Rolfe Winkler

So the Phillies just won the World Series 20 minutes ago.  In his acceptance speech, the owner did the stand-up thing by first acknowledging the Rays and their great effort.  For all you baseball fans out there: has it sunk in that the Rays made it to the World Series this year?  The Tampa Bay Rays.  Together A-Rod and Derek Jeter make $50 million per year…$6 million more than the entire Rays team…

Yet the mere mention of the Rays’ name by the Phillies’ owner sent the home crowd into a fit of boos.  Even in victory they were obnoxious.

I know, I know: Philly fans are famous for douchebaggery. And they certainly lived up to that reputation tonight.

Even though I use to work a few blocks from The Trop in St. Pete—and was scheduled to sing the national anthem at a Rays/Yankees game in ’07—a small part of me was pulling for Philadelphia fans to get their first sports championship since ’83.  I mean, they’re from Philadelphia.  They need SOMEthing to live for.

I now regret having wasted any energy rooting for ‘em.

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I just hope the Cubs can manage to win a playoff game next year.  Mark Cuban, if you’re listening, please buy the Cubs and sign CC Sabathia!

Banks AREN’T lending the money being gifted by Treasury!  They’re using it to stabilize their balance sheets.  As the WSJ is reporting this morning, most banks are hanging onto the cash being injected by Paulson, as opposed to using it for fresh loans, much to the chagrin of Democrats Chuck Schumer and Barney Frank (and the Republican administration itself as you’ll see below):

The federal government’s bank-rescue plan will spread more than $15 billion among 10 regional banks, those companies announced Monday. But some banks acknowledged that perhaps only a small chunk of the money would be funneled into loans…

Mr. Frank warned that resistance by banks to convert their new capital into loans could haunt the industry’s future efforts to seek regulatory relief and other legislative assistance…

“That’s why we did it,” Mr. Schumer said of the decision to allocate the money in phases. Lawmakers want to “make sure the stated goal [for banks to increase lending] and the result have some degree of coincidence,” he added.

These two have it exactly backwards.  The goal of the bank rescue is to protect the savings of average Americans.  It wasn’t to force banks to make new loans.  The latter approach would, in effect, just re-inflate another credit bubble using federal dollars…

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This might be old news to readers of this blog, but still a nice way of putting it.

In this article, the Times does a good job summarizing the observations of three deans of high finance, Stephen Friedman, Marty Lipton and Joseph Rice III. These guys know what they are talking about. The comment regarding compensation should buoy those who have argued that tying pay to long term performance (perhaps something like a ten year running average) is really the only responsible way to run a company.

I think that one of the modern economy’s biggest problems is the dearth of self-aware principals in the system. Everyone seems to be an agent who profits on the up-side and moves on when things go bad.

To put it all very simply: principals are owners and agents work for them. Principals have to pay up on losses when a venture fails, but get all that is left over once all liabilities are paid. The buck stops with principals. Agents are only needed because principals can’t be everywhere at once. It’s a division of labor thing.

But, with modern portfolio diversification theory and the modern corporation, all decision makers became agents. After all, it’s not worth it for shareholders – who the law technically regards as principals – investing in index or mutual funds to monitor what goes on in an individual corporation. The fallout is that management thinks like an agent and takes big risks. Sometimes those risks go “boom.”

The fact that guys like Lipton think the super banks are here to stay scares me. The government should break these places up ASAP because of the systemic risks they pose.

Moreover, I’d be interested to know who has thought about the consequences of the big Wall Street houses going public in the 1980s and 1990s (Morgan Stanley, Goldman Sachs, etc…). If these places had still been partnerships, without limited liability for the owners, would things be different today?

I hope Obama and McCain are both thinking about this kind of thing. But, I doubt it.

Stock market futures have triggered circuit breakers this morning, down the maximum they are allowed before the open.  The SPX suggests the S&P will open down 9%.  Everything is getting hammered in pre-market trading.  Japan’s Nikkei was off 10% overnight to 7649. It had been over 18,000 just over a year ago. Britain announced a lower than expected GDP number, off 0.5% in the third quarter.

