Piling On The Debt

The U.S. is currently racking up a massive amount of new debt. Here is the current tally taken by Alex Patelis, an economist at Merrill Lynch:

Treasury buying mortgage-related assets: $700bn
Potential supplementary stimulus package favoured by Democrats: $100bn
Insuring money market funds: $50bn
Treasury fortifying the Fed’s balance sheet: $100bn
Expansion of temporary swap lines with central banks: $180bn
Loan to AIG: $85bn
Fed purchase of agency discount notes & ABCP: amount not specified
Fed loans through the Primary Dealer Credit Facility: $20bn through Sep 17
Fed’s discount window: $33bn balance
Treasury purchase of GSE MBS this month: $10bn
Potential cost of Fannie/Freddie bailout: $200-$300bn

The grand total of the above list is roughly $1.5 Trillion USD and I’m sure the U.S. isn’t done yet. If the government were to completely bailout Fannie Mae (FNM) and Freddie Mac (FRE), the resulting bill would amount to $5.2 Trillion or double our national debt. My guess is that the total cost of the government bailouts, if a $700 billion package to purchase mortgage backed assets is approved, will run close to $2 Trillion before the end of 2008.

In regards to the subsequent inflation from printing all this new money, Monty Guild of jsmineset.com says:

“INFLATION IS AHEAD OF US AND IT WILL BE A BIG PROBLEM

Not for the next few months, but in coming years, inflation will be a big problem…and we had all better prepare for it. You may be getting tired of hearing us beat this same old drum but if you prepare for the next problem before it arrives, you will be much more financially secure.

The only solution for the current crisis is to liquefy the global economic system and liquefy it to an extreme never before experienced. You think that the mortgage bubble was a big one? Wait until you see the next bubbles.

The U.S., Europe, Australia, Japan, Canada, and others will all join the parade to fiscal and monetary irresponsibility by inflating their money supplies and creating our next big investment opportunity.”

All this new money entering the system to “fix” previous problems will lead to new bubbles and massive inflation. This is a formula that has been repeated in nearly every modern economic crises. Low interest rates and a “fix” of printing new money has lead to bubbles in the past. Look at how we moved from a tech bubble collapse to the problems we face with the credit bubble. I’m not sure how we are fixing a problem by covering it up in the same manner.

Credit Default Swaps, The Show Isn’t Over

If you haven’t read my previous article, The Greatest Show on Earth, please do yourself a favor and give it a read.

In this post, I am going to expand on watching CDS (Credit Default Swaps) with banks. What CDS can tell you is how much money a person is willing to pay to insure the debt of a bank. The healthier a bank is, the lower the premium will be to insure its debt. If a banks financial situation sours, the higher the premium will be to insure its debt.

Monitoring CDS is essential to determining the health of our financial investments. With the rapid falling value of bank equities, it pays to look at CDS as an early indication of whether a bank may go out of business. CDS tied to banks are one of the most heavily traded form of derivatives.

In addition to reading traditional news media, waiting for earnings results, and for a bank to announce whether or not it has additional write-downs, you should watch CDS as it can give you a glimpse at trading activity between people who may have advanced daily knowledge of a banks operations. The CDS market is laxly regulated in comparison to common equities trading.

Let’s look the current CDS premiums for some of the worlds major banks.

Looking at the CDS premium for Lehman Brothers on 9/12 before it collapsed, we can see that figures grew well above the levels of HSBC (HBC) and JP Morgan Chase (JPM). The list above can be viewed as a most healthy to least healthy list of banks.

This also demonstrates that traditional media unfairly lumps “Banks” into one simple category. A well diversified bank like HSBC with strong retail banking, commercial banking and wealth management divisions is different from an investment bank that mainly derives its revenue from dealer-broker, trading desk, underwriting and structured finance offerings. When determining possible continued or new investment in bank equities and bank debt offerings, it pays to give CDS premiums a quick glance to see an immediate outlook on a banks health.

For further information about the CDS market, please read Credit Default Swaps: Evolving Financial Meltdown and Derivative Disaster Du Jour. In the article, the author Dr. Ellen Brown says, “CDS are private bets, and the Federal Reserve from the time of Alan Greenspan has insisted that regulators keep hands off.

The sacrosanct free market would supposedly regulate itself. The problem with that approach is that regulations are just rules. If there are no rules, the players can cheat; and cheat they have, with a gambler’s addiction. In December 2007, the Bank for International Settlements reported derivative trades tallying in at $681 trillion – ten times the gross domestic product of all the countries in the world combined. Somebody is obviously bluffing about the money being brought to the game, and that realization has made for some very jittery markets.

“Derivatives” are complex bank creations that are very hard to understand, but the basic idea is that you can insure an investment you want to go up by betting it will go down. The simplest form of derivative is a short sale: you can place a bet that some asset you own will go down, so that you are covered whichever way the asset moves.

Credit default swaps are the most widely traded form of credit derivative. They are bets between two parties on whether or not a company will default on its bonds. In a typical default swap, the “protection buyer” gets a large payoff if the company defaults within a certain period of time, while the “protection seller” collects periodic payments for assuming the risk of default.”

I believe we are facing a global derivatives problem of $1,140 trillion and upwards. To echo the sentiments of my previous article, monitoring the health of your investments, especially if they are related to financial services, is of paramount importance in times of crises. Based on the CDS list, I have a stronger feeling that Intel (INTC) will be around, instead of Washington Mutual (WM) in the future.

The Greatest Show on Earth

I would like to say “the circus” in reaction to the title of the post, but sadly today we are looking at the collapse of Lehman Brothers (LEH) and the worsening of the current credit crises.

