Friday, April 11, 2008

General Electric: The Krayt Dragon Call

Today was a very unusual day, when contrasted against the rest of 2008. We saw stocks get hammered mostly on GE's earnings, but in the bond world, spread product did OK. I see the CDX.IG about 1bp wider, and the CDX.HY 3bps tighter. CDS on GE itself moved 9bps wider, with similar moves for the brokers.

Swap spreads were unchanged. MBS and agency debt both about 1bps wider.

The municipal curve flattened, 10-yr rates fell 7bps and 30-yr fell 9bps. That compares favorably to Treasuries which fell 7bps and 5bps respectively.

Anyway, this is all notable because for most of 2008, anytime there was bad economic news, spread product of all sorts got hammered. I did a quick look at the other days in 2008 when the Dow fell 200 points or more, and then looked at what happened to the CDX.HY.

Pre-Bear Stearns Day
1/2 Dow -221, CDX +15
1/4 Dow -256, CDX +27
1/8 Dow -238, CDX -1
1/11 Dow -245, CDX -5
1/15 Dow -277, CDX +8
1/17 Dow -307, CDX +14
2/5 Dow -370, CDX +31
2/29 Dow -316, CDX +22
3/6 Dow -215, CDX +24

Post-Bear Stearns Day

3/19 Dow -293, CDX -25
4/11 Dow -256, CDX -4

That makes +15 the median move on the CDX.HY given a 200 point drop in the Dow pre Bear Stearns. I'm pretty sure if we did the same exercise for more staid securities, like municipals or agency MBS, we'd see a similar pattern, where severe days in stocks almost always resulted in ugly days for spread bonds.

This seems to support the idea that the liquidity crisis is slowly lifting. It isn't over, mind you, but its on the right path. We're left with a real economy recession, and the markets need to work out what the right price should be for various risks in a world where liquidity is slowly improving but the real economy is declining.

Today's move looks like pricing a real economy recession, rather than a financial crisis. Not great news for the stock investors reading this blog, but relatively good news for those hoping to avoid another Great Depression.


shankar said...

If past is any indicator, I would say that your thinking will be proven to be quite wishful in the next 6-12 months.

5+ years of massive leveraging doesn't get resolved in a few months.

So, let's wait and see.

Accrued Interest said...


I don't mean to pick on you, because there seems to be a large contingent of people who think the way you do. But why does it have to be so all or nothing? In my post, I talk about us moving past the liquidity crisis into a more "normal" recessionary environment. I don't understand how you read what I've written and conclude that I think everything is "resolved" in our economy.

For those who think the liquidity crisis element of this period will intensify from here, please explain how. I mean, why is it so hard to imagine that the big broker/dealers and banks can just slowly delever over time? Do I claim that the era of bank credit losses is over? Absolutely not! But hell, if f'ing Washington Mutual of all people can get a capital infusion equal to half of their market value, its just unrealistic to expect rolling bank failures at this point.

James I. Hymas said...

For what it's worth, AI, I'm with you.

I'll go further: I'll say that the regulatory system has come through the episode very well.

Despite all the cowboy traders, despite all the faulty risk-management, despite the huge chain of misjudgements embodied by the word "sub-prime", the system has escaped without a major insolvency.

There may be quibbles over BSC, but I have seen no evidence that they were actually insolvent at the time of their collapse; only that they were hopelessly illiquid. I believe that their inventories were marked ... well, not "to market" because there was no market, but at a reasonable guess thereof, far below the present value of ultimate recovery. We don't know the whole story on that and, perhaps, never will; the conspiracy theorists will claim that every piece of paper they owned was worthless garbage (and they may be right! I don't want to claim that they're definitely wrong, only that I think they are!), but I suspect that if they had entered chapter 11, the shareholders would have been left with something. No jobs, maybe, but I don't think the entire book value of $11-billion would have disappeared.

Bernanke's done well; there won't be too many dividend increases in the next 5 years out of financials, and there may well be a spectacular flame-out around the corner, but by and large the capital requirements imposed by the Fed and SEC have left the financial system as a whole bloodied and in need of liquidity, crippled, but not dead.

Clearly, the stress has shown areas of regulation that are in need of adjustment; but what I am very fearful of is the chance that Son of Sarbox will destroy the industry. Which would be a damn shame, because I prefer New York to Riyadh as the capital city of world finance.

gramps said...

AI - While you constantly repeat there is some sort of liquidity crisis, I haven't heard you provide any actual evidence of such. Constantly repeating it doesn't make it so.

Now you claim the liquidity crisis that never existed is over?

