NY Times, August 24

“The size of the commercial paper market, a crucial source of short-term financing for businesses, decreased 4.2 percent last week, the biggest drop in at least seven years, as investors fled asset-backed debt and opted for the safety of Treasuries….

… The retreat may indicate that the Fed’s decision to lower the discount rate last week failed to instill enough calm to draw back investors. Commercial paper backed by assets led the fall as buyers fled debt linked to subprime mortgages. …

… ‘The commercial paper market, in terms of the asset-backed commercial paper market, is basically history,’ said William H. Gross, chief investment officer of the bond management firm Pacific Investment Management Company…”

Canada.com/NationalPost, August 26

“One of Canada’s top pension funds appears to be the first holder of troubled asset-backed commercial paper to call in the lawyers. …

… Ontario Teachers’ Pension Plan, said the fund owns as much as $60 million of illiquid commercial paper…. is only the latest in a long list of companies disclosing exposure to non-bank, asset-backed commercial paper (ABCP), and industry observers say lawsuits will soon start to fly. …several big investors are crying foul, saying they are paying the price for mistakes made the banks and brokerages that sold them what turned out to be a dud investment.

The crux of the issue is that ABCP is sold on the understanding that it is a liquid investment, almost like cash in the bank because most of it matures in 90 days or less.”

Deutsche Bank FX Special Report, August 26

“The asset backed commercial paper market has ceased to function.  With more than $1 trillion of this paper maturing in the next couple months, US banks face a potentially very large increase in loans on their balance sheets as lines of credit backing up ABCP that is not rolled over are drawn.  …

… Still, even if conditions return to normal in the credit markets over the next few weeks, it would be naïve to assume that the financial market turbulence would have no real effect. When the storm has blown over, we are likely to be left with significantly tighter credit conditions. …

… The resulting increase in the cost of borrowing is likely to dampen activity in those sectors and countries that until recently thrived on cheap credit. …

…[money markets] remain extremely stressed as they grapple with the question of how to roll large amounts of maturing asset-backed commercial paper in the next few weeks.”

Market Size Data:

Some sources talk about $2 trillion of commercial paper and some talk about $1 trillion of asset-backed commercial paper.  They do so often in such a way that the numbers get jumbled.  Here are the facts from the Federal Reserve, year-by-year since 2001, and as of last week.

      click image to enlarge

The short-term rates yield curve published by the Federal Reserve as of August 24, shows the differences between the various types of debt now.

      click image to enlarge
 
How ABCP Works:

To cut through the jargon, asset-backed commercial paper (ABCP) is generally 30 to 90 commercial paper issued by a special purpose entity set up by a bank to generate cash which is used to buy receivables from bank customers.  The special purpose entity continues to exist by refinancing its commercial paper when it comes due, and buying more receivables with the payments made on owned receivables.

There are other variations, involving large non-bank companies setting up entities to finance their own receivables, as well as asset types other than receivables.

The Problem:

ABCP paper was represented as near-cash, highly liquid and secure, in part because the sponsoring banks provided commitments or guarantees to provide liquidity to the special purpose vehicles to create the high credit rating the ABCP carried.  But now the “you know what” has hit the fan and banks are scrambling to meet their liquidity guarantees and commitments – not as easy as everybody thought. 

Not just banks as guarantors, but some money markets as investors, are having difficulties due to ABCP.

$1 trillion of liquidity problems is a big number that will role though the credit markets as risk aversion, higher rates and reduced credit availability.

The lawsuits will undoubtedly go on for years after the dust settles in the markets.  Let’s take a quick peek at what the Federal Reserve and some of the rating agencies had to say way back when ABCP was not a dirty word.  These statements will definitely be part of the evidence presented in court.  It seems to cut a bit both ways..

They all talked about the downside scenario, but nobody saw it coming.

