The US Gov't is replacing private balance sheets with its own. I am sure that this will soon include pension funds and state/municipal governments. That is fine when we have balance of payments surpluses, but we don't and haven't for about 50 years. The world's economic engine post-WWII was driven by a persistent and growing US current account deficit. Now that that finally seems unsustainable, what happens now? Can we collectively ease off of, and gently devalue, the USD as the world reserve currency or will that too fall off a cliff, as have all other asset markets and currencies of late?
It looks like this can only go in two divergent, but related paths. Each comes with a great deal of pain, but will likely lead to a change in world leadership from the US to someone else at some point in time. It doesn't seem at this point if anyone else is ready to pick up the mantle, which will likely keep this disequilibrium in place for that much longer.
Who knows what the ultimate destination is for the US and world economies but the policy road ahead seems somewhat clear. A book I recently read laid out the Bernanke recipe should the US economy be faced with a possibility of deflation. It was written by Ethan Harris, (presumably former) Chief US Economist for Lehman Brothers. While not that insightful overall, I thought the following list was thought provoking. Take a look at this list and lets review what has or hasn't occurred.
Step 1: push the funds rate to zero (getting there)
Step 2: drive down long-term Treasury interest rates by either promising to keep short rates low for a number of years or commit to make unlimited purchases of Treasury bonds until their interest rate falls. (just announced)
Step 3: push down interest rates on private securities by buying them up as well (announcment of buying Fan and Fred qualifies - wonder whats next?)
Step 4: intervene aggressively in the foreign exchange market to weaken the dollar and raise the price of imports (not yet)
Step 5: Have a coordinated easing of both monetary and fiscal policy, with, for example, a cut in taxes financed by issuing money so there is no increase in government debt ($500B+ stimulus plan likely paid by new money printing)
This list seems to be a cookbook from the Chef Ben Bernanke. Seems like he will do anything to cook up some inflation for us. While the talk now is of deflation, seems like printing up gobs of cash and placing it into the system should ultimately have inflationary effects. And my guess is that this new inflation will not be successfully transmitted into financial assets, due to the longer memories of market participants who may not be as interested in extreme credit growth.
Monday, December 1, 2008
Friday, November 21, 2008
Somali Pirates in Discussions to Acquire Citigroup
November 20 (Bloomberg) -- The Somali pirates, renegade Somalis known for hijacking ships for ransom in the Gulf of Aden, are negotiating a purchase of Citigroup.The pirates would buy Citigroup with new debt and their existing cash stockpiles, earned most recently from hijacking numerous ships, including most recently a $200 million Saudi Arabian oil tanker. The Somali pirates are offering up to $0.10 per share for Citigroup, pirate spokesman Sugule Ali said earlier today. The negotiations have entered the final stage, Ali said. ``You may not like our price, but we are not in the business of paying for things. Be happy we are in the mood to offer the shareholders anything," said Ali.
The pirates will finance part of the purchase by selling new Pirate Ransom Backed Securities. The PRBS's are backed by the cash flows from future ransom payments from hijackings in the Gulf of Aden. Moody's and S&P have already issued their top investment grade ratings for the PRBS's.Head pirate, Ubu Kalid Shandu, said "we need a bank so that we have a place to keep all of our ransom money. Thankfully, the dislocations in the capital markets has allowed us to purchase Citigroup at an attractive valuation and to take advantage of TARP capital to grow the business even faster."Shandu added, "We don't call ourselves pirates. We are coastguards and this will just allow us to guard our coasts better."
The pirates will finance part of the purchase by selling new Pirate Ransom Backed Securities. The PRBS's are backed by the cash flows from future ransom payments from hijackings in the Gulf of Aden. Moody's and S&P have already issued their top investment grade ratings for the PRBS's.Head pirate, Ubu Kalid Shandu, said "we need a bank so that we have a place to keep all of our ransom money. Thankfully, the dislocations in the capital markets has allowed us to purchase Citigroup at an attractive valuation and to take advantage of TARP capital to grow the business even faster."Shandu added, "We don't call ourselves pirates. We are coastguards and this will just allow us to guard our coasts better."
Saturday, November 15, 2008
Why Bank Equity Infusions May Not Work
If banks can borrow at the Fed Funds rate today at 1.00% and buy 30 year Treasuries at 4.25%, why would they ever lend money? Wouldn't it seem like too much trouble to actually underwrite credit, administer draws, read reports, etc. when all they have to do is buy the Treasuries and wake up in 30 years? That is what happened in Japan. Now while banks may be somewhat worried that the Federal Government may inflate, what does it matter to the banks because they are only transacting in dollars anyway. If the rate on loans to businesses and consumers is significantly above the long term bond yield, then maybe we can break this potential logjam. It will be interesting to see it all play out. It certainly would imply downward pressure on long T-bond yields. But my guess is that the government may specifically place limits on the amount of Treasuries a bank can hold so as to reduce/eliminate this arbitrage opportunity.
Right now, it seems like banks are paying massive rates to garner bank deposits from consumers. While growing these bank deposits are largely a desire to grow a stable funding base, it may also be that banks anticipate higher rates on loans and maybe even long Treasuries in the future. These factors currently seem to be at odds and it is not at all clear how it plays out.
Right now, it seems like banks are paying massive rates to garner bank deposits from consumers. While growing these bank deposits are largely a desire to grow a stable funding base, it may also be that banks anticipate higher rates on loans and maybe even long Treasuries in the future. These factors currently seem to be at odds and it is not at all clear how it plays out.
Friday, November 14, 2008
Pension Fund Bailout
I think there is a strong likelihood that there will be a significant government bailout of major pension funds across the country. If one thinks of the fact that the government is run by the Democrats, and the traditional Democrat constituencies consist of academics (university endowments), unions (corporate pension plans), teachers (CalSTRS, TIAA-CREF, etc), one envisions that the government will step in somehow to shore up these funds' balance sheets.
It would seem to me that the losses suffered by groups such as CalPERS which may be staring at a loss of upwards of 50%, will have significant troubles servicing their obligations to their pensioners. That is where the Federal Government will step in. So while the Government does have the ability to tax its people up the wazoo that will be viewed as a politically impossible solution over the next couple of years. I can't imagine they will fund that bailout through budget cuts, so that leaves more borrowing against the short end of the yield curve. There will be literally hundreds of pensions to bailout. The first amongst them all will be General Motors. That is a likely consequence of any bailout by the government.
