the broken finance industry: credit, crisis, collapse and broken business models

8/14/2019 The Broken Finance Industry: Credit, Crisis, Collapse and Broken Business Models

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Finance Industry Futures I:

Credit, Leverage, Malfeasance and Broken Business Models

Table of Contents

Re-thinking, Re-Thinking, Re-Thinking? 2

It's Over, It's Over...Yeah Right! 3

Boiled Frogs Getting Flayed 4

Fundamental Breakage in the BM 5

Private Equity Futures - from Golden(Gilt) to Iron Age 6

4 Year Crunch, Broken BizzMods 7

Bad Times, Bad Companies: More Finance Industry 8

Vicious Credit, Economy, Market Cycle Spotted 10

Frannie From Pan to Fire: Rescue Me...Us...the System ? 11

Introduction and Summary

We have all had to learn more than we ever wanted to know about the internal workings of the Finance Industry and itsimpacts on the rest of the economy. After, literally, decades of viewing the industry as a magic black box where super-intelligent wizards created wealth out of thin air weve all learned, painfully, that the wizards had more in common withcarnival side-show hustlers out to make a fast buck by fleecing the next fool in line. Weve also learned, even morepainfully and unfortunately, that Finance wasnt just another industry and part of the economy. Instead it was the lifebloodwhos credit creation mechanisms kept the real economy flowing. Now we all know that systemic risk means that thesurvival of the economy could be at stake.

Weve been tracking the Finance Industry for over two years now and following a learning curve of our own andtranslating those learnings into various postings and discussions. Starting with early in 2008, in this case, with thesuggestion that the Industry was going to have to be re-thought. And debunking other early 2008 fantasies that the creditcrunch and the problems with the Industry would go away soon. In fact they were just beginning and as the crunch went tocrisis we found out that the business models were badly flawed.

This set of postings traced the evolution of the breakdown and near-collapse of the Industry from early 2008 until the endof the year. Sadly all of this analysis is far from out of date. The problems with malfeasant behavior, willful ignorance,violations of fiduciary trust, lack of understanding and badly flawed, even broken, business models are still with us and willbe for years. As we look back at the crisis perhaps the scariest thing is that the leadership of the industry was in denialuntil the cusp of the collapse. And would have taken us all over the edge of the cliff without government intervention.

It will take years to contain, stabilize and repair the damage within the industry and, more broadly, for the economy as awhole. Perhaps the worst of all though is that it appears that the Industry is not only still in denial but attempting to return

to business as usual. Where this is important to you is in several ways. First off, as a potential direct stakeholder: investor,employee or supplier. Secondly as a customer and thirdly as a member of society. Unless these problems are correctedand new strategies, business models and services that are value-creating, instead of leverage manipulating, result theIndustry will perform poorly, credit will continue to be restricted and society will remain threatened.

Put that another wayby paying attention to the warnings and analysis at the time you could have avoided loosing a lot ofmoney, suffering a lot of pain and could even made a lot of money with the right investment tactics. We think the samething will hold true in the future because all the problems discussed are still in place, only in slightly different form.


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WRFest 20Jan08(FinInd): Re-thinking, Re-Thinking, Re-Thinking ?

http://llinlithgow.com/bizzX/2008/01/wrfest_20jan08finind_rethinkin.html#more

Last week, actually the last several, were terrible for the markets. And judging by the carnage in Asia and Europe so fartoday we can anticipate more trouble as the markets re-open. While it's not clear how much farther we've got to go it lookslike a major shift in outlook and sentiment is underway. One which, partly in a spirit of schadenfreude, we've been pointingto for quite a while now. There was so much last week in fact on the spreading credit contagion that we pulled thoseexcerpts out into a seperate post ( Ebolatization Contagion: Credit Mess II ) to highlight them. A comment on that post askedan interesting and key question:

It's as if you are discriminating between financial sector growth, which I assume you measure in financialterms, and economic value, which I also assume you measure in in financial terms. That is, there is non-value adding financial growth. Am I close to correct here?If so, how do we distinguish between the value-adding financial growth and that which does not add value?

