The Specter of Deflation

I am in a very good mood today as my sister in Crete delivered a beautiful young boy today. This is my third nephew in two months and the third Thomas Kolivakis in the family. Now, let me get into today's topics because there is lots to cover.

The stock market suffered one of its worst days since the financial meltdown Monday, slicing 680 points off the Dow Jones industrial average as Wall Street snapped out of its daydream of a rally and once again faced the harsh reality of a recession:

Not only did stocks end their five-day winning streak, they erased more than half the gains. The Standard & Poor's 500 stock index, one of the broadest market gauges, lost nearly 9 percent.

Erasing any lingering doubts, there was also finally an officially declared recession -- in progress in the United States since December 2007, according to the National Bureau of Economic Research, the nonprofit group of economists that classifies business cycles.

"This is just another episode in a long story and the story is all about recession and the question is how long and how deep," said Chuck Widger, chief executive and chairman of investment management firm Brinker Capital. "We're going to have continuing volatility until investors have better visibility."

"All the data is being filtered to answer the two questions of how deep and how long the recession will be," he added.

The selling was broad and deep. All 30 of the stocks in the Dow Jones industrial average finished lower. On the New York Stock Exchange, more than 7 stocks fell for every one that rose.

The Dow lost 679.95 points to close at about 8,149. There have only been three days in market history with bigger point losses for the Dow -- the Monday after the Sept. 11 attacks, and Sept. 29 and Oct. 15 of this year.

Bond prices jumped as investors sought the safety of government debt. The yield on the three-month Treasury bill, considered one of the safest investments, slipped to a very slim 0.03 percent. That indicates investors are willing to accept tiny returns just to park their cash somewhere safe.

Investors were also nervous after weekend sales figures indicated that many Americans will cut back their trips to the mall this holiday season. Monday brought additional bad news: Manufacturing had dropped to its worst levels in 26 years and that construction spending fell by a larger-than-expected amount in October.

Although Monday's plunge was notable because it cut short a five-day rally -- the first such winning streak for the Dow and the S&P 500 since July 2007 -- it also fit what has become a pattern on Wall Street: The market makes big moves higher, including triple-digit gains in the Dow, only to quickly give them back as another batch of bad news arrives.

"We've got a tug-of-war of war going on," said Al Goldman, chief market strategist at Wachovia Securities in St. Louis. "On one side there's the prospect of several more months of bad economic news and on the other side there's lots of stimulus already on the table."

As far as the stock market is concerned, I see a trading game where the lows will be retested several times. Nonetheless, after the market consolidates last week's gains, we will get another lift heading into the end of the year.

The problem is that the global economy is heading down the tubes fast. Across the world, we see economic contractions in China, Russia, and Germany, leading some hedge fund managers to bet on deflation:

“If you have a deflationary shock, the only instrument that will perform will be government debt,” said Hendry, 39, whose Eclectica Fund returned 38 percent this year, putting it in the top 1 percent of 1,817 funds tracked by Bloomberg.

“Inflation is going to be back some day. But forget the next 12 years; it’s the next 12 months that matter.”
As we watch Treasury yields dropping to record lows as the Fed cites buybacks, there are real fears that deflation is on the horizon, leading some to conclude that the demand for Treasuries has reached the "bubble” phase:

Demand for Treasuries has reached the "bubble” phase seen among technology stocks in 2000 and real estate six years later, according to David Rosenberg, chief North American economist at Merrill Lynch & Co.

“The 10-year note yield is now firmly below the 3 percent threshold and this next leg down in yield will undoubtedly represent the classic mania-turn-to-bubble phase that quite plausibly sees an overshoot to or even through the April 1954 lows of 2.3 percent,” New York-based Rosenberg said in a research note today.

Even though Treasuries have entered “overvalued territory,” yields may fall further and remain near record lows as the Federal Reserve, households and institutional investors increase purchases as the economy worsens, Rosenberg wrote.