My guess is that it will be the US Government via the Pension Benefit Guaranty Corporation will be the vehicle for these bailouts. But in the article below, it appears that that bailout will need a bailout too. How many dollars will be needed? The shortfall for underfunded liabilities in 2007 (not 2008) was $14 Billion. Imagine what happens once these fund suffer 50% losses? This number may be $50 Billion or more for 2008 alone. Smells like trouble.
http://news.illinois.edu/news/08/1015pensions.html
So who cares? Well the follow on effects of this are that private equitym, hedge funds, real estate, stocks, bonds, basically every conceivable asset class will lose willing investors that mainly consisted of these pension funds. Forced sales in the markets will continue in rapid succession. This will likely push many funds to go out of business.
As of right now, investors in illiquid assets effectively hold cheap/free out-of-the-money options on their properties, considering that their equity investments up front are significantly impaired. Once these options start getting expensive through required equity contributions to cover debt drawdowns, interest carry, and other costs, then suddenly investors will likely break because of a lack of availability of capital from pension funds which may have no liquid assets left to cover these additional commitments (heck, they may not even have the capital to cover their actual commitments).
Sounds like there will be much more forced sales and unwinding. Pension funds, endowments, insurance companies and the like will be continue to crater and losses will shift to government balance sheets.
It would seem to me that the losses suffered by groups such as CalPERS which may be staring at a loss of upwards of 50%, will have significant troubles servicing their obligations to their pensioners. That is where the Federal Government will step in. So while the Government does have the ability to tax its people up the wazoo that will be viewed as a politically impossible solution over the next couple of years. I can't imagine they will fund that bailout through budget cuts, so that leaves more borrowing against the short end of the yield curve. There will be literally hundreds of pensions to bailout. The first amongst them all will be General Motors. That is a likely consequence of any bailout by the government.
My guess is that it will be the US Government via the Pension Benefit Guaranty Corporation will be the vehicle for these bailouts. But in the article below, it appears that that bailout will need a bailout too. How many dollars will be needed? The shortfall for underfunded liabilities in 2007 (not 2008) was $14 Billion. Imagine what happens once these fund suffer 50% losses? This number may be $50 Billion or more for 2008 alone. Smells like trouble.
http://news.illinois.edu/news/08/1015pensions.html
So who cares? Well the follow on effects of this are that private equitym, hedge funds, real estate, stocks, bonds, basically every conceivable asset class will lose willing investors that mainly consisted of these pension funds. Forced sales in the markets will continue in rapid succession. This will likely push many funds to go out of business.
As of right now, investors in illiquid assets effectively hold cheap/free out-of-the-money options on their properties, considering that their equity investments up front are significantly impaired. Once these options start getting expensive through required equity contributions to cover debt drawdowns, interest carry, and other costs, then suddenly investors will likely break because of a lack of availability of capital from pension funds which may have no liquid assets left to cover these additional commitments (heck, they may not even have the capital to cover their actual commitments).
Sounds like there will be much more forced sales and unwinding. Pension funds, endowments, insurance companies and the like will be continue to crater and losses will shift to government balance sheets.
Wednesday, November 12, 2008
Paulson Inspiring Confidence Again
I think history my look unkindly at the steps the Treasury Department has made in trying to stem the losses from this massive credit deflation we are suffering through right now. Basically changing Treasury strategy midstream from buying toxic assets to bank capital infusion, while appropriate and ultimately more effective, is probably not going to inspire confidence in the American people that the US Government has any idea it knows what it is doing. If nothing else, they had no contingency plans for this type of scenario. I guess it shouldn't come as too much of a surprise in any case given the number of times they said that both the economy and the financial system were strong.
Tuesday, November 11, 2008
China the Commodities Trader
Given China's massive influence on the world commodities markets, one has to wonder if they have hedged their future exposure through commodity forward contracts. Being the cynical person that I am, I would not at all be surprised if we learned the following over the course of the next year:
- China locked in significant commodities exposure in industrial metals prior to the announcement of their $580B stimulus package through shell companies that transferred this exposure to the Chinese government via its sovereign wealth fund
- China is slowly and furtively selling off US Treasuries in order to fund the purchase of these USD denominated commodities
- China has been purchasing precious metals in the market to hedge against USD value declines so that they are less exposed to the impact of their massive USD exposure
- Singapore has figured this out and is moving to get ahead of this trade
While I don't think China created this worldwide economic recession, they are probably taking advantage of it.
- China locked in significant commodities exposure in industrial metals prior to the announcement of their $580B stimulus package through shell companies that transferred this exposure to the Chinese government via its sovereign wealth fund
- China is slowly and furtively selling off US Treasuries in order to fund the purchase of these USD denominated commodities
- China has been purchasing precious metals in the market to hedge against USD value declines so that they are less exposed to the impact of their massive USD exposure
- Singapore has figured this out and is moving to get ahead of this trade
While I don't think China created this worldwide economic recession, they are probably taking advantage of it.
Sunday, November 9, 2008
We're All Keynesian Now - or - What Nixon and Mao Talked About in 1972
China just announced plans to spend $586B over the next two years for internal infrastructure spending and other measures to get things moving. That is a very large amount given that the Chinese economy is $3.2B. If one believes that China's growth rate currently is "only" around 5% or so, down from the reported 8% target they just announced fro the 3rd quarter, then the Chinese Government clearly feels that they must do something to bridge this gap and keep confidence up. Clearly this stimulus will be meaningful to prop up the economy, as well as the current Communist regime.
One wonders whether this stimulus will be effective. Remember, the real issue in China is not pure, raw GDP growth but whether or not they can effectively grow their internal consumption market. Right now, they have a long way to go as consumer consumption is less than 40% of total GDP. The majority is internal investment and exports. One thing they can do, which I would imagine is in the works, is to use their surpluses to create good social safety nets available in most other developed economies (think, Social Security, Medicare), that currently do not exist. This would go a long way to help smooth the expected impacts of business cycles on consumers and spur spending.
