The Golden Age Is Ending
By Mortimer B. Zuckerman
Posted 7/29/07
http://www.usnews.com/usnews/opinion/articles/070729/6edit.htm

We have been enjoying a golden age. In the latter part of the 1990s and the first part of the 21st century, every indicator of economic health that should be up has been up: employment, income growth, stock market profitability. And everything that should be down has been down: inflation, interest rates, and unemployment. Inflation in the United States was contained by a fortuitous combination of a glut in global productive capacity, foreign competition, technological innovation, and the soaring dollar, which made imports cheaper. Everything that China exported went down in price (and everything that China imported went up in price). So we had more productivity here, more jobs, more growth, and pay rises without inflation.

Today, many of these benign forces are still in play—but to a much lesser extent. The dollar is no longer soaring but slumping, as the world engine for growth moves from the United States to the East. To get a sense of how critical Asia has become, consider that our economy is expected to expand by $526 billion this year. The Chinese economy, which is a fraction the size of the U.S. economy, is expected to grow by $420 billion. That divergence will persist as China, as well as India, grows at a 10 percent annual rate.

This is the story virtually everywhere in the developing world-tightening markets for labor and product, with inflation pressures waxing. Central banks in Europe, China, and Japan are responding with rate hikes and hawkish rhetoric. Stronger growth around the world will portend even higher interest rates.

Prices rise. A collateral result of tighter money and higher interest rates is that the currency exchange rates of these booming countries have appreciated. The dollar has plunged roughly 4 percent just in the past few months and on a trade-rated basis compared with a basket of major currencies is now down some 30 percent from its 2002 peak. Import prices have risen, which now adds rather than abates inflationary pressures here. Wage costs in foreign countries have given another twist to the spiral, not dramatic yet but noticeable: In the past several months we have been paying about 2 percent more for consumer imports, excluding autos, the fastest such advance in more than a decade. This time last year, these prices were falling.

There is no prospect of these global inflationary pressures easing. Emerging nations are enjoying rising aspirations, higher living standards, and rising incomes. Demands for food, consumer goods, automobiles, and trucks are increasing, and so are the demands for improved education and labor training. The result is increases in costs that are rising more rapidly than technology can reduce them.

Our ballooning trade deficit is a function of these global forces. Fortunately, foreign investors have been happy to underwrite our red ink by pumping nearly $800 billion into our financial markets annually. Asian banks especially have been buying large quantities of dollars and dollar-denominated securities. The big question is how much these accumulated savings will be siphoned off by our trading partners for their own domestic growth. Clearly, rising global real yield will put a floor under U.S. interest rates, limiting our ability to manage our monetary policy.

The "golden age" has therefore resulted in an immense rise in foreign ownership of all American securities. Foreigners own more than half the federal debt, about a third of corporate bonds, and 13 percent of the U.S. stock market. This represents an accumulating claim on the future output of the United States and foretells an increasing flow of dividends and interest payments abroad.

It doesn't help that Americans save so little. Personal saving rates over the past 15 years have gone down from 7 ½ percent to zero. The aggregate national saving rate, which includes the public sector and private corporations, has dropped from 13 percent in the 1960s to 0.8 percent last year. The average American with an income of about $40,000 saves virtually nothing, while the average Chinese, earning somewhat above $2,000 a year, puts away about 20 percent of his income. Compound a low savings rate with a trade gap that has nearly doubled to 7 percent of gross domestic product over 20 years, and we can understand why the net international investment position of the United States has declined from what was a modest plus-5 percent of GDP in the mid-1980s to its current minus-20 percent.

In short, we are no longer as dominant in the world's economy as we were. Everybody's lives will be affected by that. That includes both national and individual rates of growth, as well as inflation and interest rates. The trend of gradual disinflation here and around the world that we have enjoyed for the past 25 years under the pressure of price competition from imports is drawing to an end. We are now looking at a period of rising inflation driven in good part by the economic successes around the world.

Anatomy of the Bank Run
by Murray N. Rothbard

This article, from the September 1985 Free Market (that is, the Age of Volcker), is also timely for the Age of Bernanke.

It was a scene familiar to any nostalgia buff: all-night lines waiting for the banks (first in Ohio, then in Maryland) to open; pompous but mendacious assurances by the bankers that all is well and that the people should go home; a stubborn insistence by depositors to get their money out; and the consequent closing of the banks by government, while at the same time the banks were permitted to stay in existence and collect the debts due them by their borrowers.

In other words, instead of government protecting private property and enforcing voluntary contracts, it deliberately violated the property of the depositors by barring them from retrieving their own money from the banks.