One could argue that any shift of resources into newer sectors helpe the overall economy become more efficient - in thecase of the Finance Industry by helping to raise and create capital and more efficiently allocate it. The question we wereasking that led to the comment was whether or not the shift of resources into the Finance Industry had gone too far andour implied answer was "hell yes". But it was an answer based on a fair amount of prior investigation on the rapidly risingshare of the Financial sector in profits ( The Heart of the Matter: Profits vs Earnings ?), on the buyback and buyout manias(Market Drivers 3 (Buybacks):Investment, Hiring, Nah...Bonus, Bonus, Bonus ! plus two prior posts) and on what's turning

out to be alleged profits built on leverage and unaceptable risks ( Rocks, Ponds, Perverse Incentives: More on CreditContagion )

In other words, as write-downs continue, we're arguing that most of the Finance Industry profits that were booked in thelast several years will disappear. And that disappearnce is reflected in the poor outlooks for many of the major companiesAND their need to re-capitalize. Taking these arguments and investigations all together it seems reasonable to argue thatindeed to much money went into bad investment ideas, that capital was very inefficiently allocated and, as a result, theoverall health of the economy will be badly damaged.And, further, that the industry itself is going to have to re-think its' business models which increasingly appear to bebadly....badly broken. The readings, links and excerpts on the continuation sustain this argument and extend it. But toanticipate what we think is happening is at least two things.First, the industry needs to re-think and a new set of business models has yet to make an appearance. And second, as aconsequence, despite all the folks who're starting to argue that all the catastrophes have been priced into the stocks of

the Financials we're a long way from seeing a bottom grounded in fundamental realities. If and when we recovereconomically we're likely to see a major bounce in Financials based on that argument. In fact we're likely to see somebounced that will be trading opportunities before then. But not investing opportunities. Until the industry re-thinks itself itwon't be well-grounded IMHO. The trick as an investor will be to watch the evolution of the reconstruction of the industryand then invest.We covered some of these points in an earlier readings collection on the Industry ( "Interesting Times" for the FinanceIndustry: Readings & Resources ) which is worth reviewing as well). One of the stories there that encapsulates the situationand provides a nice historical overview is this:

Wall Street doesn't want you After an era of innovation in financial services that benefited the middle class,The Street has abandoned individual investors in favor of big institutions and wealthy private traders. It'stime for big changes. Wall Street doesn't care about the individual investor anymore. We're not profitableenough. Look at the billions the financial industry has made in recent years from trading, buying andpackaging mortgages and credit cards, financing buyouts and selling ways to reduce risk. That kind ofbusiness drove operating income at Goldman Sachs) to $14.6 billion in 2006 from just $3.3 billion in2002, a 340% increase, and at Merrill Lynch to $10.4 billion in 2006 from $2.3 billion in 2002, a 350%increase. Until they blew up, that is. It's not just that Wall Street's newest inventions -- collateralized debtobligations and asset-backed commercial paper and the like -- are irrelevant to the stuff we care about,like having enough for retirement. Wall Street's actions seem positively dangerous to our goals. It wasn'talways this way. For 20 years, beginning in 1975, Wall Street produced a wave of innovation for middle-class investors that brought more and more people into the financial markets. The revolution began in1975 with the invention of cash-management accounts at Merrill Lynch. From our position in time, it'shard to remember that there once was a day when all we had were savings and checking accounts, andthat the two were so rigidly separated that you couldn't write a check from an account that paid interest

If any of this makes sense to you it's a good opportunity to apply the thinking and tools for analyzing industry/companyperformance we sketched in another post as well: Winners & Loosers: Rubble Sorting


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8. When you look at individual companies from UBS to Merrill to Wachoviato National City to Credit Suisse are facing major hurdles unique to themas well as the general breakdowns.

9. There are few, almost no, good stories on any front in this mess ofmesses. A possible exception is JP Morgan where Dimon has provideddiscipline and adult supervision. As a result JPM may be in a goodposition to do a little shopping. We're hard put to find anybody else.Nominations are open.