Federal Reserve Bulletin February 1992:

“EXAMINER GUIDANCE”

“In 1990, to ensure consistency during examinations, the Federal Reserve provided guidance to its examiners to use when reviewing an institution’s involvement with asset securitization transactions. Although not specifically directed toward asset-backed commercial paper programs, many aspects of these existing examination guidelines are applicable to these vehicles. For example, the guidance instructs examiners to check that a banking organization participating in a securitization transaction–whether an asset-backed commercial paper program or some other type–has clearly and logically integrated these activities into its overall strategic objectives. In addition, it states that examiners should determine that the management of the organization understands the risks associated with the various roles that the institution can assume in such programs.

For those banking organizations providing credit enhancements and liquidity facilities, an analysis of the institution’s funding capabilities should be performed to ensure that these institutions are capable of meeting their obligations under all foreseeable circumstances. In addition, an analysis should be completed to determine the effects of the fulfillment of these obligations on the banking organization’s interest rate exposure, asset quality, liquidity position, and capital adequacy.”

Moody’s 1996:

“Understanding Structured Liquidity Facilities in Asset-Backed Commercial Paper Programs” Moody’s Asset-Backed Commercial Paper Market Review (Third Quarter 1996)

“Structured liquidity facilities are becoming increasingly common in asset-backed commercial paper (ABCP) programs. … In short, structured liquidity is credit enhancement. … It follows then that use of structured liquidity is of interest to investors because it may have implications for investors’ ability to recover their ABCP investment in a post-default environment. Although post-default recoveries are not factored into Moody’s short-term ratings, investors reasonably have an interest in the post-default scenario.”

Fitch Ratings, 2001

“Asset-Backed Commercial Paper Explained”

“An asset-backed commercial paper (ABCP) program is composed of a bankruptcy-remote special purpose vehicle (SPV), or conduit, that issues commercial paper (CP) and uses the proceeds of such issuance primarily to obtain interests in various types of assets, either through asset purchase or secured lending transactions. An ABCP program includes key parties that perform various services for the conduit, credit enhancement that provides loss protection, and liquidity facilities that assist in the timely repayment of CP.

The repayment of CP issued by a conduit depends primarily on the cash collections received from the conduit’s underlying asset portfolio and a conduit’s ability to issue new CP. The main risks faced by ABCP investors are asset deterioration in the conduit’s underlying portfolio, potential timing mismatches between the cash flows of the underlying asset interests and the repayment obligations of maturing CP, a conduit’s inability to issue new CP, and risks associated with asset servicers. To protect investors from these risks, ABCP programs and the asset interests financed through them are structured with various protections, such as credit enhancement, liquidity support, and CP stop-issuance and wind-down triggers. “

Standard & Poor’s, 2005:

“Global Asset-Backed Commercial Paper Criteria”

“An asset-backed commercial paper (ABCP) conduit is a limited-purpose entity that issues CP to finance the purchase of assets or to make loans. Some asset types include receivables generated from trade, credit card, auto loan, auto, and equipment leasing obligors, as well as collateralized loan obligations (CLOs) and collateralized bond obligations (CBOs). ABCP conduits are typically established and administered by major commercial banks to provide flexible and competitive low-cost financing to their customers. The CP issued can take a variety of forms, from traditional discount notes to extendible or callable notes.

Unlike stand-alone term securitizations, ABCP conduits are ongoing concerns and do not wind down after a few years. In a typical ABCP conduit, maturing CP is paid down with the proceeds of newly issued CP. Simultaneously, the proceeds of collections from matured receivables are reinvested in newly generated receivables.”

So Much for the Experts:

The rating agencies didn’t signal the problem.  The bank examiners didn’t see the problem.  The auditing firms didn’t see the problem.  The investment bankers didn’t see or talk about the problem.  The money markets didn’t see the problem.

The subprime meltdown was an “exogenous” event that started the dominos falling.  It came as a surprise, but should it have?  There were so many signs of craziness and excess in the mortgage markets and the private equity markets that we had to know there were problems underneath.

Anyway, here we are and here we are likely to stay for longer than most of us expect.  Years of excess are not cured by days or weeks of pain.

