From New York to Nicosia

Greenspan launched another defense of himself in the WSJ today.

The meat of his argument is below and here is the full article.

The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.

This should not come as a surprise. After all, the prices of long-lived assets have always been determined by discounting the flow of income (or imputed services) by interest rates of the same maturities as the life of the asset. No one, to my knowledge, employs overnight interest rates — such as the fed-funds rate — to determine the capitalization rate of real estate, whether it be an office building or a single-family residence.

The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier — in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.

U.S. mortgage rates’ linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.

This is disingenuous. First look at these two charts (fed fund rates and housing price index).

Federal Funds Rate

From FinancialSense.com

So here is what really happened:

a) we had a huge asset bubble in the largest sector of the consumer economy

b) because the Greenspan Fed did not believe in targeting asset bubbles and because the way CPI measures housing is insane and because of deflationary effect of Chinese manufacturing

c) Greenspan was able to keep Fed Funds at historical lows for years, while pretending inflation was tame, which of course it was not – all the easy money inflation was pouring into housing

Greenspan says:

Fed funds and mortgage rates de-correlated because of global liquidity fueling the securitization chain so there was nothing we could do about it

Why this is silly, in reverse order of importance

a) They could have clamped down on lending by both depository and non-depository institutions that were fueling the bubble with idiotic or fraudulent products

b) i suspect the reason that the correlation between short and long-term rates disappeared is because short-term rates were trading in such a small and low range. If you take short-term rates to 5 or 6% they were in the 1990s, the 4-6% long-term mortgages are obviously going to disappear.

But Greenspan never felt he needed to do that because we had reached some new golden economic paradise where easy money does not cause inflation.

c) most important:

What exactly does Dr. Greenspan think was fueling the massive liquidity and chasing for yield from all the institutional investors that held down long-term rates, except the amazingly low fed fund rates. Given the savings glut and very low yields, financial “innovation” was inevitable.

None of these excuses the various parties (homeowners, originators, securitizers, buyers) from the varied and sundry stupid or fraudulent things that they did, but for the Chairman of the Fed, who is supposed to take the punch bowl away when party gets going, to say that there was nothing he could have done, well, that is plain ridiculous.

Thanks to Josh for bringing the article to my attention and Larry for noting that nobody gets a free pass in this debacle.

The most lucid annual reading in business has just come out.

This was Buffett’s worst year (down 9.6%), but he still crushed the S&P by over 27 points.

Page 1:

Our decrease in net worth during 2008 was $11.5 billion, which reduced the per-share book value of both our Class A and Class B stock by 9.6%. Over the last 44 years (that is, since present management took over) book value has grown from $19 to $70,530, a rate of 20.3% compounded annually.*

The table on the preceding page, recording both the 44-year performance of Berkshire’s book value and the S&P 500 index, shows that 2008 was the worst year for each. The period was devastating as well for corporate and municipal bonds, real estate and commodities. By yearend, investors of all stripes were bloodied and confused, much as if they were small birds that had strayed into a badminton game.

As the year progressed, a series of life-threatening problems within many of the world’s great financial institutions was unveiled. This led to a dysfunctional credit market that in important respects soon turned non-functional. The watchword throughout the country became the creed I saw on restaurant walls when I was young: “In God we trust; all others pay cash.”

By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.

This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.

Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly.

Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.

Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 211?2% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges.

Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead

Full report here in PDF format:

2008 Berkshire Hathway Annual Report

30+ years of great reading at BerkshireHathaway.com

The Three Fates

Here is my attempt for 2009. In 2007, I was fairly certain of my predictions as we were looking at a credit and housing bubble of historic proportions. There was no doubt it had to burst. In 2008, I was less sure but it was pretty clear that straight down was still the direction we were headed.

In January 2009, we look at world of unprecedented turmoil and infinite possibilities so I am far more uncertain than in the past.

However I am not going to let doubt and ignorance keep me from sticking my head out again. When exactly zero dollars are stake, I am a bold man. Please jump in and correct me where I am wrong.

Of course, this is a parlor game and is not investment advice. If you take your macro-economic guidance from the blog of someone for whom domain names constitute a significant asset class, then I respectfully submit that passive index funds might be a better choice for you.

World Economy

1) The consensus Wall Street forecast that the US will have a 2nd half of 2009 recovery is some kind of bad joke. Full year recession in the -2% to -3% range for the US in 2009. I can’t see any recovery before middle 2010 at the earliest and even that is optimistic. There will be weakness for years.