Why are the TAF and TSLF horribly under-subscribed? If the banks have a liquidity problem, why aren't they using these facilities? Are you arguing that the Fed is lying about their under-use?

Why did JPM CEO Jamie Dimon testify under oath (before Congress) that he would not have bought Bear Stearns (even with Fed prodding) if the Fed had not agreed to carve out the $30 BILLION of questionable assets? Why has Dimon already announced that roughly half of Bear's employees won't have jobs after the merger? After everything the Fed has done, you can't possibly argue that Dimon thinks the Fed won't provide him enough liquidity? So why won't he take the other $30 billion? Unlike all the people speculating on this blog, Dimon has actually seen Bear's books and obviously didn't like what he saw. And for the record, $30 billion in trash is greater than Bear's alleged $11 billion book value

The people closest to the crisis (Bernanke and Dimon) simply do not concur with your liquidity hypothesis -- I don't want to argue whatever spin is in the press; I want to focus on their actions. People can lie to the cameras, but when they vote with their wallet it counts. Follow the money.

Meanwhile, former Fed Chair Paul Volcker has diplomatically characterized Bernanke's actions as "barely legal". Like many prominent economists the world over, he disagrees with Bernanke's performance. Volcker says a central bank is a lender of last resort -- it should lend freely **AT HIGH RATES** against **GOOD COLLATERAL**... Bernanke is lending at low rates against collateral that the rest of Wall Street does not want.

Alan Greenspan has become downright defensive against the ever growing list of people who say his policies were a mistake. Other central bankers don't spend their twilight years forced to defend failed policies. At this point, its become very obvious that Greenspan lowered rates too far and kept them low for too long-- oh, and just released Fed meeting minutes show one of the biggest proponents of Greenspan's failed policy was none other than Ben Bernanke.

Every Fed economist (including Greenspan) has said Fed easings take at least 6 months to work into the system -- meaning the first Fed ease in late September '07 would BARELY be taking effect now. Most of the easing happened later.... So how is easing that hasn't taken effect yet solving a liquidity crisis? It isn't. How are credit facilities that aren't being used solving a liquidity crisis? They aren't.

The problem all along was, is and for some time will be an insolvency crisis.

There was never any danger of a great depression like scenario -- unless the Fed caused it again (even Bernanke seems to think the Fed contributed if not caused the first one).

So the real insolvency crisis is still with us. Creative accounting and barely legal actions by the Fed have put off the day of reckoning when a piece of trash actually trades -- forcing everyone else who holds the trash to mark it to market. Sweeping the problem under the rug doesn't fix it, and the bump is getting too big to ignore.

This week, we saw several more blow-ups, albeit abroad. Mizuho and some Scandanavian banks had huge loses. The FDIC is gearing up their hiring to handle increased bank failures (regional and local mostly).

The more interesting thing is all the non-bank banks that are being effected... GE is supposedly an industrial concern-- but at least 40% of its earnings come from finance. No one wants to buy GE's credit card division (which has been on the block for 9-10 months now), and FGIC (which used to be part of GE) is having massive problems.

And in municipal-land, there's the probable bankruptcy of a sewer bond in Alabama... Yes, I know AI thinks muni's never have bankruptcies, but history says otherwise. The SEC is investigating possible kickbacks to local officials-- but the more fundamental problem (beyond whether the swaps were over-priced to facilitate kickbacks) is: why the *(^* was a municipality making interest rate bets? Beyond the silly sales pitch from Wall Street, the swaps are a **BET** on interest rates. If they bet correctly, borrowing costs might be lower than otherwise; if they bet wrong, costs would be higher... A municipality (not a brokerage or a hedge fund) was in the finance business, and making interest rate bets.

GE and Alabama are far from alone in this. GM is basically a pension fund and Ditech -- and they run an unprofitable car business on the side. Companies from Cisco to Dell to Caterpillar to Macy's Department Stores make sizable percentage of their profits from financing- not from selling whatever product. If the consumer is tight for cash (and the Fed isn't going to bail Joe Consumer out) -- these companies are all likely to face delinquencies.

I have said from the beginning that this would be a bad (but common) recession and that Bernanke's panic slashing of rates as though the sky was falling was a mistake. His poorly considered (and barely legal) policies are going to make the situation far worse than it would have been otherwise.

The insolvency problem is far from over-- ask George Soros, Jim Rogers, Paul Volcker, or Julian Robertson. Or just check Treasury yields where everything out to 10yrs is STILL yielding at or below CPI. People don't accept zero (or negative) real yields if they think alternatives are attractive.

Great Depression was never in the cards -- but the pain of forced delevering has only started.

shankar said...

