Too little too late (thank goodness): Bush sends FHA squirt gun to put out subprime inferno

Don't get me wrong, I don't think there is much that the Feds SHOULD do. Just want to say to those poor souls who are grasping at whatever shreds of hope that appear (like a mirage) in the distance - this ain't gonna work.

From the Journal's piece on Bush's "plan to rescue delinquent homeowners" (NOT):

For now, the administration's primary vehicle to help homeowners will be the FHA, which doesn't originate loans but helps riskier borrowers qualify by guaranteeing their loans against default. By allowing the agency to back loans for delinquent borrowers, the FHA estimates it can help an additional 80,000 homeowners qualify for refinancing in 2008, bringing its total of refinancing guarantees to about 240,000, senior administration officials said....

Still, the move will help only a small portion of homeowners -- and few in high-cost states such as California or New York -- because the FHA faces constraints on the size of the loans it can back and strict rules that borrowers must meet. The Bush administration has been pushing Congress to enact overhauls that would eliminate the required 3% down payment and raise the size of the loans the FHA can insure to as much as $417,000 from $362,790. Senate Banking Committee Chairman Christopher Dodd (D., Conn.) said recently that FHA reform will be among his priorities when Congress returns from its August recess, and a bill is expected to head to the full House this fall.

Not exactly buried in the fine print. But I guess for traders who can only either read headlines or listen to Jim Cramer, this may be too subtle a point. This "rescue plan" will help 80 thousand homeowners with mortgages less than 363k. I am underwhelmed. AND... I am glad because any serious attempt to actually bailout people who basically just borrowed a lot more than they should have is seriously bad policy.

How to invest in China

Please note that the topic of this post is not “What to buy in China” but “How to invest in China”. Many of the posts that I see on Seeking Alpha (China section) are about China ETFs. The ETFs seem to be of interest because they are a security which offers the buyer immediate “China exposure”. This is understandable. Any market that has tripled in 12 months as the Shanghai Stock Exchange A share index has is of course going to attract huge interest. Unfortunately, buying China ETFs is really not a very sensible way to invest in China. Yes, I know, I know, the ETFs have been tremendous performers (at least recently). But we can all think of securities which perform well for a period of time which are NOT necessarily smart investments (I seem to recall subprime backed CDOs were terrific performers for several years). The main reason not to buy the ETFs is that they are comprised almost entirely of SOEs (State Owned Enterprises). That is, the controlling shareholder is the Chinese government, i.e., the Communist Party of China. Now I am not going to make a moral or ideological argument that Communists are evil and can’t be trusted. The folks in China who call themselves Communists aren’t really communists anyway – and in fact I think the senior leaders of China have actually done a spectacular job at running China in the last quarter century. No, the reason not to buy an index composed of SOEs is the following:

1. They are managed first and foremost for the benefit of the state; employees are next and then come the interests of shareholders.

2. Senior executives, including the CEO, CFO, and board of directors are either directly appointed – or if not appointed than must be approved - by the party. Shareholders can have little confidence that management is highly qualified – or if management is qualified, that they will remain in their jobs.

3. The biggest SOEs are essentially in three sectors: telecoms, financials, and energy and other materials. Returns on investment for companies in the first two sectors, telecoms and financials, are primarily a function of government regulation. Returns in the energy and materials sectors are determined by government regulators and global supply and demand. In none of these industries is the underlying growth and productivity of China Inc primary return drivers.

4. SOE reform has been underway for decades but it takes many years and lots of hard work to turn a government bureaucracy into a profit maximizing competitive enterprise. There are some SOEs (like CNOOC) that have made great progress and are beginning to look, feel, and act a lot like a “real company”. But just as many if not more SOEs are still “Potemkin companies” (ah the irony). The banks are the best example. If anyone believes that the Bank of China is a profit-seeking enterprise run for the benefit of shareholders, this person needs to be put into restraints lest they lose all their money. Chinese banks were and continue to be, arms of the Chinese government which are operated at the local level by local government authorities. They make loans to whichever SOE they are told to and they charge the same rate on all corporate loans. The one thing these banks are really good at is creating non-performing loans – and we will see hundreds of billions more of these in due course.
Now I know someone will argue that they know a particular SOE that is well managed and has a good track record, etc. I’m not at all surprised. I heard a good pitch just today for China Life; it was very plausible and for all I know could very well be correct. My point is not that ALL SOEs are either of poor quality or who’s earnings are a function of regulatory allowance (or both), my point is that the majority of them are. Or, to put it another way, SOEs are structured to be bad investments. Why? The management and the controlling shareholder (the state) do not have as their primary objective the maximization of shareholder value. In a perverse way their interests are aligned. Unfortunately your interest is not aligned with theirs.