All this was, of course, a replay of the early 1930s: the last era of massive runs on banks. On the surface the weakness was the fact that the failed banks were insured by private or state deposit insurance agencies, whereas the banks that easily withstood the storm were insured by the federal government (FDIC for commercial banks; FSLIC for savings and loan banks).

But why? What is the magic elixir possessed by the federal government that neither private firms nor states can muster? The defenders of the private insurance agencies noted that they were technically in better financial shape than FSLIC or FDIC, since they had greater reserves per deposit dollar insured. How is it that private firms, so far superior to government in all other operations, should be so defective in this one area? Is there something unique about money that requires federal control?

The answer to this puzzle lies in the anguished statements of the savings and loan banks in Ohio and in Maryland, after the first of their number went under because of spectacularly unsound loans. "What a pity," they in effect complained, "that the failure of this one unsound bank should drag the sound banks down with them!"

But in what sense is a bank "sound" when one whisper of doom, one faltering of public confidence, should quickly bring the bank down? In what other industry does a mere rumor or hint of doubt swiftly bring down a mighty and seemingly solid firm? What is there about banking that public confidence should play such a decisive and overwhelmingly important role?

The answer lies in the nature of our banking system, in the fact that both commercial banks and thrift banks (mutual-savings and savings-and-loan) have been systematically engaging in fractional-reserve banking: that is, they have far less cash on hand than there are demand claims to cash outstanding. For commercial banks, the reserve fraction is now about 10 percent; for the thrifts it is far less.

This means that the depositor who thinks he has $10,000 in a bank is misled; in a proportionate sense, there is only, say, $1,000 or less there. And yet, both the checking depositor and the savings depositor think that they can withdraw their money at any time on demand. Obviously, such a system, which is considered fraud when practiced by other businesses, rests on a confidence trick: that is, it can only work so long as the bulk of depositors do not catch on to the scare and try to get their money out. The confidence is essential, and also misguided. That is why once the public catches on, and bank runs begin, they are irresistible and cannot be stopped.

We now see why private enterprise works so badly in the deposit insurance business. For private enterprise only works in a business that is legitimate and useful, where needs are being fulfilled. It is impossible to "insure" a firm, even less so an industry, that is inherently insolvent. Fractional reserve banks, being inherently insolvent, are uninsurable.

What, then, is the magic potion of the federal government? Why does everyone trust the FDIC and FSLIC even though their reserve ratios are lower than private agencies, and though they too have only a very small fraction of total insured deposits in cash to stem any bank run? The answer is really quite simple: because everyone realizes, and realizes correctly, that only the federal government – and not the states or private firms – can print legal tender dollars. Everyone knows that, in case of a bank run, the U.S. Treasury would simply order the Fed to print enough cash to bail out any depositors who want it. The Fed has the unlimited power to print dollars, and it is this unlimited power to inflate that stands behind the current fractional reserve banking system.

Yes, the FDIC and FSLIC "work," but only because the unlimited monopoly power to print money can "work" to bail out any firm or person on earth. For it was precisely bank runs, as severe as they were that, before 1933, kept the banking system under check, and prevented any substantial amount of inflation.

But now bank runs – at least for the overwhelming majority of banks under federal deposit insurance – are over, and we have been paying and will continue to pay the horrendous price of saving the banks: chronic and unlimited inflation.

Putting an end to inflation requires not only the abolition of the Fed but also the abolition of the FDIC and FSLIC. At long last, banks would be treated like any firm in any other industry. In short, if they can't meet their contractual obligations they will be required to go under and liquidate. It would be instructive to see how many banks would survive if the massive governmental props were finally taken away.

Hayman Capital
2626 Cole Avenue, Suite 200
Dallas, TX 75204

July 30th, 2007

Dear Investors,

Over the past few months, we have seen the exacerbation of the Subprime problem accelerate at a precipitous pace. Wait a minute…I thought the Subprime problem was neatly contained in a nice little box of risk that the Fed had put it in? After many meetings and conversations with the various leaders of brokerage firms and asset managers, I don’t think the Subprime problem is as contained as many would like for you to believe. To understand the massive ripple effects of the Subprime problem, you have to look deeply into who owns the eventual risk and furthermore, how it will affect their behavior going forward.