The key issue is that consumers have had massive wealth destruction (stocks, homes) and have to delever (too much debt, negative savings rates). That is going to be a huge drag on consumption for a very long time and why the government is stepping into the breach with unprecedented fiscal stimulus.

Real unemployment will be above 10% for sure but since the current numbers are carefully massaged to exclude large numbers of people that are unemployed by any common sense definition (e.g. they are of working age and do not have a job), that might not be the official figure.

2) Euro-zone growth will be -2% and could be worse. It will be worse in Spain and Ireland for sure.

3) UK growth will be -2% to -3% range and could conceivably be worse. The UK is a basket case; it has all the problems of the US, but more so.

4) China will be in the 5% to 7% range which is basically a recession for them. They can’t absorb their labor force at that rate of growth. The figure could be lower but I suspect they will apply as much fiscal stimulus as they can to avoid that.

5) Eastern Europe (Romania, Hungary, Bulgaria) and the Baltics are going to have a generally tough year. I don’t know enough about their economies to know specifics.

6) Icelanders will consume more herring and fewer Range Rovers in 2009. I am recruiting for volunteers to go collect this year-on-year data since I am not sure we will find it in the back of the WSJ.

Central Banks

1) Fed Reserve will keep rates at or about zero for the year

2) Bank of England and ECB will both end up at or below 100bps by year end, probably by mid-year realistically.

Residential Real Estate

1) Continues to fall in 2009 but at a reduced rate.

2) Still looking at a 30% overall decline (far side of my 2008 predictions), maybe a little bit more.

3) This is the year Manhattan will feel the pain too. 15-20% decline vs. peak in 2007 and more to come in 2010.

Commercial Real Estate

1) This is the year the bottom falls out, particularly in retail and office. I thought it would be last year that this happened but I was early.

2) A large part of the commercial real estate problem in on the credit side where assets where bought at silly prices supported by silly lending supported by silly assumptions on occupancy and rental rates…so lots of folks will default.

3) While there is a capacity problem, it is not the insane overcapacity of the 1980s

4) The CRE folks are asking for a bailout but I can’t figure out why it is an issue of federal importance if X real estate equity investor or the related debt-holders earn the cash flows from any particular building. The building will still be there generating cash flow and housing tenants…

Your Tax-Dollars at Work

1) The government will spend phenomenal amounts of your money on bailing out financial institutions and get little in return. They should just get on with nationalizing the weakest players, write down the assets to realistic levels and then refloat them once the junk has been written down so that people will believe the balance sheets.

2) Instead, they are going through extreme convolutions (TARP, guarantees, ABS guarantees, and on and on) to support inflated asset values and pouring money into the banks that is slipping back out to shareholders, creditors and management.

Painful to watch since it will just be a more expensive way to get to exactly the same place. It is the worst of all worlds: all the costs of nationalization and much less of the cleanup. Many major financial institutions are insolvent not illiquid, so we might as well get on with the clean-up, not drag it out over a decade like Japan did.

3) I have great sympathy for the fact that Paulsen et al had to make very important decisions very fast without a playbook. But a year later, there is still not an intellectually coherent framework of who gets bailed out how much nor any transparency about it.

Given that, you can be assured that much money will be wasted.

4) There will be massive (this is the word of the day!) fiscal stimulus by the Obama administration as long as the world will finance it.

5) Overall, the government has spent or guaranteed a staggering $7T-$8T so far and is going to add a few $T more. If you count the guarantees, we doubled the size of the federal obligations in 1 year.

I think lawmakers have gone numb at this stage. $30B plus $100B of guarantees for BoA raised barely an eyebrow last week. That would have been a huge event a year ago; now, what’s another $xxB to our tab?

6) The USA is in uncharted financial waters in terms of how much it is expanding its obligations on a run-rate basis (historical context: the federal govt had a higher overall debt load after WWII relative to GDP, though the overall country debt load is at record high, relative to GDP).

If the US can maintain the world’s confidence long enough to recapitalize the financial system and stimulate the economy through the upcoming consumer economy, then it is a testament to the remarkable reserve “brand” of the US economy.

But it is in a position where it is vulnerable to its external lenders and if a lender (hint: China) eventually is forced to cut and run, the options get much tougher and painful for the US.

It will either soft-default through devaluation or strangle the economy through higher interest rates (to attract capital) and fiscal restraint.

Dangerous and interesting times, watching financial common sense go against the fact that for the last 100 years, the US economy always somehow recovers faster and stronger.

Currency

Under regular circumstances, the fact that the US is printing money left, right and center would be terrible for the dollar and in the long-term we can probably expect the dollar to devalue.

But in the short-to-medium term, I have a hard timing thinking about which currency the dollar would devalue against.