What we have seen in the last year or so as the market has zoomed higher and higher is mostly a liquidity-driven bubble. Retail investors, mutual funds, and corporates have all been playing the stock market like crazy (and btw, stock market gains make up as much as a fifth of all corporate profits). Will it continue? Who knows, but if I am going to invest in Chinese stocks in this kind of market, I certainly want to invest in one of the hundreds and hundreds of companies which are NOT controlled by the state, which are managed by performance driven CEOs (often the company founders) and which are not overtly affected by regulatory changes (because they are typically smaller so they make a less attractive target; and because they tend to operate in industries which are not of great national interest, e.g., shoe retailers or travel agents or advertising). Let me say it again to make sure I am not misunderstood: there are some SOEs which can be good investments and some private companies which are certainly bad investments. My point is that buying an ETF which is made up of 100% or almost 100% SOEs guarantees you will own a portfolio the majority of which is made up of companies run NOT for the benefit of shareholders by managements of dubious skill.

Let’s look more closely at the iShares FTSE/Xinhua China 25 Index (FXI). The average market cap is $70 billion so this is a mega-cap index with zero exposure to SMEs. Second, if you look at sector weights, you can see that financials make up more than 40%, energy and materials about 30%, with telecoms at about 20%. The reason to invest in China is GROWTH but this is not a growth portfolio!

So what to buy instead of ETFs? How about a mutual fund? Not sexy enough for you? You don’t like them because they don’t allow you to jump in and out of the market each week or so with your superior market timing skills? Don’t kid yourself. China is a great – a once in a lifetime – opportunity but it is a long term play and neither you nor I nor even the most savvy experienced Chinese fund manager has the SLIGHTEST CLUE when the market is going up or down. If ever there was a buy and hold market, this is it.

Why are some of the mutual funds (and perhaps one or two actively managed closed-end funds) superior? Because some of the them hold most or the majority of their assets in small and mid-cap PRIVATE COMPANIES. I don’t mean private in the western sense of not listed, I mean private in the Chinese sense of not being owned or controlled by the state. It may come as a surprise to those who are less familiar with the current Chinese corporate environment but the single most astounding and impressive fact about China is the existence of THOUSANDS of private SME companies – the majority of which are well established and profitable and growing at 20+% per year. Why buy a highly regulated phone company or bank run by a party hack when you can buy an entrepreneur founded private company operating below Beijing’s regulatory radar screen in manufacturing or services? This is THE opportunity in China and it is available to anyone who cares to logon to Morningstar and has a Schwab account.

The clincher in the argument as to the superiority of actively managed open or closed end China funds is that you can get the “great” in “greater china”. As many of you surely know, China is three markets (at least):
- PRC A-shares: Shanghai and Shenzhen exchanges
- Hong Kong H-shares
- Taiwan companies
But for all intents and purposes, these are all China stocks and any China investor should select among all of them. FXI has zero holdings in Taiwan. Some of the mutual funds invest among all three markets.

I will post next week on which of the available China mutual and closed-end funds look most attractive. According to my first screen, there are 12 mutual funds and 1 closed-end fund with more than $100 million in assets that invest in China. Several of them have outperformed FXI (not that that should be the primary determinant). China is going to be an important and attractive investment opportunity for a great many years to come. Hence there’s no reason to rush in and buy a portfolio of poor quality (and expensive I might add) stocks just so that you don’t miss tomorrows 2% spike. Take a bit of time and invest in a good fund. You probably won’t triple your money in the next 12 months but you probably WILL triple you money over the next five years. It’s called investing.

Carlyle to critics: "We can spend as fast as anyone!"

Critics (clients?) of Carlyle's uncertain efforts in Asia ex-Japan were informed by Carlyle that the firm had, contrary to what some may have thought, been ENORMOUSLY SUCCESSFUL at spending money.

Carlyle defends its track record in Asia (FT)

Carlyle Group, which has suffered high-profile setbacks in China, has issued a robust defence of its track record and predicted that private equity investment into Asia will flourish in spite of the global credit crunch.

The US private equity fund struggled for 18 months to win approval for a sizeable investment in Xugong, China’s leading construction machinery maker, amid a nationalist backlash.

This year it failed to secure approval for an 8 per cent stake in Chongqing Commercial Bank, a provincial lender.

However, XD Yang, Carlyle’s most senior executive in Asia, told the Financial Times that the fund had closed 14 deals, with a total value of $800m, in China over the past year. All the investments were for minority stakes in companies in sectors that included financial services, media and manufacturing. Carlyle has not previously confirmed its deal activity in the country.

Mr Yang said investors had to accept that an opaque regulatory process was a part of business in China. He said that in some sectors in China the approvals process was not clear or established. “This applies not just to Carlyle but also to other funds and multinationals. We are continuing to make lots of investments.”

Carlyle was a pioneer of private equity in Asia, and has $6.3bn dedicated to investments in the region.

Its first Asia buy-out fund, which closed in 1999, has delivered a gross internal rate of return of 26 per cent against a comparable industry average of 15 per cent, according to Carlyle. Mr Yang disclosed that Carlyle’s second buy-out fund for (non- Japan) Asia, which closed in July 2006 with $1.8bn, had already committed 60 per cent of its funds to new investments.

If I was a Carlyle client, the fact they have committed 60% of a 1.8 billion buyout fund into primarily MINORITY stakes in ONE YEAR would make me feel much better.