Richard Shaw
QVM Group LLC

A year ago, the prevailing forecast was for oil prices to decline to the mid-50’s for more than a year.  Opinions have changed in the face of the reality of high current prices. 

Natural gas, which was at historic highs, was used as justification for utility companies to obtain rate increases for their electricity and natural gas customers.  Gas has managed do come down considerably since then.  We won’t hold our breath expecting those same utility companies to request rate decreases now that gas prices have declined.

You can see from the following futures charts that the price of oil and gas were not well correlated in the recent past (since June, 2006).  Within an asset allocation to commodities, oil and natural gas may provide some volatility diversification.

      Near Month Light Crude Futures

      Near Month Natural Gas Futures 

For the ETF/ETN enthusiast, there are several funds that provide direct exposure to the energy resource:  USO and OIL track oil futures.  UNG tracks natural gas futures. 

For a less direct exposure, there are mixed commodites ETF/ETN solutions that include oil and natural gas: DJP and GSP (both ETNs from Barclays) and some newer general commodity ETNs.  Goldman Sachs offers GSC and the Swedish Export Credit Corp offers EEH.

The gas pipeline master limited partnerships (MLPs) are a way to participate in gas consumption levels via the transmission fees charged by the pipelines.  Bear Stearns has recenly introduced an ETN (BSR) based on the pipeline MLPs.  We tend to think of the pipelines as more of a specialty kind of real estate.  They are definitely tied to the commodity, but they resemble real estate in that they charge a rental to use the pipeline which is an ”improvement” of the land — that’s what real estate is and does. 

On a broad scale, there is XLE, the S&P 500 energy sector ETF that tracks most large integrated oil companies and oil and gas service companies.

Note:we are not making any recommendation in this article, but simply describing the price and consumption context and identifying some ETF and ETN investment funds that are reasonably closely related.

As of September, the U.S. Department of Energy forecasts West Texas Intermediate crude to refiners (refiner acquisition cost) to average $61.60 per barrel for 2007 and $73.50 for 2008.

They forecast Henry Hub natural gas spot price to average $7.45 per thousand cubic feet (mcf) in 2007 and $8.06 per mcf in 2008.

Their summary of global petroleum market is as follows:

“Continued production restraint by members of Organization of Petroleum Exporting Countries (OPEC), rising consumption, and moderate increases in non-OPEC supply are keeping oil prices firm.  The global oil balance for the remainder of 2007 has tightened since the last Outlook due to lower projections for world oil production and a larger projected Organization for Economic Cooperation and Development (OECD) stock draw in the second half of the year.  This situation contrasts with conditions last year, when prices weakened in the second half due to slow consumption growth, rising global inventories, and the absence of hurricane-related oil supply losses.  EIA projections for 2008 also point to a tight market, with higher consumption growth in 2008 than in 2007, moderate growth in non-OPEC supply, increased demand for OPEC oil, and limited surplus production capacity, held mostly in Saudi Arabia.  These tight conditions leave the market vulnerable to unexpected supply disruptions, especially as oil inventories are reduced over the coming months. “

They provided several helpful charts of consumption patterns and expectations for key energy sources as follows (click images to enlarge):

      World Oil Consumption

      U.S. Natural Gas Consumption

      U.S. Electricity Consumption

      U.S Coal Consumption

Richard Shaw
QVM Group LLC

Disclosure:  author owns DJP

We can still remember when people were telling us that the subprime crisis was confined to U.S. housing — that it was not a big deal in the final analysis.  Well, the final analysis is not in yet, but oh were they wrong. 

 

Not only is the subprime crisis not confined to U.S. housing — it is rippling through the entire U.S. and world economy. The Federal Reserve, European Central Bank (ECB), and the Bank of Japan (BOJ) have injected liquidity .  The ECB and BOJ have talked about deferring expected short-term interest rate increases.  The People’s Bank of China has been talking up the dollar in response the crisis.