Before or after your excerpt skim the one single thing we think you oughtto dive in on is George Soros' interview on Charlie Rose: A conversationwith George Soros , Chairman, Soros Fund Management. And take a lookat the chart at the right which shows corporate profits over the long termboth in absolute terms and as shares of the total. There's a lot of information hiding there. For example why did corporateprofits surge so hugely in this decade ? Well ask all the people who didn't get the jobs a real recovery would havegenerated. But for our purposes it's the shares that tell the story. Look at shares of the Financials.After growing graduallywith the slow evolution of all this cleverness from 10% to 20% in the '80s it stayed in the 20% range thruout the '90s. Andthen suddenly boomed to 30% around 2000. Rapidly ! Now what sudden major structural innovation, say on the order ofPharmaceuticals, Electronics or the Internet lies behind that ? What new major source of value was created ? In caseyou're wondering that's both a rhetorical question and something for you to ponder. Because if there were no suchinnovation, i.e. if Financial firms were able to grab a dispproportionate share of profits thru a combination of a weakeconomy and financial engineering, then it's not sustainable. And we're back to our first point.

May 07, 2008

Business (Finance Industry): Boiled Frogs Getting Flayed

http://llinlithgow.com/bizzX/2008/05/business_finance_industry_boil.html

The meme running around the Street and the Treasury is, of course, that the worst is over. As we've noted previouslythat's a bit more than disingenuous ( WRFest 4Apr08(Markets): Do We Stay, Do We Go..Jimmy ,Readings (Finance): It's Over,It's Over...Yeah Right ). The worst of the credit crisis in terms of a deep structural breakdown is over which just leaves uswith a re-pricing of risk, de-leveraging and a burgeoning economic downturn that will lead to more writedowns, balance

sheet pressures and losses from more bad loans and be based on feedback from the real economy. As opposed tointernal dysfunctions in the broken credit markets. The real worst is yet to come and nobody's paying any attention. Ususual ?Well not quite or entirely. Finally we're seeing some serious consideration of that feedback loop as well as a variety ofarticles finally addressing the real fundamentals of the Finance Industry. Are their business models broken ? We think so.And as a result there's going to have to be some very deep and fundamental re-thinking followed by some even deeperre-building, re-structuring and painful changes. Otherwise we'll just go thru this again...and again...and again.All of which is reflected in the various company stories of continuing writedowns JUST dealing with the aftermath of allthat bad paper. Some very serious players from JPM to Wolfensohn see more serious trouble ahead. Banks are going tobe seeking and needing even more capital with all that implies about dilution, earnings pressures, tighter lendingstandards and so and so on. We've collected a bunch of stories that support that line of argument but conclude theexcerpts with two poster children. On Fannie Mae who's recent announcements of surprisingly large losses, more troubleahead and more capital raising were greeted by a stock price jump, of all things ! Which grossly misses the real, deep-

seated damages done and the work to be faced. Our other poster child is Citigroup which, under Vikram Pandit, has madethe right emergency moves but now everybody wants a clear, quick fix to make it all right. After four months in the job he'ssupposed to lay out the workable strategy for the next decade ?!Give me a break. It's this kind of thinking that created all the problems in the first place. While the jury is out and will be forsome time to come he seems to us to be taking some of the right, small steps. As he says you've got to get some of theimmediate, small and operational improvements in place before you start re-engineering the super-structure. And Citi is abadly broken as they come, at least IOHO. For those of sufficiently long memories this reminds us of the early days ofGerstner's time at IBM when everybody wanted a vision and a strategy. As he said, "that's the last thing we need rightnow". Ditto for Citi. We'll see where Pandit goes but in our book he's started right. The question is...is anybody else gettingit ?