Global Liquidity Continues to Fall; Public Pension Funds Reverse Decision to Allocate tens of billions to hedge funds

Public pension funds are the mother load of new assets for hedge funds. With corporate defined benefit pension plan assets slowly dwindling away and what remains of corporate pensions going into to 401k plans which cannot invest in HFs, and with endowments and foundations already fully allocated for the most part, publics have been THE BIG opportunity for HFs. Especially for the $10 billion hedge funds that want to become $50 or $100 billion "asset management firms".

Public pensions are notoriously slow off the mark but in recent years they've begun to notice that most other institutional investors, the world over, have 10, 20, 30% or more in hedge funds and private equity. And so the public funds set the wheels in motion (slow motion) to begin to invest. Now remember, these funds are elephants - large and slow. It can take them a year or more to make a decision, get approval, and then invest. And over the last year or so they have begun to put billions to work in HFs. According to a Greenwich Associates report from this spring:

Institutional investment represents 25% of large hedge funds’ assets. Large hedge funds were defined as ones with over $1bn in assets. Institutional Investment comprised 20% of hedge fund assets in 2005, and 23% in 2006. Corporate pension investment in large hedge funds edged up to 8% in 2007 from 7% a year ago. Investment by endowments and foundations inched up to 11% from 10% in 2006. Public pension fund contributions rose to 6% from 5% last year.

Note that this understates the magnitude of institutional flows into HFs because HF of funds represents about 20% of all large HF assets and I would guess about half or more of HFoFs assets comes from institutions.

So, alas, the opportunity for HFs to tap into the public pension gold mine may be gone. The achilles heel of the publics has always been their sensitivity to volatility and especially their sensitivity to BAD PRESS. One Amaranth per year was probably not sufficient to cause the publics to reverse their plans but TEN AMARANTHS per MONTH certainly is. And that is whats happening. This is all very predictable. If you get paid nothing to take risk and if you get fired if anything you do is the least bit controversial and if you get shot if anything in your fund shows up in the papers, well, why do it? Unless the world becomes safe and happy and stable all of a sudden and the whole subprime mess fades away and the US economy chugs along happily - unless there are no more HF blowups... this could be it for public pension fund inflows into HFs.

The money quote (from today's WSJ) from Frederick Rowe, chairman of the Texas Pension Review Board, which provides oversight of Texas public pension funds:

It's like planning a vacation to an exotic land, and finding out that there's an outbreak of bubonic plague.

Bubonic plague indeed. Like rats from a sinking ship, eh?

And to put this into perspective, to remind ourselves of the implications, more HF assets means more liquidity because every dollar that goes into a HF gets levered by 3x or 10x or whatever. The decision by public pension plans NOT to invest in HFs or possibly even take money out means that global liquidity will be significantly less than it otherwise would have been.

India refuses to take its medicine; patience of MNCs apparently not unlimited

Delhi scores own goal

Novartis declares it will take its highly sought R&D dollars elsewhere after Indian court rejects patent application on cancer drug. This is unusual because most MNCs, after getting slapped around by Indian courts, government officials, or NGOs, meekly ask forgiveness and walk away with their MNC tails between their legs. Not Novartis CEO Vasella who responded with the verbal equivalent of a nuetron bomb:

This [ruling] is not an invitation to invest in Indian research and development, which we would have done. We will invest more in countries where we have protection. It’s not a punishment, it’s just a question of the culture for investment. Do you buy a house if you know people will break in and sleep in your bedroom?

Novartis' country head, Ranjit Shahani, was equally blunt in an interview in Live Mint:

The impression given is that we are not open for business, as a country. We are losing out on investment. It is not just about China (getting the R&D investments), look at Singapore as well. The operating environment and speed at which the decisions are taken, is obviously significantly ahead (there). Between 2005 and 2007, five companies have invested in China and at least, one or two of them should have come to India. These are Johnson & Johnson, Roche, Astrazeneca, GlaxoSmithKline and my own company, Novartis Ag. Each company would have spent a few 100 million dollars, though I don’t know the exact figures. In the last 24 months, we have made an initial investment of $ 200 million in China for R&D. At the Novartis’ Institute for Tropical Diseases in Singapore, we spent about $400 million. For sure, India could have been home to some of these investments. Moreover, the Singapore institute works on treatments of dengue, malaria and tuberculosis, all of which should have rightfully come to India. We lost that out.

In response to the comment that perhaps India cannot protect drug IP because of the need to lower prices, he pointed out that

We have the lowest price medicines in India. Yet, because of poor health infrastructure, people do not have access to medicines. There is a need to focus time, money and energy on building health infrastructure. In fact, only 35% people have access to medicines in India. Even in Africa, which is called the ‘dark continent,’ 47% of the population has access to medicines.

What is the implication of this? Simple: the long term risk that India fails to attract sufficient investment has grown. Score another one for Beijing.

Will conduits sink banks? No. Will they (help) sink the economy? Yes.