The Greatest “Bait and Switch” of ALL TIME
I recently spent some time with a senior executive in the structured product marketing group (Collateralized Debt Obligations, Collateralized Loan Obligations, Etc.) of one of the largest brokerage firms in the world. I was in Roses, Spain attending a wedding for a good friend of mine who thought it would be an appropriate time to put the two of us together (given our shared interests in the structured credit markets). This individual proceeded to tell me how and why the Subprime Mezzanine CDO business existed. Subprime Mezzanine CDOs are 10-20X levered vehicles that contain only the BBB and BBB- tranches of Subprime debt. He told me that the “real money” (US insurance companies, pension funds, etc) accounts had stopped purchasing mezzanine tranches of US Subprime debt in late 2003 and that they needed a mechanism that could enable them to “mark up” these loans, package them opaquely, and EXPORT THE NEWLY PACKAGED RISK TO UNWITTING BUYERS IN ASIA AND CENTRAL EUROPE!!!! He told me with a straight face that these CDOs were the only way to get rid of the riskiest tranches of Subprime debt. Interestingly enough, these buyers (mainland Chinese Banks, the Chinese Government, Taiwanese banks, Korean banks, German banks, French banks, UK banks) possess the “excess” pools of liquidity around
the globe. These pools are basically derived from two sources: 1) massive trade surpluses with the US in USD, 2) petrodollar recyclers. These two pools of excess capital are US dollar denominated and have had a virtually insatiable demand for US dollar denominated debt…until now. They have had orders on the various desks of Wall St. to buy any US debt rated “AAA” by the rating agencies in the US. How do BBB and BBB-tranches become AAA? Through the alchemy of Mezzanine-CDOs. With the help of the ratings agencies the Mezzanine CDO managers collect a series of BBB and BBB- tranches and repackage them with a cascading cash waterfall so that the top tiers are paid out first on all the tranches – thus allowing them to be rated AAA. Well, when you lever ONLY mezzanine tranches of Subprime RMBS 10-20X, POOF…you magically have 80% of the structure rated “AAA” by the ratings agencies, despite the underlying collateral being a collection of BBB and BBB- rated assets... This will go down as one of the biggest financial illusions the world has EVER seen. These institutions have these investments marked at PAR or 100 cents on the dollar for the most part. Now that the underlying collateral has begun to be downgraded, it is only a matter of time (weeks, days, or maybe just hours) before the ratings agencies (or what is left of them) downgrade the actual tranches of these various CDO structures. When they are downgraded, these foreign buyers will most likely have to sell them due to the fact that they are only permitted to own “super-senior” risk in the US. I predict that these tranches of mezzanine CDOs will fetch bids of around 10 cents on the dollar. The ensuing HORROR SHOW will be worth the price of admission and some popcorn. Consequently, when I hear people like Kudlow on CNBC tell their viewers that the Subprime problem is “contained”, I can hardly bear to watch.

The Moral Hazard of HOT Potatoes
The key reason the Subprime problem exists as it does today has to do with the wanton disassociation of risk inherent in the machine that churns out Subprime loans. Unlike the S&L crisis of the 1980s, the mortgage lenders of today aren’t taking their own balance sheet risk when underwriting loans. These brokers get paid for quantity REGARDLESS of quality. The balance sheet risk is transferred through three entities in less than 90 days from origination. The originator will originate ANYTHING he can sell to a whole loan buyer to pass the hot potato on. Whole loan buyers are simply the aggregators of loans at the Wall St. firms that aggregate, package, tranche, and sell as quickly as they possibly can to the clueless buyer. This transference of risk is the crux of the Subprime situation. Just think about it…if you were a 20-something making mortgage loans in California using someone else’s balance sheet and being paid per loan (with no lookback to performance of the loan), how many dubious loans would you underwrite?

Buyers are now BEWARE
During and after the rout these investors are about to shoulder, how excited do you think they are going to be to purchase the next “AAA” rated piece of structured finance paper?!!?!?!? These same investors and global pools of liquidity have been funding the Leveraged Buyout (LBO) boom by purchasing the debt that funds the Collateralized Loan Obligations (CLOs) which in turn, buy 60%+ of the LBO debt used to finance these transactions. I also recently spent some time with one of the largest CLO issuers in the world. They had just returned from Japan where they were marketing a new CLO in order to be one of the buyers for new LBO debt. Needless to say, their marketing efforts fell on deaf ears. They were told by the Japanese investors that they have lost confidence in the ratings agencies (you think?) and that in an election year there is too much uncertainty. They basically said, “No more.” If there is not a CLO bid from Asian and Central European banks, where do you think the $290 billion in announced LBOs will go to sell their debt? I actually have no idea how to answer that question myself. We have seen the bank-loan index drop from 100.5 to 90.5 in 5 short weeks, and a widening in investment grade as well as non investment grade credit. In the immediate absence of liquidity, there will be many casualties of levered funds and firms. There will be a “re-pricing” of risk on a global scale that will mean more credit funds being carried out the door feet first.

