Wednesday, November 19, 2008

Leverage Rocket Switches to Reverse Thrust


Stocks got clobbered today as the Dow fell below 8,000 and the S&P fell to a five-year low:

Wall Street hit levels not seen since 2003 on Wednesday, with the Dow Jones industrial average plunging below the 8,000 mark amid a dour economic outlook from the Federal Reserve and worries over the fate of Detroit's three automakers.

A cascade of selling occurred in the final minutes of the session as investors yanked money out of the market. For many, the real fear is that the recession might be even more protracted if Capitol Hill is unable to bail out the troubled auto industry.

Investors also scoured economic data that included minutes from the last meeting of the Federal Reserve in which policymakers lowered projections for economic activity this year and next. Economic worries caused across-the-board selling, with financial stocks particularly hard hit.

Citigroup (C) lost almost $2 today, down 23%, as the credit-default swap spreads on its debt widened after the bank took on more than $17 billion in assets from structured investment vehicles and shut another hedge fund.

Moreover, the automaker bailout hit a big pothole on Capitol Hill today:

The executives are back on the Hill today, but support for the "let 'em eat cake" or, at least, file for bankruptcy option seems to be growing; if airlines can operate under Chapter 11, why can't automakers? Or so the thinking goes.

Simultaneously, the scare tactics being used by automakers about the implications of a failure — "the societal costs would be catastrophic," said GM's Rick Wagoner — seem to falling on deaf and skeptical ears.

In addition to a view the Big Three are in a mess largely of their own making, it seems Congress (and the American people) learned the lesson of falling prey to fear tactics after Paulson and Bernanke used them during the original debate over the $700 billion TARP.

It sure didn't help that the Big Three auto CEOs flew into Washington using private jets to ask for taxpayer money:

Some lawmakers lashed out at the CEOs of the Big Three auto companies Wednesday for flying private jets to Washington to request taxpayer bailout money.

"There is a delicious irony in seeing private luxury jets flying into Washington, D.C., and people coming off of them with tin cups in their hand, saying that they're going to be trimming down and streamlining their businesses," Rep. Gary Ackerman, D-New York, told the chief executive officers of Ford, Chrysler and General Motors at a hearing of the House Financial Services Committee.

"It's almost like seeing a guy show up at the soup kitchen in high hat and tuxedo. It kind of makes you a little bit suspicious."

GM has other problems brewing like the crisis in their Canadian pension fund.

Lawmakers are right to be suspicious and angry. The optics of flying around in private jets to drum up support from taxpayers is simply arrogant, highlighting their lack of judgment and lack of consideration for the plight of the employees that work for them.

This reminds me of the president of a large public pension fund who flew back with his vice-president of real estate on the private jet belonging to the real estate fund manager they invested with.

The vice-president of real estate subsequently joined that fund after a couple of years of collecting big bonuses based on a bogus benchmark and after investing billions into this real estate fund while working at large public pension funds.

Worse still, the pension fund which he left had no clauses prohibiting their senior pension officers from joining funds they invested with for a period of three or more years. Talk about lousy optics and lack of judgment!

But it didn't seem to faze the board of directors (as if they knew) who claim to be vigilantly monitoring employees' conducts (too bad they are not monitoring their senior pension officers more closely).

Anyways, back on the main topic. Back in July, I wrote about dealing with the delevaging doldrums, arguing that the deleveraging process had barely started and that pension funds should revisit their asset mix to deal with a protracted economic slowdown.

Well, the deleveraging process continues and while painful, I wholeheartedly agree with Michael Heise, chief economist at Allianz SE/Dresdner Bank, it must continue because there is no better alternative:

The credit crisis has reached a culminating point. Financial Armageddon has been averted, but the industry is not yet off the hook.

Although the reduction of risky assets has gathered momentum since the fall of Lehman Brothers, hammering stocks hard, the deleveraging process still has a long and rocky road ahead.

