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Debt Debacle IDavid and Eric
Coffin's Snippets from the August 2007 HRA Journal From HRA Special Delivery Alert #313 We noted on the front page sidebar in this month's Journal that the major markets have to be considered to be in full correction mode. The activity this week has done nothing to dispel that feeling, bi-polar though the market has been. After rising 4.5% in the first three trading sessions this week the S&P got clobbered today to the tune of 3%, along with everything else that moved. The cause was news overnight by PNB Paribas, one of France's largest banks, that it has frozen three funds that have large exposure to US CDOs (Collateralized Debt Obligations mortgage backed securities). The issue is not that Paribas is short on funds; these three funds are small potatoes for them. The part of the announcement that shocked the market was the refreshingly coherent (if not reassuring) statement that "The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating". In short, the sub-prime/near prime market has gone no bid. The panic was real enough to have banks gobbling up overnight credit, driving up short rates and forcing the ECB, US Fed and Bank of Japan to inject over $160 billion into the overnight loan market to ease the strain. As this note is completed European markets are again down a couple of percent so it's up to Wall St to salvage the week. Rest assured they will try but we're none too sure they will succeed. Tout TV happy talk can only go so far. We'd like to tell you the worst is over but it's likely that its not. There are hundreds of hedge funds that have followed the same script recently. Take in investor cash, leverage up ten to one with other people's money borrowed at prime rates from friends on the Street then invest the money in CDOs that yield a couple of percent more then you pay on the loans. At 10:1 leverage you get a 20% return on equity on what is basic bond arbitrage disguised as financial alchemy. One little problem though. If your unit holders get nervous and start redeeming you have to unwind the trade. Remember that "complete lack of liquidity" quote in the first paragraph? Little problem becomes Big Problem. If you have to repay those Treasuries at par with mortgage securities that are bid at 60, if at all, your 10% equity component just vaporized and your fund is history. Most hedge funds are secretive and have covenants that only allow quarterly redemption requests by unit holders that commonly have to be filed 45 days before quarter end. That would be August 15th. Wall Street will be sure to try and bar the fire exits over the next week and you will be hearing hourly screams for interest rate cuts by the Fed to ease the pain. We expect a lot of hedge funds will go under in the next few weeks and months. We can't summon a lot of sympathy for people who get nine figure paycheques based on, in effect, unimaginative use of other people's money. Our main concern is how widely the contagion spreads and whether the credit markets lock up long enough to stall consumer spending though fear and to cause a really big swoon on Wall St because investment banks find there are no takers for the $200 billion plus in LBO bridge financing they are suddenly saddled with. Lest you think we are just trying to spoil your breakfast we want to end on a brighter note. This too will pass. It might pass like a gallstone accompanied by scores of class action suits, tut tutting by clueless politicians and finger pointing in the media but it will pass. A lot of people in the US bought houses they could not afford and they will go back into the market but the great majority of mortgages will get repaid. When the dust settles, those with nerve and money to spend will make a lot more money buying up good loans at fire sale prices and the world will continue to turn. We still don't expect a near term recession but it will be a closer thing. Many were distressed that gold did not rise in the past couple of days but that was simply the curse of respectability. It's an asset class and people were selling anything saleable, gold included. Gold's day is coming, and probably soon. If as many hedge funds get clipped as we expect the odds of a rate cut in the US rise dramatically. Bernanke is an inflation hawk but he learned the ropes from Easy Al Greenspan. He could surprise us all and cut rates between meetings under enough pressure. That might not stop the bleeding on Wall St but it would definitely sink the dollar and send precious metals for a ride. Things will be rockier for base metals but the stupidities of Wall St will not end the striving of two billion people for a better life. The super cycle is not dead, though there may be some more price swoons ahead. From the August HRA Dispatch Bad debt is trouncing every market within reach of it. The culprit is a very real uncertainty about interest related asset classes that were considered "safe" at the beginning of the month. Some of the debt bundles that get bounced about as commercial paper have high-risk mortgage and related instruments stuck into them. It is unclear how large this aspect of the debt problems is, and that is making lenders very shy about rolling over any portfolios until there is some clarity. That will take a while. It is important to emphasize that so far only a very small part of the debt market, outside of companies and funds specifically designed to deal with high-risk mortgage lending, has reported serious problems with roll over. However, that won't matter while the current mood of panic selling persists. Bargains have already been created by this panic, but there is little reason to be wading in on these for the time being until the hemorrhaging has at least slowed