Fed Chairman Ben S. Bernanke said today during a speech in Austin, Texas, that he has “obviously limited” room to lower interest rates further and may use less conventional policies, such as buying Treasury securities to revive economic growth.

Fed policy makers may say after their Dec. 15 and 16 meeting that they’ll hold short-term interest rates at low levels for an extended period and begin working more closely with fiscal authorities, financing an expanded budget deficit through the purchase of Treasury, Rosenberg said. The U.S. economy entered a recession a year ago this month, the National Bureau of Economic Research said today. Rosenberg, who released his report before Bernanke’s speech, wasn’t immediately available to elaborate.

The 30-year bond yield fell as much as 26 basis points to 3.182 percent today, according to BGCantor Market Data. That’s the lowest level since at least 1977, when the government began regular sales of the securities. The 10-year note yield touched 2.645 percent, the lowest since 1955 as measured on a monthly basis, while the two-year note yield reached 0.846 percent.

Treasuries of all maturities returned 5.4 percent in November, the best returns since November 1981, when the 10-year note yield was 14.57 percent and U.S. government securities gained 7.8 percent, according to Merrill Lynch bond indexes.

“Investors should operate under the assumption that the Fed is going to embark on a new course of balance sheet expansion to mitigate the downside risks to the macro outlook and fight the looming deflation battle,” Rosenberg wrote. “This is bullish for long bonds.”

But looming deflation is already wreaking havoc on all asset classes, including alternative investments like hedge funds, private equity and commercial real estate.

Tudor Investment Corp. is the latest large hedge fund to report problems. The firm run by Paul Tudor Jones, temporarily suspended client redemptions from the $10 billion BVI Global Fund Ltd. as it plans to split the hedge fund into two.

Many other hedge funds are going into distress for a variety of reasons, most commonly where liquidity issues have resulted in an inability to meet redemptions. On top of halting redemptions using gates, many hedge funds are now creating side pockets as a solution to manage their fund's illiquid investments.

In private equity, bankers say the downturn will hit half of buyouts. Things are getting so bad that some funds are now resorting to underwiting their own debt:

Dunedin, a mid-market UK private equity firm, has funded the debt for three of its past five acquisitions – totalling £60m – to remove the risk of nervous banks scuppering plans at the last minute. John Hudson, investment director at Dunedin, said that given the ongoing financial crisis: "I think it's a trend that is going to increase."

Dunedin refinanced two of the three deals by bringing in banks shortly after the buyouts were complete. On the other, Mr Hudson said the firm had chosen to keep hold of the debt.

The growing trend is a marked departure from the traditional private equity model of using leverage to multiply returns.

However, Mr Hudson conceded that providing both equity and debt was a higher risk strategy – making it difficult to deliver the returns demanded of investors unless the debt can be syndicated after the deal is done.

"You have to be very confident about the company you are buying and the debt assumptions need to be deliverable in the banking market," he said. "We see it as a competitive advantage in a competitive bid process to demonstrate certainty. By taking the bank out of the equation, it is one less party for the vendor to worry about."

Dunedin's recent £28.5bn acquisition of Hawksford International from Rathbone Brothers used the "integrated finance" model, with the £13.5bn of debt later refinanced with the Royal Bank of Scotland. "We've been told we won the bid because of the confidence that we would be able to complete the transaction," Mr Hudson said.

Since the financial crisis struck, banks have been reluctant to provide credit – forcing the private equity industry to innovate to survive. In addition to underwriting their own debt on a deal, some private equity companies have started buying up distressed corporate debt at firesale prices.

And while some question whether commercial real estate is the next shoe to fall, others worry that an accelerated downturn in commercial real estate next year may spark a wave of borrowers pushing for easier terms on loans that are otherwise heading into default:

Commercial property loans originated in 2005 to 2007 that increasingly carried risky terms are likely to see a significant increase in defaults in 2009 due to lack of credit, falling property values and reduced cash flow, said Alan Todd, head of commercial mortgage bond research at JPMorgan, in published research.