While it can be argued that a major benefit of the Chinese people is their ability and willingness to sacrifice and save, this only goes so far. Think about Japan. They have shared many of the same cultural attributes as China but now appear to be in a deflationary spiral because they can't get people to spend more money and their demographics are so poor. China is kind of like Japan but only larger. Now that being said, they have much more runway ahead of them than Japan, which appears to be fully developed, for lack of a better phrase. There is still mass poverty in China and a strong secular shift from an agrarian to an urban society. That shift still has many years to play out.
So all that being said, can China overcome in the long-term those issues that have plagued Japan? That remains to be seen. This short-term stimulus may solve some problems for the Chinese government and economy today, but doesn't address those longer term issues discussed above.
Given that, one has to wonder if the Chinese government doesn't spend a lot more effort and money to foster an internal market and less time and energy looking to develop their export markets (via current account deficit supports). These things are not mutually exclusive but it would appear that if successful, the mix of GDP in China will shift from heavily export oriented to more internal investment and consumption. This reduced reliance on exports, tied into a reduced current account deficit, means less funds to prop up the US economy. That should force an even more rapid unwind of US consumer spending as there is no longer a group to support above-equilibrium consumer consumption.
That leads to a subject closer to my heart - the US Treasury market. The US Government just announced the re-issue of 3 year Treasuries. That reminds me a lot of the bridge financing that has plagued many sectors during this credit expansionary boom (including commercial real estate, which I am most familiar with). It is a reliance on a debt market that will hopefully allow the US government to roll over its debts when the come due. Sounds like playing with fire. If the market disappears (read above), then the US government will be paying massively high yields to repay these debts. Or of course, they will be forced to print massive amounts of money. Bad news either way.
One wonders whether this stimulus will be effective. Remember, the real issue in China is not pure, raw GDP growth but whether or not they can effectively grow their internal consumption market. Right now, they have a long way to go as consumer consumption is less than 40% of total GDP. The majority is internal investment and exports. One thing they can do, which I would imagine is in the works, is to use their surpluses to create good social safety nets available in most other developed economies (think, Social Security, Medicare), that currently do not exist. This would go a long way to help smooth the expected impacts of business cycles on consumers and spur spending.
While it can be argued that a major benefit of the Chinese people is their ability and willingness to sacrifice and save, this only goes so far. Think about Japan. They have shared many of the same cultural attributes as China but now appear to be in a deflationary spiral because they can't get people to spend more money and their demographics are so poor. China is kind of like Japan but only larger. Now that being said, they have much more runway ahead of them than Japan, which appears to be fully developed, for lack of a better phrase. There is still mass poverty in China and a strong secular shift from an agrarian to an urban society. That shift still has many years to play out.
So all that being said, can China overcome in the long-term those issues that have plagued Japan? That remains to be seen. This short-term stimulus may solve some problems for the Chinese government and economy today, but doesn't address those longer term issues discussed above.
Given that, one has to wonder if the Chinese government doesn't spend a lot more effort and money to foster an internal market and less time and energy looking to develop their export markets (via current account deficit supports). These things are not mutually exclusive but it would appear that if successful, the mix of GDP in China will shift from heavily export oriented to more internal investment and consumption. This reduced reliance on exports, tied into a reduced current account deficit, means less funds to prop up the US economy. That should force an even more rapid unwind of US consumer spending as there is no longer a group to support above-equilibrium consumer consumption.
That leads to a subject closer to my heart - the US Treasury market. The US Government just announced the re-issue of 3 year Treasuries. That reminds me a lot of the bridge financing that has plagued many sectors during this credit expansionary boom (including commercial real estate, which I am most familiar with). It is a reliance on a debt market that will hopefully allow the US government to roll over its debts when the come due. Sounds like playing with fire. If the market disappears (read above), then the US government will be paying massively high yields to repay these debts. Or of course, they will be forced to print massive amounts of money. Bad news either way.
Tuesday, November 4, 2008
Equity Bull Market?
Believe it or not, with this massive sell-off of the past weeks, we are actually in the middle of a bull rally. While it appears that there will be another more slow and painful downleg from here, a rally was not surprising given the amazingly oversold condition (I am no market timing expert but it was obvious how oversold things were getting). Now I don't think this is any reason to get excited about equities given that fundamental weakness will start showing up in earnings. Remember, it was not fundamentally a valuation bubble in equities we were sitting on, it was an earnings bubble.
Bonds seems to be interesting in this environment. There was an interesting article today about convertible bonds which seem to be pricing at levels last seen some 30 years ago.
http://online.wsj.com/article/SB122575841314895287.html
The one thing about bonds that frighten me is that they are still subject to inflationary pressures knocking around their yield. However, there are several bonds which are pricing at levels denoting distress, whereas the sales may have really been driven by forced selling more than anything. One of my favorite companies, Leucadia National, has bonds currently priced at 10% YTM. For what I consider an absolutely rock solid company, that is an excellent yield.
Bonds seems to be interesting in this environment. There was an interesting article today about convertible bonds which seem to be pricing at levels last seen some 30 years ago.
http://online.wsj.com/article/SB122575841314895287.html
The one thing about bonds that frighten me is that they are still subject to inflationary pressures knocking around their yield. However, there are several bonds which are pricing at levels denoting distress, whereas the sales may have really been driven by forced selling more than anything. One of my favorite companies, Leucadia National, has bonds currently priced at 10% YTM. For what I consider an absolutely rock solid company, that is an excellent yield.
Election Day!
Pretty phenomenal that we are on the cusp of having an African American in the White House. It is even more astounding that he is a liberal from Chicago. I didn't think American politics had the capacity for this for at least another generation.
One thing that occurs to me is that this may be the death-knell for affirmative action. The hiring of a black president by the citizens of the United States of America seems to prove that even the highest glass ceiling can be busted through. That is not to say that minorities are well represented in all aspects of society, business and culture, but that those areas which were viewed as bastions of exclusion and male WASPiness may be possible of transformation and dynamism not expected by many.
It gives me hope that maybe the world is more egalatarian than I imagined. Even for a cynic like myself, it is an amazing expression of the power of the individual and of a truly free, democratic society. All in all, a pretty amazing time to be alive.
Scratch that if McCain wins.
