Monday, July 07, 2008

It's Going to be a Double-Header!

7 & 14 July 2008

The current financial crisis is often likened to a baseball game. The optimists suggest this might be the 7th inning stretch, and the pessimists believe we might just be starting the second inning.

Bill Fleckenstein commented on this phenomenon today, citing Brian Carney's interview of Ted Forstmann (entitled "The Credit Crisis Is Going to Get Worse") in the weekend Wall Street Journal.

According to Wikipedia, Mr. Forstmann (born in 1940) is one of the founding partners of Forstmann, Little & Company, a private equity firm. He was featured prominently in the book Barbarians at the Gate: The Fall of RJR Nabisco, as he and his company attempted to acquire RJR Nabisco.

In the subsequent (1993) film adaptation, he was portrayed by actor David Rasche. The book portrayed Forstmann as a critic of KKR's Henry Kravis and his investment methods.

Forstmann's criticism of Kravis (and much of the rest of the financial industry during the 1980s) centred around the use of junk bond (high-yield) investments to raise large amounts of capital. When the junk bond market later fell into disfavour as a result of scandal, Forstmann's criticism was seen as prescient, as his more conventional investment strategy had been able to maintain nearly the same level of profitability as companies such as KKR and Revlon that built their strategy around high-yield debt.

The WSJ interview begins: "Twenty years ago, Ted Forstmann contributed a scathing – and prescient – op-ed to this newspaper warning that the junk-bond craze was about to end badly: 'Today's financial age has become a period of unbridled excess with accepted risk soaring out of proportion to possible reward,' he wrote in October 1988. 'Every week, with ever-increasing levels of irresponsibility, many billions of dollars in American assets are being saddled with debt that has virtually no chance of being repaid.'

"Within a year, the junk-bond market had collapsed, and within 18 months Drexel Burnham Lambert, the leading firm of the junk-bond world, was bankrupt. Mr. Forstmann sees even worse trouble coming today."

Mr. Carney offers the following background: "Mr. Forstmann denies being an expert in the capital markets. But he does have some experience with them. He was present at the creation of the private-equity business.

"The firm he co-founded, Forstmann Little, rode the original private-equity boom in the 1980s while skirting the excesses of the junk-bond craze in the later years. It was for a time the most successful private-equity firm in the world, renowned for both its outsize returns and its caution. For two years after Mr. Forstmann wrote his 1988 op-ed, Forstmann Little sat on $2 billion in uninvested funds, waiting for the right opportunities. Savvy investments in Dr. Pepper and Gulfstream, among others over the years, helped make Mr. Forstmann a billionaire."

Mr. Fleckenstein cites Mr. Forstmann's following warning, which is stated later in the WSJ interview: "We are in a credit crisis the likes of which I've never seen in my lifetime. . . . The credit problems in this country are considerably worse than people have said or know. In order to fix what's going on in the United States, there's going to have to be a certain amount of pain. The market's going to have to clear somehow . . . and it's hard for me to believe that it gets fixed without upheaval in the financial system.... This all started in August (2007), and it was going to get cleared up by October. It hasn't gotten cleared up at all. Things are going to fail. Enterprises are going to fail. The economy is going to slow."

Mr. Fleckenstein adds that, "as to a timeline, he tells Carney: 'I think we're in about the second inning of this.'"

Mr. Fleckenstein ("Fleck" to his loyal readers) adds, "That guess is not so dissimilar from (that of another commentator and close friend of Mr. Fleckenstein's), who says he's not sure what inning it is, but he is sure it's going to be a double-header."

In summary, a growing roster of financial commentators are concluding that the financial (read debt, deception and spending-related) difficulties of the United States are greater than those of the most recently analogous 1970s period.

It's looking more and more like the roaring 20s and the dirty 30s.

Imagine, by analogy, that this actually is a baseball game.

Find yourself a comfortable seat and keep some extra cash in your pocket for refreshments. In fact, you'd better keep that in gold, as in a long ball game, your cash could lose quite a bit of its value.

It looks as if we're in the early innings - maybe the second - and remember, this time you've bought tickets to a double-header.

Prepare yourself for a lot more baseball before this all-day event is done....

And bring a jacket. It's going to be a lot cooler by night time!

By the way, there has been notable action in financial markets over the past week. Fannie Mae (Federal National Mortgage) fell 16.19% today, plumbing its lowest levels since 1992.

Zion's Bancorp is also collapsing, looking at its lowest levels since 1997.

Lehman, on the investment banking side, is revisiting its 2000-2001 lows. Single digits could follow soon thereafter.

I offer this as a backdrop for what is currently occurring in the world of US financial companies. In essence, the common stocks of these companies are in free fall. This cannot be a good omen for the economy in general.

14 July 2008: For more on Treasury Secretary Paulson's plan to launch yet another taxpayer-funded bailout of two additional careless and imprudent financial companies, this time for the federally-sponsored mortgage lenders Fannie Mae and Freddie Mac, which back about half of all mortgage debt in the United States (most, but not enough, of it still good - at least for now), click here.

