Thoughts From The Frontline : Ben Bernanke

I Meant to Do That

John Mauldin — Sat, 20 Dec 2008 02:28:02 GMT

I Meant to Do That
The Lights of Myanmar
Some Good News for Borrowers
Madoff May Give Us a Sell-Off
Conversations with John Mauldin
New Orleans, La Jolla, and Merry Christmas

The Fed has taken interest rates to zero. They have clearly started a program of quantitative easing. What exactly does that mean? Are we all now Japanese? Is the Fed pushing on a string, as Japan has done for almost two decades? The quick answer is no, but the quick answer doesn't tell us much. We may not be in for a two-decades-long Japanese malaise, but we will experience a whole new set of circumstances. In what will hopefully be a shorter holiday version of the e-letter, I will tackle these questions and more.

The Lights of Myanmar

Most of us are familiar with the devastating hurricane that hit Myanmar (Burma) this last year, and the difficulty in getting aid to those who were suffering. My friends and colleagues at Knightsbridge were able to get in and help where others couldn't.

Knightsbridge International is a small group of volunteers who go to places that are definitely not safe but where the need for help is critical. Like the knights of old, who ran hospitals and relief efforts, these modern-day knights go to where the need is greatest. They took food and medicine to northern Afghanistan before the troops went in (very dangerous!). They went to rebel-held territory in Sri Lanka after the tsunami, when no one else could get medicine and other aid in. Whether it's driving in to rescue nuns in Rwanda (fascinating story!) or taking solar power to clinics in Myanmar, or water purification units and medicine to Darfur, they go where other groups fear to tread. They have no political or religious agendas, just the drive to get aid to where it can do the most good.

Last year an award-wining documentary was made about three of the Knightsbridge men, Ed Artis, Dr. Jim Laws, and Walt Ratterman. It was shown on PBS and viewed all over the world. These men are the real deal, heroes who like to do good deeds but get an adrenaline rush at the same time. Some of the things they do I cannot write about, as it would put them and others in serious danger. They are a little bit crazy, but then you'd have to be to accomplish everything they do.

Last year you generously supported missions to both Darfur and Myanmar, where a team led by Walt Ratterman (a leading expert on solar power) put into place solar power systems that help power clinics. Walt once showed me a photo of a doctor in Myanmar who had to do an amputation on a child (as a result of a land mine) in the dark, holding a flashlight in his teeth. You can bet that doctor was very happy about getting solar power.

For the past few years your generosity has helped provide solar power for health clinics for refugees in Thailand, as well as in villages in Myanmar. Walt wrote me about the project he recently finished:

"The project we just completed provided solar power for a medical and training facility in the Karen State that is operated by the Free Burma Rangers (www.freeburmarangers.org) The project started with a 4-day journey on foot to get into the area. Equipment for the solar systems had to be carried in by over 100 people prior to our arrival. After we all got in place, and completed the training for the solar installers, we installed twelve 2-panel solar systems. These systems provided electricity for the central communications center, the medical training center, the human rights training center, and other miscellaneous buildings. Once the work was done, we had to take the same 4-day hike back out of the area."

This is not an easy hike. It is through very dense, mountainous jungles, over rivers, and through deep valleys. The Free Burma Rangers have trained over 110 multi-ethnic relief teams, and there are 43 full-time teams active in the Karen, Karenni, Shan, Arakan, and Lahu areas of Burma. Seven more teams have been formed recently in the Chin area on the Indian Border. The teams have conducted over 350 humanitarian missions of one to two months into the war zones of Burma. On average, between 1,000 and 2,000 patients are treated per mission. You can see more about this last project at www.sunepi.org/SunEPI/Burma_files/PP_FBR.pdf

Partially due to your generosity, there are literally thousands of people (many of them young children) who are alive today. This year Walt wants to complete another clinic on the Thai border and then one on the India border with Myanmar. It will take approximately $75,000 to do both.

We are grateful for any donations to this year's project. Donations can be made at the website, www.sunepi.org or by directly going to our Funding Burma page, www.sunepi.org/SunEPI/Funding_Burma.html. Checks can be made out to SunEnergy Power International and sent to 11 Laurel Lane South, Washougal, WA 98671.

As I said, these guys are the real deal. They are helping people who the world has mostly forgotten yet who work hard day in and day out to keep their families alive. I know we are in a recession, but when you compare what is happening here to the devastation in Myanmar, our plight does not seem so bad. Please give generously.

By the way, Walt is in Palestine right now, installing more solar power for clinics. I can't mention where some of the other teams are, but a little extra prayer wouldn't hurt. (Did I mention that none of these guys take any money, and pay their own way? And if you too are a little crazy and are in decent shape and you want to join in some of the projects, drop them a line.)

I Meant to Do That

In my house, when someone stumbles or does something odd, they quickly say, "I meant to do that." It's a running joke, and we all have fun with it. This week the Fed did something rather interesting. Quoting from the release after their two-day meeting:

"The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent."

Normally they have a specific rate and not a range. But for the last few weeks the market has pushed the Fed's fund rate close to zero, making the Fed look like they were behind the curve at the then-official rate of 1%.

Now the Fed, with a range rather than a specific rate, will be able to say, "I meant to do that." They can keep the Fed funds rate from rising over 0.25%. And if it stays near zero? Well, now they can say it is within the target.

And with Fed funds at an effective zero, it is having the effect of bringing down other rates as well. I wrote in 1998, and have repeatedly made the point over the past five years, that deflation will be the primary force that must be dealt with, rather than inflation, before we are done with the current credit cycle. Over the last year, when CPI (Consumer Price Index) inflation was high and rising, I kept insisting that the problem would be deflation in 2009. (That brought more than a few letters telling me I was wrong.) Because of my view about deflation, I have long held that, ultimately, interest rates on the US 30-year bond would fall below 3%. That was rather bold in 1998, or even last year.