The UK is in worse shape than the US and GBP is not a reserve currency. Large parts of the EMU are in terrible shape and the euro has never been tested in a crisis (will Germany support Club Med in a crunch?). Also, qualitatively on a personal level, the Euro feels overvalued in PPP terms coming from the US. Even the less affluent parts of Europe are expensive in dollar terms for basic items and that does not quite make sense.

1) Dollar will stay stable or strengthen against the Euro. I would expect 1.15 to 1.35 to be the trading range this year

2) China will not let the yuan rise against the dollar nor will it radically devalue. Stable.

3) I have no opinion about the GBP. It has already collapsed against the Euro and fallen hard against the dollar.

Web 2.0 or whatever it is called

1) Lots of silly ‘social’ companies will die this year

2) Lots of entertainment oriented video-viewing companies will die this year, but video is here to stay in a big way online

3) But overall VCs have been more sensible than in ‘97-’01 so it won’t be the vast value destruction of the .com bust.

This time, it is their financial brethren in NY & London who have shown the world what type of value destruction real Masters of the Universe can achieve. The VCs never came close to shutting down the whole global economic and trading system and breaking every single financial market.

4) Good time to invest as competition for deals, market spaces, teams and opportunities is about to go way down. You can actually focus on building a company without a dozen clones a week.

PE

1) As predicted, 2009-2010 will be years of destruction for the companies purchased based on “everything going right forever” valuation models.

Some might drag on longer due to weak covenants but it is not going to be pretty for 2005-2007 vintage investments.

The “it’s all about the velocity of investing” nonsense is hopefully dead and buried.

2) PE will return more to its historical roots in terms of buying solid companies, though for now, re-caps and investing through the debt side appears to be more feasible.

3) How good you feel as a GP in private equity probably has a lot to do with where you are in the fund-raising cycle…some folks are going to really struggle as LPs reduce their allocation to the field.

Probably we are looking a similar situation as the last down-turn where 30-40% of firms will either wind down or become substantially less prominent over the next 5-7 years.

4) In any case, PE heads seem to have suffered from the curse of being declared Masters of the Universe in mainstream publications and lauded, applauded and feared. Like naming a stadium, it is probably the perfect contrarian indicator.

Hedge Funds

1) Good luck to the quants. They got killed in 2008 and I doubt 2009 will be much better. Their models require some predictability in markets and I am not sure they are going to get it this year.

2) Needless to say many hedge funds will fail this year, deservedly so.

The thought that there could be 8,000 to 9,000 funds capable of beating the market on a post-fee, risk-adjusted basis was idiotic. 90% of them probably should go; maybe 50% will.

Investing

These are not market timing predictions. Just things that I would consider if I had a portfolio to rebalance:

1) Long dated TIPS seem pretty attractive as they are basically pricing in no inflation forever and inflation will come back eventually given all the liquidity being created. I think this is great protection for someone who is otherwise preparing for a super-recession.

2) Treasuries are overbought. While they won’t collapse this year, there is really no upside from here

3) High grade corporate debt at 500bps+ above Treasuries seems like a good buy if you / your manager is a picker

4) High-Yield at 1500bps above Treasuries is certainly a far better deal than the exact same High-Yield was at 200-300bps above Treasuries 18 months ago.

This would be a risky bet for the bold since many of these companies will fail, but if you are bold, now is the time to buy high yield when you are actually getting paid for the risk.

As with #3, probably good deals here for the person who get deep in the financials. But I have no idea; maybe all these firms will fail.

5) I have no opinion on US equities except that they will be volatile all year. It seems like we could go through a prolonged period of uncertainty, multiple compression, and general distaste with stocks like in the 1970s.

On the other hand, Buffett made one of his very rare market calls and it was a Buy and he is the undisputed master of this domain.

So listen to him, not me.

And some more qualitative thoughts

1) Pakistan is the most important battleground in the world right now and the Islamicists are having great success. Islamabad is losing control of the NWFP; Swat is getting overrun and Peshawar is endangered. All of this is happening 100 miles from Islamabad.

2) The West feels like it is at an inflection point. The economic system has failed to a significant degree, there are powerful though immature competitors emerging in Asia, and peoples’ expectations of their future well-being will not be met. The riots in Greece and Latvia are fundamentally about economic opportunity and expectations.

These types of events have lead to political, social and geopolitical re-orderings in the past.

It could happen again or we could muddle through. But there is definitely the possibility for big change in the air, in a way that there hasn’t been since the fall of the Communist bloc.

3) There will be hearings and there will be indictments.