One U.S. money market fund issuer has filed for bankruptcy and the large French insurer, AXA, had to infuse money to avoid “breaking a buck” on one of its money market funds.

The U.S subprime crisis is not just a U.S. housing problem, it is an overall problem for the U.S. and world economy.  For a further example, yesterday, the Bank of China (#2 bank in China) announced that it holds $9.7 billion of U.S. subprime mortgage debt and has begun putting up new loss reserves for that.  The reserves are only $152 million so far, but when Chinese banks start having U.S. subprime problems, we’d say the problem is not domestic, is not contained and is not likely fully revealed.

We’d like to add an anecdote from our firm’s direct experience to further illuminate the situation.

Yesterday, we managed the bid process for a municipal bond refinancing and the market information was astounding.

In a municipal bond refinancing a city that has muni bond proceeds that need temporary investment prior to use will invest the bond proceeds to generate income to pay the coupon on the muni bonds.  One method — the one we were hired to manage — is to ask a major institution to provide a guaranteed fixed return for a specified period for a particular sum of money, but with full flexibility for the municipality to withdraw funds as may be required during the life of the guarantee. That is called a “flexible bond repurchase (repo) agreement”.

Normally, the bid manager (that’s us) would send a request for proposal to a significant number of large, high credit quality banking, insurance and investment banking institutions; and then sort through the responses, organize the data in a consistent way and recommend to the municipality which to chose.

The selected repo issuer then puts Treasury securities in the amount of the guarantee in the hands of a third party custodian, and the custodian passes the muni bond proceeds to the repo issuer.

Normally, there is serious competition from institutions to get the business, but not yesterday.  We sent proposal requests to 20 major institutions that routinely do muni flexible repo business asking for a 90 day repo for $20 million and a 1 year repo for another $20 million.  Of the 20 institutions only 3 submitted a proposal, while 17 (85%) sent declinations.  That level of non-availability is unprecedented.

The reasons given in the responses from the 85% that did not make an offer were of two types: “We have no collateral available” or “We are not currently offering collateralized products.”

NO COLLATERAL!  NO COLLATERALIZED PRODUCTS!  Those two statements represent a depletion of resources for new investment in the first case, and a general shift away from risk in the second case.  The problem is popping up everywhere, and everybody is impacted.

Richard Shaw
QVM Group LLC

Sometimes risk reduction and capital preservation are of higher importance than pursuit of return.  When major questions about underlying holdings of a fund arise and potential risks are significant, we think standing aside and waiting for the issues to resolve is the prudent thing to do.  That’s where we stand on money market funds today.

Consider, for example, these excerpts from the Financial Times (Aug. 20) in an article titled ” Money market funds abused, claims founder”

“Bruce Bent, the inventor of the money market fund, has criticised the ‘flagrant abuse’ of the concept – which he introduced in 1970…  [He has] a sense that many money market funds have exposure to sectors or securities they should not be in .

… [The] desire of some cash managers to post the best possible yield has left many overextending their reach and investing in areas such as subprime paper. … [an extreme current example] Sentinel Management Group, a US money management firm, pointed to problems in the money markets when it filed for bankruptcy last week after having frozen its funds.

This month, Axa Investment Managers in France said it would shore up two of its money market funds that had invested heavily in subprime loans.”

Also consider today’s page one Wall Street Journal article titled “Fed Fails So Far In Bid to Reassure  Anxious Investors” which said.

“… The latest wave of risk aversion in the credit markets is being led by managers of money-market funds, which are designed to behave like bank accounts and whose primary goal is to avoid losing money for investors. … Michael Cheah, a fixed-income portfolio manager at AIG SunAmerica Asset Management, said ‘This is about dealing with what we don’t know. There is little margin for error in money-market funds.’ “

It is unlikely that the vast majority of money market funds hold “bad paper”, and those few who may will probably “eat” their losses to avoid “breaking a buck” price level for their funds.  However, today with so much confusion and so many responsible experts saying that pricing and valuation are difficult at best, we chose to stand aside for a while.