Now, that prediction seems rather tame. We went right through 3% this week, and as I write we are at an astounding 2.54% on the 30-year and 2.1% on the 10-year!

Note that the 3-month is at zero. Indeed, to get even 1% you have to go all the way out to a 3-year maturity. This is going to make it very hard on money market funds to offer any type of yield. Indeed, several large firms have closed their Treasury money market funds, as it costs more to operate the fund than the interest paid on the bills, notes, and bonds.

And this is precisely what the Fed wants to see. Investors are going to have to start looking to other avenues to get yield. If you can't get a return on your money market, why not put it in a bank certificate of deposit? You can get a federally insured CD for one year at over 3% at many institutions, and 4% if you want to tie your money up for three years. Making the competition - money market funds – less profitable is one way to recapitalize banks.

The Federal Reserve, as noted last week, has significantly increased the monetary base, but the money supply has not risen in concert. I failed to explain why last week. It is because banks have not taken those reserves and lent them out. Until that happens, the Fed is not really "printing money," they are just making it available. At some point, let's hope the banks decide to use it.

This week's FOMC statement was rather remarkable, in that it was very clear. Normally, and especially under Greenspan, you had to take each sentence apart to try and divine the meaning of the release and what that meant for the future. And the statements are typically short. Not this one. Let's look at three paragraphs from it (emphasis mine).

"Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.

"Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."

The Fed expects inflation to fall well into next year. They have noted their concern. They have also said they will hold the Fed funds rate at these low levels for a long period of time. This is to encourage longer-term lending at low rates.

How serious are they? Richard Fisher is the President of the Federal Reserve Bank in Dallas (just down the road from my new office). Over the past few years, he has been the most outspoken "hawk" on inflation of all the Fed governors and presidents. He spoke yesterday at the Dallas chapter of the World Affairs Council. Let me quote a paragraph:

"Price pressures now are in the other direction...[and] we have to do everything we can to lift the economy up and prevent deflation from taking [hold].... We are well aware that at some point, God willing, we'll have to tighten and we'll have to act; and I'm here to tell you that my voice will be very loud at that juncture, but right now that's not the issue."

That is a rather remarkable statement for Fisher. I don't ever recall him talking about preventing deflation. The FOMC meeting this week (where he is currently a voting member) must have been a real eye-opener for him.

The Fed has already committed to buying mortgages and consumer loan securities. In Ben Bernanke's famous "helicopter speech" in November of 2002, he stated that one of the ways the Fed could fight deflation would be to "move out the yield curve" and set target rates for longer-dated securities, like 2- or 3-year US notes. In the FOMC release, the Fed noted that they might indeed use that tool. That is one of the reasons interest rates are falling, as the market must sense that the Fed is prepared to do just that. This meeting simply put the market "on notice" that at some future meeting it is quite possible for them to set a target rate on longer-dated securities.

Some Good News for Borrowers

Remember that ARMs (Adjustable Rate Mortgage) reset problem I was writing about late last year? This includes all the alphabet of ARM mortgages, interest-rate-only mortgages, pay-option ARMs, etc. Resetting the rates has been a problem up until now, as the rates which are the usual base for the resetting have been high, forcing mortgagees to pay a much higher monthly mortgage when the rates reset. However, given the current environment, that may no longer be a problem in the near future.

The large majority of ARMs are linked to either 1-year LIBOR or 1-year Treasuries. We saw above that 1-year Treasuries are 0.39%, and 1-year LIBOR is 2.09. Both were at 4.5% in 2006. Those getting ready to reset in the near future are actually going to catch a break and see their payments go lower!

Fellow analyst Mish Shedlock writes that he has an interest-only mortgage tied to 1-month LIBOR, and his annual rate is going to drop to 1.75%.

You can bet that between the Fed and the incoming administration they are going to pull out all the stops to get 30-year fixed-rate mortgages to drop along with the 10-year US bond, with which mortgages normally move in tandem. The spread is now as wide as I can remember, at well over 3%. Not all that long ago it was 1%. It is quite possible that we will see mortgage rates below 5% and approaching 4% in the next year, at least for conforming mortgages. Since I have two kids that have bought homes this year, I hope they will be able to get refinancing at lower rates with whatever new program the administration introduces.

Madoff May Give Us a Sell-Off

Much of the selling pressure that has come in the stock and credit markets has been rightly attributed to forced selling by hedge funds in an effort to meet redemptions for January 1. I wrote a few weeks ago that this could be the kicker for a powerful rally in the first quarter. Most of those redemptions will show up in the last two weeks of January, with the rest by the middle of February. Institutions, which are the bulk of redemptions, are going to have to put that money to work. Do you put it into bonds at 2%? That is not going to get you to the target returns that you need for the future if you are a pension or insurance company.

Much of that money is going to go back into either the stock market or into other hedge funds. This could be the fuel for a real rally. However, that was before Madoff. I have no hard evidence, but I know a lot of funds of funds had exposure to Madoff. Those funds are likely to see further redemption requests and face the need to further liquidate underlying hedge fund positions. Also, a lot of people who did have investments with Madoff are now going to need to get their liquidity somewhere else.

This all has the potential to put more selling pressure into the market. Enough to overcome the tsunami of money that is coming back into the market? I don't know, but I think it could put a damper on the rally I was predicting. The actual redemptions for most funds of funds will be next April 1, as only a few offer monthly liquidity, but the selling will have to be in the months before. This will need to be closely watched in March.