down. The extent to which funds need to create cash will determine how much more selling is to come. That in turn will depend on redemption requests more than paper losses on badly leveraged borrowing. SD readers will recall from last week's alert that we commented that many hedge funds require 45 day redemption notice. Unit holders that want out this quarter had to have requests in yesterday. We don't think it's a coincidence that so much selling across all markets arrived the day after those notices. Many of the funds being affected had equity positions in the resource stocks and were selling anything with a bid. Today was selling to make redemptions, with plenty of risk aversion and margin calls and panic piled on top. Yesterday was a nasty day and market players left after pulling anything but stink bids. Heavy selling started in Europe. "Sell at market" orders from the Continent at or near the open hitting an almost bid-less landscape guaranteed one of the worst market days in many years. We won't bore you with details but there were some amazing day lows this morning on many stocks thanks to these sorts of sell orders. Selling on margin calls and selling by funds fearing and/or getting heavy redemptions are creating the extremely vicious circle playing out in the market right now. That and plain, simple panic that has people blindly selling whatever they can. This is however ignoring that the real economy, measured by global economic growth and employment opportunities still looks pretty good. Central Banks are flooding the system with cash and will continue to do so, so funds will be available. Any who think they are seeing a safe haven should keep this mind. You will see the end of this downdraft in the rear view mirror. Again, as noted in the SD, the odds of a Fed and perhaps even ECB and Bank of Japan rate cuts has increased markedly, though we're still not sure it's a good idea. They will be eying credit markets and carry trades. A quick look at the Aussie and Kiwi dollars shows how rapidly carries are being unwound. We don't suggest joining that blind panic, but that does not mean you should ignore asset preservation either. Right now that means looking to your own debt concerns first. Once some order is restored it will be time to think about bargain hunting, but after a sell off of this size it has to be kept in mind that gains, net of a reactive bounce, will take some time to build. If you are margined that needs to be dealt with. Stocks will little chance of near term news and no resources should go first as they are likely to be the last to pull back up. Trading today actually ended looking very much like a capitulation day, especially for the larger indices. That may be surprising to anyone looking at juniors, but we would point to the volume column as partial justification for the comment in that market. Volume was very, very heavy today and that is usually the hallmark of at least an interim bottom. We won't and can't say yet if it's "the" bottom yet. We do not expect most of the private players in this drama - private equity and hedge funds - to fess up about either holdings or cash positions until they have to as part of quarter end reporting. As we noted a few times recently, we expect to see a number of these funds go under in coming weeks. Whether this results in more full blown panic or traders become so used to it that no longer shocks only time will tell. You will see a lot of commentary from those who feel that recent selling of metals and other commodities infers something meaningful about the longer term direction of the world economy. We don't agree. We certainly don't discount the physiological impact of a market meltdown but until we see "real world" evidence of sharply lower world economic growth we see no reason to change our basic premise on commodities. Remember that commodities were popular with many hedge funds precisely because it's a market that allows huge leverage. While we agree that that leverage is being removed that should not be confused with demand drops in the real world. As evidence of this we note that many minor market metals that do not actually "trade" anywhere, like molybdenum and tungsten, have seen little if any price pullback in the past few sessions. We, like most that look at resource companies, have not been using recent high metal prices to value companies. So there will be room to look for distressed assets on the list. Adjustments to cash flow based companies will be on a one off basis, and obviously dependant on how far their underlying commodities have lost ground. Cash in the bank will also be a good thing. Few companies will want to be calling brokers to do placement in this environment and the brokers are likely to duck those calls when they arrive in any case. If you have been taking gains along the way, it is unlikely you are in panic mode on most of what we have had to say. We don't think you should be. Smart money will be bargain hunting in the weeks to come. David Coffin
& Eric Coffin David Coffin and Eric Coffin are the editors of the HRA Journal, HRA Dispatch and HRA Special Delivery publications focused on metals exploration, development and production stocks. They were among the first to draw attention to the current commodities super cycle and have generated one of the best track records in the business thanks to decades of experience and contacts throughout the industry that help them get the story to their readers first. Please visit their website at www.hraadvisory.com for more information. If you would like to be added to the HRA FREE mailing list to get notifications about articles like this and other free analyses and reports just add yourself to our list here.
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