Thursday, March 19, 2009

Road to Reflation?


Before delving into tonight's topic, a few words about the AIG bonus blunder. The New York Times reports that many in government knew weeks ago about AIG bonuses:
The question was direct and prescient. Representative Joseph Crowley, Democrat of New York, asked the Treasury secretary in an open hearing what could be done to stop American International Group from paying $165 million in bonuses to hundreds of employees in the very unit that had nearly destroyed the company.

Timothy F. Geithner, the Treasury secretary, responded by saying that executive pay in the financial industry had gotten “out of whack” in recent years, and pledged to crack down on exorbitant pay at companies like A.I.G. that were being bailed out with billons of taxpayer dollars.

The exchange took place before the House Ways and Means Committee on March 3 — one week before Mr. Geithner claims he first learned that the failed insurance company was about to pay a round of bonuses that have since caused a political uproar.

A Treasury spokesman, Isaac Baker, said in a statement on Thursday night, “Although Congressman Crowley raised the issue of the bonuses two weeks ago, Secretary Geithner was not aware of the timing or full extent of the contractual retention payments or the other bonus programs until his staff brought them to his attention on March 10.”

Mr. Baker said that after Mr. Geithner had been briefed on the bonuses, he called Edward M. Liddy, the chief executive of A.I.G., and “insisted that they be renegotiated and restructured, in light of the extraordinary assistance being provided by taxpayers.”

Mr. Baker added that Mr. Geithner “takes full responsibility for not being aware of these programs before last week.”

Interviews with senior Federal Reserve and Treasury officials, as well as members of Congress, leave little doubt that the bonus program was a disaster hiding in plain sight. Mr. Geithner is not the only one who appears not to have understood the populist fury the bonuses would set off.

Career staff officials at the Treasury, Fed and Federal Reserve Bank of New York exchanged e-mail messages about the A.I.G. bonus program as early as late February, according to a person familiar with the matter. A.I.G. itself revealed the bonus plan in regulatory filings last September.

In November, when the bailout of A.I.G. was restructured, Treasury and Fed officials negotiated the terms under which A.I.G. could make the retention payments. And in December, Democratic lawmakers sought a hearing about the payments.

A.I.G., which incurred staggering losses through its sale of complex financial instruments tied to mortgage-backed securities, has received more than $170 billion in capital infusions, loans and credit lines from the federal government since last September, and is about to get $30 billion more.

A.I.G. executives have insisted that they informed the New York Fed about the bonus plan, and that they assumed the New York Fed was informing the Treasury.

Treasury officials have suggested that the New York Fed and the Federal Reserve Board in Washington failed to alert the Treasury staff until March 5. And Fed officials said that they not only alerted the Treasury staff weeks earlier, but discussed the issue with them via e-mail.

Despite the interagency discussions in February about A.I.G.’s ill-starred bonus plan, as well as Mr. Geithner’s exchange on the matter in a hearing, Mr. Geithner continued to insist on Thursday that he had not really understood the magnitude of the bonuses until one week ago.

“I was informed by my staff of the full scale of these specific things on Tuesday, March 10,” Mr. Geithner said in an interview with CNN on Thursday. “As soon as I heard about the full scale of these things, we moved very actively to explore every possible avenue — legal avenue — to address this problem.”

As early as December, two Democratic lawmakers had vociferously and repeatedly complained about the bonuses, and one of them went so far as to demand the resignation of A.I.G.’s chief executive.

But both Mr. Geithner, and the chairman of the Federal Reserve, Ben S. Bernanke, were preoccupied at the time with multiple crises. The nation’s banks were reeling from as much as $2 trillion in mortgage-related losses. The recession was deepening and unemployment was soaring.

Mr. Bernanke’s team at the Fed and Mr. Geithner’s team at Treasury, moreover, were reluctant to impose what they viewed as “punitive” and possibly self-defeating pay restrictions on companies being bailed out.

