and housing will start to look better; with this level of steroid injection, it would be almost impossible if they didn't. What I am struggling with is the cost of the program below. Maybe they are long-term costs (inflation, crowding out of private sector investment, permanently higher savings rates, the $, lack of confidence, lower productivity, etc), some may not happen, and maybe its way too premature to think about them now. But its amazing how crowded the bearish view is.

hat tip reader Michael. Sphere: Related Content

PPIP: The Long View

The below piece, courtesy of Gorelick Capital, nicely summarizes the bull view on PPIP. The reasoning by author Chris Skardon is likely shared by the markets, at least over the past week, when no good news was too little, and no bad news was possible. While ZH agrees in principle with the near-term benefits and has in fact discussed these in length, it is the PPIP in context that should be considered, and just what the ramifications of the context leading to over 10 trillion in incremental US debt are, will be topic for the next post...

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Frontrunning: March 27

  • Must read: The silent coup d'etat by the finance industry (Simon Johnson, former IMF, The Altantic)
  • So now he loves them? Obama seeks support from JPM, GS, Citi on bank plan (Bloomberg)
  • ...and: Obama back banks, seeks to block fair-lending probe (Bloomberg)
  • Top risk officers remain at AIG (WSJ)
  • Krugman: The market mystique (NYT)
  • Henderson: Did Fed cause housing bubble (WSJ)
  • Buiter: Moral hazard lite and strong (FT)
  • Smith: Deconstructing the senile former Fed chairman (Naked Capitalism)
  • Greenwald: comparing the U.S. to Russia and Argentina (Salon)
  • China stock optimism overdone according to Morgan Stanley (Bloomberg)
  • Tension builds at Nomura over Lehman bonuses (Reuters)
  • How will cities in 2100 look (McKinsey)
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Overallotment: March 26

  • Alles ist gut in China, except for those pesky missing profits (Bloomberg)
  • ...While its central bank governor says Chinese recession recovery greatest thing since slided bread (Bloomberg)
  • Top Swiss banks execs banned to travel abroad (FT)
  • More ruminations on the Cinderella market (WSJ)
  • ...and while alles ist gut in the U.S., nobody knows where the money really is (WSJ)
  • GM to reveal VP3 or version 3 of its bailout plan as taxpayers' fund the defunct company's life support (FT)
  • MGM Mirage deathwatch: Citycenter hires Dewey & LeBoeuf ahead of likely Friday bankruptcy (WSJ)
  • More Geithner plan graphics (FT)
  • ECB to join BOE in direct market corporate bonds purchases (WSJ)
  • Japan not happy with North Korea's nuke flyovers (Bloomberg)
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Thursday, March 26, 2009

What's Up Or Rather Down With The EUR And General Market Observations

Another perfectly normal day in the market, marked by the totally logical run up in stocks, bonds, commodities... and the USD. Why is the USD stronger? Some of the commentary suggests this is due to risk aversion trades but US equities are higher, oil is higher and many point to this weeks economic data as suggestive of economic stability. So in the search of more satisfying explanations:
1) The month-end flows. While we think most of the flows should be EUR positive there is a natural mismatch to the week. Many of those that need March 31 as their closing date may be trading now rather than waiting for the exact fix next week. The US passive hedgers seem to be dominating today rather than Europeans making the USD bid.
2) The ECB. Worry is high that the ECB is behind the deflation curve witness the series of really ugly confidence numbers from Europe today. The ECB catch-up to QE is a risk and its being priced into the EUR.
3) Positions.
Its really quite simple anyone that is bearish USD is being punished right now as US assets do better.
concerns were overblown this is a key and very worrying risk for market as the FED buying of $7.5 bn US Treasuries yesterday didnt lower US rates. In fact the US Treasury issued $34 bn in 5Y notes overwhelming the effect of the FED action. Market has sold bonds this week as economic data turned and as the FED actions are proving insufficient to turn the market around. Until and unless we get negative CPI prints the market wont believe that US bonds arent rich. Also the market suffers from asset allocation where bonds are being sold to buy equities to reweight battered portfolios. All of this supports the USD, as it's an indication of tighter conditions. Eventually this will hurt growth outlooks and stocks but not just yet, as stock buyers are tempting fate under the soothing chants of the CNBC and the Geithner siren brigade, who seem to practice their Jedi mind tricks oh so successfully on the investing public every single day.
5) Technicals. On the technicals we are far from any level where the EUR is going to be in trouble for another shot at 1.3750 or 1.39. Yet all the momentum players are watching a sagging market and giving up. The 1.3250 or 1.3120 support seems far far away. The interest in USD buying in EUR has put pressure on JPY as well and the technical line to watch there is 98.70 which we saw tested briefly a few moments ago.
6) Fundamentals. If you read the stories below more regulation from SEC and US Treasury; more doubts about the US banking system as the Senate pushes back on more bank bailout funds and Lacker highlights the need for stress tests. The mix of data hasnt been positive or negative so arguing that anything new has hit the tapes about economy or policy misses the point.