Today's FT has an nice article on the conduit, ABCP situation, as it relates to banks. I especially like the opening about the large UK bank, HBOS:

HBOS’s annual report for 2006 covers almost 200 pages. But the document does not carry a single reference to Grampian Funding, the vehicle the bank uses to help lower its financing costs. So investors could be forgiven for expressing some surprise on Tuesday when HBOS announced that it would take direct responsibility for financing Grampian.

Grampian, which has assets of about $37bn, is one of Europe’s largest bank conduits. These are funding vehicles usually kept off a bank’s balance sheets that have emerged as pivotal players in the current market turmoil. HBOS, the UK’s fourth-largest bank, is the largest financial institution so far to publicly admit the effects of the drought in the market for asset-backed commercial paper, which conduits such as Grampian rely on for funding. But other banks are suffering as well.

The article goes on to discuss the impact on banks generally of putting all the conduit's onto their balance sheets. Analysts - those clever creatures who know all the facts but rarely seem to be able to notice the forest before it crashes on top of them - have used their sharpest pencils to calculate that bank's capital ratios will drop by only a bit (0.4 in the case of HBOS to 7.3%) and yes there is the obligatory reference to the Basel II Framework (zzz). The analysts - many of whom will soon be unemployed - go on to note that the SIVs (special investment vehicles), cousins of the conduits, generally have higher asset quality and less reliance on CP funding.

Oh well that's all right then. But hang on, is it? I think the FT hit upon perhaps the key point in this odd mess when noting that HBOS's annual report of however many pages had nary a mention of this $37 billion beastie called Grampian. So for shareholders or creditors or others where HBOS is a counterparty, the point isn't really that Basil the 2nd is still pretty fit. The point is that one's confidence in the intelligence and skills of the managers of HBOS has taken a hit. Quite a big hit I would say. And though one cannot quantify the effect this has had and will have on HBOS and the other banks and the market in general, it is fair to say based simply on what we see happening, that the hit has been large. It is like the old chesnut that one's good reputation takes a lifetime to build but only a moment to lose. And once lost is recovered slowly and painfully.


Analysts are paid to quantify whatever is laying about that can be quantified. This may or may not have anything to do with the crux of the situation. In the case of ABCP and conduits, I think it does not. Confidence has been lost. At the margin the impact will be more expensive credit and less available credit. Multiplied across the hundreds of banks with - yes it is fair to say - secret conduits, the impact on the real economy will be significantly negative.

Remember, its a GLOBAL property bust

Spain looks worse than South Florida...

Bank of China Holds $9.7 Billion of Subprime Assets

Now things are getting interesting! Bloomberg reports that BOC holds a whopping $10 billion in sub-prime MBS. This far exceeds amounts admitted to by any other global bank. Very little is know at this point about what types of securities are owned, are they CDOs and if so which tranches (presumably AAA). All that can be safely assumed at this point is that there will be losses and that they could easily amount to a billion or more. I would say this moves the sub-prime mess into a new chapter. Last week's headline was ABCP (not very catchy really). This week its:

"Fort Myer's condo losses hit Beijing"

India to cut off nose

Ah the Indians. The range of emotions one feels when watching events unfold in the country range from great optimism and admiration to feelings of sadness at the staggering and entrenched poverty. But often what one feels is amazement at how the bitterness and suspicion, a legacy of India's colonial past, combines with a political realm overpopulated by neo-Fabian socialist-communist nutters with a nostalgic fetish for non-alignment. Pardon my bluntness (if any neo-Fabian non-alignment nutters happen to be regular readers) but the truth must be told. There is a tragically strong and predictable tendency by the Indian body politic to speak rubbish and shoot themselves in the foot. Witness the crumbling support for the US-India nuclear deal.

Headline from Hindustan Times:

Nuclear deal standoff

CPI(M) warns Govt of pulling back support

The Central Committee of CPI-M authorises Politburo to take an appropriate decision at an appropriate time.

Um, say there fellows... I have to ask... what planet are you on exactly? The Politburo? The following from NDTV is an accurate reflection of how those of us in the US see the Indian debate (btw, Ambassador Sen is the poor chap who quite accurately characterized the debate as one among headless chickens and of course the highly dignified BJP and Left Front roosters are calling for his head):

India's Ambassador to the US Ronen Sen is not the only casualty of the opposition to the Indo-US nuclear deal in the Indian Parliament.

The ramifications of the political impasse in New Delhi are being felt amongst experts and think tanks in Washington DC too.

In fact, in the US, even those international relations experts who have been the most fervent proponents of the deal have had no option but to agree with Sen's remark that if the nuclear deal unravels because of opposition in New Delhi, India will have ''zero credibility.''

According to Teresita Schaffer, Director, South Asia Program, CSIS, ''The fact that there has been such controversy over it and that the government is even considering slowing things down inevitably leads people to wonder whether India is a country that cannot take yes for an answer.

Or, to put it more bluntly, who needs friends like these? If the Indian's generally agree with the view of the Communist Party of India (Marxist) - yes, not to be confused with the CPI (Lennon) or CPI (Stalin) - that any deal which includes cooperation with the US simply must be bad, I can only wish them well when dealing with those altruistic fair-dealing highly ethical partners, the Russians and the Chinese. And one other thing, a minor point really, but how are you fellows planning of keeping the lights on?