One thing that occurs to me is that this may be the death-knell for affirmative action. The hiring of a black president by the citizens of the United States of America seems to prove that even the highest glass ceiling can be busted through. That is not to say that minorities are well represented in all aspects of society, business and culture, but that those areas which were viewed as bastions of exclusion and male WASPiness may be possible of transformation and dynamism not expected by many.
It gives me hope that maybe the world is more egalatarian than I imagined. Even for a cynic like myself, it is an amazing expression of the power of the individual and of a truly free, democratic society. All in all, a pretty amazing time to be alive.
Scratch that if McCain wins.
Sunday, November 2, 2008
Treasury Yield Discussion
Here is a letter from Vineer Bhansali at Pimco regarding his outlook for Treasuries.
http://www.pimco.com/LeftNav/Viewpoints/2008/Bhansali+Duration+Goodbye+Sept+2008.htm
Given the US government's rapid inflation exercise, which will likely have some sort of effect on currency depreciation, the Treasury yield should move out. If you look at the the long term bond yields in the chart linked above, you can clearly see that the Treasury market has experienced bouts of extreme volatility in the past. If you believe that there will be a massive contraction of liquidity on top of a general disenchanment with US Treasuries, then it is easy to envision how Treasury yields would blow out. Despite a lack of short-term volatility in the Treasury market, one can imagine that it would pick up to some increased level. What that level is is unclear.
So given that, it would seem that buying out-of-the-money puts on long dated Treasuries could turn out to be a fantastic play, particularly while the pricing on the bonds are high and the volatility is low. Still trying to figure out the specific mechanism for the trade. If anyone has ideas, please let me know.
http://www.pimco.com/LeftNav/Viewpoints/2008/Bhansali+Duration+Goodbye+Sept+2008.htm
Given the US government's rapid inflation exercise, which will likely have some sort of effect on currency depreciation, the Treasury yield should move out. If you look at the the long term bond yields in the chart linked above, you can clearly see that the Treasury market has experienced bouts of extreme volatility in the past. If you believe that there will be a massive contraction of liquidity on top of a general disenchanment with US Treasuries, then it is easy to envision how Treasury yields would blow out. Despite a lack of short-term volatility in the Treasury market, one can imagine that it would pick up to some increased level. What that level is is unclear.
So given that, it would seem that buying out-of-the-money puts on long dated Treasuries could turn out to be a fantastic play, particularly while the pricing on the bonds are high and the volatility is low. Still trying to figure out the specific mechanism for the trade. If anyone has ideas, please let me know.
Sunday, October 26, 2008
Inflation in Foreign Countries
Given the massive flight to quality out of emerging markets and into the US Dollar and Japanese Yen, they must feel as if they can't catch a break. Given the strengthening of the US dollar, we are experiencing deflation here Stateside, but if you are sitting in a place like Australia or South Korea, the deflationary effects on import and commodity pricing haven't been anywhere near as strong given that your currency just fell by 30-40%. A fall of oil prices by 50% in US Dollar terms doesn't feel that dramatic to you. So if you were the central banks of one of those countries, I would imagine you would end up selling your dollar reserves, if you have any, or buying back Treasury-issued notes to try and prop up your currency. Won't this selling of dollars around the world end up putting back a ton of eurodollars back onto the market and weaken the dollar from its current position? The US would probably want a weaker US dollar so they would probably tacitly support USD selling.
http://www.straitstimes.com/Breaking%2BNews/Money/Story/STIStory_295370.html
Similarly, it sounds as if Japan is likely to start intervening to break the strengthening of their currency as it would and likely is massively impairing their export business.
http://www.straitstimes.com/Breaking%2BNews/Money/Story/STIStory_295371.html
Also, a great article from the WSJ regarding the reason for Bretton Woods in 1944. Much of it was due to battling currency devaluations between exporting countries. Although not quite the same here, massive disruptions in currency markets should lead to some form of international resolution around these issues. As the article states, China's participation, nee leadership, seems to be critical.
http://online.wsj.com/article/SB122489333798168777.html
http://www.straitstimes.com/Breaking%2BNews/Money/Story/STIStory_295370.html
Similarly, it sounds as if Japan is likely to start intervening to break the strengthening of their currency as it would and likely is massively impairing their export business.
http://www.straitstimes.com/Breaking%2BNews/Money/Story/STIStory_295371.html
Also, a great article from the WSJ regarding the reason for Bretton Woods in 1944. Much of it was due to battling currency devaluations between exporting countries. Although not quite the same here, massive disruptions in currency markets should lead to some form of international resolution around these issues. As the article states, China's participation, nee leadership, seems to be critical.
http://online.wsj.com/article/SB122489333798168777.html
From Bob Prechter - The Deflation Counterargument
"Believers in perpetual inflation think that the government can keep assuming others’ bad debts infinitely. But it can’t. The only reason that Congress has gotten away with issuing this latest blizzard of new IOUs is that society is still near the top of a Grand Supercycle, so optimism and confidence still have the upper hand. But as pessimism and skepticism continue to wax and the economy contracts, the bond market will figure out that the Treasury will be unable to fund all these obligations with tax collections. Then Treasury bond prices will begin falling as if they were sub-prime mortgages. A collapsing bond market is deflation; it is a contraction of the outstanding credit supply. Recent bailout schemes will not reverse the deflationary freight train. They will serve only to confuse the marketplace and hinder the efficient retirement of bad debts, thus exacerbating the crisis and aggravating investors’ uncertainties and thereby falling right in line with the declining trend of social mood."
I think it is an important perspective and certainly viable. There is one investment move that seems to be a winner in both an inflation and deflation scenario. That scenario is short long US Treasuries. As Bob states above and we have stated in previous posts, the question hinges truly on whether or not the US government can overwhelm the massive credit deflation in the market. If yes, then you will get inflation which will cause Treasury yields to rise. If no, then as Bob states above, Treasury yields will blow out because of perceptions of US credit and the ability of the government to pay these debts.
For retail investors, an interesting way to play this would be buy TBT, the ultrashort 20+ year Treasury index. They charge a 1% fee but if the direction is correct the returns should overwhelm those fees. Just look at what happens to bond prices if Treasury yields move from 4% to 8%. It gets sliced in half. That is a significant move.
