Thursday, August 7, 2008

Global Ponzi Scheme Unraveling Fast


U.S. stocks fell today led by insurer American International Group (AIG) which posted huge second quarter losses (see my previous entry). Wal-Mart's (WMT) cautious sales forecast added to concerns that consumer spending is slowing. AIG's shares plunged 18% and Wal Mart's shares fell by 6% today.

Citigroup added to the financial sector's unease after the bank agreed to unfreeze $19.5 billion of illiquid auction-rate securities to settle charges it misled investors about the debt's risk. American Express shares fell after Moody's Investors Service said it may downgrade the credit card company's debt rating.

Citigroup's settlement is worth looking at more closely. According to Bloomberg:

Citigroup estimated that securities eligible for the buyback have a face value of $7.3 billion and may be worth about $500 million less on the market than their purchase price. Under accounting rules, Citigroup may have to record a pre-tax loss to reflect the difference. The actual loss "will depend on the market value at that time and the amount of securities purchased,'' the bank said in the statement.

The article goes on to state:

Auction-rate securities are bonds or preferred shares whose interest rates are reset by periodic bidding run by dealers. Firms including Citigroup abandoned their routine role as buyers of last resort for the debt in mid-February as demand dried up, allowing the market to collapse and leaving investors stuck in what had been pitched to them as money-market-like instruments.

Municipal borrowers whose interest costs at failed auctions rose to as high as 20 percent refinanced or made plans to replace at least $97.5 billion, or 59 percent, of their $166 billion in the market, according to data compiled by Bloomberg News. At least $23.6 billion, or 37 percent, of the closed-end funds' preferred shares have been redeemed or tagged for replacement, according to Thomas J. Herzfeld Advisors, and there also have been about $3 billion in student-loan refinancings.

That leaves as much as $207 billion in mostly frozen securities left in the market, of which the $19.5 billion cited in the Citigroup settlement would represent about 9 percent.

"Lots of investors are still stuck,'' said Joseph Fichera, chief executive of Saber Partners, a New York-based financial advisory firm. It's a "light at the end of tunnel, but not a full resolution.''

The way I read this is that investors are getting royally shafted (what else is new?) and that banks will settle and get away with a slap on the wrist.

Last night the FT published an article, SIV fire sales in the spotlight, which shows that banks are dumping 'toxic' debt on their off-balance sheet books. According to the article:

Deloitte and Goldman Sachs are halfway through a series of auctions to establish the value of assets held by four failed structured investment vehicles (SIVs) as part of a restructuring plan for these off-balance sheet funds that were a main pillar of the so-called shadow banking system.

Meanwhile, banks such as Merrill Lynch have bitten the bullet and sold off some of their own holdings of such structured bonds. Also several large collateralised debt obligations that held bits of mortgage backed bonds and of other CDOs have been liquidated.

The extremely low prices seen so far in these sales will be carefully monitored by the banks and investors who still hold large pools of similar assets.

The article goes on to add:

But within this, a group of collateralised debt obligations of asset backed securities (CDOs of ABS), which made up the biggest single bucket, drew the lowest winning bid of between 20 and 30 cents in the dollar, according to people familiar with the results of the sale.

The auction saw heavy discounts for even the strongest prime residential mortgage backed bonds and the monoline-insured asset backed securities.

A bundle of monoline wrapped ABS, which comprised largely residential mortgage backed securities, was sold at slightly more than 40 cents in the dollar, while the non-wrapped prime mortgage bonds achieved a price in the high 40s.

Commercial mortgage backed securities were sold in the low 80s, while real estate CDOs were sold in the high 60s. Another bucket of CDOs and collateralised loan obligations was sold in the low to mid 80s per cent of face value.

In a second such auction, about half the assets of Rhinebridge, a SIV formerly run by IKB, a German bank , were sold and a similar overall price was achieved. Five different buckets of structured bonds raised about 45 cents on the dollar in total. With the addition of cash holdings in the vehicle, senior creditors got back 55 per cent of their investment.

Three more auctions as part of SIV restructurings are expected from September onwards.

However, banks and SIV investors are not the only parties facing such losses under fire sale conditions. Up to $50bn of defaulted CDOs of ABS are expected to be liquidated in the next six months on top of those that have already been or are being sold, analysts at Citigroup estimate.

In one, investors in a $1bn CDO called G Squared were told last month its liquidation would raise much less than $500m.

With liquidity still very restricted in structured credit markets, part of the problem remains the volumes of assets still being released through forced sales. Citigroup analysts estimate that $40bn in CDOs of ABS have been liquidated with another $33bn already in process.

The fact remains that banks are eager to dump this junk off their books (why didn't regulators learn from Enron and prohibit off-balance sheet books in the first place!) and many institutional investors, including pension funds that bought CDOs (and ABCP here in Canada) are going to take more writedowns in 2008 and 2009.

As far as the economy is concerned, it looks like we are heading for a good old fashion consumer recession. Take the time to listen to this Teck Ticker interview with Joshua Rosner, managing director at Graham Fisher & Co. Mr. Rosner believes that slowing consumer spending will first hit retailers, then manufacturing, then warehouse space.

According to Mr. Rosner, in such a scenario, rising unemployment is a lagging indicator, meaning the recent four-year high 5.7% unemployment rate is highly unlikely to be the peak. As unemployment keeps rising, consumer spending will slow further, putting more pressure on corporate balance sheets, leading to more jobs losses.

That, in turn, will lead to defaults on commercial mortgage-backed securities (CMBS) on par with what's occurred in residential MBS. CMBS defaults are rising, indicating that commercial real estate will continue to struggle in 2009. (Pension fund fiduciaries should take note!!!)

The timing remains uncertain but Mr. Rosner says it will come only after "capitulation" by the rating agencies and corporate executives, who he says are still playing "accounting games" and not really owing up to the severity of losses.

It's all pretty depressing news but I am glad that there are realists like Mr. Rosner who are rebuking all those Wall Street cheerleaders telling us to buy financials because they have "bottomed". (Yeah right!)

The U.S. financial system looks like a house of cards that is ready to crumble and it looks like the global financial system will suffer significant collateral damage. In fact, to me it all looks like a massive Global Ponzi Scheme which is unraveling fast and I fear that things will get a lot worse before they get better. Bagholders beware!

Update (08-08-08): This morning ABC News' Good Morning America reported that delinquencies among credit-worthy homeowners have quadrupled over the past year. As housing prices decline, these homeowners have been forced to pay interest and capital on their Alt-A mortgages (as long as housing prices were stable, all they had to pay was interest payments). The subprime mortgage crisis has now spread to the Alt-A mortgage market.

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