In early February, Mr. Geithner opposed a provision in the economic stimulus bill that would have slapped a steep tax on the kind of bonuses that A.I.G. was about to pay.

If A.I.G.’s plan to pay out an additional $165 million in bonuses came as a surprise to Mr. Geithner, it did not come as a surprise to staff at the Treasury, the Federal Reserve in Washington or the New York Fed.

Staff at all three agencies had been in daily communication with each other about A.I.G. ever since the Fed agreed to lend the company $85 billion in September in exchange for almost 80 percent of the company.

In late November, after A.I.G.’s plight became worse and the Treasury jumped in with a $40 billion capital infusion, the three agencies negotiated cuts in bonuses and salaries for many of the company’s top executives.

Officials at the New York Fed carried out the most direct oversight of A.I.G., and they were well aware of the coming bonus payments, said a person familiar with the matter.
President Obama told talk show host Jay Leno Thursday he was stunned by the millions in AIG bonuses, and he vouched for embattled Treasury Secretary Timothy Geithner, saying he's doing an outstanding job.

The Treasury Seceretary obviously missed the ball on the AIG bonuses and is now slated to testify before the House Financial Services Committee on Tuesday, March 24 and Thursday, March 26.

The Republicans smell blood and a couple of the GOP congressmen are calling for Geithner's resignation. Some are laying the blame for the AIG bonus scandal at the feet of Sen. Christopher Dodd (D-Conn.) for altering his recently-enacted executive pay proposal to exclude AIG, but this misses the mark. Moreover, let's not forget, Republicans backed up then Treasury Secretary Hank Paulson with all his bailout nonsense.

Swept up by a wave of populist economic anger, the US House of Representatives overwhelmingly voted Thursday to slap a 90 percent tax on bonuses for top executives at bailed-out firms like AIG.

I don't know about you, but watching this circus play out in Washington makes me feel like I am witnessing the world's new Banana Republic all over again.

For me it's simple. All these firms that accepted bailouts should not be allowed to dole out bonuses. They would have ceased to exist if it wasn't for U.S. taxpayers so why is the U.S. government rewarding their reckless risk-taking? It's completely ridiculous.

No wonder pressure is mounting on the U.S. dollar. On the one hand you have incompetent politicians in Washington pandering to Wall Street and on the other you got Ben "the helicopter gambler" Bernanke, betting that inflation will remain at bay:
Before he was named chairman of the Federal Reserve Board, Ben Bernanke was one of the foremost scholars of the central bank's response to the Great Depression. It tells us much about his state of high anxiety that the Fed is injecting another $1 trillion into the economy by buying Treasuries and other government securities. Bernanke clearly believes this is not just another recession. And he's mindful that the Fed's biggest mistake in the Depression was to tighten credit, which worsened deflation of the 1930s.

But it's a gamble. The Fed's purchasing power is not made in a tree by elves. It comes from, essentially, printing more money. If the world's biggest danger is deflation, as Bernanke and a number of economists believe, then this action is wise. The trick to price stability is "reflation" not tight-fisted central banks. If conditions are different, however, it bakes serious inflation in the cake. Thus today's market gyrations, which at the moment have the dollar down, gold and oil up and stocks falling. This is less a fear of raging inflation, than a fear of uncertainty itself, to paraphrase FDR.

But the Fed is out of the conventional tools it has used in post-World War II recessions. Interest rates are virtually zero. So now it's a step into a risky undiscovered country. Among the risks is how our overseas creditors react if they believe this will dilute the value of their dollar-based assets, including Treasuries. Then there's the danger that Bernanke is creating yet another Fed-made bubble, with an even worse crash to follow. If it works, however, it may finally get credit moving. Stay tuned.