Conversations with John Mauldin

Yesterday, some of you got a special email from me talking about a new subscription service that we will be offering beginning next month, called "Conversations with John Mauldin." One of my "secrets" is that I have a very powerful rolodex (or, for the younger crowd, my contacts list). Each month, I will call up one of my special contacts in the investment and economic world and hold a conversation with them about the important topics of the day - how we should be investing, what opportunities and pitfalls are out there in the world, etc. Some will be names you recognize, and others you should. You will get to listen in, download to your computer, or read a transcript, whichever you prefer.

Right now, we are offering a subscription for $99, half off the regular $199 price. This is only available for the Holiday season. You can click here and subscribe, if you haven't already. Insert code JM44 for this special offer.

And for those of you who experienced errors signing up, please email eu@2000wave.com and we will let you know whether your subscription and credit card went through.

If you like my regular e-letter (and it will still come to you each week), then you are really going to like this new service. This letter will not change at all. This new service is to let you look over my shoulder as I talk things over with colleagues who are in the know. I hope you join in and get to hear the January conversation, where we will discuss the forecast for 2009. You won't want to miss it.

New Orleans, La Jolla, and Merry Christmas

It is time to hit the send button, as I am off to New Orleans, where I'll spend the next four days with Tiffani, working on our new book, Eavesdropping on Millionaires. I really am looking forward to getting out of the office and focusing on the project. It's a lot of fun to interview millionaires and get their stories. There are just so many ways to achieve wealth, and so many interesting paths and personal insights that we have come across.

Tiffani and I will be in La Jolla in mid-January to have our annual planning meeting with my partners at Altegris Investments. I always look forward to meeting with Jon Sundt and his team, and feel they do an excellent job for our mutual clients. After that, I have a few trips planned in the US, but no trips lined up yet outside the country. That means I will have to get my travel "kicks" by reading International Living. It is an inexpensive way to learn about traveling and living outside your home country. For me, it is cheap fantasy about that beach home in Paradise. You can get your own subscription at http://web-purchases.com/ILV2008/WILVJC04/

The move into the new offices has been rather hectic, to say the least. Getting used to a new phone system, trying to unpack boxes, traveling to Phoenix (where it was rainy and cold), getting Trey ready for a new school, and more than the usual number of distractions has all made life more interesting. But then I have so many blessings that complaining about the small hassles seems out of line this season.

I am not sure if I will write another letter between now and January 9, when I will do my annual forecast issue. Let me take the time to wish you, gentle reader, a heartfelt Merry Christmas and the best ever New Year. While the economy may be a tad bumpy, the important things like family, friends, and health are where our real wealth is. Enjoy this season and all that it means.

Your still having to pack analyst,

John Mauldin

Leverage Is an 8 Letter Word

John Mauldin — Sat, 22 Nov 2008 04:52:29 GMT

Leverage Is an 8 Letter Word
If Loans Are So Cheap, Why Don't They Sell?
Deflation and Helicopters: Time for a Review
Commercial Property Loans Start to Haunt the Banks
Warren Makes a Bet
Thanksgiving, Moving, and New Orleans

Leverage is an eight-letter word, which the markets now regard as twice as bad as the two four-letter words debt and pain (or fill in your own four-letter words). This week I try to give some insight into what is happening in the credit markets, some of it below the radar screen of most analysts. We will look at the potential for deflation and the Fed's response. There is a lot to cover, so let's jump right in.

If Loans Are So Cheap, Why Don't They Sell?

I talked with a friend who runs a collateralized loan obligation fund, or CLO. There are a lot of these funds in the Shadow Banking System. Typically they buy certain types of debt, with a lot of it in the bank loan space. In the "old" days of the last few years, banks would make loans to corporations and then sell them to CLOs and other institutions, making a spread on the loan and a profit on the servicing business. Some funds would typically leverage up somewhat and make a decent return.

Today, many highly rated loans are selling for 80 cents on the dollar. There is nothing wrong with the collateral or the corporation which owes the money; there is just no one with ready cash to buy the loans. I asked my friend why he doesn't buy them, since they offer very good returns.

The problem is that his fund, and most other CLOs, have covenants in their offering documents that prevent them from buying debt at less than 85 cents on the dollar. That covenant is a good thing in normal markets, as it prevents possible mischief by the manager, but right now it means that a lot of opportunity is being missed. The only way he can buy these highly undervalued bank loans is to create a new fund, which he is in the process of doing. But getting the money is tough, as the pension funds and endowments who would normally be the investors are waiting for cash to come from their redemptions in other funds, which are of course selling whatever they can to raise money for the redemptions, including these very same bank loans. Can you say vicious circle?

The good news is that the market is (albeit slowly) responding to low prices and a market for undervalued assets. But the bad news is that it could be months before there will be meaningful recovery in asset prices. In the meantime, these and many other assets are being marked down and impairing the balance sheet of a lot of banks, funds, and institutions.

As an aside, the prices for loans made for leverage buyouts in the last few years have fallen significantly. Anybody want to buy some loans made on the Chrysler sale to private equity fund Cerberus? I think not. Just because a loan is cheap does not mean it is necessarily a reasonable value.

Commercial Property Loans Start to Haunt the Banks

As I have written for a very long time, there are two aspects to the current recession and financial crisis. The first is the fallout from the subprime crisis, which has morphed into a full-blown credit crisis. That coupled with a housing crisis has sent the nation into what looks like it will be the worst recession since 1974.

The second phase to hit banks and lending institutions is the normal recession problem of increased losses on all sorts of loans. Credit cards, home equity loans, residential mortgages, and especially commercial property mortgages all suffer during a recession. As documented a few letters ago, default rates are soaring on all types of consumer loans. That is what you would expect to happen in a recession. The problem is that many of the larger banks have already had their capital depleted dealing with the credit crisis. Now they are going to have to raise even more capital (or reduce lending) to deal with the normal loan problems that come with a recession.