Latest Casualties
Just today, the latest firm to suffer the wrath of too much leverage and mis-priced risk was Sowood Capital. What is truly remarkable about this particular situation is the fact that Jeff Larson, the former manager of the $30 billion Harvard Endowment, is the principal Manager at this firm. Sowood was renowned as being a “best-in-class” fund. If the former manager of the Harvard endowment managed to lose 57% of his fund (more than $1.7 billion in losses) in just 30 days, how are the “other” credit funds out there doing? How are they calculating Value-at-Risk? This afternoon, brokerage firms were sending collateral calls to other funds positioned similarly to Sowood. They joined the ranks of the two Bear Stearns funds managed by Cioffi, Australia’s Basis Capital, Absolute Capital, and Macquarie Fortress Funds as well investments by Korea’s Woori Bank, and London’s Caliber Fund by liquidating and eventually returning what is left to investors. Not to mention the downfall of the poster child of the levered “positive carry” industry, United Capital Market’s Horizon Fund – managed by John Devaney, owner of the aptly titled 142ft yacht, the Postive Carry (which is incidentally now for sale, all enquiries can be directed to http://www.iyc.com/featured_yachts.cfm?mn=1).

I have recently discovered the insightful writings of someone with whom I have not had the pleasure to speak or meet in person. Howard Marks is the Chairman of Oaktree Capital Management and he recently sent a letter to his clients entitled, “It’s All Good”. Mr. Marks had a most astute observation with regard to the recent investing environment:
“…investors’ recurring acceptance that it’s different this time – or that cycles are no more – is exemplary of a willing suspension of disbelief that springs from glee
over how well things are going (on the part of people who’re in the market) or rationalization of the reasons to throw off caution and get on board (from those who have been watching from the sidelines as prices moved higher and others made money). In this way, the bullish swing of the investment cycle tends to cause skepticism and risk tolerance to evaporate. Faith, credence and open-mindedness all tend to move up – at just the time skepticism, discrimination and circumspection become the qualities that are most needed.”

Credit Markets and Where we are today in Subprime
Last week, I spent some time in the “Inland Empire” of California on a diligence trip to survey the actual damage. As many of you already know, 55% of all Subprime loans were made in California and Florida. The inland empire of California can be described as the central valley that extends from the southern part of the state all the way to the northern part of the state at least 1-hour inland from the coast. Let me start by saying it is MUCH WORSE than even I thought it could be. I met with various mortgage lenders, originators, economists, and capital markets professionals. The overriding theme that I got from them was that “Everyone committed fraud and everyone is responsible for the problem”. They told me that they believe that 90% of all Subprime loans that were made contained some kind of fraud. Either borrowers lied about their incomes or mortgage brokers fudged numbers on the applications to make them pass muster with the needed ratios in order to get loans approved. They also said that of the borrower frauds, 50% of applicants overstated their income by MORE THAN 50%!!! As Kindleberger put so well in his book, Manias, Panics, and Crashes:
The implosion of an asset price bubble always leads to the discovery of frauds and swindles. The supply of corruption increases in a pro-cyclical way much like the supply of credit. Soon after a recession appears likely the loans to firms that were fueling their growth with credit declines as the lenders become more cautious about the indebtedness of individual borrowers and their total credit exposure. In the absence of more credit, the fraud sprouts from the woodwork like mushrooms in a soggy forest.

In California today, home prices are down between 25%-40% in the central valley. From San Bernadino to Stockton, home prices are in free-fall and their physical condition is actually worse than their price decline. The borrowers are locked out of the financing market and there is no logical buyer for these homes outside of the original borrower. The foreclosure wave will hit these neighborhoods like the Asian Tsunami. If you plug in 15% depreciation in housing prices and 50% loss severities into our Subprime model, the capital structure is wiped out all the way to the “AA” tranches.

In the Subprime Credit Strategies Funds, we continue to hold our initial positions and have not taken any profits yet. In Hayman, we are short credit in the US (both Subprime RMBS and corporate credit) and long non-US equities and debt. We are short US consumer based equities, preferreds, and debt. I think the world is going to begin to decouple from the US and realize that currency appreciation coupled with the globe’s best growth is an attractive alternative to fraudulent ratings, US dollar depreciation, and financial inventions used to export risk.