(Update: at 9:37, the Dow is down a little over 400.  And it’s coming back.  So who knows, we may actually end up today….though I doubt it.)

People are saying a lot of this is forced selling.  There are too many overlevered players that have to sell everything to raise the cash they need to pay back investors.  I guess that’s as good a reason as any for the violence in the markets.

The trade out of commodities and into the dollar continues as my college friend Becky Jarvis is reporting on CNBC. Oil is down below $63, the Pound and Euro are getting clobbered as the dollar spikes.

Right now Treasuries and the dollar are a refuge, but what happens when there’s the inevitable reversal out of the dollar and dollar-based assets?   Brad Setser published a fascinating piece a couple days back about the fundamental reversal of capital flows that have driven the world’s economies for decades. In a nutshell that relationship has been that they give us stuff, and we give them dollars, which they lend back to us to buy more of their stuff.

But what if they’re no longer benefiting from this trade flow and are forced to reverse it. What if they lose so much money on the dollar assets they’re holding that they decide to stop holding them? In the case of China, for instance, Brad quotes the following:

“Charles Dumas of Lombard Street Research estimates that China makes 1-2 per cent on its (largely) dollar reserves. It then loses up to 10 per cent on the exchange rate and suffers a Chinese inflation rate of 6 per cent for a total real return in renminbi of about minus 15 per cent. That is a loss of $270bn a year, or a stunning 7-8 per cent of gross domestic product.”

When the Chinese decide it’s too expensive to keep recycling their dollars back into the U.S., what then? We could see a spike in U.S. interest rates as the demand for U.S. debt can’t come close to meeting supply.  Where do people think the money is going to come from to fund trillions of dollars of bailouts and “stimulus?”

It has to be borrowed, which means we have to sell more Treasury bonds and hope people will buy them.  Right now they are, because they perceive Treasuries as a safe haven in a violent market.  But it’s my belief that, eventually, the supply of Treasury bonds will vastly outstrip demand to buy them.

That is to say, our need for borrowed money will eclipse the rest of the world’s ability to provide it. That will lead to higher interest rates and possibly a run on the dollar.

It’s been said that the Chinese have to keep this reciprocal relationship going.  They have no choice.  If you owe the bank a little bit of its money, they own you.  But if you owe them all of their money, you own the bank.  But that sentiment ignores the obvious truism that unsustainable things do not sustain themselves. We may own the Chinese, but if we go bankrupt, so do they.  This Ponzi game we have going with them, where we spend to infinity and they lend to infinity, is just not sustainable forever.  It will reverse.

Maybe not today, maybe not tomorrow, but soon and–possibly–for the rest of our lives.

Rolfe is right: capitalism requires failure. But it requires failure on the small scale, not systematic failure.

When Joseph Schumpeter published The Theory of Economic Development and identified the business cycle and the losses and gains associated with creative destruction he was analyzing firms and industries, not economies as a whole. Capitalism requires investors to take risks. Some will be winners and some will be losers. If the system works properly, the gain on the whole will offset the losses. If everyone, or a disproportionate number, become losers all at once the system breaks down. If you don’t believe me, go ask John Maynard Keynes, about sticky economies and the problems associated with pulling out of deflationary cycles. If enough banks fail things get bad and fast.

Moreover, banks – like healthcare and education – have not been normal businesses, free from heavy government regulation, for some time. The Feds insure deposits, try to manage the money supply and supposedly regulate bank risk. The problem is that they have not been doing a very good job. Or in the case of the self-regulated markets (OTC derivatives) they haven’t been doing any job. We regulate banks because if they break down –which seems to have almost happened – the economy breaks down and the business cycle will cease to function in the short term. And, “in the long term we are all dead,” so we shouldn’t concern ourselves with so called market forces that make everything work out in the end…

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A question for readers:  capitalism without failure is like…..what?  Fill in the blank.