Let's look at a few charts from www.markit.com which show the stress in commercial property lending. A number of very large firms come together to create a market index for commercial mortgage-backed securities, or CMBS (which is listed at market.com). They put 25 different commercial property trusts, created by JPMorgan, Merrill, UBS (the usual suspects), and so on into the index. Traders can then trade on the market value of the underlying combined assets by trading the index. In principle, this is just like trading a stock index that gives you exposure to all the stocks included in the index.

If you have bought commercial mortgages and want to hedge your portfolio, you can do so with this index, or if you want to sell protection (insurance) you can also do so. The price is determined by the spread between the coupon and (I believe) the 10-year US Treasury bond. From trading at a spread of 100 basis points in May and 200 basis points (bps) in July, the spread on AAA-rated commercial mortgages skyrocketed in the last few weeks to 850 before settling back to 667, or more than six times what it was just a few months ago.

According to the Wall Street Journal, at the peak a few days ago this meant that the AAA part of this index was trading at $.70 on the dollar. That suggests there will be losses of 70% on the lower tranches!

Every six months the 12 investment banks that help create the index build a new index comprised of recently created trusts composed of hundreds of individual mortgages. As with most asset-backed paper, these trusts are divided into different tranches, with the highest-rated tranche getting the lowest return but first call on the return of principle and interest. Lower-rated tranches take successively more risk.

There are seven different indexes on the Markit platform, from AAA to lowly BB. Each index is composed of the corresponding tranche in the 25 trusts within the index. Let's look at what the lowest-rated tranche has done.

The lowest tranche is now trading at 4,750 basis points or, if you add in the Treasury price, at over 50%! If you were an institution or fund and wanted to buy protection on a BB-rated CMBS in your portfolio, you would have to be willing to pay 50% annual interest!

On the web site, they note that they have not created a new series that was planned for October 25^th of this year, as there have not been enough new commercial mortgages created to actually build an index. Why? Because any commercial mortgages that the banks now make will have to be kept on the books of those banks, since the price to securitize the loans is prohibitive. Is it any wonder there has been a serious reduction in large commercial property loans?

On a rather sad note, look at the logos of the banks involved in creating this index, from the marketing brochure that Markit uses to inform potential buyers and sellers of the CMBS index:

Fourteen banks were involved as of a few months ago, but now? Bear, Lehman, Wachovia, and Merrill have either passed from this world or have been swallowed up. It makes you wonder who is next. (Side bet: the Treasury or Fed will inject some capital into Citibank this weekend.)

We could do the same analysis on high-yield bonds. Interest on high-yield bonds is now approaching 20%. Credit default swaps on many issues are simply out of sight. That means that if a lower-rated company wanted to issue bonds, they would have to pay 20% or more! There are very few projects that can justify 20% in a low-inflation world. And without access to capital, it will be difficult for businesses to grow. It also means they have to cut costs and jobs. As noted above, even highly rated corporate bonds are selling at steep discounts. Deleveraging is going to be a problem for a few years. We need to get used to it.

Deflation and Helicopters: Time for a Review

I wrote six years ago (November 2002) about Ben Bernanke's speech on deflation, where he tried to make a joke about beating back deflation by dropping money from helicopters. He was immediately tagged as "Helicopter Ben." My thoughts on that speech took up about half of one chapter in Bull's Eye Investing, and I still think it is a very important speech.

I have been saying for a long time that we would be dealing with deflation next year, and that has been met with a lot of reader skepticism. And when inflation hit 5.6% last July, that skepticism was understandable. But this would be a strange world indeed if you had the twin bubbles of housing and credit burst and didn't see a whiff of deflation. Recessions and the bursting of bubbles are by definition deflationary.

And I have been giving thought to the idea that we may have seen a mini-bubble in the price of many commodities, and that bubble has been bursting as well. And since commodity prices were the main cause of inflation, as they retreat the rise in the inflation rate is retreating. This week the latest inflation numbers showed a drop to 3.7% on a year-over-year basis.

But the Consumer Price Index (CPI) fell by a full 1% in October. You have to go back to the 1930s to find a one-month drop as large. And I don't think this is just a one-month anomaly caused by falling energy prices. The housing component, which is 32% of the index, is based on Owners' Equivalent Rents (OER). As I have written elsewhere, over very long periods of time this works as well as actual housing prices. You simply have to pick your basis for comparison and stick with it.

If, for instance, we had been using house prices for the last ten years, we would have seen large increases in inflation up until a year ago, and since then the index would have been in outright (and serious) deflation. But we use OER, so prices in the CPI have been more stable. But that looks like it could be changing.

OER has been rising steadily over the last decade as rents went up. The index showed a 3% rise in 2007, for instance. The recent trend has been down from there, and last month there was no rise in the cost of shelter. Given the number of houses for sale and a weakened economy, I think it is likely we will see outright reductions in the cost of rent, which will translate into a much lower inflation number.

Lower prices are a two-way street. When they result from improved productivity and efficiency, that is considered to be a good thing. But when they are the result of lower demand, that can be problematic.

There is the likelihood that the Fed will lower rates to 50 basis points, and some major and very seasoned economists are now predicting a zero percent Fed funds rate early next year. Given that Fed funds are actually trading at 38 basis points, a drop to 50 basis points would change nothing on a practical level. (Can we say Japan?)

With that in mind, let's revisit Bernanke's speech. Every central banker is mindful of Japan and the 1930s in the US. Deflation is something that will not be allowed. But what if the Fed lowers interest rates to zero and demand does not pick up, along with a little inflation? Quoting Ben:

"To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system -- for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation."

Just a thought here. We could see real drops in the CPI next year. We could also see a US government deficit approach $1 trillion and go right on through that heretofore unthinkable number. As I wrote last week, a reduced trade deficit means that there will be fewer dollars abroad to buy our debt. The difference will have to be made up by either increased savings in the US or higher rates to attract buyers OR the Fed monetizing the debt.