Therefore, several days ago we converted our personal money market assets, and recommended that our clients convert their accounts, to money market funds holding only U.S. Treasury securities.  We gave up approximately 50 basis points in doing so – a price we gladly pay for the next few months to have cold comfort that our $1.00/share money market assets will be worth $1.00 in the future.

Consider that if we wait 3 months for the situation to settle, we lose only 17 basis points of return on an annual basis.  We think that is a reasonable price to pay for cold comfort.

The money market component of a portfolio is supposed to be the lowest risk component, exposed to inflation risk, but not to market risk.  We recommend this temporary redeployment to assure that it remains the lowest risk component without market risk.

If return were the goal, the assets would not have been in money markets in the first place.  Money markets are the place to park money that has near term uses and for assets that should not be exposed to market risk.  Either way nominal capital preservation is the #1 goal.

News of the risk is not new, but the advice still makes prudent sense for a temporary change in portfolio composition for risk reduction.

Richard Shaw
QVM Group LLC 

Sometimes it’s better to listen than to talk.  That’s where we are today concerning the current market turmoil.  The following are excerpts from the PIMCO montly letter and a piece in Fortune Magazine called “Crisis Counsel” . 

Bill Gross (Chairman, PIMCO)

“[August newsletter] No longer will double-digit LBO returns be supported by cheap financing and shameless covenants. No longer therefore will stocks be supported so effortlessly by the double-barreled impact of LBOs and company buybacks[financed with cheap borrowings]. … High yield lenders, perhaps if only in their frozen, frightened passivity, are signifying that the wealth must be redistributed, that the onerous oppressive tax in the form of low yields must change, and that finally enough is enough!”

Steven Roach (Chairman, Morgan Stanley Asia)

“… For the second time in seven years, the bursting of a major-asset bubble has inflicted great damage on world financial markets. In both cases–the equity bubble in 2000 and the credit bubble in 2007–central banks were asleep at the switch. The lack of monetary discipline has become a hallmark of unfettered globalization.
… When the bubble burst in early 2000, the optimists said not to worry. After all, Internet stocks accounted for only about 6% of total U.S. equity-market capitalization at the end of 1999. Unfortunately, the broad S&P 500 index tumbled some 49% over the ensuing 2 1/2 years, and an overextended corporate America led the U.S. and global economy into recession.

Similarly, today’s optimists are preaching the same gospel: Why worry, they say, if subprime is only about 10% of total U.S. securitized mortgage debt?”

Warren Buffet (CEO, Berkshire Hathaway)

…Many institutions that publicly report precise market values for their holdings… are marking to model rather than marking to market. The recent meltdown in much of the debt market, moreover, has transformed this process into marking to myth. … for a few institutions, the difference in valuations is the difference between what purports to be robust health and insolvency…. pinning down market values would not be difficult: They should simply sell 5% of all the large positions they hold. That kind of sale would establish a true value …”

Will Ross (CEO, WL Ross & Co)

“… Liquidity, however, is not about physical cash; it is mainly a psychological state. Subprime problems have consumed only trivial amounts of global cash but already have burst bubbles by shocking lenders.

…The present $200 billion of delinquencies will grow to $400 billion or $500 billion next year because $570 billion more low, teaser-rate mortgages will reset to market and consume more than 50% of the borrowers’ income. Therefore most of the loans will be foreclosed or restructured. Probably 1.5 million to two million families will lose their homes. Meanwhile, few lenders will put mortgages on the foreclosed houses, so the prices will plummet. Despite these tragedies, total losses will probably be less than 1% of household wealth and only 2% to 3% of one year’s GDP, so this is not Armageddon.