Saturday, October 25, 2008
How Prices Inflate: Lessons from Germany
In the case that we have inflation, it is a fair question to ask how exactly prices inflate? It seems to be much taken for granted that inflation would cause general rise in the price level. However, it is really not that straightforward. First of all, most people confuse monetary inflation (which is the technical definition of inflation) with price inflation (which is how it is commonly used).
In any case, when the system is flooded with additional dollars, how does this end up getting translated into prices, and furthermore, which prices does it end up getting translated into? Probably the best source to figure this out would be to see what happened during the most famous case of inflation that ever existed - Germany during the Weimar Republic in the early 1920s.
In Germany, the most immediate effect on a huge influx of additional currency in the system served primarily to drive down the exchange rate on the currency vis-a-vis other currencies. This was driven partially by true supply-demand imbalances but also on speculative activity. Given a drop in the exchange rate, the prices for imported goods would therefore rise, including the price of inputs, such as raw commodities. Given the US's massive reliance on foreign-produced goods, this would be a major impact.
While at first, internal prices would remain relatively stable and provide something of an anchor for the exhange rate, at some point if the government persists in printing dollars, internal domestic prices will ultimately rise, as will wages and other items. But that is an effect of persistent monetary inflation, and not short-term inflation. This does not mean that inflation will ultimately be persistent in nature? While the German mark was on a major devaluation trend, there were periods of stabilization and even currency strengthening that led to lower import prices during that interim period. Also during a major inflation, credit creation becomes massive which further increases the money supply.
Clearly there are differences between the US today and the Weimar Republic then. But history may be rhyming. The big difference today is the debt deflation happening. If you think inflation is coming strong, best to get back into, as Jim Rogers says, "unimpaired" commodities as they will once again feel the surest impact of this inflationary boom and dollar devaluation.
In any case, when the system is flooded with additional dollars, how does this end up getting translated into prices, and furthermore, which prices does it end up getting translated into? Probably the best source to figure this out would be to see what happened during the most famous case of inflation that ever existed - Germany during the Weimar Republic in the early 1920s.
In Germany, the most immediate effect on a huge influx of additional currency in the system served primarily to drive down the exchange rate on the currency vis-a-vis other currencies. This was driven partially by true supply-demand imbalances but also on speculative activity. Given a drop in the exchange rate, the prices for imported goods would therefore rise, including the price of inputs, such as raw commodities. Given the US's massive reliance on foreign-produced goods, this would be a major impact.
While at first, internal prices would remain relatively stable and provide something of an anchor for the exhange rate, at some point if the government persists in printing dollars, internal domestic prices will ultimately rise, as will wages and other items. But that is an effect of persistent monetary inflation, and not short-term inflation. This does not mean that inflation will ultimately be persistent in nature? While the German mark was on a major devaluation trend, there were periods of stabilization and even currency strengthening that led to lower import prices during that interim period. Also during a major inflation, credit creation becomes massive which further increases the money supply.
Clearly there are differences between the US today and the Weimar Republic then. But history may be rhyming. The big difference today is the debt deflation happening. If you think inflation is coming strong, best to get back into, as Jim Rogers says, "unimpaired" commodities as they will once again feel the surest impact of this inflationary boom and dollar devaluation.
Friday, October 24, 2008
CBRE in trouble?
Someone recently suggested to me that CBRE was at risk of going out of business. I am not sure if there is much, if any, truth to that but I figured the answer probably lie in their balance sheet. Buying Trammell Crow Company at what in retrospect was an absolute market peak in late 2006 for $2.0B, may turn out to be the albatross around their neck. And they levered up to buy it. Oops. CB's market cap right now is roughly $930mm.
Let's look at the debt on book. The debt on the book mainly consists of the following:
1) A $600mm credit revolver due June 24, 2011
2) $1.1B tranche A term loan due December 20, 2011, with payments starting March 31, 2009
3) $1.1B tranche B term loan facility due December 20, 2013, with quarterly payments due. Quarterly debt service payments are $2.75mm.
4) A $300mm tranche A-1 term loan facility, with balance due December 20, 2013. Quarterly debt service payments total $0.75mm.
Looks like 2011 ($1.7B) and 2013 ($1.4B) are the big debt maturity dates for them. These dollars don't include any compounded interest that will increase the principal balances to be paid. As of their latest 10Q dated June 30, 2008. They had ~$275mm in cash ($24mm restricted). This help them carry the firm for a little time. However, negative CF from operations for the first 6 months of the year totaled $380mm. The burn rate is high and cash on hand only gives them another 2 quarters at this rate. I am not sure all of the specific loan convenants but they may be at risk of making debt service payments and MAY already be at risk of busting through some loan covenants and getting into technical default.
They have some operations that have real value such as CBRE Investors and Trammell Crow Company development but sales of their best operations may not be enough to plug the hole. I have not dug in that deeply, but the balance sheet looks quite risky.
Let's look at the debt on book. The debt on the book mainly consists of the following:
1) A $600mm credit revolver due June 24, 2011
2) $1.1B tranche A term loan due December 20, 2011, with payments starting March 31, 2009
3) $1.1B tranche B term loan facility due December 20, 2013, with quarterly payments due. Quarterly debt service payments are $2.75mm.
4) A $300mm tranche A-1 term loan facility, with balance due December 20, 2013. Quarterly debt service payments total $0.75mm.
Looks like 2011 ($1.7B) and 2013 ($1.4B) are the big debt maturity dates for them. These dollars don't include any compounded interest that will increase the principal balances to be paid. As of their latest 10Q dated June 30, 2008. They had ~$275mm in cash ($24mm restricted). This help them carry the firm for a little time. However, negative CF from operations for the first 6 months of the year totaled $380mm. The burn rate is high and cash on hand only gives them another 2 quarters at this rate. I am not sure all of the specific loan convenants but they may be at risk of making debt service payments and MAY already be at risk of busting through some loan covenants and getting into technical default.
They have some operations that have real value such as CBRE Investors and Trammell Crow Company development but sales of their best operations may not be enough to plug the hole. I have not dug in that deeply, but the balance sheet looks quite risky.