I think the Fed would be highly reluctant to monetize debt in a period of inflation like we have been in, no matter what problems we face. But in a period where we could be facing deflation? It is very possible they would consider monetizing the debt, as will central banks all over the world.

We are in unprecedented times. A (1) deep recession coupled with (2) financial institutions deleveraging, added to (3) a consumer who is going to be forced to save more and spend less while (4) commodity prices are falling, on top of (5) a serious slowdown in the velocity of money, and you have the makings of a perfect deflationary storm. The Fed would be forced to fight it.

What would they do if lowering the Fed rate to zero was not enough? As Bernanke stated, they would simply set the rates for 1- and 2-year notes and further out the curve if they felt they needed to. And if Goldman Sachs is right in its latest revised forecast, the economy is going to need some help:

"Goldman said it now expects U.S. GDP to fall 5 percent in the current quarter, with unemployment rate reaching 9 percent in the fourth quarter of 2009. It also forecast the 10-year yield to fall to 2.75 percent by the end of the first quarter of 2009, as compared to previously estimated 3.5 percent.

" 'The combination of weaker real activity and slower inflation means that profits of U.S. companies will fall even more sharply than we had previously expected,' Goldman said in a note to clients. Goldman now sees economic profits falling 25 percent in 2009 on an annual average basis, the biggest drop since 1938. It had earlier expected a fall of 20 percent. Goldman expects unemployment rates to further go up in 2010 as well, as there is little chance of the economy returning to trend growth by that year."

Other mainstream economists think GDP might fall this quarter by as much as 5%. That does not bode well for retails sales this Christmas.

Warren Makes a Bet

And let's close on this note brought to my attention by Bill King.

"MSN Money's John Markman: Shares of Warren Buffett's insurance holding company are on the ropes this month, plunging 30% in part because the famed investor dabbled in an area of the market he has long publicly derided: derivatives. And due to a tangled web of financial relationships, they may be taking Goldman Sachs shares down with them. Investors are concerned about a $37-billion bet that Buffett made last year that U.S. and world equity values would be higher in 15 to 20 years than they were then, when the Dow Jones Industrials were trading around 13,000. Through his firm, Berkshire Hathaway, Buffett sold option contracts, known as "naked puts" to an undisclosed group of investors for around $4.85 billion, reportedly using Goldman as broker...

"Because of its solid-gold credit rating, Berkshire Hathaway was not required to put up collateral to make this trade. But now rumors are flying on Wall Street that the owners of the contracts have demanded that broker Goldman Sachs put up collateral for the rest of the amount due. Since the value of the trade could be infinite, the collateral demands are said to be large, and fears that Goldman will struggle to make good on its obligation has panicked shareholders. Indeed one theory making the rounds this week is that Buffett put $5 billion into Goldman at around $125 per share in September not as an investment but to help provide funds for the collateral.

http://blogs.moneycentral.msn.com/topstocks/archive/2008/11/20/buffett-s-huge-derivatives-bet-proves-costly.aspx

"Isn't this the oracle that called derivatives, 'financial weapons of mass destruction'?"

I personally think that Warren made a very good bet. I would be shocked if the Dow was not at 13,000 in 20 years. Inflation will do most of that heavy lifting. But it does make for an interesting discussion now.

Thanksgiving, Moving, and New Orleans

Tiffani has decreed that I am going with her to New Orleans in a month to spend four days huddled away from the office, pouring over the research for our new book Eavesdropping on Millionaires and getting started on the actual writing. Somehow, she thinks I will be distracted if I am in the office.

I am looking forward to Thanksgiving next week. Most of my kids and some of my family will be coming to my apartment. I will be cooking all morning, preparing prime, lots of mushrooms and veggies, and more. I really get into it when I get the chance. And a very thoughtful reader has sent Tiffani and me some really great wines, which we will uncork.

Hopefully, this year we can avoid a fire in the building and having to carry my 91-year-old mother down 21 flights of stairs. And then the next day we pack everything up and move a few miles away to a house that will become my office a few weeks later. I am really quite excited about the move, as I really do like the house and am really enamored of the thought of a ten-second down-the-hall commute. Ask me in three years how I like it.

Congratulations are in order to my assistant of the last three years, Sommer Dooley, who has passed the exams for her nursing degree. She will be leaving us soon. She has been a real help the last few years and will be missed.

Next week I am going to write a special letter on why I am optimistic that we will come through this whole financial mess, but now it is time to hit the send button. Have a great week and enjoy your family and Thanksgiving! I think it is my favorite holiday.

Your thinking life is really pretty good analyst,

John Mauldin

Betting on Financial Armageddon

John Mauldin — Sat, 20 Sep 2008 01:40:00 GMT

Pricing in Financial Armageddon
Inside a RMBS
Ratings to Collateral to Ratings: A Vicious Cycle
This Too Shall Pass
South Africa, Boulder and Stand Up to Cancer

My Dad used to tell me there is no accounting for standards when looking at something that seemed odd. Today, we have faulty standards for accounting that are ripping apart the fabric of the world's economy. How can a security that has a high probability of full repayment be downgraded from AA to junk levels? What we will explore today tell us a lot about why we are in the crisis state of affairs. Since I wrote you last Friday, the financial landscape of the world has changed even more. And what will happen this weekend will change it even more. And our kids will be paying for it for a long, long time. At the end I offer a few thoughts on the events, and if there is time my thoughts on the new short covering rules. All in all, it should make for an instructive and interesting letter. We'll jump right in with no "but first."

I was invited to an invitation only presentation to a room of chief executives of a number of small Texas banks made by Rich Berg of Performance Trust Capital Partners this week (http://ptcp.performancetrust.com). He graciously gave me permission to go over the main points of his presentation. I think you will find it eye-opening to say the least. You probably have seen Rich, as he is all over the media lately.