Sincerely,

J. Kyle Bass
Managing Partner

The best news of the year...the implosion of quant funds! Headlines this week are all about the implosion of quantitative hedge funds, investment funds that pay no attention to underlying fundamentals but focus their trading strategy on statistics...technical analysis. A Goldman Sachs quant fund managed to loose over $1 billion in just a week, 30% of its value, leading Goldman to bail it out with a $3 billion investment. Several others have blown up this week as well, having us real investors laughing at the old tale of "technicals work until they don't work anymore" coming true. Here is an article regarding what these funds are up to today and how we should react...

How Speculators Exploit Market Fears
by Ben Stein

Here's a fact: The speculators and hedge fund managers who run today's stock market need market volatility in order to make money.
They can't make enough money if the market stays flat or moves only a bit, so they like extreme and unexpected price movements. They especially like sudden, surprise movements down, when they can make money off stocks they borrow and sell -- or, as they say, "sell short."

Money Lust Satisfied
That's what's been happening the past couple of weeks. But it's not interesting to say that the speculators are whipping the market around to satisfy their money lust. So the speculators themselves make up reasons for why the market is fluctuating, flog those reasons to the media, and then profit if some other speculators believe the jive reasons and jump in the way the manipulators want them to.
Supposedly, the market is "correcting" because of worries about the housing slowdown, and also because of fears that the debt markets that support mergers and acquisitions is drying up.

These are interesting theories, and people who don't know a lot about the stock market or the economy might find them beguiling. What follows are a few truths that show how shallow these "reasons" for the stock market moves are.

Housing a Theory
Yes, the housing market has slowed from a spectacular bubble level to a simply pretty good level. Housing sales and starts are now about what they were in 2002, and no one thought we were in a housing depression then. In any event, housing is only about 5 percent of the economy. If it falls by 15 percent, that would represent a fall-off of about .75 percent. That's not trivial, but it's also not the stuff of which recessions are made.

The fact is that there is no recession. The economy is suffering from a labor shortage, not a surplus of unemployment. The Fed is worried about excess demand, not slack demand.
Corporate profits set new records every day. Whatever's happening in residential sales and building is simply not slowing down the economy. Why should a Boeing or a Merck or a Pfizer have any reaction to housing at all? Because the speculators sell everything they can when nervousness sets in -- and for no other reason.

A Minor Major Mess
Subprime is a mess. But it's a small mess. Subprime mortgages account for roughly 20 percent of mortgages even in the most heavily exposed states. About 20 percent of them are delinquent in some way. That's 4 percent of mortgages. Of these, maybe half, or 2 percent, will go into foreclosure. There will be roughly 50 percent recovery on sale of these. This is a loss of 1 percent in the mortgage market -- a sum the lenders have already made many times over because of the hefty fees on those deals. In the context of the size of the U.S. financial sector, it's nothing.

And why should a crisis in subprime drive down stocks in Mexico and Thailand? Again, because the speculators seek to create panic to make money by selling short, and they sell short everything. There's simply no connection between subprime and developed or developing nations' stocks. This by itself shows the thin context of the selling wave late last month.

Money's Still Cheap
What about the supposed drying up of loans for mergers and acquisitions by private equity firms? Well, here's a good, simple test of just how valid that explanation is for stock market moves: The majority of private equity takeovers are financed with junk debt.
If there really were a major shortage of funds for these deals, the interest rate on the junk would skyrocket. Instead, while the rate has risen by about 150 basis points in the past month, the spread between junk and investment grade is now about 290 basis points, according to leading junk analyst Martin Fridson.

This is a lot lower than the year-end average of the spread from 2002 to 2006, and far below the almost 800 basis point spread during a true interest-rate crunch like the one after the tech meltdown in 2000-2002. So that's phony, too. Interest rates have risen, but not anything like what they've done in real crises. And besides, the Dow fell by about 550 points the week before last, yet not one of the Dow stocks is involved as either acquiror or acquiree in a private equity deal.

In short, money is no longer virtually free the way it was for private equity deals in the past year. But it's not expensive by historical standards, either.

Spreading the Fear
In other words, it's all the speculators trying to panic us so their sell programs will make money. And they'll make money as long as they can spread their panic. When they can't do that any longer, they'll work the long side -- and make up reasons for that, too. In the meantime, the economy is strong. Profits are great, and interest rates are low and will stay that way. Don't sell. With all the shrieking about the market, it only fell to what it was about five weeks ago -- and we didn't think we were poor then. So let the speculators shout "fire." As of right now, they're not blowing anything but smoke.