The fallout from failed banks, like Lehman Brothers or the Icelandic banks, will continue to show up in banks' upcoming quarterly results. Emerging-market bonds and currencies have plummeted amid foreign capital flight.

There is significant counterparty risk on the credit-derivatives markets, causing more writedowns. Corporate and consumer loan defaults are set to rise in the months to come. Last but not least, hedge funds face severe liquidity constraints and substantial investor withdrawals. The resulting "derisking" of hedge funds is dragging global stock markets down; hundreds of funds are likely to close.

So where is the ray of light? For one, there is public money on the sidelines and governments will not let further big bank failures happen. Central banks are cutting rates and flooding markets with liquidity. Yet while these measures are helpful, they cannot substitute for the necessary consolidation of banks' balance sheets.

There is no alternative. The persistence of an overleveraged financial sector would pose a much bigger threat to the real economy than the deleveraging process itself.

Deleveraging does not necessarily mean reducing loans to the private sector. It is first and foremost a financial affair.

The decade prior to the meltdown saw an explosion of activity between financial institutions. Financial assets, such as mortgage loans, were used and reused many times over to create new trading and hedging opportunities. Much as a small amount of sugar can be spun up into a huge cone of candy floss, investment engineers created a new financial cosmos with only thin real underpinnings.

As a result, balance sheets mushroomed, more or less unconstrained by capital requirements. The total assets of U.S. investment banks saw compound growth of roughly 15% per year between 1997 and 2007; U.S. issuers of asset-backed securities grew by 17.5% annually.

That is the story of leveraging. It provides striking evidence for the decoupling of at least some parts of the financial sector from the real economy. The financial industry, propelled by ever higher leverage, entered its own orbit of stellar profits and bonuses.

Now that banking and capital markets have come crashing down to earth, the leverage rocket has switched to reverse thrust.

As too many of the new financial instruments morphed literally overnight from low-risk securities into toxic assets, bloated balance sheets required considerably more capital. The shrinkage of the balance sheet will concentrate on financial assets within the financial sector, such as repos, hedge-fund loans, leveraged loans, credit derivatives, CDOs and the like.

With the refocusing of the U.S. Troubled Asset Relief Program away from buying toxic assets, the challenge for banks has changed.

The easy part will be to call short-term loans, passing the burden to business partners such as hedge funds. Banks will also sharply reduce their own trading activities, eliminating repo demand.

For other more complicated and toxic assets, some banks will probably follow the lead of UBS and others, shifting them onto special-purpose vehicles and thereby ring-fencing their own balance sheets. Others will choose the route of further writedowns. Either way, more capital is needed. No wonder that banks are now queuing up for government funds.

The whole process would of course be simpler if private investors could be tempted to enter the field. However, given the bleak outlook for the world economy and the mounting domestic problems for many sovereign wealth funds, one of the biggest investor groups, the arsenal of public measures is indispensable to restore the health of the financial sector in an orderly process.

In a sense, this process will result in the focus of business shifting away from ever more sophisticated ways of shunting risk around the financial cosmos, and toward the more traditional banking practice of acquiring, holding and monitoring risks.

In other words, it will engender a kind of reconnection of financial markets with the real economy. After years of tremendous growth, the ratio of financial assets to GDP will decline; levels of above 400% no longer look compatible with markedly lower financial-sector leverage.

If the adjustment proceeds quickly, the flow of credit from the financial sector to the real economy will not be impeded for long. With recapitalization still under way, growth in corporate and household lending is possible -- if the demand is there.

However, apart from this deleveraging process within the financial sector, there remains another question: Are not sectors of the real economy sorely in need of some balance-sheet repair?

That is the story of unwinding imbalances in the real economy -- which have existed for much longer than the financial excesses in quite a number of countries. The process of rebalancing the world economy does indeed look long overdue, with a starring role for the U.S. household sector.

For that reason, it is of overwhelming importance to make a clear distinction between the deleveraging process within the financial sector and debt consolidation in the real economy.