Let's jump back 18 months. I spent several letters going over how subprime mortgages were sold and then securitized. Let's quickly review. Huge Investment Bank (HIB) would encourage mortgage banks all over the country to make home loans, often providing the capital, and then HIB would purchase these loans and package them into large securities called Residential Mortgage Backed Securities or RMBS. They would take loans from different mortgage banks and different regions. They generally grouped the loans together as to their initial quality as in prime mortgages, ALT-A and the now infamous subprime mortgages. They also grouped together second lien loans, which were the loans generally made to get 100% financing or cash-out financing as home owners borrowed against the equity in their homes.

Typically, a RMBS would be sliced into anywhere from 5 to 15 different pieces called tranches. They would go to the ratings agencies, who would give them a series of ratings on the various tranches, and who actually had a hand in saying what the size of each tranche could be. The top or senior level tranche had the rights to get paid back first in the event there was a problem with some of the underlying loans. That tranche was typically rated AAA. Then the next tranche would be rated AA and so on down to junk level. The lowest level was called the equity level, and this lowest level would take the first losses. For that risk, they also got any residual funds if everyone paid. The lower levels paid very high yields for the risk they took.

Then, since it was hard to sell some of the lower levels of these securities, HIB would take a lot of the lower level tranches and put them into another security called a Collateralized Debt Obligation or CDO. And yes, they sliced them up into tranches and went to the rating agencies and got them rated. The highest tranche was typically again AAA. Through the alchemy of finance, HIB took subprime mortgages and turned 96% (give or take a few points depending on the CDO) of them into AAA bonds. At the time, I compared it with taking nuclear waste and turning it into gold. Clever trick when you can do it, and everyone, from mortgage broker to investment bankers was paid handsomely to dance at the party.

Will we ever forget Charlie Prince's line, the CEO of Citigroup, saying that "As long as they are playing music, you have to get up and dance?" just a few weeks before the market imploded? Apart from having his rhythm being proven totally horrendous and overseeing an implosion which cost Citigroup tens of billions, it was a great statement of the zeitgeist of the financial world at the time.

The key word here is model. The ratings agencies used data supplied by the investment banks on what the likely default rates would be. It was something like taking an open book test where you get to write the questions. And since home values had only gone up, default rates were low. And of course, the data was from an ear when bankers lent money actually expecting to get paid back.

Inside a RMBS

Let's look at a RMBS. As Berg points out, when you are buying a mortgage backed security, there are really only three questions you need to know the answers to:

How many mortgages will default?
How much will I get back on a defaulted loan?
How much credit enhancement is there in the security?

Let's set the table by looking at a few terms and definitions. Using his example, let's take a mortgage where the home was originally appraised for $400,000 and there is a $300,000 mortgage on the home. Let's assume a default and the bank takes back the home. If they sell the home and recover $240,000 that means they lose $60,000. This is called a 20% severity. If they sold and recovered $150,000 it would be said to have a 50% severity.

Next, let's look at how the rating agencies come up with the AAA rating. First they model the expected losses, with emphasis on the word model. If they figure that worst case that 8% of the loans default at a severity of 50%, then the security would lose 4% of its value. To get an AAA rating you have to have at least two times the coverage of the "modeled" loss. In this illustration, that means that 92% of the loans would be put into the AAA tranche. An A rating assumes a coverage of more than 1 times but less than 2. B means you expect to get your money back and if they model that you will get below 100% back then the rating would be at junk levels.

Now, this next fact is important. All ratings assume a par value of 100. The rating of these bonds has nothing to do with price. After the presentation, Rich sat down with me and pulled up an actual mortgage backed security that was being offered that day on his screen. It was once a AAA rated Alt-A security. If I remember correctly it was a 2006 vintage security.

As of the latest reporting, a little over 5% of the mortgages were over 60 days past due or in foreclosure. In this security, there are no toxic option ARMS. The numbers of mortgages in this security that are in trouble are rising. S&P has downgraded that AAA tranche to BBB, which of course means its value is going down.

And sure enough, the offered price of the security is 70 cents on the dollar, or 70% of the original par value. Now remember, this particular AAA bond will only start to lose money after the lower tranches take up the first 8% of losses. Thus, this bond can be said to have an 8% credit enhancement.

Pricing in Financial Armageddon

Now, let's stress test that loan. For the AAA portion of the loan to lose money, that would mean that 16% of the loans would have to default with a severity of 50% losses. Could that happen? Sure.

But let's look at what buying that loan at 70 cents on the dollar does for the new owner. First, you are getting a much higher yield (interest rate) because you are buying the security at a lower valuation. But something else even more interesting happens.

Even though the security sold at 70 cents, it still gets all of the first of the proceeds of the home owners who pay their mortgages, up to 92% of the original value in the security. How many loans would have to default in order to make the buyer at 70 cents lose money? Remember, we already had credit enhancement of 8%. But at 70 cents, we just "bought" or priced in another 30%. Let's think Armageddon and that 50% of the mortgages default and they only recover 50% of the loans. That would only be a total loss of 25% to the entire collateral of the deal, but it would mean that the new investor still get all of my 70 cents plus another 13% back! The proud new owner could get up to 92% of the monies paid. Even in a pretty bad scenario, you get more than you paid for the security.

Let's walk through the math. Let's say the original security was $100 million (which would be a very small RMBS). The AAA tranche would have cost $92 billion. If you have it at 70 cents on the dollar you paid approximately $64 billion. In my Armageddon scenario above, the security loses 25% or $250 million. The lower rated tranches are completely wiped out losing $8 billion. Your tranche loses the remaining $17 billion which means you get $75 billion and you only paid $64 billion.