We have only seen the beginning because the crash just happened and we had a pro-Wall Street administration.

I will be very surprised if Washington does not deliver some heads on a stick from Wall Street by 2009-2010. As with the Pujol and Pecora Hearings, Wall Street will be brought to DC and given a good spanking and a few more tomes worth of (re) regulation.

4) The financial services sector will start deflating back to more normal standards as a percentage of economy-wide profit and employment. Slow, cyclical process that will continue until the next mega bubble (10, 15, 20, 30 years?). There will always be swash-buckling financial types making billions throughout the whole period, just like there have been in every period, but the overall industry has to contract substantially and instant deca-millionaires of the past few years will be rarer.

5) The current recession has done wonders for oil prices but does nothing to change the medium-term dynamics that demand is steadily rising while supply is not.

We will still have a crunch in the medium-term. Stock up now while it is cheap! Contango saying the same thing.

6) Ongoing theme from the past: Biotech, nanotech and artificial intelligence will revolutionize society in the next 10-30 years in a way that is hard for most to appreciate, so to some degree, we are still worrying about our horse-drawn carriages when a Ferrari is on the horizon.

I continue to prepare for the day when we will welcome our robot overlords.

7) If you are reading this blog and wondering about how high-yield might trade relative to Treasuries, you are likely already one of the 0.0001% luckiest humans to ever live.

So, don’t forget that and have a very happy and healthy 2009.

The best investment story of 2008 relates to a banker who had a modest shareholding in his employer – a storied investment bank. Upon being transferred to London, he sold the stock to finance a Range Rover. As business in London turned down, the banker was transferred to Dubai.

When selling his Range Rover, he suffered a loss of around 50% of the price he paid barely six month ago. The interesting thing was that the proceeds from the sale of the car (despite the 50% loss) would have allowed the banker to purchase five times the number of shares he sold to finance the car. 2008 is perhaps the only year on record in which a distressed price for a Range Rover outperformed equities.

From Satyajit Das

Reeling from previously undisclosed losses from its Merrill Lynch & Co. acquisition, Bank of America Corp. received an emergency capital injection of $20 billion from the Treasury, which will also backstop about $118 billion of assets at the bank, said people familiar with the plan.

Reports of the unexpected Merrill losses sent Bank of America shares to their lowest levels since 1991, and set off a new round of debate in Congress about the scope and mission of the Treasury’s financial-system bailouts. Thursday’s 18% stock-market drop gives the Charlotte, N.C., bank a market value of $41.8 billion, a sum below the $46 billion in shares it originally offered for Merrill.

From WSJ

As taxpayers are forced to digest the latest Wall Street-Treasury outrage–a secret bailout of Bank of America to the tune of $15 billion of capital and $120 billion of trash-asset guarantees–it’s clear that, this time, someone has to be held responsible. And that someone is Bank of America CEO Ken Lewis.

….

Let’s walk through the possibilities:

* If it didn’t occur to Ken Lewis that Merrill might be forced to take additional “monstrous” writedowns (as he now reportedly describes them), he should be fired.
* If it did occur to him and he didn’t check this out during the due diligence process, he should be fired.
* If he didn’t think the global debt markets could continue to deteriorate to a level that required such writedowns, he should be fired.
* If he fully expected the writedowns and just didn’t realize what they would do to Bank of America’s own stock price, he should be fired.

From Silicon Valley Insider

From the Wall Street Journal

In the end, investors and financial institutions could face as much as $2 trillion of losses from bad U.S. loans and bonds, far more than anybody thought even a few months ago. A sustained recovery for markets and the economy is unlikely until the hole is filled. Bank stocks are falling sharply as investors come to grips with the worsening outlook for loan losses.

Analysts at Goldman Sachs were the latest to raise estimates of potential U.S. loan losses. In a report released late Tuesday night, Goldman economists estimated that losses from delinquent U.S. residential mortgages alone would hit $1.1 trillion as home prices sink, up from an earlier estimate of $780 billion.

Add in losses from commercial real estate, credit cards, auto debt and business debt, and Goldman’s loan-loss estimate hits $2.1 trillion. Only half of those losses have yet been recognized. Many will be borne by investors and banks overseas. The estimate doesn’t count losses that U.S. institutions will take on bad overseas loans that they hold.

18 months ago, $200B was the expected loss number when people first noticed that we might possibly have credit losses.

In the aftermath of Bank of America’s acquisition of Merrill — valued at $50 billion when it was announced and worth $19.36 billion when it closed — its chief executive, Kenneth D. Lewis, was viewed as a savior of the financial-services industry, having rescued both Merrill and Countrywide without government assistance. Mr. Lewis had also argued that Bank of America didn’t need the first round of federal rescue funds that the Treasury offered last fall.