In countries that have experienced a credit boom, such as the U.S., the U.K., Spain and many eastern European countries, both adjustments are necessary -- and painful.

Public assistance is required, but using recapitalization funds or monetary policy to duck inevitable adjustments in the real economy is dangerous. The longer the reduction of debt is postponed the more brutal the final reckoning.

Trying to grow out of the problems -- or, put differently, growing into the high debt levels -- would mean repeating the "Japanese problem." Japan resumed its growth only after it tackled its bad loan crisis head-on.

A swift correction of balance sheets may have painful effects for financial markets, but it is the surest way to restore confidence quickly and avoid a "lost decade" with a lingering credit crunch.

Please print this article, save it and read it again in a couple of years. Why? Because it is the most honest assessment of what needs to happen over the next few years.

This is why the financial sector will experience a huge contraction and why the days of limos and stratospheric bonuses on Wall Street are over.

The deleveraging process has been painful for all investors, including Warren Buffett, top multi-strategy hedge funds like Citadel Investment Group, and large pension funds like CalPERS who are now backing away from alternative investments:

The California Public Employees' Retirement System (CalPERS), the nation's largest pension fund, said it recently sold 26 percent of its private equity fund interests. A calculation from Prequin, a group that compiles information about alternative assets, shows that the selloff includes interests in 74 funds, leaving CalPERS' total portfolio standing at 288 funds overall. The net asset value of funds sold is $1.9 billion, or 9 percent of its overall portfolio.

Prequin said in its report on CalPERS, which now has $21.5 billion in its private equity portfolio: "This indicates that CalPERS is seeking to streamline its portfolio and focus on a smaller number of larger fund commitments."

Prequin said that the majority of fund interests sold ranked in the third and bottom quartiles of private equity benchmarks, although the sale did include some top performing funds.

Included mainly were venture funds from 2000 and 2001, it said, noting that the activity "indicates a shift away from venture funds." Altogether, 54 percent of the funds sold were venture funds, with 27 percent being buyouts, and 19 percent from other fund types.

The biggest fund interest sold was a $500 million commitment to Global Innovation Partners — a top quartile fund which is showing a 31.6 percent internal rate of return. The median IRR for funds sold is minus-0.5 percent.

The best performing fund interest sold was in Doughty Hanson Fund II, a buyout fund of vintage 1995 with a net IRR of 46.3 percent. The worst performing fund interest sold was in American River Ventures I, a 2001 vintage fund with net IRR of minus-27.7 percent.

"In selling part of its private equity portfolio" back in the first quarter, "it is likely that CalPERS gained a better price for its fund investments than it would have achieved in the current market where private equity funds are trading at a significant discount to net asset value," said Etienne Paresys, head of performance for Prequin.

"This secondary sale was aimed to focus CalPERS relationships on the best performing managers, and it is therefore not surprising that CalPERS is abandoning most of its venture funds of vintage 2000/2001, with funds of this era being severely hit by the technology crash."

"As with many other investors, it is likely that CalPERS has liquidity issues and it will be interesting to see if it will need to re-enter the secondary market in the near future."

CalPERS should have taken its cue from CalSTRS and streamlined their private equity portfolio a long time ago, focusing on larger commitments with top quartile buyout funds.

Now, they are paying a dear price for wanting to be the pension industry's "sugar daddy".

All these big pension funds who blindly threw money around to private equity funds, real estate funds, hedge funds and commodity funds are going to get creamed as the deleveraging process continues. They are going to end up selling their fund stakes on the secondary market for a lot less than what they are worth.

As deleveraging reinforces the downward liquidity spiral, the denominator effect picks up speed:

Private-equity fund managers are salivating at some of the opportunities out there in the market, but they've been stuck on the sidelines for lack of loans. Now, there are signs that they may also find that they don't have access to the capital from pension funds that they've enjoyed for years.

Private-equity capital raising looks to be in for the same kind of reckoning that the loan market is facing because investors putting their existing interests in funds up for sale at cut-rate prices, making it even more difficult for private-equity firms to raise new money.