…Similar excesses occurred in corporate debt markets. Leveraged buyouts were financed with few or no restrictive covenants … The debt-to-cash-flow ratio hit record highs, and more than 60% of junk bonds issued are rated B or lower. Only 13% of high-yield issuance proceeds was for capital expenditures for expansion–87% went for sponsor dividends, stock buybacks, LBOs, or refinancings, none of which inherently advance credit worthiness. And this exotic lending paid only 2.5% to 3.0% more interest than Treasury bonds’ 5.5%. Therefore investors received only 8% or 8.5% interest on bonds that had a 25% probability of defaulting, the same ignoring of risk as in subprime.”

Henry Paulson (Secretary of the U.S. Treasury)

“… The current strained situation will take time to play out, and more difficult news will come to light. Some investors will take losses, some organizations will fail–but the overall economy and the market are healthy enough to absorb all this. As I have said, a repricing of risk is occurring, not just in the subprime credit markets but across all capital markets.”

John Mack (CEO, Morgan Stanely)

” … It’s not so much a credit crisis as a liquidity crisis, largely because of the subprime market meltdown. As a result, the quant funds de-leveraged.
… There’s still liquidity in the markets. There’s plenty of investor money in China, Russia, the Middle East, as well as the U.S.

… It’s too early to tell how this will shake out. The markets will eventually normalize, but things have changed. Investment banks and commercial banks will be much more conservative with their leveraged loans (for private equity buyouts). … There will be much stronger covenants structured into deals so that if things go wrong, the deals can be repriced.”

Bill Miller (CEO, Legg Mason Capital Management)

“These sorts of things are … “endogenous to the system”… they’re normal. They happen usually every three to five years. So we had a freezing up of the market for corporate credit in the summer of ‘02. We had an equity bubble just before that. In ‘98 we had Long-Term Capital. In ‘94 we had a mortgage collapse like we’re having right now. In 1990 we had an S&L collapse. In ‘87 we had a stock market collapse. These things flow through the system, and they’re part of the system.

… But these events represent opportunities. When markets get locked up like this, it’s virtually always the case that you’ll have opportunities if you have liquidity. Instead of worrying how bad it’s going to get, I think people should be thinking about where the opportunities might be.

The NYSE financial index is probably the best barometer of what’s to come. The financials tend to be a very good indicator of where the market’s going. They tend to lead the market because they’re the lubrication for the economy. So I think the financial index will tell you if this thing is over … just as financials lead on the downside, they will lead on the upside.”

Robert Shiller (Professor, Yale University)

“We have been in a spectacular boom in both stock and housing … boom psychology brought us lower lending standards and a lot of wishful thinking about how easy it is to make money, and both real estate and stocks have been at record highs.

… It’s possible that we are at a major turning point, but I’m not sure. So far, I don’t see any major change in investor psychology. [based on homeowner surveys about future real estate prices]”

Jim Rogers (private investor, former George Soros partner)

“We’ve had the worst bubble in credit we’ve ever had in American history. As the bubble got bigger and bigger, it spread to emerging markets and leveraged buyouts and all sorts of things. And it hasn’t been cleaned out yet. I don’t think you can have a bubble like this and clean it out in six months or even a year. It has always taken longer.

… [homebuilders] I think that bottom is a long way off.

…As far as the credit bubble, we have another several months, if not more, of mortgages that are going to reset and people who are going to find themselves with even higher monthly payments. There are many, many more losses to come, most of which we won’t know about for weeks or months.

Normally you have markets go down 10% or so every couple of years. We haven’t had a 10% correction in the stock market in nearly five years.

… It wouldn’t surprise me to see a little bounce–say if a central bank cuts rates. But that will just lead to the markets falling further late this year or next year.

… I have been and continue to be short the investment banks and the commercial banks.”

Jim Chanos (CEO, Kynikos Associates)

“People keep pointing to the fact that capital spending is great. But they pointed to the same thing in 2000, when the market was tanking even as telecom was booming. We pointed out then that the telecommunications build-out was almost over–and was increasingly focused on projects that didn’t make any sense. Today, whether it’s the 48th planned community in Dubai or the marginal factory in rural China, you’re going to find out that the capital projects in the works don’t make a whole lot of sense either. But there’s a huge lag effect on that. Financial firms are the canaries in the mineshaft, and the laggards are the capital-goods companies.