The Back Story: Moody's says it may downgrade $241 billion in securities backed by so-called jumbo mortgages. This is a pretty big deal because these are considered prime loans, as opposed to the risky subprime mortgages that began the bubble burst. Jumbos, mortgages usually larger than $417,000, go to borrowers with good credit, and they've been widely used in the Seattle area. The credit rating service obviously expects more defaults -- not unreasonable given rising joblessness. And who knows what scary creatures are hiding in those tranches.
I can only imagine what will happen if Moody's does downgrade those jumbo mortgages. More financial pain for everyone, including pension funds that are overexposed to alternative investments.

Speaking of alternative investments, the situation is getting uglier by the day. As hedge fund liquidations hit a record high, some are saying it's time to revisit hedge funds.

The head of investment strategy at Union Bancaire Privee (UBP) was quoted as saying on Thursday that the hedge fund industry could shrink by two thirds from its peak as market losses and a slough of redemptions take their toll:

Christophe Bernard told French language financial daily L'Agefi that hedge fund assets, which data show peaked at more than $2 trillion in early to mid 2008, could fall as low as $700 billion as investors seek out less risky climes amid continuing market turmoil.

Bernard is responsible for investment strategy at UBP, which at end 2007 was the world's second-largest investor in hedge funds with more than $53 billion invested in single funds and funds of funds. Data is not yet available for 2008.

Bernard also said UBP might cut about 10 percent of its staff of about 1,390, in line with the banking industry, through a combination of layoffs and early retirement.

A spokesman from UBP said half of the layoffs would be in Switzerland and half in the rest of the world.

Bernard said UBP would reduce its own hedge fund exposure by two thirds, and would restructure its range of funds of funds by the third quarter of 2009.

Last week, UBP said it would partially reimburse investors with exposure to Bernard Madoff's $65 billion fraud. Many invested either directly through UBP or had exposure via its fund of hedge funds products.

UBP said in the future it would only invest in funds with independent custodians, who hold the fund assets, and administrators, who calculate the value of those assets.

On Wednesday, a leading hedge fund manager said that the shakeout of the hedge funds industry could be over by June 2009, with nearly half of firms likely to shut up shop:

"The hedge fund bubble has popped and, unfortunately when any bubble pops, it's a painful process," said Ken Kinsey-Quick, head of multi-manager of hedge fund firm Thames River Capital.

"If half were to close down, I wouldn't be surprised. But the nice thing about hedge fund land is that things move very very quickly, it will probably be done and dusted by June," he continued

Hedge funds returns were a negative 19 percent last year, when investors pulled out a record $158.9 billion (113.86 billion pounds), according to data from Lipper.

Kinsey-Quick believes that only strong hedge fund models are likely to survive the financial meltdown.

"You will have only very robust models -- only the fittest will survive. But there is going to be some collateral damage. There will be some good players taken out," he said.

And he noted that the hedge fund industry was already adapting to meet the calls for greater scrutiny.

"Transparency has gone through the roof. Liquidity terms are beginning to match the liquidity of underlying assets," he said.

In private equity, firms are trying harder to please powerful investors as dollars for new commitments become harder to come by:

Buyout firms have sent letters to investors highlighting increased communication, adjusted fees or changed management structures as they struggle to keep investors and attract new capital.

Many limited partners -- the pension and endowment funds that invest in private equity -- have found themselves over- allocated to alternative investments simply because the value of their equity portfolios have plummeted. That's created what is known as a "denominator effect."

Some have been trying to get out of commitments by selling stakes in private equity funds in the so-called "secondary" market. They are also more cautious about where they put available cash, making it tough to raise new money.

That means some private equity firms have had to become more proactive about keeping investors informed on how funds are run and how portfolio companies are faring.

Kohlberg Kravis Roberts & Co, one of the world's biggest private equity firms, told investors in a letter recently that it would be communicating more with them in 2009.

The letter, dated February 6, but obtained by Reuters last week, said KKR's success this year would be defined by a number of things, including "communicating more with each of you so you understand what we are seeing, how we are looking at the world and what is happening in our portfolios."