Rejection of the nuclear deal would of course be a disaster for financial markets and foreign capital inflows into India but we'll leave that for another time.

The US Slowdown and What does it mean for Asia? Part II

Regular readers know I have for many months been of the view that the US economy is very likely to experience a slowdown if not outright recession as a result of the housing recession and the fact that the US consumer, prior to the housing meltdown, was in such a vulnerable state. Please don't talk to me about the low unemployment rate. Firstly it is lower than one might expect today not because of rapid job growth but because of sluggish labor force growth. Secondly, unemployment will certainly grow as the full force of the housing collapse works it's way through the construction, mortgage, banking, and other industries This week the number of announced layoffs is already in full swing.

Anyway, the big question is not what will happen in the US, it is what will happen in Asia. For those of us who are long term bulls on Chindia, this is the big test we have been waiting for. In one sense, it is a good thing. Valuations - not to mention emotions - were getting crazy as double digit economic growth mixed with unlimited capital. Now there will be maybe a bit less growth and certainly less capital, at least less foreign capital. My first thoughts on this issue were pretty straightforward: China, no problem; India probably okay but a small but not insignificant risk of a balance of payments problem. Let's look at this again.

In one sense, we can think of a bit of global headwinds as accentuating the advantages that China already has over India. Let's take infrastructure - human and physical. China has done a far better job than India in this respect and the gap grows every year. As foreign investors are likely to become more risk averse, as declining global stock markets are likely - at least initially - to make foreign investors less willing to invest in Indian stocks, India will have an even greater difficulty in financing infrastructure projects. The fact that they have still not worked out some major kinks in terms of land acquisition and public/private financing structures, again makes what was a not so great situation into one that looks really pretty bad.

Indeed, the more I think of it, the more it seems to me that slower global growth (I also don't buy the idea that the World ex-US will grow nicely dispite a US recession; Japan and Europe both appear rather wobbly to me while LatAm and Russia will only grow if the rest of the world grows so don't look for any help from EM ex-Asia) and reduced global capital flows will provide a test to China and India which China is quite well positioned to pass whilst India seems poorly prepared for and just might fail. Don't get me wrong, I am still bullish on India longer term. But being a LT bull does not mean that we ignore the fact that there will be both economic cycles as well as the occasional crisis along the way. It is an old bit of wisdom, a bit of a cliche really, that real reform only happens (in any country) when there is a crisis. This is probably true, most of the time - the number of examples one can think of off the top of one's head are quite numerous - including of course, India herself. Maybe the answer to the question posed in the title of this post is the following:

China: nothing
India: crisis followed by the next phase of reform

US Manufacturing: Rumors of death greatly exaggerated

According to the WSJ, many of the world's largest steel makers are adding capacity in the US. Yes, you heard that right. Contrary to the widely believed but largely unsupported view that the US manufacturing sector is doomed to oblivion, steelmakers are putting their money behind their view that the US is a great place to invest and produce.

This latest wave of steel investment by both foreign and domestic companies represents a long-term bet on the health of the U.S. steel market and its manufacturing sector as a whole.

The reasons for the renewed interest include:

...transportation costs, which have more than doubled in the past decade to about $50-$70 a ton from $20 a ton, and it makes shipping steel to the U.S less attractive.

Meanwhile, building in the U.S. has advantages beyond lower transportation costs. As U.S. manufacturing has become more sophisticated and customized, steel customers are demanding more technically challenging products that fetch higher profit margins. Some of the coming capacity additions come from integrated steel mills -- the traditional type that often use steelmaking ingredients like iron ore and coal, two minerals easily found in the U.S.

Other developed nations like Germany, which has high labor costs, or Japan, which has high energy costs, are seen as bad bets for new steel mills, says Mr. Marcus, of World Steel Dynamics.

Commercial paper market: hidden time bomb?

Like most of us, as I try to comprehend the latest facts about the sub-prime mess, I sort of rub my eyes and scratch my head like a country bumpkin just arrived in the big city who’s innocent, unsophisticated mind can hardly comprehend all the big lights, tall towers, and fast operators. The latest piece of the SPM (sub-prime mess) has me gaping wide mouthed in awe. “Golly Ma, never thought I’d live to see the day!” This has to do with what, once upon a time, was about the most boring and uncomplicated market there was: commercial paper. Well, it ain’t boring anymore and it’s complexity has reached byzantine levels. Over the last couple days, as I read about problems with commercial paper, I was surprised but didn’t fully grasp the import and simply took it as an indication that the subprime unraveling had entered a potentially explosive new phase. But then I read about KKR in the same sentence as commercial paper. Say what? That got my attention. Then on Friday I read about “asset-backed CP” and “bank conduits” and I became curious and did some more reading. I don’t claim to understand all the ins and outs of this thing (like who does?) but the gist of it is becoming clear.