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May 23, 2008

Finance Ind II(Readings): Fundamental Breakage in the BM

http://llinlithgow.com/bizzX/2008/05/finance_ind_iireadings_fundame.html#more

Let's keep cranking on trying to take apart the current situation and strategic outlook for the Finance Industry. But first we should note that BM stands for "Business Model" . Not what you thought it stood for but, nontheless, the pun wasintended. And gets to the heart of our argument - which is that the business models of key sectors of the Finance Industryare flawed to badly broken, and we believe that many of the readings support that. The extent of the breakage dependson the sector but those which depended on leveraged trading and investment are most exposed for multiple reasonswhich are discussed below. Those closer to traditional banking and finance practices have lots of room to improve butequally a good dose of sound business practice, a little innovation and an increased focus on marketing and customerservice would go a long way. If you are a stakeholder in any of these you needto walk thru the blueprint and use it as a checklist for assessing their statii andoutlook.The chart at right will be no surprise of course. It shows the Industry as a whole(XLF), the Broker-Dealers (IAI), the Insurance sub-industry (IAK) and RegionalBanks (IAT). If you buy the arguments of the last three posts ( Market , Economy ,Finance I ) we've had a bull rally with terrible misjudgments on valuations andearnings outlooks with a weakening economy which has yet to tip over into areal downturn. Consumer demand has been weakening in any case, and that

was before factoring in the implicit tax of energy and food costs surges, whichwould feedback destructively to hiring and investment spending (per the normalcausal linkages). And as a result we were about to see many more boulderstopple into the credit pond with a series of feedback loops betweendeteriorating economics and worsening delinquencies. Net net the questionwould therefore be how much farther on that chart - over and above where wethink the markets are going ?Well we could let you just skim the readings excerpts and reach your own interpretations. Which we urge you to do.BUT...we'd also like to testfly the framework we deployed against our strategic evaluation of Citi as a way of thinkingabout the industry as a whole. Both because we think the general enterprise framework works and because the work thatPandit and his team have done strikes us as capturing 80-90% of the total industry situation (excluding the Insuranceindustry of course). ( Poster-child II: Citi's Potential Turn-around as Performance Examplar ) You'll find the readings belowcollected in various takes on the Strategic Outlook, specific companies (including one that shows AIG's writeoffs and

capital raising changing radically in a week as well as UBS's huge discounted rights offering...shocking though nobodyappeared shocked...numbness setting in all over ?). The final section gets to the heart of the matter by providing variousreadings on thinking about the futures of the industry...that is does theirbusiness model and strategies still work, if they ever did ?Based on those readings, all the prior posts which basically dealth with thesame question and the strategic assessments in Citi's presentation we end upwith the graphic at right. After two decades of innovation in the '70s and '80swhich provided tremendous value-add and new services for consumers andbusiness the industry shifted its' emphasis to leverage, complex products andtrading on its' own account. That worked, apparently, since the mid-90s til lastyear. And then broke badly despite bringing us an unprecedented series ofbooms and busts for the same underlying structural reasons.Now we're in a regime where de-leveraging will be the dominant macro-environmental theme and as a result capital requirements will be raised,explicitly by regulation or implicitly by investment returns. So instead of beingable to reap the profits from being leveraged 30x, or 40x or 70x the banks,brokers/dealers are entering an era where they'll have to return tofundamentals. Hence our judgements in the various shade of warning indicators as to whether the business models of thelast decade are sustainable going forward.We could argue thru each sector individually and then discuss each of the major players but won't - though we do thinkthis is the kind of evaluation any employee, investor or stakeholder needs to do for each and every one of them. What wewill assert though is that these fundamental re-thinkings aren't widely recognized, acknowledged or accepted thoughseveral key commentators have made similar observations. And this kind of re-thinking is clearly implicit in Citi's newstrategic framework. So apply the Buffett test - which of these are businesses you'd want to own a piece of asbusinessess ? Our answer - not many until these re-structurings are begun. On the other hand as Rubenstein, Buffett,


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Jubak, et.al. are pointing out there will be lots of gems to be sorted from the rubble. Once the rubble all falls down...whichpoint we are IOHO a long way from.