In the wake of recent financial tumult, the world’s governments have extended an implicit guarantee to the worldwide financial system.  There will be no more Lehmans.  No more large bankruptcies.

So companies like Wells Fargo and General Motors buy—or try to buy—distressed assets (Wachovia and Chrysler respectively) in order to make themselves “too big to fail.”

Not only is it politically unpalatable to let major American industrials go under, but the government thinks it’s cheaper to save them.  Uncle Sam is on the hook anyway.  In the case of banks, via deposit insurance.  In the case of other industrials like Detroit automakers, via pension insurance.  All those obscene retirement benefits that are bankrupting auto companies are, you guessed it, backstopped by taxpayers….

(Update: news on pension problems out today)

This doesn’t necessarily mean good things for the stock market.  “Too big to fail” doesn’t mean that equity isn’t going to zero.  It just means that if it does, the government will be there to rescue bondholders, depositors, and pensions.

If I were inclined to put money to work, I’d wait till financial panic returns (because it will) and then scoop up the senior debt of large distressed banks.  The government won’t let you lose any money.

Yeah, yeah, Gordon Gekko doesn’t have much to teach us now. Insider trading is passe.

With that in mind, check out what politically ambitious prosecutors cut their teeth on today.

If Gekko was trading now he would be playing the spread between credit default swaps (CDS) and the equities of the reference entity. The scheme is easy. Buy huge amounts of CDS on firm (x). Turn around and short the hell out of firm (x). That market will get jittery, which should raise the value of your CDS(x) contracts, since more people will want to insure there (x) bonds. You can also do the reverse by first selling short on (x) and then buying hard into the CDS market, trying to drive up price of default insurance on (x). When the CDS spreads for (x) go up the market will again get scared and (x) share prices should fall, giving you a nice profit on your short sale.

As a mutual fund manager told a buddy of mine, “Not good.  Not very nice.  Mean and nasty.”

But, there is more money to be made in trying to get the value of your CDS contracts to go up. CDS is a derivative and that means, at least for cash settled CDS contracts, the number that exist on a trading screen don’t have to mirror assets in the real world. For you insurance mavens: there is no indemnity requirement. This means the only thing limiting the size of your CDS bets is the extent to which your counter-parties want to take on the risk. The size of a short position in the stock market is limited by the number of shares out there.

And that is the big difference between derivatives and old Wall Street. Stocks and bonds are subject to limitations based on what exists in the reality. With OTC derivatives you can, in theory, bet the world on a coin flip.

I’d never heard of Andrew Lahde until I saw CR‘s post on him tonight.  He scored AMAZING returns betting against subprime.  Below is his farewell letter to investors.

According to Forbes, he closed up shop last month because, he said, “his bank counterparties had gotten too risky to trade with.”  Interesting.

I found an FT article from November 2007 that offers good background.  Says his YTD ’07 return had passed 1,000% by that point.  That article quotes him at the time:

“Our entire banking system is a complete disaster,” he wrote. “In my opinion, nearly every major bank would be insolvent if they marked their assets to market.” He also said he would be putting some of his own profits into gold and other precious metals.

A very prescient analysis.  That November 2007 article says he started returning money to investors back then b/c risk-reward characteristics weren’t as favorable.  I guess he finally closed up shop last month.

And this was his farewell to investors…

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Tune in to Ron Smith’s show at WBAL.com by clicking on the “listen live” link at the top left of the main part of the page.

The segment should begin after weather, news, traffic at about 4:35.

Where did the Lehman payouts go?

