Pyramids Crumbling
John Mauldin's Outside the Box

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This week look at a short but very important piece by Bill Gross. He has my same concern about credit default swaps, but he puts a number to it. He thinks the cost to the world economic system could be in the $250 billion dollar range. Add that to the $250 billion in losses due to the subprime markets, and you are starting to talk real money. The Shadow Banking System is at the center of the problem. I trust you will find this of interest.

Bill Gross was just named Fixed Income Manager of the Year by Morningstar. He sits on the largest pile of bonds in the world at PIMCO and is their Managing Director.

But before we get to Gross's piece, let's look at these few paragraphs which set the scene for the problem in the CDS market from good friend Michael Lewitt of HCM:

"This brings us to the second and, in our view, greater concern raised by Mr. Seides, which is the financial strength (or weakness) of counterparties and their ability to post additional collateral when their positions move against them. This is undoubtedly going to be a growing concern as mortgage and other credit losses swell in 2008. The dirty little secret in the leveraged finance market is that many participants, including many CDS counterparties, are "weak hands." A "weak hand" is an investor whose capital base is subject to erosion due to losses or investor redemptions, such as a hedge fund. "Weak hands" are usually significant employers of leverage as well.

"It is a widely acknowledged fact that many of the participants in the CDS market are hedge funds whose capital is subject to the whims of performance-chasing investors. As the disappointing performance of some previous top performing hedge funds demonstrated last year, investment banks and other financial institutions that are counting on these counterparties to fulfill their part of the bargain in CDS contracts could be left holding the bag if the current credit environment continues to deteriorate, as many of us expect.

"A case in point was the collapse of Dublin-based Structured Credit Company (SCC) in December 2007, which is seeing its 12 trading partners lose about 95 percent of what they are owed, according to the Financial Times. SCC was just a couple of years old and was one of a new brand of Credit Derivative Product Companies (observation: these companies should use a "skull and crossbones" as their corporate logo). It had no credit rating (although HCM would not have been surprised to see it obtain one since the rating agencies were handing out ratings left and right during this period) and $200 million of capital on top of which it wrote $5 billion of credit default swaps. We will save our readers from doing the math ? that is 25-to-1 leverage (significantly less than many Structured Investment Vehicles, just to place this insanity in some kind of context). Low and behold, when the credit markets collapsed last summer and SCC was required to post additional collateral on its trades, there was ? to quote Gertrude Stein ? "no there there."

"Court documents show that collateral demands rose from $55 million to $438 million, but SCC ran out of funds after managing to post $175 million, and the game was up. Was such an outcome unforeseeable? Only for someone completely ignorant of the last 500 years of economic history, HCM supposes. SCC boasted, of course, that "we have stress-tested our capital to the ?nth' degree and believe that the platform we have is the most flexible and comprehensive you could have." Right. HCM would respectfully suggest that the only ones more misinformed than SCC itself were those who were lured into taking the other side of their trades and are now nursing $250 million of losses (and frankly it's shocking that the losses aren't much larger). Of course, these firms included some of the largest financial institutions in the world, so once again HCM finds itself scratching its head in amazement at the madness of crowds."

25 to 1 leverage and stress testing do not belong in the same sentence or marketing pitch. This type of ending for various funds is going to become all too common.

John Mauldin, Editor
Outside the Box

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Pyramids Crumbling

Investment Outlook
Bill Gross | January 2008

My college experience dates so far back that it can only be labeled "ancient history." Still, there are a few seminal lessons I learned at Duke University?unfortunately none of them having much to do with the classroom. "Ticket Scalping 101" and "Beginning Blackjack" probably head the list, but not far behind would be "Introduction to Pyramid Schemes." While the first two courses may be rather unique to my own experience, the latter I assume is standard fare, and has been since the first diploma was awarded at Harvard, Yale or whichever college claims to have been the "firstest" with the "mostest." A second semester senior who never signed up for a dorm-born chain letter cannot really claim to have received a college education at all. The chain's lesson was that you should be the originator of the letter, not the 500th recipient. You wanted your name at the apex of this upside down pyramid not at the broadened top, which signaled the exhaustion of additional fish, tuna or whatever derogatory noun one could employ to signify the university's last few suckers.

Wall Street and its global lookalikes, of course, are life's largest colleges where lessons can be mighty expensive and downright bankrupting. The last two decades alone have witnessed pyramid schemes involving savings and loans/junk bonds, the small investor/dot.coms, and now global bonds/subprimes. I could go on and you have your own candidates to be sure, but in each and every case the originator of a surefire "can't miss" concept collected huge premiums from a willing investment public, only to see the pyramid collapse either of its own merits or from the lack of additional gullible investors. There will be more to come, much like a regular university that welcomes a never-ending stream of new "students" who pay annual "tuition" to be "educated."

In addition to the pyramid shape of its securitized assets and the endless chain of its letters, finance and especially modern finance is centered around banking and now, unfortunately, around shadow banking. Both, The Economist magazine points out in its September 22nd issue, are built on a fundamental (and ever present) mismatch: they borrow short and lend longer and riskier. Recognizing this flaw, governments have for over a century mandated that banks have an ample percentage of reserves in order to bridge the liquidity and investment risks that periodically ensue. Like Jimmy Stewart in It's a Wonderful Life, the critical job of a traditional banker was to have enough reserves or cash on hand to prevent a run. Stewart's modern day counterpart must follow similar guidelines, although a 21st century banker now can always look skyward for a guardian angel in the form of the Fed, the ECB, or the Bank of England. Recent infusions of over a half a trillion dollars by this triumvirate point to the perennial need for reserve banking in either an earthly or a more heavenly sense.