Thursday, October 23, 2008
Deflation and Inflation
So the number one burning question that I am focused on today is that of inflation vs. deflation. It is interesting in that through the first 8 months of this year, everyone seemed to be absolutely convinced of very crippling inflation. Now everyone seems to be 100% convinced of deflation. Despite this being what I consider the most critical question we face as investors and Americans, I haven't found much good subject matter on it. Here are my thoughts in the form of answers to some basic questions. If I am wrong, please step into correct me.
HOW MUCH DOES THE US NEED TO FUND?
While it does seem like deflationary trends are indeed in full bloom, the lurking nature of inflation seems to be not to far in the background, or our futures. The government seems to be only days away from monetizing the huge volume of debts that the federal government has been forced to put on its shoulders in recent weeks. Lets count them up:
Fannie Freddie Losses: $1 Trillion (presuming roughly 20% loss on prime mortgage assets)
AIG: $122 Billion
Government Bailout Package: $850 Billion
Money Market Fund Guarantees: $540 Billion
TOTAL: ~$2.5 Trillion
Now those are rough numbers but these are still early days. It is also important to note that of the government bailout package, $250 Billion of that is bank equity infusions. Compared to the Euro Zone's $2.5 Trillion bailout, the US government seems to be at least another $1 Trillion short of the dollars necesssary to fund the banking losses. If you layer on additional dollars to shore up money market funds and other commercial paper losses, and the dollars pile up. But for now, let's stick to the $2.5 Trillion number.
WHY DO WE WANT TO EVEN FUND THESE LOSSES?
The big lesson of the Great Depression apparently was that we would not want to allow another massive deflation event to hit the US economy. This Great Depression was really a big deflation of asset values and prices, exacerbated by a strong dollar pegged to gold, isolationist tariffs, and unaddressed liquidity issues in the banking system. Given this, Ben Bernanke and Hank Paulson have initiated a set of policies designed to reinflate the system and combat the debt deflation spiral that would lead to falls in prices, significant job losses, credit losses, and more. While it is still not clear that inflation is better than deflation, the vested interests in the government seem very much aligned towards this type of policy response.
While one would envision this opinion to be expressed to lawmakers only through Wall Street types and Fortune 500 CEOs, it will also be seen fully as a liberal cause once the major pension plans (e.g., CalPERS) announce year-end losses of up to 40% on what was once their $200 Billion portfolios. http://online.wsj.com/article/SB122469119659558689.html. Keep in mind that CalPERS and the big pension fund groups of the US will have massive, unrealized losses on their private equity and real estate portfolios that will not be "marked-to-market" due to loose reporting standards for doing so. In other words, Thank goodness for Level 3 assets! The only way out of these losses is to reinflate asset values.
Interestingly enough, the amount by which they will need to reinflate these values will require even more effort on the Fed's part as we are seeing risk premiums expansion in the form of lower P/Es for companies and higher cap rates for real estate, which will need to be offset by increasing net operating income. Doing that in the middle of a long recession will be tough. The only way to do it is through nominal revenue increases. Sounds like inflation to me as real gains will not be available anytime soon. No one said it would be easy! OK, it will only be a nominal improvement, but it will make people feel better.
On top of the political impetus for reinflation, that has been the whole source of Ben Bernanke's academic research and writings. Attached is a great read for those who want to understand more about BB's thoughts on tools to reinflate. http://www.gloomboomdoom.com/gbdreport/download/GBD0602.pdf (Start reading on Page 5).
HOW DO WE FUND THESE LOSSES?
It seeems that there are three ways to fund these losses. 1) We can issue new Treasury securities, 2) We can print more cash, and/or 3) We can charge more taxes. My guess is that we do some combination of the first two. The third does not seem like an option at all given the myriad needs for what should be a shrinking tax base.
Treasury Market
At last count, the total Treasuries in the market total roughly $4.8 Trillion (we do not include Fannie and Freddie debt which is held "off balance sheet"). This includes everything owned by China, Japan, private institutions, and individuals. If we were to fully tap these markets for the full $2.5 Trillion, we would increase the total Treasury supply by over 50%. That is a massive increase given that it took us some 225 years to get to this point. The question is would there actually be buyers to show up to purchase the bonds if they went for sale. We will find out as time goes by.
The natural target for these bonds are the Chinese, Japanese, and Middle East. They bought them largely with US dollars they acquired as a function of the US's consumer-driven current account deficit. But the US current account deficit peaked at $800 Billion in 2006 and has been shrinking since. Yet as the current account deficit shrinks, they will have fewer and fewer US dollars to buy this debt. 2008 will probably come in at $600 Billion or less. In 2009 and beyond it will likely be even less as US consumer spending further weakens. If the dollar amount of Treasuries is at or less than $2 Trillion, we may come out all right. If it is more, we won't be able to keep issuing Treasuries to fund these costs.
And don't forget that Treasuries are yielding what are the lowest yields soince 1977, when the 30-year bond was first issued. It is conceivable that the issuance of more Treasuries will cause yields to increase dramatically.
Print More Cash
This is obviously the cheap short-term answer. In many ways, it would be a flat tax across all holders of US dollars, domestic and foreign, as an infusion of capital should reduce the value of all USDs in circulation. The infusion of capital into the banks may very well take this form. I suppose this is what is meant by the US government's "exclusive privilege" of being able to print unlimited US dollars to pay US denominated debts. Ironically, and much to the US government's benefit, they will actually reduce the value of their liabilities and increase the value of their foreign holdings if they force a devaluation of the currency. From that perspective, printing more dollars, forcing a currency devaluation, seems to be a great idea. It is certainly politically expedient.
Raise More Taxes
There is already talk of another tax stimulus package. And given Ben Bernanke's stated preference for another tax stimulus, that would provide cover for many politicians to provide just such a stimulus package shortly. This further deficit will need to be funded, of course. Likely through one of the above two methods. Given that there is already a big federal budget deficit, cutting into entitlements AND raising taxes to funnel tax dollars to pay off the bailout package probably won't have a lot of political support.
CAN'T THE FED STOP INFLATION?