In the loan market, there are so many existing loans floating around for sale at big discounts to par value that there's almost no demand from investors for new loans. That's leaving many would-be borrowers high and dry.

The private equity market is now facing a similar situation. Many big pension funds are selling their interests in private equity funds to bring their allocations to the asset class down to target levels after they were pushed all out of whack by the fall in other asset types such as stocks.

The phenomenon is known as the denominator effect because of the mathematical formula that dictates that the size of an investor's target for private equity funds must fall when the overall size of the portfolio declines.

One way to get it back in line is to add to beaten down investments in equities. The other way is to sell down the private equity class, and that's what's happening.

California's public sector pension manager sold 29 per cent of its fund interests earlier this year, consultancy Prequin reported today after combing through CalPERS' disclosure, and many in the industry expect similar moves from other big money managers.

The prices aren't pretty. Fortune magazine reports that the bids are often on the order of 50 cents on the dollar, though CalPERS probably got a better deal since most of its sales were months ago.

This leaves Canada's pension funds in two camps. The pressure to sell at cut-rate prices will be most acute on those that are facing imminent withdrawals and drawdowns, while those money managers such as the Canada Pension Plan that have contributions pouring in will have the option of picking up some of the private-equity fund stakes on the cheap.

The Caisse de Depot et Placement du Quebec has already stated that it plans to reduce its focus on private equity by putting less into new investments in the industry. But given the fall in stock markets in the two weeks since that announcement, that may not be enough.

The clear outcome is that for private-equity firms such as Onex Corp., which is trying to convince investors to write the final checks for its latest buyout fund, the task of raising money gets all the harder.

Harder? That is an understatement. In this environment, raising funds is next to impossible.

But I would caution pension fund managers to stop and rethink their strategy going forward. For example, look at what John Paulson is doing nowadays:

John Paulson, the hedge-fund manager who generated sixfold returns last year with the help of bets against subprime mortgages, has started buying debt backed by home loans, investors said.

Bonds linked to U.S. residential mortgages fell last week after U.S. Treasury Secretary Henry Paulson abandoned plans to buy distressed securities using money from the $700 billion Trouble Asset Relief Program.

The ABX-HE-PENAAA 07-2 index of credit-default swaps tied to AAA-rated securities has fallen 13 percent to 36.25 since the Treasury’s announcement on Nov. 12, according to Markit Group Ltd. That indicates the bonds might fetch about 36 cents on the dollar.

John Paulson, whose New York-based Paulson & Co. oversees $36 billion in assets, said at a conference in June that he sees “opportunities this year” to buy mortgage-backed debt. While he said it was “premature” to start buying, the ABX indexes have since fallen 35 percent.

“Paulson’s timing is typically very good,” said Louis Gargour, chief investment officer of LNG Capital LLP, a London- based hedge fund that invests in distressed credit markets. “Pulling the TARP program was the last straw for this market. Now that Paulson is buying others may say this is a great trade.”

Gargour said he isn’t buying residential securities for “technical” reasons, including the prospect for legislative changes to home-foreclosure rules in the U.S.

The deleveraging process has been brutal and it's not over yet. However, if pension funds align themselves with "John Paulsons" of the world, they will eventually make money after massive financial consolidation takes place and buyers come back to the private markets.

As for individual investors, I would caution you to stay away from financials during this long cycle of virulent deleveraging and focus your attention on long-term secular themes like alternative energy, biotechnology, infrastructure and deflation.

As banks tighten up credit, hedge funds continue to deleverage, leading to incredible opportunities to pick up stocks on the cheap. And I mean extremely cheap - ridiculously, below book value cheap (for example, check out the slaughter in solar stocks and why HSBC still favors this sector).

Deleveraging doldrums will persist in the foreseeable future, but if you play your cards right, focusing on the secular themes I mentioned above, you will come out of this difficult period in better shape.

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