As I said, let's wait and see. Its too early to declare the victory. The credit contraction is just beginning to spread to the other sectors of the economy and will take time to ripple through. In addition, it will also ripple through the rest of the world.

In your article you indicate that liquidity is slowly improving, but the real economy is slowly declining (or liquidity crisis is slowly lifting).

This was the statement I objected too. Your statement is akin to all those bottom callers who have been calling bottom to housing market and at every stage the housing market seems to dive off the next cliff.

Nothing goes down in a straight line, and this could simply be a headfake/stabilization before another spike in liquidity crunch.

A casual reading of recent statements by G-7, IMF etc. may perhaps persuade you to avoid declaring 'mission accomplished'.


gramps said...

Here is the detail from the Fed's recent TSLF auction. The Fed got bids for $34 billion out of $50 billion offered. If banks are having trouble with liquidity, and the Fed is literally throwing loans at them, why aren't they taking advantage?

Answer: because liquidity isn't the problem.

The TAF facilities have a higher usage rate, but bid to cover is still rather low-- especially if banks are supposed to be desperate for liquidity.

As reported in many other blogs, Wall Street banks are securitizing **UNSELLABLE** LBO debt into CLOs-- not to sell to the street in pieces, but strictly so that the "securities" can be used as collateral at the Fed... Its clearly not an economically motivated trade-- its a trade motivated by accounting loopholes. The banks get to borrow money from the Fed based on rather imaginary collateral (that no one, not even the banks themselves, want). This conveniently allows the banks to avoid having to mark these "assets" down to market clearing prices. With the Fed's help, they can pretend these things are worth 100 cents on the dollar, even though no economically motivated player will buy them for even 80 cents on the dollar. Its accounting fraud by another name.

Did anyone look into the details of Citi's "sale" of LBO debt? It sold about $12 billion in debt originated last year at 90 cents on the dollar (that's a $1.2 billion loss already) -- but even this price is a half truth... Citi agreed to cover approximately the first 20% in losses. So the actual price received may very well turn out to be closer to 70 cents on the dollar. Heads, Blackstone and TPG (the buyers) get above market interest rates (because they bought the debt below par), tails Citi gets hit with the downside. Why would Citi agree to take the first 20% of downside (after already taking 10% downside)? Citi can get virtually unlimited funding from the Fed, so they had the option of holding on to it and riding out the storm. Yet they chose to dump the debt at a significant loss rather than wait it out...

Citi is being forced by the markets to delever -- and they MUST sell whatever they can, even if it means taking a loss. Again, the Fed would lend them seemingly unlimited amounts -- but the markets won't trade with them unless they delever and demonstrate basic risk management competence.

Therein lies the basic problem. Wall Street has SHOWN it doesn't understand the risk it has taken and is taking. Mark to model depends on people believing that your model is materially right -- but Wall Street's models aren't even close to right.

The sad truth is that Wall Street CEO's aren't really certain what their firms are worth. Too many assets aren't worth what the accounting statements say they are. Too many liabilities that are supposedly off balance sheet turn out to be very much on balance sheet. And the CEO's simply don't know-- so how on earth would a counterparty? If you take the conservative approach, taking big haircuts on assets and pull liabilities back onto the balance sheet -- these firms are completely insolvent.

I am sure AI will suggest that this route is overly conservative and some assets will eventually pay in full. But such a statement is a total guess in the dark. How much would you pay for a security where you get paid some undetermined amount at some undetermined point in the future? Maybe you get paid in full, maybe 50 cents on the dollar, maybe you get almost nothing-- you can't be sure. And you might get paid tomorrow or you might get paid 50 years from now, again you don't know... Quick, how much would you pay for this "privilege"?

The CEOs of Wall Street simply don't know what their firms are worth. Neither do their risk managers (who were asleep at the switch at any rate). The traders, who get paid a percentage of profits, claim the stuff is valuable, but they all want to be paid in cash-- not in the bonds they trade.

What we do know is that many of these imaginary assets are backed by home loans with 90% LTV or higher -- and home prices are down at the national level more than 10% (and still falling). Many markets (like California) are down 30%. The underlying loans are clearly at a loss. Wall Street has carved this loan into a million CDO tranches, but in aggregate it is a loss-- the only question is which tranches get the loss.

At 30-1 leverage (which is disturbingly common), a 3.3% loss from the above housing mess leaves an entity insolvent. With home prices down 15% (which is greater than 3.3%!), we know with absolute certainty that SOMEONE is insolvent (quite a few acutally). We just don't know exactly who, and Wall Street CEO's aren't saying (most likely because they don't know).

Refusing to lend money to people you know are insolvent is not a liquidity problem -- its just common sense.