Banks, investment banks, hedge funds, and PE firms have been issuing commercial paper as funding for carry trades. They put in capital of $100, borrow $2,000 in CP, and invest the proceeds in higher yielding stuff: CDOs, MBS (including sub-prime) and other ABS. So, sports fans, this is why we are all rushing to call our Schwab brokers and blowing out our cash sweep accounts and other money market funds as though they were leveraged Egyptian equity funds. The (ex-)masters of the universe were using the commercial paper market – formerly a way for quaint old fashioned “companies” to get short term funding – as financing for leveraged carry trades. Now some of these conduits (also known as SIVs, structured investment vehicles) may be related to the bank’s operations (e.g., a bank makes mortgage loans and then sells them to the off-balance sheet conduit) but I suspect that a lot of these vehicles – like that for KKR – were just another way to play the ponies – er, execute investment strategies. They look suspiciously like off-balance sheet credit hedge funds. Btw, remember the last time the world read about off-balance sheet vehicles in connection with severe market dislocation and potential bankruptcy? Begins with E and rhymes with moron. This also bears more than a passing resemblance to the S&L bankruptcies in the early nineties: funding long term assets of questionable quality with short term deposits.

Well it all started with a tiny German bank with the funny name that no one had ever heard of, that was one of the first shoes to drop week before last. IKB Deutsche Industriebank was in fact one of these “bank conduits” set up expressly for the purpose of investing in MBS, financed by CP. Then we learned early last week that the entire Canadian ABCP market needed a bailout:

Several third-party issuers of ABCP, traditionally regarded as a safe investment because it is backed by assets like home and car loans, have warned this week of trouble raising money to repay debt that is maturing. They had asked banks for funding lifelines, but several have refused…


What started out as defaults in the risky U.S. subprime mortgage market has widened to concerns about debt markets in general, including Canada's ABCP market, in particular that segment operated by non-bank or third-party players, estimated to be worth C$40 billion.

The remaining C$75 billion segment of Canada's ABCP market is mostly operated by the country's big five banks and looks set to escape the credit squeeze…

The group's proposals include an agreement to roll third-party ABCP for a 60-day standstill period. Signatories will not pursue liquidity calls, or make new liquidity calls for 150 days after the standstill agreement.

In the longer term, the players propose converting all outstanding third-party ABCP into term floating-rate notes, which will pay interest monthly or quarterly. "Existing liquidity facilities will therefore not be necessary and will be canceled, and all outstanding liquidity calls will be revoked," the group said.

But others cautioned that the proposal was just postponing the problems until later when the notes fall due.

"That's just a stopgap," said Paul Gardner, principal, and portfolio manager for the equity and fixed income portfolios at Avenue Investment Management.

If you are the manager of a Canadian money market fund that holds this paper, you’ve got to be pretty unhappy.

And then on Thursday we learned that KKR wasn’t satisfied making 2 & 20 on $20 billion LBO funds so they set up KKR Financial Holdings. KKR owns 12% of KKR Financial Holdings which in turn owns two entities called, KKR Atlantic Funding Trust and KKR Pacific Funding Trust.

According to the WSJ:

The two issuers raised money with $500 million in equity backing from KKR Financial and invested in mortgage securities based on a debt-to-equity ratio of about 20 to 1, said the people familiar with the situation. Such mortgages might fetch only 90% or less of their face value now, these people said.

KKR Financial's strategy for KKR Atlantic and KKR Pacific was to issue highly rated commercial paper at low short-term rates and invest in triple-A mortgage securities, which paid slightly higher rates. However, the strategy depended on the ability to resell the mortgages on short notice, while demand has dried up unexpectedly.

So who else is playing this game? Who else has a highly leveraged credit hedge fund masquerading as a boring old fashioned CP issuer? Well, everyone it seems. The Journal reports that the huge increase in ABS CP issuance is

primarily due to growth in conduits, bank affiliates that issue paper and use the borrowed money to invest in securities, which back future borrowing…

A number of large banks operate some of the world's biggest affiliates, or conduits, including ABN Amro Holding NV and Fortis NV in the Netherlands, the U.K.'s Barclays PLC and Royal Bank of Scotland Group PLC, and Germany's Deutsche Bank AG. Big U.S. operators include Citigroup Inc., Bank of America Corp., and Wachovia Corp., according to a Morgan Stanley report issued Thursday…

The conduit issues commercial paper and uses that money to buy longer-term bonds that pay higher interest rates than the conduit is paying on its debt. The conduit issues a steady stream of paper to invest and repay past borrowings. The bank behind the conduit harvests asset-management fees and investment profits.

And it isn’t “just” every large bank in the world, in a separate article, the Journal reports that:

Hedge funds, private-equity firms and investment banks have played a major role in this expansion by setting up companies that borrow by issuing commercial paper and then invest the money, sometimes in the types of mortgage-related securities that have proliferated in recent years.

As the value of those securities has become unclear -- and the companies holding them come under pressure -- the commercial paper they have issued has come into question, as well.