If you wonder how Fannie Mae & Freddie Mac work, here is a link (courtesy of the New York Times), and here is a diagram:

As the NYT explains, the two companies (government-sponsored entities formed in 1938, privatized in 1968-1970) "provide the capital that banks use to write new loans. If Fannie and Freddie stop buying loans, banks may stop making new loans, freezing the United States housing market. Fannie and Freddie provide stability and liquidity to the mortgage market. If it is harder for them to borrow money, mortgage interest rates will rise.... Fannie's and Freddie's combined cushion for absorbing losses is thought to be too small."

According to the Times, "Fannie Mae and Freddie Mac own or guarantee about half of the nation's $12 trillion mortgage market." The implication is that a bailout "could raise the government's potential obligations, which currently stand at about $9 trillion, by an additional $5 trillion" to $14 trillion, an increase in the US government's accumulated present debt obligations of 56% in a single step. In an understatement, the Times adds, this "would most likely make it more expensive for the United States government to borrow money in the future."

John Doody, the Gold Stock Analyst, asserts that the problem in the capital markets is that under new legislation intended to make financial companies dealing in mortgages and loans more responsible, the mortgage lenders are supposed to raise $75 billion in new cash to back their securities, but their combined market capitalization has fallen to $15 billion, only 20% of that amount. (Mr. Doody explains: "new FASB rules are to be implemented Nov 15, 2008. The rule brings formerly off-balance sheet liabilities onto financial statements and requires $75 billion more equity to meet required minimum levels.")

I calculate that if the companies were to follow the normal mechanism of raising cash through an equity sale, the current outstanding shares would account for only 16.7% of the equity of the company following the sale of securities - an 83.3% dilution of shareholders' equity - and this is assuming that anyone would buy them at this point - - - certainly a questionable proposition in itself!

In other news (courtesy of the AP), the U.S. government signalled that "it won't throw a lifeline to struggling financial companies — except for mortgage linchpins Fannie Mae and Freddie Mac — marking a shift to a new and potentially more volatile phase of the credit crisis.

"Such an approach could mean beaten-down investment banks like Lehman Brothers Holdings Inc. (whose shares have lost 78 percent since this year's peak in February) and regional banks must now fend for themselves as they try to recover from billions of dollars in mortgage-related losses — unlike Bear Stearns Cos., whose buyout the government helped orchestrate in March.

"That is bound to unnerve an already turbulent Wall Street and make investors even more anxious as they await financial companies' earnings expected to be down a stunning 69 percent from a year ago when all the numbers are in....

"Some of Wall Street's biggest investors believe there was another message in the government's announcement — the rest of the financial sector seems unlikely to get a helping hand. Global banks and brokerages have already written down nearly $300 billion in soured mortgage investments — a number projected to ultimately reach $1 trillion.

For more on this story, click here.

Mr. Mortgage adds that $700 billion of Fannie Mae and Freddie Mac's $5.3 trillion in receivables (outstanding loans) are in non-insured (highly at-risk, possibly worthless) subprime and Alt-A mortgages. That is 13% of the total outstanding loan portfolio, leaving $4.5 trillion in insured loans. Mr. Mortgage (who has basically been right on everything so far) estimates that if bondholders absorbed this loss, taxpayers would not have to pay the $700 billion (or more) bill for bad loans, nor take over the company (assuming $5.3 trillion in additional US government liabilities).

Oh, and another point of interest, SPDR Gold Shares (formerly Streettracks Gold Trust, US trading symbol GLD) added 46 tons of gold to its holdings on Friday, July 11. Yes, you heard that right - tons! The recent addition to this conservative investment vehicle's holdings constituted a one-day increment in the gold holdings of the trust from 660 to 706 tons, setting a new record for the trust.

SPDR Gold Shares' holdings (accumulated over just the past 3 years) presently surpass the gold holdings of all but 7 of the world's nations, according to Wikipedia. The US continues to hold the most tonnage of gold by far, at 8,133.5 tons, but SPDR Gold Shares now holds more gold than such countries as China, Russia and Saudi Arabia.

As you may know, the once massive gold holdings of the United Kingdom (now only 310 tons) were decimated by Prime Minister Gordon Brown, who sold most of that nation's gold at the bottom of the market at the turn of the millennium.

Bad news for Canadians - the Canadian government in its wisdom has sold all but 3.4 tons of the country's gold holdings, placing Canada in the same league as Bangladesh and Slovenia as a holder of national gold reserves.

For much more in-depth running commentary on the mortgage-based US economic meltdown, visit Mr. Mortgage's website here.


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  2. Thank you. Obviously there has been much more unwinding from the time this post was published. How is the present era different than the 1930s? The changed element appears to be monetary inflation - a massive growth in money supply. As governments around the world have agreed to throw the equivalent of trillions of dollars at the problem, we could see some preservation of stock market values against a backdrop of declining currencies. A caveat is that companies have difficulty generating profits in an inflationary environment. Thus flat stock prices are perhaps the best-case scenario. When consumer price inflation climbs, that will force interest rates up, discouraging business investment - and stock buying. As John Paulson demonstrated recently, only gold looks to be a secure investment in this scenario.

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