In other news, what is the SEC seeing about money market accounts that others aren't? It is no secret that the SEC will not react to a vicious dog attack until the fido has planted its mollars deep in the commission's gluteus maximus.
Thus one is left to wonder what Mary Schapiro knows when she told congress that U.S. securities regulators will bolster the regulation of money market funds and the protection of investors who entrust their funds to broker-dealers and investment advisers. In testimony prepared for a Senate Banking Committee hearing, SEC Chairman Mary Schapiro said the agency is considering ways to improve the credit quality, maturity, and liquidity standards applicable to the money market funds. Schapiro also said SEC lawyers are working on a plan to require investment advisers with custody of client assets to undergo an annual third-party audit, on an unannounced basis, to confirm the safekeeping of those assets. We smell smoke...

Lastly, Senator Kent Conrad had some amusing quibs about Obama's recent spending rampage reminiscent of a valley girl's first trip to soon-to-be-bankrupt-unless-inevitably-bailed-out-as- systematically-imporant Nordstrom's with daddy's gas card, better known as the taxpayer's printing press. As is widely known,
Obama has requested in his budget $250 billion, to add to the $700 billion widely-criticized financial bailout fund. But the chairmen of both the House of Representatives and Senate Budget Committees refused to include it in their budget plans. Senate Budget Committee Chairman Kent Conrad told National Public Radio that he would not include it "when there is no plan as to how to use the money and no assertion by the administration that they're even certain it would be needed." The bailout fund was originally designed to prevent a complete meltdown of the financial system by taking bad real estate investments off institutions' balance sheets to get credit flowing again. But lawmakers have panned it for not doing the job sufficiently. Obama's request for more money came in his budget proposal for fiscal 2010, which begins on Oct. 1. But it was described as a "placeholder" and White House officials said that they may not seek the extra funds from Congress, where lawmakers are now drawing up their own budget plans. Both congressional budget committees quickly jettisoned it, giving them an easy way to cut massive red ink from their budget plans for the few years. The Congressional Budget Office last week forecast that Obama's budget would make the deficit balloon by $9.3 trillion through 2019, $2.3 trillion more than forecast by the White House. "You know, when you lose $2.3 trillion in a revenue forecast, we simply can't budget money for things that are theoretical," Conrad told NPR.

The schizophrenia-cum-amnesia in U.S. capital markets has reached an unprecedented stage. From utter despair a mere 3 weeks ago to irrational exuberance currently, the conviction in the infallibility of the financial system is hindering all administration attempts to extract nickels and dimes from the taxpayer for the financial armageddon boogeyman. And as most traders will confirm, there are many more invisible hands in the current market than even the most vetted conspiracy theorist will attest. The last time macroeconomic second derivatives indicating existing home sales, or economic spending are "slowing
", despite all primary indications still showing much more pain is in store, last caused a 20% rally in, well, never... Anyway, long story short, in order to demonstrate the weakness of the financial system, and to get a quick signature for any bailout placeholders, we would not be at all surprised to see stock borrow of Citi (and other financial) shares mysteriously come back with a vengeance. Bottom line is that the administration has realized it can effectively fly even the most egregious hedge fund enriching, and treasury debt multiplying proposal past the US public which is only transfixed by day-to-day market gyrations and the occasional flare out of populist anger against 10-20 Salem witches who are singled out by the WSJ and NYT for collecting bonuses. In the meantime, that great sucking noise you hear is the greatest wealth transfer in decades, transferring some marginal peace of mind to the current generation at the expense of the great unknown of the future. But when we are talking $9.3 trillion deficit increases in 10 years, who really gives a damn. After all, it is Nordstrom's, and the valley girl will not have to worry about a 3rd term (and very likely a 2nd one either).

Also thanks to reader Michael for his donation and kind words. Sphere: Related Content

Geithner pushes for increased regulation

In a move to avert the next crisis, Geithner & Co. are seizing the political initiative and populist momentum to call for "New Rules of the Game"; i.e. more regulation. Looking past the rhetoric, it's interesting to assess each leg of the proposal independently.

- make it mandatory for "large" hedge fund, private equity firms and venture capital firms to register with the SEC, new disclosure requirements and potential inspections

First, it will be interesting to see what gets defined as "large". The specific number will give some indication of what the administration's true motives are; if the number is legitimately high to prevent a LTCM-type unwind vs. a generic $1B AUM limit to cover every mom and pop corner store in Greenwich to simply rattle the cages. 

The disclosure requirements are going to require beefier compliance departments for (insert household fund name here) but the end result will be minimal, especially to the industry leaders which tend to hold themselves to higher audit standards. For example, the mega funds with a strong institutional base are already used to a detailed level of scrutiny of their operation. 