They normally could with the standard Fed toolkit which consists primarily of 1) selling Treasuries to sop up cash, 2) pushing the Fed Funds rate upwards (a la Paul Volcker when he pushed rates to nearly 20%), or 3) raising reserve requirements. However, as a creditor nation with huge outstanding debts and a fragile banking system, these three tools are severely impaired. The Fed balance sheet may not be able to issue many more Treasuries above and beyond the required amounts and even if they did, who would buy them? And pushing short-term yields (which is what the Fed controls) to 10%+ may not be feasible given the need to service the outstanding debt. Raising reserve requirements will be a tool that they could use but they would likely have to do so with a very fragile banking system in the midst of rebuilding itself. But it could work to tighten money when the time comes. So the Fed will likely be stuck keeping rates low, feeding the system with the same kind of loose money that caused the credit problems in the first place.
BUT CAN THE FED STOP DEFLATION?
This is really the big question. If they can't stop it, then our course towards a Japan-style deflation is set. However, Bernanke himself declared in a 2002 speech that it was really the lack of political support in Japan that prevented the Central Bank from reinflating. It doesn't seem as if there is any internal political divisions around the need to reinflate here in the US. The failed first bailout vote aside, it appears that the political direction will be around reinflation particularly given the aforementioned pension fund losses which will affect big Democratic power bases, such as teacher and laborers. As he further notes, "deflation is always reversible under a fiat money system follows from basic economic reasoning". However, despite Bernanke's stated optimism in having a broad enough range of tools to beat deflation, it is not a certainty. But he will throw the kitchen sink at beating it back.
OK, SO NOW WHAT?
Deflation is clearly happening today but it is somewhat likely that the Fed will succeed at some point in the using the US government balance sheet to reinflate the credit, and as a consequence, the asset markets. While it is perceived as a binary outcome, we could see inflation in things we use and deflation in things we own. That is the worst possible outcome of all. How would that happen? The inflation could cause a devaluation of the currency, raising import prices which would ultimately spur rises in domestic prices as well, although with a lag to it. A weak dollar would also cause a rise in commodity prices, in particular food prices and precious metals which would presumably still be priced in US dollars.
But this type of inflation would be bad for many stocks as the costs of inputs would rise and PE ratios would fall as the risk free rate would significantly increase. However, stock prices could stabilize or rally if the dollar falls which would result in a nominal gain, but a real loss. Bonds would definitively be damaged in such a scenario. Anyone have thoughts on what this means for distressed fixed income investors? I would curious to get a perspective.
However, at the end of the day, it all comes down to timing. At some point, the inflation bets, should inflation occur, will pay off but that may not be for awhile. For example, the performance of gold has been less than exemplary over the past two weeks and could continue to head lower. And needless to say, real estate hasn't exactly been caught in an inflationary spiral.
A good trade to get things started could be short long Treasuries. I think they would weaken from current levels in both deflation (real credit risks and/or fear of future currency debasement) and inflation (higher required yield) scenarios. Not to mention that at some point people will want to risky assets again and may all try to move out of Treasuries at the same time.
In all things, it is important to remember the saying, "Being early is indistinguishable from being wrong."
HOW MUCH DOES THE US NEED TO FUND?
While it does seem like deflationary trends are indeed in full bloom, the lurking nature of inflation seems to be not to far in the background, or our futures. The government seems to be only days away from monetizing the huge volume of debts that the federal government has been forced to put on its shoulders in recent weeks. Lets count them up:
Fannie Freddie Losses: $1 Trillion (presuming roughly 20% loss on prime mortgage assets)
AIG: $122 Billion
Government Bailout Package: $850 Billion
Money Market Fund Guarantees: $540 Billion
TOTAL: ~$2.5 Trillion
Now those are rough numbers but these are still early days. It is also important to note that of the government bailout package, $250 Billion of that is bank equity infusions. Compared to the Euro Zone's $2.5 Trillion bailout, the US government seems to be at least another $1 Trillion short of the dollars necesssary to fund the banking losses. If you layer on additional dollars to shore up money market funds and other commercial paper losses, and the dollars pile up. But for now, let's stick to the $2.5 Trillion number.
WHY DO WE WANT TO EVEN FUND THESE LOSSES?
The big lesson of the Great Depression apparently was that we would not want to allow another massive deflation event to hit the US economy. This Great Depression was really a big deflation of asset values and prices, exacerbated by a strong dollar pegged to gold, isolationist tariffs, and unaddressed liquidity issues in the banking system. Given this, Ben Bernanke and Hank Paulson have initiated a set of policies designed to reinflate the system and combat the debt deflation spiral that would lead to falls in prices, significant job losses, credit losses, and more. While it is still not clear that inflation is better than deflation, the vested interests in the government seem very much aligned towards this type of policy response.
While one would envision this opinion to be expressed to lawmakers only through Wall Street types and Fortune 500 CEOs, it will also be seen fully as a liberal cause once the major pension plans (e.g., CalPERS) announce year-end losses of up to 40% on what was once their $200 Billion portfolios. http://online.wsj.com/article/SB122469119659558689.html. Keep in mind that CalPERS and the big pension fund groups of the US will have massive, unrealized losses on their private equity and real estate portfolios that will not be "marked-to-market" due to loose reporting standards for doing so. In other words, Thank goodness for Level 3 assets! The only way out of these losses is to reinflate asset values.
Interestingly enough, the amount by which they will need to reinflate these values will require even more effort on the Fed's part as we are seeing risk premiums expansion in the form of lower P/Es for companies and higher cap rates for real estate, which will need to be offset by increasing net operating income. Doing that in the middle of a long recession will be tough. The only way to do it is through nominal revenue increases. Sounds like inflation to me as real gains will not be available anytime soon. No one said it would be easy! OK, it will only be a nominal improvement, but it will make people feel better.
On top of the political impetus for reinflation, that has been the whole source of Ben Bernanke's academic research and writings. Attached is a great read for those who want to understand more about BB's thoughts on tools to reinflate. http://www.gloomboomdoom.com/gbdreport/download/GBD0602.pdf (Start reading on Page 5).
HOW DO WE FUND THESE LOSSES?
It seeems that there are three ways to fund these losses. 1) We can issue new Treasury securities, 2) We can print more cash, and/or 3) We can charge more taxes. My guess is that we do some combination of the first two. The third does not seem like an option at all given the myriad needs for what should be a shrinking tax base.