So, how bad would things have to get to lose money on this security? If I am doing the math right, 72% of the loans would have to default with a severity of 50% before your investment of $64 billion was impaired by even so much as 1 dollar. If that happened, it would be Armageddon.

So, why is it rated BBB? Because the rating is over the entire tranche and it is made at a par price of 100. The rating is not affected by the current price. As of today, assuming that even double the number of mortgages currently delinquent default with a 50% severity, your returns over the life of the security would be well over 12%. You would get back $92 million for your $64 billion dollar investment along with interest payments.

The reason this presentation was being made to banks and institutions? Because if you are a bank, you can generally only get prime plus 2% on a loan you make. But if you buy this security with your capital, you can make prime plus 6%. That is a large difference to a bank. Performance Trust has sold billions of this type of paper to banks and institutions.

If this is such a good deal, then why isn't everyone hitting the bid? Because these securities are very difficult to analyze. It is time consuming. You need to analyze every loan and develop your own valuations. You simply can't trust the ratings, as they are measuring something completely different.

And the real truth is that many of the various RMBS securities will in fact be totally wiped out or lose a great deal. Many are seeing default rates of 30% or more. You have to be very careful when you walk through this minefield. And in a time of crisis, it is not clear what the new rules will be. What if the government forces lenders to re-set mortgages at some loss level? What if the housing crisis gets worse? On the other hand, what if the government comes in and buys up all the bad mortgages in an attempt to stop the erosion in the home markets. The level of uncertainty in these times makes people a lot more cautious.

There are Alt-A RMBS like the one mentioned above that are probably not worth even 70 cents on the dollar. These things are marked to a market that is frozen. Everything gets lumped into the same basket and it all has to be marked to market by the new accounting rules called FASB 157. The institution selling the above mentioned security is being forced to do so, either because they are in financial trouble or they are not allowed to hold BBB securities in their portfolios and by law are required to sell. And in times of crisis, the selling price is not that of normal times.

Ratings to Collateral to Ratings: A Vicious Cycle

What's a recipe for a perfect financial storm? Let's make a massive amount of bad loans and get them on the books of most of the major financial institutions because they are rated investment grade. Then let's have the loans start to go bad. Throw in some general panic as everyone tries to sell the loans. No one is buying.

Let's make a new rule that you have to mark your illiquid securities to the last price paid by someone desperate to sell. That means that many institutions now have to mark their capital down and that means those pesky rating agencies must by their own rules mark down the ratings of the institutions which of course means that it costs them more to raise capital at a time when they can't get it which means they get lower ratings and so on. It becomes a vicious cycle.

In the early 80's, every major US bank was bankrupt because they had loaned Latin American countries far more than their capital they had on their books. The Latin American countries defaulted. If the US banks had been forced to mark to market, they would have all gone down taking the US economy along with them. So, the Fed simply allowed them to carry the loans at book value, offering liquidity and allowing the banks to buy time to make enough money to eventually write off the loans.

The current mark to market rule, while nice in theory, works in normal times. But it has the unintended consequence of making things worse in crisis times. Why should an institution have to write down a security which over time is going to pay back the lion's share or more of its value just because a severely stressed institution was forced to sell that security at a very low price in a time of crisis?

Yes, there needs to be transparency and we as investors need to know what is on the books of the companies that we invest in. But it is somewhat like my bank asking me to mark to market my home and pricing my loan daily based on that new price. If my neighbor loses his job and sells his home at auction, does that mean my home is now worth less two years from now. Maybe an even better analogy, if I am renting that home to a very good tenant, does my neighbor's price impair my income?

I was, and am, a fan of mark to market pricing. But we need to think through what a market price is. Not all things can be easily marked to market. This is doubly true when "market price" is a nebulous index of mortgage securities which may or not have a fundamental relationship with an illiquid security on the books of an institution which has no intention of selling, especially in a time of credit crisis.

It is one thing to require that you mark your stocks or bonds to market values. It is another thing entirely to require all mortgage backed securities, which are extremely complex things, can be very different one from another and which require a lot of time and effort to value, to be priced as though they are all the same.

FASB 157 needs to be amended this week. If Congress can create a new Resolution Trust Corp in a week, the surely the accounting board, with the suggestion of Treasury, can figure out a better way to price illiquid securities.

This Too Shall Pass

I know that you probably are reeling from all that has happened the past few months and especially the past two weeks. Lehman and Mother Merrill gone? We the people own AIG? Fannie and Freddie? A new housing bailout which will cost hundreds of billions? The Fed creating whole new programs to provide liquidity? Did you notice they loaned some $250 billion this last week to banks all over the world? Stopping short selling?

Want to see in graph form how bad it got and what spooked Paulson, Bernanke and company to act so quickly? Look at these graphs from my friends at Casey Research (http://www.caseyresearch.com/crpmkt/crpSolo.php?id=119&ppref=JMD119ED0908A). 30 day commercial paper went to 5% from 3% a week ago. The market was literally freezing. And the amount of paper issued is in free fall. Commercial paper is the life blood of the financial and business world. Without it commerce will soon grind to a halt.

It simply takes your breathe away. As President Bush said today, it does not help to find who is at fault today, we have to figure out how to get out of this mess. It is going to cost the taxpayers a lot of money. While I think the losses on AIG will be rather minor in the grand scheme of things, if you add up Fannie and Freddie and a new RTC, coupled with the stimulus package, you can easily get to $500 billion, and that is probably a low number.

For such a price, we had better get a new regulatory scheme which requires reduced leverage. Want to get really mad? Up until 2003, all investment banks were allowed only 12 to 1 leverage. Then in 2004, the SEC basically gave five banks (and only five banks) the ability to lever up 30 or even 40 to 1. Bet you can guess the five banks. Bear, Lehman, Merrill, Morgan and Goldman. Three down.

