February 24, 2009

The Story of the Junkie and the Pusher

How did we get into this mess? Well to begin with it started with housing. In America it has been thought of for quite a long time that the American dream (security and prosperity) was synonymous with owning a home (mortgages and repair bills). I’m getting ahead of myself, but the truth be told there was never a time when owning a home had anything to do with security at least until the months after the FOMC stopped lowering rates in 2003. At that time there was a shift in sentiment that caused things to happen. The FOMC, while on hold, was sending discreet snippets of information to the press that a rise in interest rates was close at hand. The 2yr note yield jumped a full 30 basis points (one Fed ease and a little insurance) and treasuries in general were being sold in favor of owning the credit spreads found in corporate bonds and municipals. And forget what was happening in stocks. The broad indexes got a lift, beginning in June 2003 that drove investors into a frenzy that held nearly all the period leading up to late 2006 when, while in the midst of making new highs, there were little cracks forming in the otherwise solid scenario.

Some people began to think it was the rapid start up of Hedge Funds anxious to take advantage of anomalies in the currency markets. Specifically the “Yen carry trade” that allowed the borrowing of low yield yen, the conversion to expensive dollars and the subsequent leveraged purchase of long bonds in favor of an equally eye watering hedge with two year notes. When you consider that historically the hedge would require six two year notes for every long bond, or roughly $180/$1475 basis points per million dollars invested in bonds. Get where I’m going here? There were billons put into this trade and forget the piggy backing that was going on, the net result was a steady rise in the two year note yields and a steady decline in the thirty year bond yields. Alan Greenspan called it a conundrum.

NOW flash forward to 2006, the trade was able to merrily skip along with the benefit of what the industry called positive carry. Low borrowing costs and high leveraged income grabbed the attention of the traders, the money managers, and the press. Who it didn’t captivate was the mob representing the growing interest in asset management that all the investment and commercial banks were taking on. But rather then face the hard sell of a leveraged product outright, the “street” embarked on a different tact that included the ramping up of mortgaged product on the back of the public rush to “buy and refi”. No one noticed that familiar characteristic like common WAC (weighted average coupon) and common collateral (mortgages that look alike) were being blended with mixed collateral, for example ALT A and Sub Prime. What they created was a cover that glossed over the low interest rate environment and lifted the characteristic carrots enough to grab the interest of institutional buyers, and boy did they buy by the truck load.

NOW as the street was printing money (making the spread) on mortgages, there were innovative folks who saw comparable potential in structuring all kinds of interest and principal baring contracts. Planes, Trains & Automobiles were bundled into Asset Backed Securities (ABS) and leveraged just enough to earn a triple “AAA” rating, an intoxicating attraction for institutional investors.

NOW there came along some innovative fellows with the lofty academic credentials to prove it, who couldn’t rationalize unrestrained risk parading as something else, they devised a form of insurance (CDS and CDO) to indemnify (insurance term) the holders. In fact they were so smug in their belief that they’d found the “perfect hedge” they dubbed it…..A Fixed Income Alternative” Wow!!!

NOW not to get lost in the pack race for stardom a new structure was devised, destined for a bad rap even though they were the best of the bunch, creating baskets (previously called bundles) of a product called “Structured”. Every known asset class that developed an index to provide the bedrock of legitimacy that became a candidate for the “Structured Product Movement”. It was a step right up and give your customer an alternative moment that was going to give no return on principal or multiple return on principal depending on the outcome of the underlying investment (usually overvalued equities).

NOW…every body owns everything, every company is a provider and to make matters worse (remember you can’t change the system you can’t even make it worse” )the world took their cue from America and joined in the dance.

AND THEN IT ENDED too many sellers, too few buyers, too many junkies and too many pushers. The economy started to sink; our coffers started to shrink and for the first time in a long time Americans have begun to think.

I Had a wonderful exchange with a friend today, his name is Monohar Daga, and he said to me that he’d listened to the comments from an economist at Nomura who simply stated that in the ten years Japan was stagnant it was not so because it was in recession. On the contrary, it had one quarter the nineties when GDP was negative and Unemployment never went above 5.5%. Stagnation was caused by a rebalancing of the balance sheets, public and private, too heavy to stand under their own weight, and only in need of time to repair.


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