At the time, it was clear that Thain got the “Great Seller” award of the year by getting Lewis to pay tens of billions for a firm that would probably otherwise be driven to a Bear/Lehman style event within days or weeks. As with Countrywide, Lewis was early and high.

Discussions over these funds began in mid-December when Bank of America approached the Treasury Department. The bank, already the recipient of $25 billion in committed federal rescue funds, said that it was unlikely to complete its Jan. 1 purchase of the ailing Wall Street securities firm because of Merrill’s larger-than-expected losses in the fourth quarter, according to a person familiar with the talks.

Treasury, concerned the deal’s failure could affect the stability of U.S. financial markets, agreed to work with the Charlotte, N.C., lender on the “formulation of a plan” that includes new capital from the $700 billion Troubled Asset Relief Program, according to the person familiar with the talks.

But…who is going to end up paying for Merrill driving themselves into the ground and Thain’s eagerness?

Not the shareholders, not the creditors, but you dear taxpayer.

Here we go…Time to review the 2008 predictions.

My overall assessment is that:

a) All major directions were right in this prediction

b) Where I was wrong, I was either too early and (amazingly) too optimistic.

It has hard to realize how long ago in financial terms Jan 2008 was. As you read these predictions, they look almost mild, yet in January 2008, they would have been placed on on the far side of pessimistic.

The average Wall Street economist was predictiing S&P 1400-1500, credit losses were still going to be contained and consensus opinion was still in the 200B range, many if not most were predicting positive GDP growth and “decoupling” was still the consensus belief.

As last year, I failed to make any market moves that would actually monetize any of these predictions, but so it goes; this is economic forecasting, not investment advice…

As I have mentioned, the accuracy of last year’s predictions will be basically impossible to beat as we head into more uncertain times, but here’s my shot for 2008.

Sure. Blah. Blah.

The summary answer is 2008 will be a down year.

Well, that was an understatement.

Economy

The 15 year party for the US economy is now over. Given the technology excesses of 1999-2001, the 2001 recession should have been more severe.

As is now well-known, the severity of that recession was mitigated through very loose monetary policy which sparked a housing bubble that directly stimulated the economy and indirectly stimulated consumer spending through the wealth effect and home equity extraction.

This game is now over and with: a tapped out consumer, a tapped out federal budget and a weak dollar preventing massive rate cuts, it is hard to see what can possible drive growth in 2008

One of many underestimates in hindsight…

1. The US is mostly likely already in recession. Regardless, in 2008, the US will enter a recession of moderate-high severity. Let’s call Q1 2008 as the most likely official market of recession.

Got this one. Official start of recession was Dec 2007 it turns out.

2. A best case scenario is 3 recessionary quarters. A worst case would be 5 or 6 quarters if housing and recession intertwine in a very negative manner

Definitely will have at least 5-6 quarters of recession. This prediction will have turned out to be too optimistic I suspect.

3. The European Union will slow down as well. Certain parts of Europe, such as the United Kingdom and Spain had housing bubbles larger than that of the United States.

EU is slowing rapidly. Spain and UK housing bubbles deflating at horrifying speeds.

EU growth in 2008 will be lower than 2007. If I had to guess a growth recession for the EU overall with UK and Spain in actual recessions by the 2nd half of 2008.

Not sure if the figures have been released but I think this will turn out to be technically correct.

4. China will not decouple from the US. In a recession, growth will slow there as well by at least 3%.

Again, not sure if the full-year figures have been released but I think we will see a slow-down in China for 2008 of about this magnitude for FY2008 or maybe the 4 quarters ending Q1 2009.

5. Equity markets and risky assets overall are not going to have a good year

ha ha ha. I guess that would be a correct statement!

6. US interest rates, needless to say, are headed down. There is a 100% chance of a 100bps drop by year-end and a 65% chance of 200bps.

Yes, this was true since interest rates have gone to 0

Mortgage / Housing Market

We are, at most, in the 3rd inning of the housing market collapse

1. Last year, I predicted housing prices could fall 20% peak to trough. I stand by that prediction and revise it to be 20 to 25% in real terms with an outside shot at 30%.

Again, this was severely negative at the time; it is accepted wisdom now. The “housing prices will never fall because we like to make numerical predictions without using math” lunatics have gone to hide in shame. Again, this will likely turn out to be too optimistic by a little.

2. This is going to be the worst housing crisis in modern financial history and substantially exceed the damage caused by the S&L crisis in terms of total losses. I will come back and quantify later what S&L did.