As Barry Ritholtz wrote: "So while the SEC runs around reinstating short selling rules, and clueless pension fund managers mindlessly point to the wrong issue, we learn that it was the SEC who was in large part responsible for the reckless leverage that led to the current crisis." (Don't get me started on blaming the short sellers. Let's not blame the people who leveraged up their companies 40 to 1 with bad investments.)

We absolutely must move credit default swaps to a regulated exchange, no matter how much investment banks and hedge funds scream. Must be done. Do it now. Real rules about writing mortgages, although now that losses are in the hundreds of billions, underwriting rules are already becoming quite restrictive.

And while we are at it, a thorough revamping of the rating agencies and the rules they use should be at the top of someone's list.

South Africa, Boulder and Stand Up to Cancer

It is time to hit the send button. Chuck Butler of Everbank and Thomas Fischer of Jyske Bank just walked into the office to watch the Texas Rangers play Anaheim from my balcony (which is inside the Ballpark where the Rangers play). That would be baseball to those not from the states. Chuck is a huge baseball fan and when I heard he was going to be in town I had to have him come, even on a writing day.

Everbank is known for letting clients open CDs denominated in scores of different currencies. If you are interested in diversifying away from the dollar, you can go to Everbank.com. Or call EverBank at 800-926-4922.

Chuck has had some very serious cancer, and has been going through lots of chemo. He just told me that his latest scan shows him 100% cancer free, and he is going off the chemo. Sometimes good things do happen to good guys.

And speaking of cancer, Stand Up to Cancer is a charity formed to raise money to find cures for cancer and fund innovative new therapies and research. SU2C is going to make a difference in how cancer research is conducted over the next five years, with its focus on targeted treatments that interrupt the mechanisms of uncontrolled cell growth. This is the kind of emphasis that can make cancer into a disease patients live with, rather than one they die from (sort of like AIDS has become for most of its victims in developed countries). You can and should see the program broadcast live a few weeks ago on most major networks. And then send money. Their web site, with tons of information is http://www.standup2cancer.org/ and the TV show is at http://www.nbc.com/Movies_Specials_More/Stand_Up_To_Cancer/video/episodes/.

I leave for Cape Town in South Africa tomorrow morning. I will be speaking at the ABSIP (Association for Black Securities & Investment Professionals) Annual Conference in Cape Town on September 23. Then that evening I fly to London for meetings with my partners and clients there and fly back to Dallas on Thursday. I hope to be able to keep up with what is going on and write the letter next Friday. And then Sunday I fly to Boulder to meet with Dr. Bart Stuck and learn about a company called InPhase which is making holographic memory. Pretty cutting edge stuff.

I mention this because it is companies like InPhase, and a thousand more like them, which will power the next big wave of change. The crisis on Wall Street will pass and the world will continue to change. I think it is going to change for the better for most people.

The game ahs started, so I think I am going to find an adult beverage and really, truly celebrate with Chuck, who was on the road when he got the news. I know he will be celebrating with his family when he gets home.

Your not looking forward to a 15 hour flight analyst,

John Mauldin

Stagflation and the Fed

John Mauldin — Sat, 01 Mar 2008 04:47:16 GMT

How Do You Spell Stagflation? Memo from the Fed: Inflation? What Inflation? The Fed Will Cut and Cut Again Damn the Inflation Torpedoes! Full Speed Ahead! Apple, Sprint, AT&T, and Going to the Dark Side This week's topic was inspired by a discussion...(read more)

Sea Change at the Fed

John Mauldin — Fri, 21 Sep 2007 08:12:00 GMT

Sea Change at the Fed "Of his bones are coral made: Those are pearls that were his eyes: Nothing of him that doth fade, But doth suffer a sea change Into something rich and strange" (The Tempest - Shakespeare) The term "sea change"...(read more)

Should the Fed Cut Interest Rates?

John Mauldin — Fri, 07 Sep 2007 08:10:00 GMT

Should the Fed Cut Interest Rates? The Shocker in the Employment Numbers Should the Federal Reserve Cut Interest Rates? Will A Cut Make Any Difference? How Housing Woes Hurt the Rest of the Economy Home Again, Home Again The unemployment numbers came...(read more)

The Inflation of Expectations

John Mauldin — Fri, 06 Oct 2006 06:58:00 GMT

Introduction This week we had two more Federal Reserve members repeat what has become the theme for their chorus, but not one the market seems to be paying much attention to. It should be. The market believes the Fed will soon start to cut rates, perhaps...(read more)

Economic Whiplash

John Mauldin — Fri, 11 Aug 2006 06:44:00 GMT

Introduction The Fed elected to pause in its rate hiking assault on inflation this week. With the backward looking data pointing to higher inflation that must mean they expect the economy to slow down and thus tame what incipient inflation is lurking...(read more)

The Sacrifice Ratio

John Mauldin — Fri, 13 Jan 2006 06:25:00 GMT

Introduction This week we will look at a few very interesting items that did not make it into last week's forecast, as that letter was already overly long. Bernanke's arrival, the importance of the housing market to the economy, the length of...(read more)

Forecast 2006: On the Gripping Hand

John Mauldin — Fri, 06 Jan 2006 06:23:00 GMT

Introduction Once again it's time for me to demonstrate the foolhardy part of my nature by putting to electronic pen my forecast for 2006. I spend more research time on this one letter than on any four or five combined, simply reading hundreds of...(read more)

The Bernanke Era

John Mauldin — Fri, 28 Oct 2005 05:08:00 GMT

Introduction The King is going. Long live the King. We now know that Ben Bernanke will be the next Fed Chairman. His approval by the Senate is as close to a lock as you can get. This week we focus on Bernanke, and specifically his most famous, and what...(read more)