… At the individual level, what’s happening right now is probably an argument for indexing and not taking the risk of individual stocks.”

Amy Brinkley (Chief Risk Officer, Bank of America)

“…hit to business confidence and the wider credit spreads…. There will continue to be pain in both the subprime mortgage and the leveraged loan markets. In the leveraged loan market, unlike the subprime market, the credit fundamentals haven’t changed. But there’s an oversupply of new issues–$237 billion worth of leveraged loans in the pipeline.

… The very substantial changes in the financial markets over the past five years have presented new challenges. We have new players: foreign investors, hedge funds, and private equity firms. And we have new products–more complex products than in the past. The changes do distribute risk more broadly, but they’ve contributed to the uncertainty. Getting a handle on where the risk is isn’t as easy as it used to be … These more complex products are less transparent [than banks making and keeping their own loans].. And the hedge funds are less transparent. The uncertainty creates a higher level of risk aversion.

…The longer there’s risk aversion, the greater the impact on the markets. The oversupply of leveraged loans will take a few months to go through the system. The subprime issues will continue to be problematic through 2008.

… Global economic growth is expected to remain strong. The U.S. economy continues to be sound. One of the most important indicators is low unemployment, at 4.6%. We’re seeing steady gains in personal income. There’s a continued acceleration in exports. And corporate balance sheets are strong.”

Laura Tyson (Professor, Haas School of Business)

“Financial market innovation in the form of credit derivatives has broadened the range of investors willing and able to hold risky new assets like securities backed by subprime mortgages, despite the fact the markets for such securities are both illiquid and non-transparent. Proprietary quantitative trading models, designed by the best possible minds using the best possible information technology, have yielded lemming-like behavior that has fed market gyrations. And the extent and location of market losses are hidden behind hedge fund walls.”

Jeremy Grantham (Chairman, GMO)

“…The risk premiums had hit a world-record low back in February. It was probably the lowest point in history and across a very broad base of assets. But the essence of the bubble was risk-taking.

It was a bubble of liquidity and a consequence of liquidity.

The proximate cause of this is subprime. …that is the local cause. The general cause is that risk was mispriced on an extensive basis globally. … elaborate fixed income instruments typified by subprime but also to leveraged debt to private equity, junk bond spreads, credit default swaps.

…The selling might accelerate. On the other hand the markets could easily rally. But in the end risk will be repriced. Whether it’s now or in 18 months, risk premiums will be more normal.

The focus of the mispricing is in fixed income. That was more impressive than mispricing in equity markets. But the equity markets were also mispriced. The junky companies were selling at a premium to the blue chips. We had never seen such a deviation in performance between the junky rated companies versus the really high quality companies. It’s been going on since September of ‘02.

The leakage into the equity markets from the fixed income is of course private equity. Private equity is a function of how much debt you can get, the cost of the debt, etc. That fed right through into overpaying for fairly expensive companies. And then of course the ordinary investor, both institutional and individual, began to guess where the next deal would be. And when they saw one, they tried to position around similar ones.

… I think this is the very early stages of repricing risk, particularly in the stock market. It may be rapidly entering the middle stages in the fixed income market, although I think it will go quite a lot further in the next couple of years. But the equity markets have barely started to address this issue. Still, today the risky stocks are badly mispriced relative to the blue chips. They have a long, long way to go. I have no doubt they will do it. The pendulum always swings completely. In other words, you can guarantee that one day there will be a substantial premium for high quality companies.

There is a lot of pain still to be had in the equity markets, particularly aimed at the risky end of the spectrum. We think the fair value on the market is about a third lower in the U.S and EAFE from today and about a quarter less in emerging markets.