He said the slowing economy that is wreaking havoc on cash flow expectations may also present mortgage companies with a dilemma as borrowers confront them with the choice of either easing loan terms to preserve value, or default. The number of loans transferred to companies that specialize in troubled mortgages has already risen significantly and will climb into 2010, Todd said.

"Moral hazard may become an issue as borrowers begin to claim 'dire straits' with the hope of having their loan terms modified by the special servicer," he said.

General Growth Properties Inc GGP.N, the No. 2 U.S. shopping mall owner, said on Sunday it received a two-week extension on the maturity of $900 million in Las Vegas loans as it tries to negotiate a longer-term plan. Results of the negotiations are closely watched in the $750 billion commercial mortgage-backed securities market, which has been battered on expectations a recession could boost bondholder losses.

The imminent default of two of the largest loans in CMBS less than a year old, including one for the Promenade Shops at Dos Lagos in a foreclosure-ridden area of California, this month helped propel bond risk premiums to record levels.

Todd said he was most concerned about retail properties since a recession and a "severely weakened consumer" with limited access to credit will continue to curb retail sales. Investors sold shares of retailers on Monday on expectations an initial holiday-season spending surge would not last.

Delinquencies on loans in CMBS remain low relative to residential mortgage debt, but are rising at fast rates. In retail, delinquencies increased to 0.4 percent in October from a low of 0.08 percent in July 2007, more than twice the rise in the multifamily sector and 151 percent of the jump for office properties, he said.

The most important factor for CMBS value in 2009 will be the availability of credit, which will prevent many loans with aggressive terms such as high loan-to-value ratios from being refinanced, Todd said.

"Many of these loans will become a nightmare as a severely slowing economy, significantly tighter credit requirements and falling commercial real estate property prices force many borrowers to default over the coming years, or to infuse equity at the refinance date," he said.

Commercial property prices may fall as much as 40 percent from peak-to-trough, Todd said. Prices are down 11.5 percent from October 2007, he said, citing Moody's Investors Service.

Given the outlook, special servicers may adopt an "extend everything" policy since liquidating assets in a distressed and illiquid market may cause deeper losses, Todd said.

"It has become increasingly obvious that commercial real estate credit problems will finally materialize and intensify in 2009," he said.

Increasingly obvious to many but pension funds continue to shove billions into real estate thinking they are getting in at a bottom.

It is important to remember that there is an eight to twelve month lag between commercial real estate and residential real estate. Given the prolonged weakness in the latter, there is no reason to believe that commercial real estate will not suffer a similar fate.

The Wall Street journal reported today on 'alpha' bets turning sour at the Pennsylvania state employees' pension fund:

The stock-market downturn could force the Pennsylvania state employees' pension fund to make cash payments of $2.5 billion or more to trading partners on Wall Street.

The potential hit to the $27 billion pension fund is the result of an exotic strategy used to help finance $9.2 billion in hedge-fund investments. Those bets helped the pension fund beat the market when stocks were rising, but backfired when the market sank.

Use of the aggressive strategy, called "portable alpha," has been cut in half, with officials of the Pennsylvania State Employees Retirement System acknowledging that the pension fund's exposure was "too ... (subcription required)

'Portable alpha' made sense as long as hedge funds added true alpha. In theory it worked like this: pension funds would swap into equities and bonds, allowing them to use the cash proceeds to invest with hedge funds.

Since beta is cheap (typically Libor + a few basis points is the cost of financing), the better pension funds would make sure to swap into a bond or equity index and then use the cash to allocate into hedge funds that offered Libor + 500 to 700 basis points. As long as hedge funds were delivering true alpha, then pension funds would be able to add 50 to 70 basis points a year to the overall returns (assuming 10% allocation to hedge funds).

But if hedge funds are losing money, then you end up paying fo the cost of financing the swap and losing money on management fees. This is where portable alpha runs into problems.

To sum up, the specter of deflation will haunt all asset classes, especially alternative asset classes where serious liquidity issues arise.

Pension funds are simply not ready to confront the challenges of deflation and this is why the pension crisis will get worse in 2009 and possibly well beyond that.