Treasury Market
At last count, the total Treasuries in the market total roughly $4.8 Trillion (we do not include Fannie and Freddie debt which is held "off balance sheet"). This includes everything owned by China, Japan, private institutions, and individuals. If we were to fully tap these markets for the full $2.5 Trillion, we would increase the total Treasury supply by over 50%. That is a massive increase given that it took us some 225 years to get to this point. The question is would there actually be buyers to show up to purchase the bonds if they went for sale. We will find out as time goes by.
The natural target for these bonds are the Chinese, Japanese, and Middle East. They bought them largely with US dollars they acquired as a function of the US's consumer-driven current account deficit. But the US current account deficit peaked at $800 Billion in 2006 and has been shrinking since. Yet as the current account deficit shrinks, they will have fewer and fewer US dollars to buy this debt. 2008 will probably come in at $600 Billion or less. In 2009 and beyond it will likely be even less as US consumer spending further weakens. If the dollar amount of Treasuries is at or less than $2 Trillion, we may come out all right. If it is more, we won't be able to keep issuing Treasuries to fund these costs.
And don't forget that Treasuries are yielding what are the lowest yields soince 1977, when the 30-year bond was first issued. It is conceivable that the issuance of more Treasuries will cause yields to increase dramatically.
Print More Cash
This is obviously the cheap short-term answer. In many ways, it would be a flat tax across all holders of US dollars, domestic and foreign, as an infusion of capital should reduce the value of all USDs in circulation. The infusion of capital into the banks may very well take this form. I suppose this is what is meant by the US government's "exclusive privilege" of being able to print unlimited US dollars to pay US denominated debts. Ironically, and much to the US government's benefit, they will actually reduce the value of their liabilities and increase the value of their foreign holdings if they force a devaluation of the currency. From that perspective, printing more dollars, forcing a currency devaluation, seems to be a great idea. It is certainly politically expedient.
Raise More Taxes
There is already talk of another tax stimulus package. And given Ben Bernanke's stated preference for another tax stimulus, that would provide cover for many politicians to provide just such a stimulus package shortly. This further deficit will need to be funded, of course. Likely through one of the above two methods. Given that there is already a big federal budget deficit, cutting into entitlements AND raising taxes to funnel tax dollars to pay off the bailout package probably won't have a lot of political support.
CAN'T THE FED STOP INFLATION?
They normally could with the standard Fed toolkit which consists primarily of 1) selling Treasuries to sop up cash, 2) pushing the Fed Funds rate upwards (a la Paul Volcker when he pushed rates to nearly 20%), or 3) raising reserve requirements. However, as a creditor nation with huge outstanding debts and a fragile banking system, these three tools are severely impaired. The Fed balance sheet may not be able to issue many more Treasuries above and beyond the required amounts and even if they did, who would buy them? And pushing short-term yields (which is what the Fed controls) to 10%+ may not be feasible given the need to service the outstanding debt. Raising reserve requirements will be a tool that they could use but they would likely have to do so with a very fragile banking system in the midst of rebuilding itself. But it could work to tighten money when the time comes. So the Fed will likely be stuck keeping rates low, feeding the system with the same kind of loose money that caused the credit problems in the first place.
BUT CAN THE FED STOP DEFLATION?
This is really the big question. If they can't stop it, then our course towards a Japan-style deflation is set. However, Bernanke himself declared in a 2002 speech that it was really the lack of political support in Japan that prevented the Central Bank from reinflating. It doesn't seem as if there is any internal political divisions around the need to reinflate here in the US. The failed first bailout vote aside, it appears that the political direction will be around reinflation particularly given the aforementioned pension fund losses which will affect big Democratic power bases, such as teacher and laborers. As he further notes, "deflation is always reversible under a fiat money system follows from basic economic reasoning". However, despite Bernanke's stated optimism in having a broad enough range of tools to beat deflation, it is not a certainty. But he will throw the kitchen sink at beating it back.
OK, SO NOW WHAT?
Deflation is clearly happening today but it is somewhat likely that the Fed will succeed at some point in the using the US government balance sheet to reinflate the credit, and as a consequence, the asset markets. While it is perceived as a binary outcome, we could see inflation in things we use and deflation in things we own. That is the worst possible outcome of all. How would that happen? The inflation could cause a devaluation of the currency, raising import prices which would ultimately spur rises in domestic prices as well, although with a lag to it. A weak dollar would also cause a rise in commodity prices, in particular food prices and precious metals which would presumably still be priced in US dollars.
But this type of inflation would be bad for many stocks as the costs of inputs would rise and PE ratios would fall as the risk free rate would significantly increase. However, stock prices could stabilize or rally if the dollar falls which would result in a nominal gain, but a real loss. Bonds would definitively be damaged in such a scenario. Anyone have thoughts on what this means for distressed fixed income investors? I would curious to get a perspective.
However, at the end of the day, it all comes down to timing. At some point, the inflation bets, should inflation occur, will pay off but that may not be for awhile. For example, the performance of gold has been less than exemplary over the past two weeks and could continue to head lower. And needless to say, real estate hasn't exactly been caught in an inflationary spiral.
A good trade to get things started could be short long Treasuries. I think they would weaken from current levels in both deflation (real credit risks and/or fear of future currency debasement) and inflation (higher required yield) scenarios. Not to mention that at some point people will want to risky assets again and may all try to move out of Treasuries at the same time.
In all things, it is important to remember the saying, "Being early is indistinguishable from being wrong."
Welcome
So this is my initial foray into writing a blog. I hope that people enjoy it. Much like Sarah Palin, I read anything and everything people put in front of me so much of my blog will probably be stolen materials from others that I find interesting, and that I hope you would too. I will be writing this blog specifically as a way to gather my thoughts and trade ideas, should anyone be interested in discussing ideas or concepts.
The focus of my blog is to discuss all manner of asset class investments, with an eye to discerning longer term trends, both secular and cyclical. I may go into specific individual investments I am focused on as a platform to launch into some of these broader topics. As I have a background in US Commercial Real Estate, some of what I say will likely have to do with that subject matter.
The focus of my blog is to discuss all manner of asset class investments, with an eye to discerning longer term trends, both secular and cyclical. I may go into specific individual investments I am focused on as a platform to launch into some of these broader topics. As I have a background in US Commercial Real Estate, some of what I say will likely have to do with that subject matter.
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