The immediate focus of concern has been a variety known as asset-backed commercial paper, a form of financing that has been hit by a downturn in the value of collateral such as subprime mortgages, which have been damaged by rising default rates. The amount of asset-backed paper has grown in recent years, soaring 48% to $1.13 trillion today from $765 billion two years ago, according to data from the Federal Reserve.

Kind of makes you shake your head in dazed wonderment at this funny old world. Okay, let’s step back and think about what we know at this point:

One, there is a Trillion dollar-plus commercial paper market backed by ABS, some of which are residential US mortgage paper. Goldman estimates only about 10% of the assets are MBS but count me skeptical. I seem to recall more than a few Goldman backed dot.com IPOs so they may not be the place to go for unconflicted analysis.

Second, that the great majority of large global banks were doing this. The Europeans seems to have been the biggest. According to the Economist:

One of the busiest in these markets is Deutsche Bank, Germany's biggest bank. In a March filing with America's Securities and Exchange Commission it estimated its maximum exposure to loss from structured products at €2.3 billion ($3.1 billion). But it will not, indeed cannot, put a number on its exposure now. It is the same at other big European banks, such as Royal Bank of Scotland or HSBC.

More worrying are the exposures of some German Landesbanks. On August 13th DBRS, an international rating agency, noted that rumours had been circulating for a week about the liquidity of some German banks, especially after IKB's state-sponsored bail-out. Part of the problem, it noted, was that investors no longer trusted the ratings of the asset-backed securities that the banks had invested in. And who can blame them. As late as June, Moody's issued a report calling SIVs “an oasis of calm in the subprime maelstrom”.

Third, after the German and Canadian bank bailouts and after the KKR Financial bailout, S&P looked into the whole conduit/ABCP issue and pronounced, confidently, “no problem”:

Standard & Poor's Ratings Services said today that all of its outstanding ratings on the commercial paper (CP) notes issued by U.S. asset-backed commercial paper (ABCP) conduits including multiseller, loan-backed, arbitrage, and single-seller (other than those placed on CreditWatch on Aug. 14, 2007) are not affected by any exposure to U.S. residential mortgage assets that these conduits may have…

Standard & Poor's also believes that liquidity from internal cash flow and existing third-party support arrangements with highly rated banks will serve to effectively manage any disruption to funding resulting from stress in the CP market…

In light of the recent events in the U.S. mortgage markets and in the global ABCP market, Standard & Poor's has reviewed all of its U.S. ABCP conduits and identified those with any exposure to U.S. mortgage assets. A U.S. ABCP conduit can have exposure to U.S. residential mortgage assets directly through an investment in mortgage loans or residential mortgage-backed securities (RMBS), or indirectly through an investment in collateralized debt obligations (CDOs). In its review, Standard & Poor's examined each conduit's portfolio of assets and the structural characteristics of each conduit, including the level andavailability of credit and liquidity enhancement.

Yea… right… so now I’m really worried.

Fourth, the reason that ABCP is rated AAA is because of “liquidity enhancement” or backfunding commitments by the parent bank to step in should the conduit need liquidity. But there seems to be uncertainty as to when and under what circumstances the bank must honor these commitments. As reported in the FT:

Investors in the European financial sector are scrambling to establish how much banks have pledged in credit lines to so-called “conduits” after Sachsen LB became the second German bank to be rescued amid turmoil in the credit markets. The German savings banks association had to take over a €17.3bn credit facility that Sachsen LB had pledged to one of its special investment funds, or conduits, late on Friday…

The rescue was triggered when commercial paper investors refused to refinance Ormond Quay and Sachsen was unable to provide the credit it had pledged. The collapse may raise further questions about the German banking system as it came just a week after the bank said it had “sufficient liquidity” and days after the Bundesbank said the failure of IKB, the German bank bailed out three weeks ago, was an “isolated incident”.

It is likely to trigger fresh concern about European banks’ exposure to the credit market via credit lines to conduits, which face their own liquidity crunch in the asset-backed commercial paper market.

More than 30 European banks run conduits worth about $500bn, according to Moody’s Investors Service, the credit rating agency. The banks include Britain’s HBOS, ABN Amro of the Netherlands, France’s BNP Paribas and several German Landesbanken. US banks such as JP Morgan Chase and Citigroup have also set up European conduits.

Which leaves two big questions we don’t know the answer to yet:

1. How much of the $1.3 trillion ABCP, if marked to market, is under water?
2. For those conduits with “impaired assets”, who will ultimately take the hit, the conduit parents or the CP investors?

Perhaps the People’s Bank of China will end up losing billions on AAA rated CP issued by KKR. That may sound too far fetched even by the standards of the current bizarre situation. But it is becoming clear that what we mean by “sub-prime mess” is actually a massive subterranean labyrinth/ecosystem/carnival – wherein all the major financial entities, be they banks, hedgies, PE funds, are players. This isn’t over by a long shot.


Fyi, Brad Setser's Blog has an excellent post on this topic for more information.

Bad for Chinese banks, good for China

Financial system in China takes a big step forward
What's the mandarin word for disintermediation?