KKR also plans to expand relationships with its LPs to "help you think through the current environment and provide whatever assistance we can."

Other priorities include an "unrelenting focus on all of our private equity portfolio companies" and "developing direct relationships with capital providers to assist our portfolio companies and to facilitate new transactions."

KKR declined comment on the letter, which was addressed to its LPs and was from founding partners Henry Kravis and George Roberts.

"There are some funds where (firms) have already been communicating pretty consistently," said Steven Kaplan, a professor of finance specializing in private equity at the University of Chicago. "Funds that haven't have an incentive to do so."

He added that fund-raising is now "very, very tough."

Separately, British private equity house Terra Firma Capital Partners Ltd said on Tuesday that founder Guy Hands would relinquish day-to-day control to concentrate on investments and building relations with investors.

There have also been some moves to relieve fees.

Sources told Reuters in February that Boston-based Bain Capital was proposing temporarily waiving management fees for investors in its private equity funds.

Carlyle Group co-founder David Rubenstein said in February that LPs would hold the "balance of power" for the next few years and their concerns on issues such as fees and the size of funds would have to be heard much more.

According to a recent report by London based research firm Preqin, 21 percent of investors have already exceeded their optimum level of exposure to private equity -- of which the greater proportion are in North America.

And although 79 percent have not exceeded their target, many find themselves closer to targets than anticipated and have had to "alter their immediate plans for investment in private equity," the report added.

But the problems in private equity are structural. The Financial Times reports that private equity faces refinancing headache after an era of easy money:

Debt markets have been showing signs of life in recent weeks with even poorly rated companies issuing some small chunks of debt. It will have to show a lot more life soon though: about $800bn to $1,000bn of debt needs to be refinanced over the next few years for all the low rated companies that borrowed when money was easily available.

The debt was raised to pay for leveraged buy-outs in the boom years of the private equity industry.

The debt of some of the biggest buy-outs such as TXU, the Texas utility, is trading at discounted levels, partly on fears about the ability to refinance all that debt.

So the game seems to be to refinance sooner rather than later, and get a headstart on the problem.

HCA, the hospital company which three private equity firms bought in 2006, illustrates the problem. HCA raised $310m in the high yield market in February.It has also secured the right from creditors to replace some of its bank loans with bonds that have much longer maturities.

HCA has years to repay its $27bn in debt and the bulk of it does not fall due before 2013.

Nevertheless, bankers are already trying to advise clients about what they can do to handle the debt before it comes due, given how dramatically capacity in the debt market has dwindled.

John Eydenberg, head of financial sponsors for Deutsche Bank, says: “Plan A is to do what HCA is doing and take the bank debt out and replace that with bonds.

“Firms like KKR are chipping away at the debt of their portfolio companies. Everyone should be doing that.”

In addition to trying to refinance a portion of its debt, HCA could, they say, try to list itself and use the proceeds partly to pay down debt and reduce its leverage. But stock market sentiment remains fragile.

HCA could also sell assets. But in these markets, there are not many buyers.

Other private equity firms are asking (or forcing) creditors to exchange debt in a trade-off between greater security and giving up a claim on part of the debt.

The maths is so daunting that bankers refer to a “maturity cliff” that few firms will be able to surmount. “But these are just bites at a problem which could amount to $1,000bn,” says a managing director in charge of the portfolio of debt backing buy-outs for one leading bank.

In past cycles, private equity firms used the bond market, where debt can be up to 10 years in duration, to finance their buy-outs. During the recent buy-out cycle however, they took advantage of generous terms and supply in the loan market, even though loans have to be repaid sooner.

But now most buyers of these loans have gone away, as have the buyers of complicated securities known as collateralised loan obligations. Hedge funds that could once borrow a lot of money to buy the loans, now can not borrow to make such investments worthwhile.

Stephen Kaplan, a founding principal and head of private equity at Oaktree Capital, warns that unless private equity firms are prepared to put a lot more money into the companies they bought in a vastly different world “there will be the greatest transfer of ownership from equity owners to creditors in history”.

