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Collateral Damage

-- Posted Thursday, 20 December 2007 | Digg This ArticleDigg It! | Source:

 from The December 2007  

HRA Journal

David Coffin and Eric Coffin


A couple of stories crossed the newswires in the past week that illustrate the tug of war going on in the markets. The final outcome is still too close to call.  

The Citibank “bailout” by the Abu Dhabi Investment Authority (ADIA), a sovereign wealth fund, with $7.5 billion in convertible notes representing about 4.9% of the world’s largest bank made Wall St. delirious.  This “proved” those smart guys in the Middle East could see the bad stuff in the markets would be over soon.  Well, maybe.

ADIA did not structure this like it expects near-term miracles.  The notes convert into Citibank shares between March 2010 and September 2011 at prices from 8% below to 11% above November’s closing price.    More to the point, the debentures carry an 11% coupon rate until conversion. 

11% is a couple of percent higher than mortgage brokers were offering unemployed crack addicts at the start of the year.  This is a sign of confidence?   Wall Street’s optimism clearly knows no bounds.

We expected someone  to make a score by buying the right debt at the right time and price.  We expect more of that buying to come from Middle Eastern and Asian sovereign funds.  They are collectively sitting on about $3 trillion, and the markets look like they could use it.  You can also expect just as much, and probably more, of the Asian sovereign money to go into “real stuff” like mineral deposits and related infrastructure.

The other story emerged from Florida at month end.  The state suspended new withdrawals from a municipal investment pool due to a “run” on the fund.  County departments that park money there panicked when news got out that the fund had $700 million in delinquent ABCP.  The pool saw $8 billion in withdrawals over the space of a few days before the halt.

What was chilling about this story was not the $700 billion in toxic paper.  It’s the fact that concerns about roughly 2.5% of a fund’s holdings caused the whole thing to lock up.  This is the real problem with the system right now.  This sort of reverse leverage has the potential to generate enormous trouble.

Credit market participants have been shooting first and asking questions later. Funds, debt-tranches and institutions that seemed a world away from the sub-prime mess are being drawn in.  As we have noted before, lack of transparency and trust are the real issues.

There is still a very real lack of counterparty trust prevailing within the financial sector.  This is creating a very strong divergence between Treasury bill and LIBOR yields, to the point where it should be causing concern. 

Over the past month the two-year treasury note yield has dropped to about 3%.  This reflects both rate cuts by the Fed and risk aversion that drove buyers into the treasury market, raising prices and dropping yields.   Short term LIBOR rates were following treasuries, until mid November when LIBOR started to shoot up again.  At the end of November 30-day LIBOR rates were over 1.3% higher than 2-year treasury yields.     

This implies that banks simply don’t trust one another. These sort of inter-bank loans are usually considered close to risk free.   The fact that ever higher risk premiums are being demanded, and paid up, is not a good sign.  Add to this changes in accounting rules that alter what banks can classify as “Tier 1, 2 and 3” capital, and the stage is set for more nasty surprises. 

One last news story illustrates potential for bank capital reclassification.  E-Trade sold a bundle of sub-prime assets to hedge fund Citadel Investment Group as part of a cash infusion by Citadel.  Outside analysts have pegged the price of these sales at 11 to 27 cents on the dollar.  Clearly E-Trade took a bath on this. 

The question is, do  brokerage houses up and down Wall St. have to use these numbers to mark similar assets to market?  

E-Trade can be viewed as the extreme, for the moment, but with the debt system still so locked up it is amongst the few transaction based gauges for pricing sub-prime bundles at the moment.  How it and other distressed sales are worked into the give and take between auditors and CFOs for year-end reporting will determine if the financial sector puts up merely bad or truly awful numbers over the next 2-6 months.

We’ve said before that nothing short of dismantling structured credits sold in the past few years will fix things.  We believe that more strongly with every story about a fund or institution 12 time zones from New York having to answer for sub-prime holdings.  The Wall St wiz kids blew up the lab, and we are not yet done toting up the collateral damage from that mess.

The response of the Treasury department was a broad plan to freeze rates on the bulk of the “teaser rate” mortgages at their pre reset level.  Hmm.

As much as we dislike market interference, there are too many loans resetting in the next few months to have any hope of dealing with them on a case by case basis.  Investors in these notes that would see lower coupons are rightly upset, but given the default rates and cost of foreclosure its possible they will be better off too with this scheme. 

Is this plan a salvation?  No. It might create breathing room to deal with some of the underlying problems, on a “least worst” basis.  The real issue is that a lot of people bought too much house.  Even if the plan goes through the default rates will be high, and the real estate market will be ugly for a long time and probably longer then it otherwise would be.   

The rest of the structured credit market is also a mess, and will take many quarters to fix.  Funds will go under and a few banks and investment banks will have close calls, or worse. While the “tease freeze” may keep a bunch of homeowners in their houses it won’t magically end the deterioration of the debt markets. 

Like the tech bubble, the housing/sub-prime bubble will likely end in lawsuits and show trials.  Something will be cobbled together to renew investor trust and show things are “really different”.  Too early to say what form that will take, but we would not be comfortable if we were running, say, a bond rating agency. Recent bubbles didn’t really end until the lynch mobs arrived.

 Bottom Lines

We have suggested cash generation a number of times in the past few months.  We reiterate that suggestion here, but on an assumption most of that has been done.   There is heavy tax loss selling underway right now.  Although this could technically continue until month end its usually pretty much done by the second week of December.  This opens up potential for a short Santa Claus rally, but that will only occur if the Fed and other central banks drop interest rates, not lumps of coal, into traders’ stockings.

There is also profit taking, but we continue to be concerned that it will continue in January.  But at least some of the pressure has been taken off that already by this year’s huge shift away from risk.   

Part of the reason for our own profit taking suggestions is that we think there are bargains out there, and there will be more before this is over.  It’s hard to bargain shop with an empty wallet. 

We continue to view gold as the metal to focus on.  Base metals will one at a time resume favour, and that is worth being ready for.  The sector has also suffered from development cost shocks, but we will deal with them further in January.   Ω

David Coffin and Eric Coffin are the editors of the HRA Journal, HRA Dispatch and HRA Special Delivery publications focused on metals exploration, development and production stocks. They were among the first to draw attention to the current commodities super cycle and have generated one of the best track records in the business thanks to decades of experience and contacts throughout the industry that help them get the story to their readers first. Please visit their website at for more information.

If you would like to be added to the HRA FREE mailing list to get notifications about articles like this and other free analyses and reports just add yourself to our list HERE.

-- Posted Thursday, 20 December 2007 | Digg This Article | Source:


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