This has been in the works for some time but is just now going into effect. Chinese companies can now issue corporate debt, hence will have cheaper and more flexible source of capital. (Regulations had permitted this in the past but the government entity in charge was hyper-risk averse and essentially didn't allow any issuance. The CSRC is now in charge and will allow broad issuance.) Banks will no longer have captive high spread business. For China Inc it means higher profits and increased efficiency of capital allocation.

Incidentally, China may be the only country on earth where debt is being issued today...

The best laid plans... China H share discount WIDENS

After the enactment of enhanced QDII in China which enabled PRC retail investors to buy H shares via domestic mutual funds, many China fund managers thought they spotted a sure bet. The 25% or more discount between H shares and A shares would narrow or close. Ah well, not yet! The new provisions came into effect June 30. Since then the CSI 300 (A shares) has outperformed the HK China Enterprise Index (H shares) by almost 30%!

Infrastructure as an asset class - reason #9003 why it makes no sense

Japanese banks, those savvy investors who over the years lead the world in creation of bad loans, are reported to have ambitions to significantly increase their international project finance lending. So they will be competing with the Goldman, Carlyle, and Macquarie infrastructure funds, along with the global infrastructure companies. I predict, over the next ten years, average returns after fees will be single digits. Worst case (like if those juicy Venezuelan projects don't pay off) returns could be lower than treasury bonds.

Dawn of toy manufacturing in US

Three stories today show - not surprisingly - that there is increased momentum to shift toy manufacturing for US consumers back to the US.

Mattel's latest mammoth recall. Analysts assume that the 2nd and 3rd tier toy companies have just as big if not bigger problems and that the recalls will accelerate. Hey, where is Chuck Schumer? Chuck, what's taking you so long?

Toy R Us "baby bibs" contaminated with lead. Downright Un-American!

The few, the tiny, the US toy manufacturers - are swamped with new business.


Very predictable. When you buy a toy for your kid, it will now be commonplace to ask where it's manufactured. If the answer is China, no sale. If the answer is US, sale. Gee, how important are low costs now?

EM as panecia for global markets - the clock is ticking

Although the US is the center of recent financial market turbulence and potential economic distress, data points continue to accumulate which indicate that developing markets, far from being the answer for whatever may ail global markets, will - along with the US - be key factors contributing to the next economic and financial market downturn.

Led by Goldman but now more or less consensus is the received wisdom that:

• EMs are far stronger and sounder "this time"
• EMs will continue to grow at a rapid pace with less variability, and hence will power global growth
• EMs have unlimited human resources and hence will restrain global inflation - as they have in the past - for many years to come
• EM = new economic paradigm (I always wanted to use that word but never before had the opportunity. thanks EM).

For example, those who argue that US commercial RE, though expensive compared to historical valuation metrics, is fairly valued because there has been a secular decline in global economic volatility and inflation. This, it is argued, means one ought to pay higher prices for all financial assets.

But what if developing markets turn out to be a lot like every other economy in human history? What if their economic growth (though more rapid on average) is cyclical? What if the human resources in certain EMs (China, India) , instead of being unlimited, are finite and substantially less abundant than estimated by consensus? Hence, rapid growth results in full utilization of labor (as well as physical supply factors) causing inflation. What if multi-year commodity booms caused much of the growth in certain EMs (Brazil, Russia) over multi-year periods and masked the lack of fundamental economic and financial market reforms?

It is my view that anyone who thinks that the qualities of developing market economic growth and inflation are such that one ought to be fundamentally bullish on global asset prices... has a BRIC for a brain. And if you didn't see this a year or two ago, you should certainly see it today. Resource constraints are fueling inflation in India. Average wages are growing at 15-20% in China. Inflation in Russia is 9%, Hungary 9%, South Africa 7%, Argentina 9%. Global investors are bullish because "we all know" that EM currencies will significantly appreciate over the next few decades. But appreciation of the Rupee and Renminbi = depreciation of the dollar which will put upward pressure on prices in the US. Last Friday import prices on products from China were reported as rising for each of the last two months. This week's Economist provides the latest grist for my, "EMs may be hazardous for the health of global asset prices" view: EM money growth (real) has been steadily accelerating and is now growing at 16% per year. Developed market central banks - those smart fellows who were never going to allow inflation to get out of control again - "no longer determine global monetary conditions".

And you thought all you had to worry about was tighter global credit and a housing bust...

You made your bed...

Bank of England Gov. Mervyn King this week said, "Interest rates aren't a policy instrument to protect unwise lenders from the consequences of their unwise decisions."

...and now you'll have to lie in it.

You made your bed...

Bank of England Gov. Mervyn King this week said, "Interest rates aren't a policy instrument to protect unwise lenders from the consequences of their unwise decisions."

...and now you'll have to lie in it.

How quaint

This paragraph in the WSJ caught my eye. Everything old is new again...

The fright among investors is forcing lenders to go back to more-conservative practices that were the norm before the housing boom of the first half of this decade. Many now are focusing on loans to borrowers who are willing to document their income, can make a down payment of at least 5% and have a history of paying bills on time.

Wait, you mean they're only going to lend to people who can demonstrate they have the capability to pay it back? How peculiar.