Currently out of the top 5 investment banking firms in the U.S., (Goldman Sachs (GS), Morgan Stanley (MS), Merrill Lynch (MER), Lehman Brothers and Bear Stearns), only two will remain in business going into the fall of 2008. The source of all of this is of course the over leveraged nature of investment banks. At the end of 2007, Lehman Brothers was leveraged 31:1. Lehman turned $1 into $33 through the magic of leverage. On a mark to market basis, every bank with exposure to complex CDO (Collateralized Debt Obligations) and derivatives is prone to an amazing loss of value at staggering speeds.

It’s important to understand what mark to market means. Investopedia states mark to market as “The act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value.”

In a bullish market, the investment banks and stock market participants valued portfolio’s of mortgage securities and other derivatives far greater than its book value. In a bearish market, a portfolio of these securities falls far below book value. Since most investment banks trade on margin a drop in mark to market forces the investment bank to write down the value of the security or portfolio as a defensive measure against even greater losses. A rapid drop in mark to market can also force a margin call as some hedge funds for example do not have sufficient additional collateral to protect against the margin call. Creditors who have lent money to investment banks will require certain margin and capital ratios and will refuse to extend additional credit to funds or investment banks as the value of their assets dwindle.

Holding a portfolio of CDO’s and MBS (Mortgage Backed Securities) was a threat to investment banks since the beginning, due to the difficult nature of determining the actual owners of the collateral behind the security. A mortgage portfolio was often divided into pieces and packaged into MBS products, then sold and repackaged several times into other securities. The investment banks were essentially playing a game with each other with the lack of regulation and reporting in the structured finance market.

Holding a portfolio of common equities is much easier to value in comparison to CDO and MBS assets since you can take into account traditional valuation methods such as earnings and cash to debt ratios. Interestingly MBS were regarded as rock solid since the collateral behind the mortgages, physical property, was previously regarded as good as cash. With the fear of mortgage defaults, MBS values are falling faster than the actual physical property values. This has lead to recent buying by private equity funds seeking to buy distressed mortgage backed assets for pennies on the dollar.

What we have witnessed with CDO’s and MBS doesn’t stop there, similar problems exist for the entire OTC derivatives market. As stated by this Market Watch article: Buffett and Gross warn: $516 trillion bubble is a disaster waiting to happen.

In the words of Pimco’s bond fund king Bill Gross: “What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.”

I’ve written about derivites in a past article in which I said:

Because derivatives are just contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

Estimates vary on the potential total economic risk derivatives present. I like to use the largest figure I’ve found. As of December 2007, The Bank of International Settlements estimated that the amount of listed credit derivatives, i.e. tradable in some form through an exchange, stood at roughly $548 trillion. The amount of OTC derivatives was estimated at $596 trillion notional value. This brings the total derivatives estimate by The Bank of International Settlements to 1,140 trillion.

With the possibility of a global financial meltdown it’s important to educate yourself on how to anticipate the failure of a business or bank. You need to know what is, and what isn’t at risk. It’s definitely not enough to read the news, since the figures you need to watch are often found buried in balance sheets.

-On the top of my list is leverage and in a bear market less is better. This applies to all businesses and banks.
-High capital reserve ratios. The more cash a bank has the better.
-Diversified currency base. A bank or business holding a variety of foreign currency reserves has a better chance to hedge Forex risks, enhance liquidity and security.
-Low exposure to derivatives and complex structured finance products.
-A diversified business model to protect against falling earnings. It’s better to seek-out banks and businesses that have a variety of income streams.
-Operation in international markets. If a bank is limited to business in the U.S. or Europre for example, it is at greater risk at suffering a loss from an economic downturn.
-For banks you must have a careful watch of CDS (Credit Default Swaps). A credit default swap is the cost to guarantee a banks debt.

In examining where the potential risks are, we can help protect our own investments and determine which investments are safer bets. As we look at Asian banks for example, we can see that state owned Chinese Banks are flush with RMB and far less exposure to derivatives. Many chinese banks have diversified lines of business and derive income from retail banking services, an early credit card market with low penetration and a growing wealth management divisions. European banks such as UBS (UBS) also enjoy many of the same advantages in a far different geographical location.

Forbes published an article today titled: “UBS Likely To Avoid Lehman’s Fate” The Forbes author goes on to say:

“The reason for this lies in UBS’ diversified business model, which brings in a relatively safe stream of profits from wealth management and private banking–despite that its investment banking division is in meltdown. This in turn has helped the bank avoid the kind of crisis in confidence faced by Lehman Brothers Holdings (nyse: LEH – news – people ), which threw in the towel and filed for bankruptcy over the weekend as its shares tanked and its credit default spreads widened.”

“Credit default spreads for UBS are still relatively low,” said Dirk Becker, an analyst with Landsbanki. “They are still in the region where they can stay in business.”

Chinese and European banks are of course getting sold off along with the fall in financial markets. Investments in ETF’s that do hold these securities offer an opportunity to cycle out of U.S. financial equities if you decide that your portfolio should include a portion in the financial services sector.

With all of the bad news emerging from U.S. financial markets, I can’t help but draw the conclusion that the USD is due for a major fall in value. The U.S. literally doubled its national debt with the bailout of Fannie Mae (FNM) and Freddie Mac (FRE). We are printing dollars at an exceedingly rapid pace, the Fed has expanded its loan window to distressed investment banks and now we may be faced with another quarter point interest rate cut. All of this is dollar negative. As we watch the financial turmoil unfold and wait for markets to repair themselves, you may have already looked at currency diversification as part of your investment strategy. Before making money, capital preservation has and will always be of the upmost importance.