This is clearly the case. s&L was several hundred billion. This will easily be measured in the trillions.

3. Defaults are still below their peak in subprime and will spread to alt-a, near prime, prime, credit card and other consumer debt. Particularly with the escape hatch of a subprime loan out of the picture for most people, the alternative is going to be defaults.

Prediction: Mortgage default rates peak and plateau in last 2008, early 2009. Credit card will track closely or a little later.

Data not clear yet. Default rates and credit card delinquencies are still rising. I think this will have ended up being too optimistic and that default rates will rise through 2009

4. Housing prices will trail foreclosures, will fall through 2008 and not bottom out until 2009. I am not comfortable making quarterly predictions but if I had to guess on a bottom, I would say Q3 2009 in real terms.

Too soon to tell but headed in about this direction.

5. Commercial real estate is about to enter a similar downturn with defaults starting to show up right about now: Q1 and Q2 2008

Correct but too early. Commercial is about to go down the drain NOW – Q1 and Q2 2009

Financial Markets

By 2006, we were seeing the biggest credit bubble possibly since the 1920s across every asset class, including residential real estate, commercial real estate, corporate bonds, high yield.

This was driven to a large degree by a fragmentation of the financial system that exceeded the pace of appropriate risk management, control and incentive structures.

To take the example of a mortgage, every party in the chain: mortgage broker, mortgage appraiser, mortgage originator, mortgage securitizer (and re-securitizer into CDOs, etc), credit rating agencies and even ultimate hedge fund investor either have completely non-aligned (fee-based) or asymmetrical (performance fee based) incentives.

Sparked by low nominal rates and the classic early phases of a bubble, this system spiraled out of control.

The results are evident in the last 6 months of mind-boggling write-downs at our major financial institutions that look like they will total > $100B this first phase alone. This is a complete repudiation of the “we have to be in this business/at these terms/etc to be competitive/maintain market share/etc” or other related stupidity.

These words should strike terror in the hearts of any rational, economically driven shareholder. The net result of all of this is that existing shareholders are getting diluted out to the Gulf states, Singapore and China.

There is no doubt in mind that the writedowns at most firms will far exceed the fee income they generated during corresponding time period. Note: the bonuses for executives from the go-go days will not be clawed back of course which tells you all you need to know.

Well, yes.

1. This phase of write-downs is almost complete. There will be another series of confessionals this week (Jan 14th) and then I think we will be quiet for a whole.

2. The next large phase of write-downs will occur in second half of 2008 when mortgage holders actually start defaulting and later (late 2008 to mid 2009?) when high yield starts to feel pain and all consumer credit categories suffer

Well, we basically had write-offs all year long. I think the peak of consumer and high yield losses is still ahead of us so this remains in progress.

3. When all is said and done (2009), I am going to put the total credit market losses (mortgage, commercial real estate, credit card, high yield, CDS) at above $800B

Big number at the time. Looks like it will have been too optimistic again.

4. We will have substantial credit contraction as banks protect their balance sheet and off-balance sheet structures evaporate. I am not in a position to guess the magnitude but it will be meaningful.

yes, clearly “meaningful” was an understatement

Private Equity/High Yield

1. I am holding to last year’s predictions that we will start to see the first losses in high-yield backed CDOs in 2008, though the worst of it won’t show up until 2009-2010

2. PE Fund vintages invested too late (2006 to early 2007?) to do the fast dividend recap before the credit market closed are going to be hurt. At some point you have to sell and with credit spreads back at historical norms, buyers can’t bid the companies up the same way. Most likely response by PE firms will be to wait it all out, but that means, at best, mean longer holder periods, anemic growth and lower IRRs.

Most deals done in late 05 to early 07 did not bake in much tolerance for a recession!

Still in progress, but I think this will turn out to be right.

3. More generally, in 2008 we will start seeing the first corporate defaults. High yield has had unnaturally low defaults not through underwriting genius but due to the fact that companies could refinance out of trouble (just like homeowners).

That window is closed. Expect something closer to historical default rates in 2008 and above historical default rates in 2009

I believe this is turning out exactly as predicted. Lots of PE defaults in 2008; more on the way.

I think 2008 was back to about historical, maybe a bit higher. Any PE guys have the numbers?

4. Last year, I told a friend that we are going to have an iconic PE blow-up in this cycle and guessed it would be a deal that badly violated the traditional parameters of where PE makes sense: Sallie Mae, Chrysler or third deal that I can’t remember (maybe TXU).