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But today's banking system as pointed out in recent Investment Outlooks, has morphed into something entirely different and inherently more risky. Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever. Financial derivatives of all descriptions are involved but credit default swaps (CDS) are perhaps the most egregious offenders. While margin does flow periodically to balance both party's accounts, the conduits that hold CDS contracts are in effect non-regulated banks, much like their hedge fund brethren, with no requirements to hold reserves against a significant "black swan" run that might break them. Jimmy Stewart?they hardly knew ye! According to the Bank for International Settlements (BIS), CDS totaling $43 trillion were outstanding at year end 2007, more than half the size of the entire asset base of the global banking system. Total derivatives amount to over $500 trillion, many of them finding their way onto the balance sheets of SIVs, CDOs and other conduits of their ilk comprising the Frankensteinian levered body of shadow banks.

Defenders might claim no harm, no foul. Theoretically, many of these trillions represent side bets between risk seeking or risk avoiding parties?both adults at a table where the calming benefits of diversification work for the systemic good of all. Originators and existing supporters of these securitized WMDs might also point out that their reserves come in the form of equity and subordinated tranches comprising 10 or 20% of the repackaged loans. They do. But as this equity/subordination shrinks due to underlying defaults, the pyramid begins to unravel. Rating servicer downgrades can and do lead to the immediate liquidation of certain CDOs. The inability to rollover asset-backed commercial paper does and has led to the liquidation of SIVs or, pray tell, a misguided attempt to restructure them as super SIVs. CDOs and even levered municipal bond conduits known as "Tender Option Bonds" have been and will be similarly vulnerable to "Jimmy Stewart-like" runs as the monoline insurers that theoretically stand behind them are themselves downgraded to less than Aaa status.

The withdrawal of deposits from our new age shadow banking system has frightening potential consequences because a thinly capitalized banking system is always at risk relative to its more conservative counterpart. Visualize, as does Chart 1, in crude yet understandable form, today's shadow system versus that of two decades ago.

While the exact amount of reserves supporting the Bank of Shadows is undeterminable, let's go back to the $45 trillion BIS estimate of outstanding CDS for more insight. If total investment grade and junk bond defaults approach historical norms of 1¼% in 2008 (Moody's and S&P forecast something close) then $500 billion of these default contracts will be triggered resulting in losses of $250 billion or more to the "protection selling" party once recoveries are inserted into the equation. To put that number in perspective, many street estimates ascribe similar losses to subprime mortgages, a derivative category substantially distinct from CDS insurance. Of course, "buyers of protection" will be on the other "winning" side, but the point is that as capital gains and capital losses slosh from one side of the shadow system's boat to the other, casualties and shipwrecks are the inevitable consequence. Goldman Sachs wins? Fine, but the losers in many cases will not be back for a return match. Much like casinos depend upon a constant stream of willing gamblers believing that this is their day, so too does Wall Street. But a trillion dollars of SIVs with their asset-backed commercial paper may be a dinosaur relic of yesterday's shadow system. They will likely not be back. And the New Century mortgage originators? The Bear Stearns hedge funds? The chastened Freddie Macs and Fannie Maes, and all of the banks and investment banks requiring fresh capital through the sale of stock? They'll be back but not in risk taking, fighting form. Throw in an embarrassed regulatory network consisting of the Fed and Congressional watchdogs asleep at their post, but are now more than willing to display their prowess, and you have a recipe for credit contraction, a run on the shadow banking system that would give Mr. Stewart shivers aplenty. The unfairly "Ben Stein pilloried" Jan Hatzius of Goldman Sachs estimates that mortgage related losses of $200-400 billion alone might lead to a pullback of $2 trillion of aggregate lending. Even if this occurs gradually, he writes, "The drag on economic activity could be substantial." Add to that my $250 billion loss estimate from CDS, as well as prospective losses in commercial real estate and credit cards in 2008 and you have a recipe for a contraction in credit leading to a recession.

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Pyramid schemes and chain letters collapse because there is no more credit to feed them. As the system of modern day levered shadow finance slows to a crawl, or even contracts at the edges, its ability to systemically fertilize economic growth must be called into question. And as the private shadow banks of the 21st century are found wanting, so then must public finance in the form of lower interest rates and increasing fiscal deficits fill the breach. The Fed will likely reduce Fed funds to 3% by midyear 2008. Congress and the Administration should, but likely won't, join hands in a tax relief program that benefits low income homeowners. Market based, regulation-lite American style capitalism, seemingly so ascendant after the madness nearly a decade ago, has met its match with the subprimes and the poorly structured and supervised derivative conduits of today's markets. Financial innovation will inevitably march forward, if not in distinctly new forms, then into new asset markets and even unexplored continents. For now, however, its current surge is spent. Investment survivors will have to learn to live in a different world, filled with new risks, lower leverage, and at some point, hopefully greater rewards.

Your very concerned abut the Credit Default Swap market analyst,

John F. Mauldin


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.


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Posted 01-14-2008 4:11 PM by John Mauldin
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