Over the weekend, the Depository Trust & Clearing Corporation (DTCC) issued a release stating that the net credit default swap (CDS) payout on Lehman bonds, to be paid on October 21. I’ve been talking to a few people about this over the last few days and this is the consensus. Sorry for only producing notes here…

The DTCC knows what it’s talking about. Unlike most of the characters or organizations that write on the subject (like me) or get quoted in the press, the DTCC is intimately involved with the CDS market. In 2006, the DTCC set up a registry for CDS, where both sides to a trade could document an agreement. Almost every serious CDS market maker – JP Morgan, Goldman, Morgan Stanley, and BOA – contributes to use the registry and buy-side firms get the service for free. To the extent that anyone can survey the CDS market, DTCC can. Most of those with whom I’ve spoken said that unlike the International Swaps & Derivatives Association, they are not professional PR for the OTC market. The DTCC hardly ever releases its proprietary information regarding OTC derivatives. They issued the release to counter the fear regarding CDS payments on Lehman bonds and until I see something to make me change my mind, I’m not going to be worried about October 21.

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It’s well-known that bond investors flew to quality last month, buying up short-dated Treasuries at fantastic rates (chart courtesy of Curious Cat).  In a world where anyone could go bankrupt as the financial system melts down, who cares about yield?  Investors are more concerned with principal protection.  They trust Uncle Sam to pay back debts, even he has to run the printing press, so Treasuries are perceived as “riskless.”  Over the long-term inflation is a threat, but no one cares about inflation next year when they think their bank could implode next week.  Apologies I don’t have a more updated chart, but know that yields on the 3-month are still very low at 0.20%.

Bank depositors are also flying to quality.  Today the Journal published this chart, showing bank depositors flying to the two largest banks: B of A and JP Morgan.  Are they the two safest?  I haven’t studied their balance sheets in detail, so I can’t offer an informed opinion.  But being the largest, the government won’t let them go under.  That’s why I’ve split my savings account between these two.

Citigroup reported Q3 results this morning, so it isn’t included in the chart.  But its domestic operations also benefited from the flight to quality, as U.S. deposits climbed nearly $17 billion or 6% in the quarter.  (International deposits declined 7%, however, pushing overall deposits down 3%….)

JPM’s number is boosted significantly by the acquisition of Washington Mutual.  Backing out the acquisition, JPM’s “same-store” deposits still grew a whopping $60 billion in the quarter, up 8%.  Not quite the $90 billion increase for B of A, but still pretty good.   That should give Jamie Dimon something positive to consider while he’s ruminating about how terrible everything is.

The chart doesn’t include WaMu, which saw an outflow of nearly $17 billion in deposits in the nine-days before it was seized and sold off.  That outflow was despite ridiculously high CD rates of 5%.  Let that be a lesson to you savers out there.  If a bank offers CD rates that seem too good to be true, they probably are.

Brad Setser recently commented: “All major financial institutions in the G-10 ultimately now have access — through their national central bank — to the Fed.” To avoid another bankruptcy the size of Lehman, the Fed has basically guaranteed, well, the worldwide banking system.  The problem is that an “unlimited guarantee requires unlimited access to financing.” No one, not even the Fed, has unlimited access to financing.  The Fed only has unlimited access to a printing press.  If the dollar loses all its value due to hyperinflation, it won’t be worth much to anyone as insurance against loss.

And it isn’t just banks that are getting unlimited access to Fed loans.

• Through the new Commercial Paper Funding Facility, industrial corporations get access too.
• After raising deposit insurance limits to $250,000 and extending it to non-interest bearing accounts, the FDIC also plans to insure new bank debt.
• And how ’bout this nugget: at the behest of regulators “Fannie and Freddie began notifying bond traders last week that each company needs to buy $20 billion a month in mostly subprime, Alt-A and non-performing prime mortgage securities.”  Already the government is on the hook for Fannie’s and Freddie’s losses, which will run into the hundreds of billions over time.  Now it will compound those losses by vacuuming up financial trash to the tune of $40 billion more per month.
• That’s in addition to the hundreds of billions to purchase “troubled assets” as part of Paulson’s huge bailout.
• AIG’s credit line is over $100 billion now.  Ironically, as the company tries to sell assets to pay back that government loan, it’s finding that potential buyers can’t get financing to buy their assets.  Unless they get it from the federal government.  So, effectively, the only way for AIG to pay off its loan to the government is for the government to give a loan to another corporation to buy AIG’s assets.
• $25 billion for carmarkers; hundreds of billions for “stimulus” packages; tax cuts for banks to buy other banks; perhaps a bailout for states, like California, facing cash shortfalls
• Over a trillion dollars lent to banks via the FHLB system.
• This is just the stuff I can think of off the top of my head.