Hedge fund and private equity woes are also impacting commercial real estate, especially in London and Manhattan where deflation rolls on as apartment sales see a huge drop.

U.S. commercial real estate prices tumbled in January, Moody's said on Thursday, suggesting problems that began in housing have spread well beyond that sector;

Commercial property values fell 5.5 percent, the biggest drop in since the ratings agency began compiling this index in 2000.

"Prices have nominally returned to the levels they were in the spring of 2005," Moody's said, adding that transaction volumes were at their lowest levels since October 2003.

GE's real estate arm said Thursday its debt-default rate on loans in its portfolio could rise to 10% under adverse economic conditions:

Speaking to investors in New York, executives said a stress test on its portfolio based on a Federal baseline assumption for the economy implied the default rate could be 8%, rising as high as 10% if U.S. GDP and unemployment turn more negative. That would result in a potential 2009 segment loss of $900 million, or $1 billion, respectively. For the fourth quarter, GE Real Estate said its debt-default rate was just 1.2%, compared with a 5.4% rate seen at commercial banks, due to unit's avoidance of construction and development loans, second mortgages, malls, and resorts, and having just 3% of its portfolio in subprime lending.

The U.S. commercial real estate market is bad and investors expect it to get a whole lot worse, according to a closely followed survey by PricewaterhouseCoopers:

Real estate investors do not expect the commercial real estate sector to rebound until well into 2010 at the earliest, according to the survey.

"Investors are not expecting this recovery, when it does happen, to be a sharp recovery where it hits bottom and bounces up," said Susan Smith, a director at PricewaterhouseCoopers in the real estate group and the survey's editor.

"It's going to be a very slow sluggish recovery," she said. "There are just too many things right now that are impacting the industry to make investors very confident about what's going on," she said.

Some property owners are lowering rental rates and increasing concessions, which results in lower revenue. Compared to a year ago, the average amount of free rent
landlords are offering has increased to six month in several major office markets, such as Boston, where it rose from 2.15 months; Manhattan, where it grew from four-and-half months and San Francisco, where increased from three-and-half months, the survey said.

One investor in the survey suggested "making the best deal you can today because tomorrow's deal will be worse."

Investors believe that the overall cap rates, or returns, for U.S. commercial real estate over the next six months will rise by an average 0.47 percentage points from 7.49 percent in the first quarter 2009, the survey said. When cap rates rise, prices fall.

In the retail real estate arena of malls and shopping centers, investors expect power centers, home of the big box stores, to lose value by the greatest amount, with cap rates rising by an average of 0.744 percentage points from 7.63 percent, according to the survey. They see cap rates for regional malls rising 0.65 percentage points.

Investors expect rent and occupancy for retail properties to continue to decline in 2009, the survey said. Last year, store closings rose 50.1 percent to 6,913 and forecasts call for more than 8,000 store closings in 2009, according to the survey.

Most investors said they expect the eroding fundamentals to press values down by 10 percent to 26 percent from the 2007 peak, with the most pessimistic investors seeing declines of about 40 percent, the survey said.

Investors expect that values of regional malls will fall an average of 3.25 percent and as much as 15 percent over the next 12 months. The decline will depend upon the location and quality of the mall.

Now, let me ask you, if you are the Fed Chairman and you are seeing signs of deflation everywhere - soaring unemployment, a mortgage mess, pension funds imploding, etc. - wouldn't you try to reflate your way out of this mess?

The market seems to be betting that reflation will persist. Chris Puplava wrote an excellent analysis, Commodities - Signaling Reflation or Stabilization?

But the jury is still out on quantitative easing and its effects on pension funds. Today's stock market was clearly not a sign of confidence.

If successful, the road to reflation will be long and arduous. I remain skeptical, fearing the age of deflation, knowing that you can't reflate deflated balloons.

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