- these same "large" pools of capital may be ordered to raise capital or limit leverage

This has the potential to really screw over some funds - it's all dependent on what "large pools of capital" is defined as, and what the target capitalization levels are set at. If the administration's philosophy is purely to prevent systemic risks, this shouldn't pose a serious damper to returns but Zero Hedge has a sneaking suspicion that some asset classes are going to be severely curtailed.

-would require a central clearinghouse for derivatives

Great move. The initial transition period will be more than offset by a lower probability of a Lehman London type scenario. 

-new rules to require banks to build up capital during boom times for the slumps

Great in theory, but I'm short this idea being executed well. How do you define boom times, slump, adequate capital, and over/undercapitalized? It's foolish to think that banks won't figure out some way around this in 6 months to increase returns on capital.

- future plans to generally police fraud more effectively, plug gaps in regulation and collaborate with international counterparts on tax evasion and leverage rules

More details are really needed - there are a bunch of simple, logical actions that the government could take but that is far from a given.

As a final note, it's important to realize that this is far from getting passed. ZH is reasonably sure something to this effect will get passed but keep in mind that Congress will attempt to amend this to ride the populist wave as much as possible. This could result in additional, poorly thought out legislation, including curbs on compensation; we'll be watching this very closely.
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Will Geithner End Up As XLF's Last And Only Bagholder?

When I wrote about the implications of Geithner's upcoming stress test, I observed that the institutions that have the lowest metrics in the "tangible common plus reserves plus pre-provision earnings less cumulative losses as a percentage of assets" ratio are the companies most at risk for test failure and nationalization of conservatorship. Globalmacrotrader has rerun the numbers and seems to conclude that things are even worse, concluding that absent the PPIP luring up to $750 billion in new private capital, banks are in for a world of pain. Inversely, if through the generous leverage terms, PIMROCK et al do in fact commit massive funds to bail out the asset side of the balance sheet, the outcome would again be adverse as banks will "end up less profitable" by the virtue of the downsizing in their cash flow generating assets.

While Zero Hedge does not promote trade recommendations, GMT concludes that the XLF is enjoying a sucker rally, and the best risk/return is shorting banks with low TCE ratios.

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Cuomo To Subpoena CDS Information From AIG

Or so reports the WSJ. The attorney general has proven to be quite successful at getting whatever information he wants (especially with public lynching as a negotiating tool), so the entire credit community is drooling in anticipation to find out just how scary the real picture at AIG FP's global operations truly is (ZH is quite curious what the DV01 on AIG's entire portfolio is). This may end up being one of those rocks one doesn't want to peek under, as the nicely manipulated and well-hidden truth on AIG's mutual assured destruction interconnections within the financial world will be revealed, and should make for cheerleader sessions just a tad more difficult to conduct once the real fact are exposed. Sphere: Related Content

Brazilian real carry trade

As we have noted before in part 1 of the carry trade series, the carry trade is essentially a negatively skewed asset class as carry traders smooth out the typical fluctuations until liquidity concerns and/or risk appetite decreases and everyone heads for the door at the same time. Below, we have the AUD/JPY spot since 2005:

In the current environment, with ongoing liquidity problems, decreased risk appetite, high volatility and drastic central bank actions it would seem suicidal to consider any kind of carry trade for a while. Additionally investors are currently extremely gun shy about emerging markets, seeming almost reflexively due to the current bunker mentality.

On Tuesday, Banco Central do Brasil released the external accounts results for February, which provides great fodder to examine BRL as an investment currency.

Rate spreads

The BRL overnight rate is currently at 11.25% after dropping 1.5% earlier this month. At first glance, it seems likely that the BCB will drop the rate given the inflation numbers being under target and the global depression looming. However even given that, the final rate is targeted to hit 9% by late 2009; rising commodities prices and increased foreign capital are expected to temper the central rate. With the neither dollar or yen unlikely to move much for the rest of the year, the spread is likely to remain pretty healthy.

Currency risk

The Brazilian real is currently somewhat historically weak compared to the dollar, but given the outlook for the dollar going forward it's not unrealistic to see the real appreciate against the dollar. Specifically with US->Brazil FDI being ~6.5x of the reverse, and that number only going to go higher as emerging markets return, there seems to be room for the real to gain some ground. It's important to note in the above graph, the currency hump from roughly mid '02 to mid '05 was due to the hyperinflation of the time (e.g. ~17.25 % in May '03). Additionally, current account numbers shrunk by ~43.5% YTD on a month to month basis from 2008 and a trend of Banco Central open market spot and repo interventions over the past 6 months to strengthen the real are strong indicators going forward.


There are a lot of potential minefields out for the real as a funding currency. Lower commodity prices, a sudden dive back to safe haven currencies and fluctuation in inflation numbers all have the potential to squeeze the spread on carrying the real. Additionally the giant wave of predicted inflation in the US is a huge risk, somewhat mitigated if the yen is used instead. The real is also not the most liquid cross - open interest is laughably small compared even to the peso. Given all that, it is worth exploring in more detail.
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