The Collapse of Fixed Commitments

I’ve begun portfolio triage here, and am debating what to sell, and buy, if anything.  More in my next post, if I have the strength tonight.  I’m feeling a little better, though the market is not helping.

Why the collapse of fixed commitments?  Consider what I wrote In RealMoney’s columnist conversation today:

David Merkel
Yielding Illiquidity
8/15/2007 4:02 PM EDT

Liquidity is the willingness of two parties to enter into fixed commitments, which can be measured by yield spreads, option prices, and bid-ask spreads. At present, the willingness to be on the giving liquidity side of the trade is declining. Even the willingness to do repos, which is pretty vanilla, has dried up. Roughly double the margin needs to be put up now to hold the same position. That dents the total buying power for what are arguably high quality assets — agency RMBS and the AAA portions of prime whole loans. This means that prices fall until balance sheet players with unencumbered cash find it sufficiently attractive to take on the mortgage assets.

I thought this era of unwinding leverage would arrive, and arrive it has. (That said, I did not expect that mortgage repo funding would be affected. That was a surprise.) I could never predict the time of the unwind, though, and though I have a decent amount of cash on hand, it can never be enough at the time.

One of the few bright sides here is that most of the real risk is concentrated in hedge funds, and hedge fund-of-funds. (Some pension plans are going to miss their actuarial funding targets dramatically.) Hopefully the investment banks with their swap books have done their counterparty analyses correctly, and didn’t cross hedge too much.

I’m still up for this year, but not by much. Perhaps I liked being intellectually wrong better while I made money on the broad market portfolio. Sigh.

Position: none

Could Countrywide failIt’s not impossible.  I had an excellent banking/financials analyst when I was a corporate bond manager, and she taught me that if you are a finance company, your ratings must allow you to issue commercial paper on an advantageous basis in order to be properly profitable.  If not, the optimistic outcome is a sale of the company to a stronger party.  The pessimistic outcome is failure.  We last tested this late in 2002 when we accumulated a boatload of Household International debt on weakness after they lost access to the CP markets, but had announced the merger with HSBC.  If you can make 12% in two months on bonds, you are doing well.  Paid for a lot of other errors that year.

But if Countrywide fails, the mortgage market is dead temporarily.  It would be a help after a year because of reduction in new mortgages, but in the short run, the rest of the market would have to digest the remains of Countrywide’s balance sheet.

Shall we briefly consult with the optimists?  Exhibit A is William Poole, who is more willing to speak his mind than most Fed Governors, for good and for ill.  He doesn’t see any effect on the “real economy” from the difficulties in the lending markets.  At the beginning of any lending crisis, that is true.  Difficulties happen in the “real economy” when current assets have a difficult time getting financed, and consumer durable purchases and capital investments get delayed because financing is not available at reasonable prices.  By year end, Poole will change his tune.

Now, I half agree with the Lex column in the Financial Times.  The level of screaming is far too loud for a decline of this magnitude.   But that’s just looking at the stock price action.  The action in the debt markets in relative terms is more severe, and bodes ill for the equity markets eventually.  Remember, the debt markets are bigger than the equity markets.  Problems in the debt markets show up in the equity markets with a lag, as companies need financing.

One more optimist: private equity funds buying back LBO debt.  The steps of the dance have changed, gentlemen.  It is time to conserve liquidity, not deploy it.  The time to deploy is near the end of a credit bust, not near its beginning.

How about the pessimists?  Start with Veryan Allen at Hedge Fund.  He tells us that volatility is normal, and that it often drags the good down with the bad.  The difference is risk control, and the good don’t die, and bounce back after the bad die.  Now let’s look at the rogues’ gallery du jour. Who is getting killed?  Pirate Capital, Basic Capital, and let’s mention the Goldman Sachs funds again because the leverage was higher than expected.  Toss in an Austrialian mortgage lender for fun, not.  Consider those that are trying to remove money from hedge fundsIt may not be as severe as possible, but it could really be severe.  Investors, even most institutional investors, are trend followers.

Five unrelated notes to end this post:

  1. Could this be the end of the credit ratings agencies?  I don’t think so.  It might broaden the oligopoly, and weaken it, but ratings are an inescapable facet of finance.  Ratings go through cycles of being good and bad, but people need opinions that are standardized about the riskiness of securities.  Go ahead, ban all of the existing ratings agencies now.  Within five years, debt buyers and regulators will have recreated them.
  2. What is funny about this article from the Wall Street Journal is that they mix some residential mortgage REITs into an article on commercial mortgage REITs.  DFR and FBR both are residential mortgage REITs.  There may be more there too, but I haven’t checked.
  3. If you can’t trust your money market funds, what can you trust?  I was always a little skeptical about asset backed commercial paper [ABCP] when it first arrived, but it survived 2000-2003, and I forgot about it.  Now it comes back to bite.  Some programs will extend maturities.  Some backup payers will pay, and some won’t.  Fortunately, it is not ubiquitous in money market funds, but it is worth looking for, if you have a lot in money market funds.
  4. How rapid has this 1,000 point decline in the Dow been?  Pretty fast, though 1,000 points is smaller in percentage terms than it used to be.
  5. Sorry to end on a sour note, but the Asian markets are having a rough go of it, and will make tomorrow tough in the US as well.

It’s late, so I’m going to post on my portfolio tomorrow.  I’ll give you the skinny now.  I’m evaluating the balance sheets and cash flow statements of stocks in my portfolio, and I am starting with those I have lost the most on, and evaluating their survivability under rough conditions.  I have some good ideas already, but I fear that I am too late; some names are so cheap, though leveraged (DFR is a good example), that it is hard to tell what the right decision is.  I will be making some trades, though, no doubt.

Full Disclosure: long DFR