Apolitical said...
This comment has been removed by the author.
Apolitical said...


The Fed doesn't take collateral at par unless the bank actually has the thing marked at par. They take the bank's mark and then haircut it by some set rates (they can be looked up on the Fed website).

The stuff being tendered in the various lending facilities is not marked anywhere near par. If it is, the banks are lying to the Fed and they've got some pretty serious problems. Banks may lie or skirt the truth when it comes to shareholders or public filings -- they don't like to the Fed.

Anonymous said...

The problems with China's economy are such that being out of emerging stock markets is a very good idea. China's leaders have fooled the world's population into thinking they have a huge amount of dollars at their disposal, which is untrue. The trade surplus is being used to a) line the leaders' pockets; b) feed the trillion peasants who earn around $5 per day; c) build the thousands of buildings to house and work the population; d) build a world-leading defence for the upcoming commodities war e) build a space ship to flee to Mars once global warming gets going f) buy all the abortionable records their pop stars release g) invest in lead h) you're still reading this? You are a div.


Scott Finch said...

gramps, thank you for linking the auction stats. I have been watching the bid-cover on past TAF's (watching more demand for FED short term (to be rolled over for a long time) paper. It is good to see an undersubscription on these auctions, i think. I do think the system saw a liquidity crisis, though it appears the proper facilities have been established to meet short term financing needs for most institutions.

shankar said...

Al, James et al:

FYI. Just so you are a bit careful in proclaiming a win over the Credit Crunch. Here's the other side of the coin.

Credit Crisis Could Affect Markets for Decade: Study

James I. Hymas said...

shankar -

I'm not sure where you get the idea that I have proclaimed a win over the credit crisis.

Where did you get this idea?

I'll repeat my actual words, from above:

Bernanke's done well; there won't be too many dividend increases in the next 5 years out of financials, and there may well be a spectacular flame-out around the corner, but by and large the capital requirements imposed by the Fed and SEC have left the financial system as a whole bloodied and in need of liquidity, crippled, but not dead.

I'm left echoing AI: why does it have to be so all or nothing?

Accrued Interest said...

I've written multiple commentaries about how bad liquidity is. A great example is FFELP Student Loan ABS, which have moved about 100bps wider, and yet are gtd by the government.

Anyway, please please please don't confuse me with those who try to claim that all our problems will be solved once liquidity improves. Improved liquidity will merely allow securities price risk properly. That will allow the financial system to keep functioning normally as we get through this period.

Accrued Interest said...


Send me your e-mail address and I'll e-mail you the whole report from J.P. Morgan. Its very good, and but not as dour as your link makes it out. Actually, JPM's analysts are pretty damn bullish on asset-backed securities right now. I was just in New York at one of their conferences.

Anyway, the report makes a lot of points I've been trying to make. We may be past the worst of this liquidity crisis, but its going to reverberate for years to come. That isn't the same thing as saying the liquidity crisis will continue for years to come.

Accrued Interest said...

To follow up on what James just said... if by "win over the credit crisis" you mean "our system is going to come out the other side of this basically in tact" then yes. I'm claiming victory. If you mean "we won't have a recession and the stock market will be up 40% from here" then no. I'm not claiming victory at all.

shankar said...


Would love to get the report. A bit embarrassing on my part - how do I send you an email?

Again - I am sorry if I have come across as a bit rude to you or James.

In general, I am a bit irritated with people calling bottom at every turn. We'll do much better (and especially bloggers like you can help tremendously) if we balance our views and show both the sides of the coin. Hope is critical, but it should not trample the truth.

As Hercule Poirot would say - 'Truth, how ever ugly in itself is beautiful to the seeker after it'.

By facing the reality and adapting, we'll increase our odds of success tremendously.


Accrued Interest said...

Anyone who wants the report, e-mail me at accruedint (at)

James I. Hymas said...

shankar - Don't worry; no personal offense was taken.

I'm not even sure if we're at the bottom yet. Things will gradually become more clear over the next year, but I feel quite certain there are landmines of overexposure yet to be tripped.

What I do see is that - by and large - the big money banks have survived this. Their shareholders have lost a lot of money, but (as all bond guys know) that's what shareholders are for. Even if one of them should fail, the others are big enough and strong enough to pick away at the carcass and keep things functioning ... perhaps with a little liquidity help, as with BSC/JPM.

The sign of hope that I see is that, slowly and haltingly, people are beginning to look at financial statements again and analyze things rather than running away from all things financial in blind fear. That's the first thing you need for a functional market and the (more-or-less) efficient pricing of risk.

Eveline said...

Thanks for this article, pretty helpful piece of writing.