Sallie Mae escaped just in time by not concluding the deal otherwise it would have been the star disaster show, though the mega-breakup fee-to-be will for the record books I think in PE.

In the meantime we can get to watch great business drama with Chrysler to see if Cerberus can find a way forward there. From some parties’ perspective this is already a mess since the investment banks are still sitting on $10B of loans they have not placed

If Cerberus manages to escape with a dollar from Chrysler they deserve a gold medal in Governmental Lobbying. Under any “free-market” conditions they would be in BK by now.

5. Go long distressed funds in 2009! (if you have access to them)

Still the case.

Currency

1. GBP will weaken. The GBP:US will drop to at least 1.8 over the course of the year

Same theme. Right direction, but too conservative. I thought 1.8 would be a big move!

GPB:US was down to 1.47 on 12/31/2008

2. Dollar-Euro will spend the year primarily in the 1.40 to 1.60 range. Yes, the dollar is weak and will weaken but the Euro-zone is not as strong as it looks.

Got the range just about right. Dollar:Euro spent 77.5% of the year in that range. At the beginning of the year, the fear was dollar weakness; i figured the euro-strength would not last and by the end of the, the euro was trading below this range.

Online

1. By Q3-Q4 2008, we will have a mini internet bust. The internet is now a permanent part of the economic structure and will continue to take disproportionate share of growth over the next 10 years.

But there are quite a few companies being funded recently at levels that don’t make much sense to me.

Still, this bust will be nothing like that bust of 2001 as the amounts at play are much smaller ($2M to $10M rounds).

Starting soon at a theater near you. Probably was 3-4 quarters early on this one.

2. Most online video startups will fail particularly badly. The economics of general, entertainment or user-generated online video are not very good. Generic advertising dollars at a $10CPM are just covering bandwidth costs and partial content generation costs, let alone SGA or profits. It is going to be almost impossible to make a destination video site, particularly with original content, successful from scratch. I will give a detailed analysis of the economics of online video in a different posting

I don’t know how to quantify this prediction since most startups fail, so I will have to take a raincheck on quantification.

Disclaimer: we are invested in online.tv which has a very large collection of .tv domains on which we hope that we or others will build online video businesses so this post might be dismissed as competitive sniping!

Again, this is going to happen. Hope we don’t get bit by this too!

That’s all for now. I think generally will be a bad year in 2008 from a financial [long] perspective, but that does not matter all that much. You need some downturns to make the upswings fun.

Have a great 2008!

Indeed…

I apologize for the long delay from polemitis.com. As many of my close friends know, I have been absolutely buried work-wise.

One of my friends pointed out in the Fall – these are such dramatic days in finance, why aren’t you posting?

This is probably a weak excuse, but to some degree, what need is there to post when suddenly we are watching A-class financial drama on a daily basis?

I have continued to post some of the more interesting articles of my daily reading to http://antonis.polemitis.com.

However, it is that time of year again and wanted to do a few things:

1) How did last year’s predictions do?

2) Take a stab at this year’s predictions

3) Try to put some context on the year-in-review (we’ll see if this happens)

4) Try to give a more detailed updated on the personal side.

Anyway, onward with Part 1 which will be the subject of the next post!

I don’t understand how that would work. Even the Fed can’t backstop every company looking for short-term financing.

How will they pick and choose exactly? This makes the survival of one firm vs. another basically a political crapshoot.

How can Wells Fargo pay $15B more for Wachovia than Citigroup when Citigroup had the government backstopping losses on $250B in assets and Wells Fargo has no government support.

Either Wells Fargo or Citi/FDIC did their math very very wrong.

a) Either Citi was getting the steal of the century and let it slip through its hands

OR

b) Wells is going to blow itself up 6 months from now

Time will tell…

Wow. This is a tour de force of data. Nothing shockingly new, but a great compilation of the greatest data hits. From the Milken Institute

Bear Stearns = Acquired by JP Morgan Chase
Lehman = To be liquidated
Merrill = Likely acquired by Bank of America

Roubini says Morgan Stanley and Goldman are also finished as independent entities. Full article here.