The government is lending and insuring so much so quickly, it’s impossible to keep track of it all. (Though Barry Ritholtz figures the total cost is now in the $4-$6 trillion range).  I’ve said it before: a trillion here, a trillion there and pretty soon you’re talking about real money.  I fear this will all end very badly, much worse than if the government had allowed the system to fail last week…

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My old employer, The Providence Journal, has been kind enough to publish another one of my Op-Eds. This one lays out why I think the bailout bill, or TARP, is needed. It’s a little behind the curve, but that is because news travels faster than the ProJo’s publication schedule.  

I know many who read OA might not agree. And yes, I’m scared of hyperinflation, or something similar. But, I think deflation is worse and that is why the bailout is necessary.

I’m open to changing my mind. Please post your arguments. I don’t know what we are going to do about the viability of the dollar long term. I just don’t think massive unemployment is a strong choice or any kind of choice.

Morgan Stanley needs cash and fast. Let’s hope Mitsubishi UFJ, or someone (Secretary Paulson?), is feeling generous. 

Last week, I wrote that regulators should not allow another big financial firm to declare bankruptcy because of the consequences such an event would have in the credit default swap (CDS) market. I was wrong. Bankruptcy is not the only issue. Credit ratings matter just as much.

Credit Default Swaps work like insurance in the sense that they transfer downside risk in exchange for a fee. However, unlike insurance contracts, CDS are swaps and that means they involve real time cash flow.  This is a big difference.

The financial conglomerate that insures your car doesn’t monitor, on a day-to-day basis, the speed you drive. In other words, it doesn’t monitor the changes in the risk affecting your car. Moreover, your insurer doesn’t have to show you that it has the money to pay if something goes wrong (That is why you have insurance company advertising: “you’re in good hands…”). Instead, both you and your insurer wait until something bad happens and then the policy is settled according to the damage done. It’s a system built on trust.

CDS payments are built on proof. A protection seller – the insurer – must prove to the protection buyer that it can pay.  A portion of the payout amount the protection seller would owe the buyer upon the occurrence of a credit event is posted as collateral at the onset of the contract. As the risk of a credit event increases (as the market value of the CDS contract goes up) the proportion of the total payout, the amount of collateral that must be posted, increases.

Increased risk of a credit event, however, is not the only thing that can force a protection seller to post more collateral. A protection seller’s ability to pay upon the occurrence of a credit event, what’s known as the counterparty risk, also affects how much collateral must be posted. And a protection seller’s ability to pay is determined by the seller’s credit rating.

The better the rating the less money the protection seller must have available to show the protection buyer it can meet its CDS obligations. As a seller gets downgraded, the seller must post more collateral. It wasn’t a particular credit event, such as a bankruptcy, that caused AIG’s CDS portfolio to implode. It was AIG’s credit rating downgrade on September 15th that forced it to post more cash than it had, which ultimately led the Federal Reserve to come to the rescue.

Increased risk of a credit event and increased counterparty risk affect one another. But, increased risk of a credit event only affects one CDS at a time. A credit rating downgrade for a protection seller, a change in counterparty risk, forces that seller to come up with cash for all its CDS positions. Therefore, as I understand it, a credit rating downgrade has more potential to create catastrophe in the CDS market than individual changes in the market’s perception of credit risk for a particular reference entity.