Most of that is not because P/E’s are high. The great weakness in equities is that profit margins are off the scale globally. They’re off the scale for the same reason that the risk premium got so low–that we’ve had wonderful global conditions, wonderful global growth, wonderful global liquidity, wonderfully low inflation. That will do it every time, without fail. So the profit margins went steadily up under a constant series of pleasant surprises…

…the longer the pleasant surprises, the higher the hurdle. The hurdle is now desperately high. It is virtually impossible to pleasantly surprise the world now. And profit margins will of course drift or drop down to normal and below. That’s the pressure on the markets. That is what causes the market value to be a third less than it is today.

And people don’t get that. People always look at P/E and take great comfort. Often it’s perfectly fine to do that. But today it’s horribly misleading because the main pain is in profit margins.

In five years, I expect that at least one major bank (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist.

Ben Stein (Economist, Lawyer, Writer, Actor)

“No one is too stupid to make money in the stock market. But there are many who are too smart to make money.

To make money, at least in the postwar world, all you have to do is buy the broad indexes domestically–both in the emerging world and in the developed world…

… right now we are stewing over what everyone calls “the subprime mess” and going crazy …

… The subprime mortgage world is about 15% of all mortgages, or $1.5 trillion worth, very roughly. About 10%–approximately $150 billion–is in arrears. Of that, something like half is in default and will likely be seized in foreclosure and sold. That comes to about $75 billion. Roughly half to two-thirds of that will be realized on liquidation, leaving a loss of maybe $37 billion. Not chump change by any means–but one-thirtieth, more or less, of what has been knocked off the stock market.

The “smart” investor … reads the papers, bails out, heads for the hills, and stocks up on canned foods. He gets a really big charge out of reading in the press that there are also problems in the mergers and acquisitions market and that some deals will not go through because there are problems raising the funds for the deal. He does not see that the total value of the U.S. major stock markets (the Wilshire 5000) is roughly $18 trillion. The value of the deals that have failed in the private equity world is in the tens of billions or less. The loss to investors–what the merger price was compared with the normalized premerger price–is in the billions. It’s real money, and I could buy my wife some nice jewelry with it, but it’s pennies in the national or global systems.

… the “smart” investor is far too busy looking for reasons to run for cover and thinks he can outsmart long-term trends.

The stupid investor knows only a few basic facts: The economy has not had one real depression since 1941, a span of an amazing 66 years. In the roughly 60 rolling-ten-year periods since the end of World War II, the S&P 500’s total return has exceeded the return on “risk-free” Treasury long-term bonds in all but four ten-year periods–the ones ending in 1974, 1977, 1978, and 2002. The first three of these were times of seriously flawed monetary policy that allowed stagflation, and the last one was on the heels of the tech crash and the worst peacetime terrorist attack in the history of the Western world.

The inert, lazy, couch potato investor … knows that despite wars, inflation, recession, gasoline shortages, housing crashes in various parts of the nation, riots in the streets, and wage-price controls, the S&P 500, with dividends reinvested, has yielded an average ten-year return of 243%, vs. 86% for the highest-grade bonds. …

The “smart” investor, in a bunker in the Montana wilderness, keeps his money in gold bullion. After all, he’s heard that home prices are falling slightly nationwide and a lot in some areas (he ignores areas of rising prices like San Francisco and New York City).

The stupid investor, the guy who just lies on his couch, knows that the consumer is always about to stop buying and never quite does. … if the consumer could keep spending after the bursting of the tech bubble wiped out $7 trillion or so of wealth, maybe the consumer can keep spending even if the subprime “mess” wipes out roughly half of 1% of that tech-bubble loss and the stock market has a fit. And maybe he knows that, even if there is a recession, recessions rarely last more than two quarters, and the economy and the stock market revive mightily after that–and that buying stocks in a recession is a good idea, not a bad idea.

…The real story is that long-term investors who have some sense of proportion make money. Short-term investors who live and die by the sweep-second hand of the $300,000 watch get rich fast and poor fast …

For the rest of us, the stock market is cheap on a price-earnings basis, profits are fabulous, Mrs. Clinton and Mr. Giuliani are far from being socialists and in the long run, both here and abroad, stocks are a lovely place to be.”