Friday, February 15, 2008

Am I Over Your Head?

One of the frustrations I have in writing this Blog is not knowing for sure if the people who read it truly understand what it is that I’m saying I do get feed back in the form of questions or comments that help but when the issues become complex I can just see eyes gloss over. In my quarterly paper newsletter I wrote about the housing and credit markets problems. In fact I was warning people long before the concern was raised in the widely read financial press. I remember that a certain person on CNBC, last Spring, was saying the “sub prime” problem is a small percentage of the economy (GDP) and was contained there was nothing to worry about.

I was saying that the housing problem was just gaining momentum and from the peak late in 2006 it would take probably 3 years for the housing market to correct. If I’m right that means we may not hit bottom in housing prices till sometime in 2009. I warned that we had other problems in the credit markets. The markets were not pricing the true risk of the investment investors were taking.

Late this week the spread in the junk bond market widened to almost 1,500 basis points. You are probably asking yourself (EYES GLAZING OVER YET) what does the 1500 basis points mean? If the 10-year T-Bond is yielding 3.75%, then high risk bonds (junk) has to have a yield 1,500 basis points more in yield to attract investors. In other words if the T-Bond is 3.75% then a 10-year junk bond has to yield 3.75% plus 1,500 basis points in additional yield in order to attract investors or 18.75%. These bonds command this return because the economy is declining and high risk investors demand very high returns to invest their money because the greater chance they will loose some or all of their money if the company can’t make the interest payments.

Recently, on the Blog, I spoke of the problem of greed and how it permeated many decisions. This week we heard of more problems with structured products and the markets reacted negatively. I was asked by a client this week, “have we seen the peak in the credit problems?” I said that I believe that the dollar amount of write offs and defaults and write offs yet to come will be greater that what we have already experienced.

The magnitude of the abuse in search of yield has to be paid back at significant pain and disruption of markets and losses to investors. We all want all of these problems to be over, but I do not see a bottom for a significant period of time. The question that needs to be asked now, “what is the next big problem in the credit market?” I think the problem will be not with a particular type of instrument, but a problem of liquidity. With more write offs on the horizon balance sheets will come under more and more pressure to provide liquidity and the commercial and investment banks won’t have the capital to lend or provide the needed liquidity.

I do want to finish this posting with some comment about earnings reported this week. Many of the companies that reported this week talked about growth outside the United States being much stronger than inside the US. In addition to greater growth earning were significantly affected by the decline of the dollar. When a company sells something outside the US and then the converts that money back into the dollar, the earnings are inflated by the decline in the dollar against the other currency. Currency swings in my opinion are not real earnings. When the dollar turns, and it will, someday perhaps sooner than most people think, the previous positive will turn into a negative for earnings.

Volatile markets on in our future for months if not a few years to come and the markets will from time to time be hit by shocks. The best illustration of the problem came many years ago to by a friend who was the president of a major mutual fund and money management firm. He said the only way to hold a pyramid on its point was with support wires. But, every time a business or market fails, a support wire snaps. The risk load of the pyramid falling is transferred to the other remaining wires. As each wire breaks the pyramid get more and more unstable until the weight of the upside down pyramid finally collapses and all the wires break.

We are breaking some serious support wires.

Dan Perkins

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