I also argued in follow-up pieces that, in a matter of two years, no one of the remaining independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley and Goldman Sachs) would survive as: 1. their business model is now impaired (securitization is semi-dead); 2. they will need to be regulated like banks given the PDCF support and thus have lower leverage, higher liquidity and more capital that will erode their profitability; 3. Their severe maturity mismatch – borrowing very short term and liquid, leveraging a lot and lending and investing in more long term and illiquid ways – makes them very fragile – in the absence of deposit insurance and in the presence of only limited LOLR support by a central bank – to bank like run that are destructive even of illiquid but otherwise solvent institutions. Thus all such broker dealers need to merge with larger financial institutions that have a commercial banking arm and thus access to stable and insured deposits and to true LOLR Fed support. That process of unraveling of independent broker dealers started with Bear Stearns; now it is moved to Lehman; tomorrow Merrill Lynch will be on line; and Morgan Stanley and Goldman Sachs will be next. No one of them can and will survive as independent entities. So, the Fed and Treasury should advise them all to start finding a large international partner (international as almost no domestic partner is now sound to take them over) and merge with such partner before we get another Bear or Lehman disaster.

Frankly the best advice that Bernanke, Geithner and Paulson can give to John Mack of Morgan Stanley and Lloyd Blankfein of Goldman is: “dont wait a single further minute and find a large domestic or international bank you can merge with, a large commercial bank that has a stable base of deposit-insured deposits; otherwise you are bust”. This is the end of the Wall Street of independent investment banks; as predicted months ago the collapse of a structurally flawed shadow banking system is now underway in very rapid order.

1/ Fuld really blew it for his shareholders. He had nearly seven months since the Dealer Facility was put in place for him to find a buyer. But he clearly did not realize the depth of his balance sheet troubles because the price of Lehman kept falling faster than his price expectations.

Alternative explanation: He knew, but Lehman was in such bad shape that no-one that looked at the books could close.

I think the former is more plausible. He probably could have gotten a “firesale” deal done 3 months ago. But it must be hard given that he was able to tough it out through the 1998 crisis to admit defeat.

2/ I hope the Fed/Treasury stick to their no bailout approach because it is time for the bondholders to get hit. This was a *credit* bubble, not an equity bubble and in the last 3 (Bear, Fannie, Freddie) the bondholders were protected. I understand the reasons why: Bear because everyone was unprepared and Fannie/Freddie because of the implicit government guarantee. But it is only fair that bondholders eventually take a hit

3/ What this shows is that this was a solvency issue, not a liquidity issue.

4/ Does anyone know the last time trading desks were open on a Sunday?

http://www.nakedcapitalism.com/2008/09/gentlemen-net-your-positions-emergency.html

I was asked today if I thought that parts of the financial system, greased by petrodollars, hadn’t recapitalized and repaired themselves fairly effectively and were working down the backlog in syndicating LBO debt etc.

This was my response.

1/ If “repair” is code for “write off amounts exceeding the fee revenue earned from ‘financial innovation’ in said lines of businesses over the last 3-4 years, blow your capital ratios, panic and raise capital from the Gulf and China that dilutes current shareholders from 10% to 30%, wipe the 5th largest US i-bank off the face of the earth and watch the 4th largest teeter on the brink, stick the Fed, the ECB and the Bank of England with all types of bullshit assets that will ultimately be eaten by the tax-payers (e.g. privatized gains and socialized losses for the least worthy interest group of all time). all the while not clawing back any bonuses that were paid along the way” then I agree that that those businesses have been “repaired”. And some of them (Citi, Wachovia, etc) still have more pain coming.

But I am not sure why as a shareholder or taxpayer or US citizen that might not consider selling off chunks of our economy to be a good idea, why this isn’t grounds for public flogging as opposed to being impressed by how “quickly” it was repaired

2/ Check out the 5 year stock charts

Morgan
Lehman
Citi
Merrill

Goldman
JP Morgan

Morgan, Lehman, Merrill, Citi = Flat or down; Only JP and Goldman are up and even then the CAGRs are pathetic. In no other industry do employees get so rich at the expense of shareholders. Actually hedge funds are even worse but the data is not publicly visible.

3/ Lest we forget, Americans are cumulatively 50% poorer against much of the rest of world since we have had to take sensible monetary policy to the woodshed to help with these repairs and the dollar is flirting with a run on the currency. Incredible for the global superpower and world’s reserve currency.

USD-Euro Ratio

Another socialization of loss.

Plus huge reduction in strategic scope of action against competitors like China with their huge reserves locking up natural resources and with the ability to send the dollar falling to the floor if they ever started selling. Sure it would hurt them too, but that does not mean that the leverage is not there

4/ And anyway, Round 2 is still to come. And that is the slowdown in the real economy which will swing around and punch everyone in the nose again. We are not done yet.

5/ also note that the mortgage market outside of conforming is basically closed for business as are large parts of the student loan market and increasing amounts of home equity (and car loan is next)

If you have even the slightest interest in markets and monetary policy, just read Jeremy Gratham’s latest GMO Quarterly Letter.

There is very little that I could possibly add.

From www.gmo.com