Long story short, watch for a downgrade of Morgan Stanley’s credit rating. If it happens the consequences for Morgan’s CDS portfolio will be catastrophic, regardless of whether or not it is a net protection seller. 

Have the markets finally caught a break?

Fears that Lehman’s Credit Default Swaps (CDS) settlement would lead to more bankruptcies might be unfounded.

The net fund transfers from CDS protection sellers to CDS protection buyers is expected to be in the $6 billion range, according to a release issued yesterday by the Depository Trust and Clearing Corporation (DTCC).  With $400 billion of outstanding CDS on Lehman’s debt, $6 billion of actual losses is far smaller than many had feared.  How could the losses have been so well-contained?  It appears financial firms may have done something right for a change, hedging their exposures to Lehman CDS appropriately.

CDS are a type of Over-The-Counter (OTC) Derivative that act like insurance on debt. Like the rest of the OTC derivatives market, the CDS trade is unregulated, but that is likely to change soon (See SEC and New York Department of Insurance). And a CDS settlement is what happens when those that have bought CDS insurance file a claim and find out how much their insurer is going to pay.

On Friday, the market found out that CDS sellers would pay a little more than 90 cents for every dollar of Lehman debt they insured. The CDS market had never before been faced with settling such significant claims for a company with so much debt.

The big worry, with the Lehman settlement and with CDS generally, is the size of the market.  It is estimated to be in the tens of trillions of dollars (most up to date number I’ve seen is $34.8 trillion, but nobody really knows because there are no mandated reporting requirements).

When CDS were invented during the early nineties they were considered innovative because of the manner in which they allowed risk to be spread. Trading desks across the globe could accept a fee for taking on the downside risk that a given credit obligation could not be met. Those desks could offset that risk by turning around and buying CDS insurance from another trading desk for nearly the same amount.

Instead of huge insurers and reinsures centralizing massive amounts of risk, CDS contracts allowed risks to be traded and therefore to be spread thinly across huge portions of the market. This was supposed to lower the price of taking on risk by allowing more participants access to the market.

Potentially huge pools of money get transferred when CDS contracts settle. For years, smart people on Wall Street have wondered what might happen if one of the trading desks in the chain failed to pay up. The answer seemed straightforward: if the chain of payments broke, those firms closest to the end would bear the largest liabilities. Friday’s Lehman Bros. settlement was the biggest test of the market yet.

According to the DTCC, the CDS market passed that test, with only $6 billion changing hands. What’s the DTCC? It’s basically the most important financial institution nobody has ever heard of. It provides back office and settlement services to pretty much everyone. If you own any kind of stock or bond, chances are a trust run by the DTCC holds it for you.

What’s more, the DTCC is claiming that it is the “central registry” for CDS trading:

“The idea that the industry lacks a central registry for over-the-counter (OTC) credit default swaps (CDS) is grossly misleading and has resulted in inaccurate speculation on a number of matters, including the overall size of the market, its role in the mortgage crisis, and the size of potential payment obligations under credit default swaps relating to Lehman Brothers. The extent to which such speculation has fueled last week’s market turmoil is difficult to determine.”

For Wall Street firms whose balance sheets account for hundreds of billions of dollars, $6 billion is nothing. If the DTCC is right, this is the best news the market has had in weeks. It means that most of the fears regarding the Lehman CDS settlement, perhaps the CDS market in general are unfounded. It means the system works.

But, before I break into song, I think there are a few questions that need to be answered: 1) Why is this the first time we have heard anything regarding CDS from the DTCC? 2) Why have regulators, including the Federal Reserve Bank of New York, been working to create a central registry for CDS if one already existed (a registry is not the same thing as a clearinghouse, but it certainly gets the system closer and it seems odd that the DTCC would not be mentioned in clearinghouse discussions)? 3) What are the chances that the DTCC doesn’t know what it is talking about?

I’ll be looking into this over the next few days. If any of you have answers please post them in the comments. No matter what happens going forward, this is big news.

(To better understand CDS, read this post)