May 25, 2008

Finance Ind III (Readings): Private Equity Futures - from Golden(Gilt) to Iron Age

http://llinlithgow.com/bizzX/2008/05/finance_ind_iii_readings_the_f.html

A major and critical part of the financial frenzies of the last several years have been the LBO buyout and somewhatrelated buyback booms. As most of us know by now there's been a relative freeze on LBO activity since last summer, atleast among the very large/large PE funds. Talking to my friends in the mid-size business that began to show up abruptlyaround the holidays and, judging from various statistics on mid-size deals, has spread there as well, if not as seriously.Yet at the same time the various PE firms have continued, successfully, to raise enormous amounts of investment dollars.Despite the fact that, if anything, the freeze continues and, if youbelieve our analysis, is likely to face much worse.Part of it of course is that buyout funds have, over the years providedunusually good returns and part of it is that there have been fewalternatives in this era of low returns...so why not ? And another part,how much we don't know, is that LBO activity, or more correctly PrivateEquity investing is actually facing several interesting opportunities.Thought not as business as usual. But let's backtrack a bit and startwith this chart, slightly dated, of the cycle in buyout fund investments.You'll have to update it a bit in your minds eye with the '06 and '07 datawhich was even larger than the illustrated '05. The catch is that buyoutinvestment kept on during YTD for this year as well. As you can seehistorically there were pronounced cycles in the business accompaniedby a general upward trend in the amount of funds raised. A trend thatwas non-linear. It'll be interesting to see what updated versions of this chart look like when they become availablebecause if the news headlines are right fund raising hasn't busted so fareven if investing has.There's another interesting aspect of this, which is what do you do with themoney. With so much of it floating around there was not only an enormousincrease in total funds but a lot of new firms and funds got started. Like the

Hedge Fund industry though there are also enormous differences inperformance. My suspicion is that these historical differences in fundperformance and in performance over the years are about to get greatlyexaggerated as we find out who's been swimming naked indeed. In the firstsub-chart notice that the top firms enormously outperform the rest of thepack. And then bear in mind that all the newbies performance is not yet,and won't be for some time, reflected in those numbers. The second sub-chart suggests that there's also a big difference in performance over timethat's worth looking at as well.

Take a careful look at this chart and notice that the years of greatperformance are years of significant downturn - that is investmentsmade during '91 and '01 did exceptionally well. Why ? Well largely

because they weren't made at extraordinarily high multiples withunusual leverage built into them. All of which is not true this last fewyears. This time around there were three things that were generallytrue. 1) Prices (EBITDA multiples) were exceptionally high - mostlikely as a friend of mine has pointed out historically unique andnever to be repeated. 2) Funding was easy and cheap so the levelsof leverage in deals was also unusually large - which is about tocome back and haunt folks a great deal. And 3) the terms of thatborrowing were extraordinarily lenient - what're called "covenantlite" in terms of re-payment, default and other loan terms. Whichmeans a lot of deals got done at too high a price, with too much


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leverage and assuming that prices would keep going up. Stop me when this all sounds familiar.

Yet in these potential disasters lurks at least a couple of key alternatives. Actually several. First off all that debt is going togenerate a lot more distressed debt than in previous cycles and the PE firms are going to be able to pick it up for halfprice, or perhaps better. Though they'll then face some serious workout problems. Which leads to the second majoropportunity for those who kept some dry powder and their heads - as Wilbur Ross has shown in his beginning to buy upmortgage servicing firms. There'll be a lot of companies across many industries who used capital to buyback their ownstock, are now leveraged at the beginning of a major downturn AND didn't make the operational improvements theyshould have with those funds. Judging from the historical cycles illustrated above that suggests that as we move into andthru the downturn, whatever it's length and depth, PE companies who focus on returning to their roots and have the skillsand acumen to do so will be doing well in the years ahead.

By return to their roots we mean moving away from financial engineering, though not ignoring or neglecting the benefits ofcapital re-structuring. And moving toward what's been claimed as the major benefit, capability and strategy of PE firms.Putting in money, re-vamping operations, instilling good management and management practices and in general returingenterprises to high performance status. The firms that can do that in the next few years stand to do very well indeed andought to be entering a new era. Not a golden one that turned out to be gilt. Rather an "Age of Iron". Look back at thesecond chart and the huge jump in performance between the top and restof the pack, especially during tough times.As you go over the readings below you'll find a lot of these various aspects reflected from the section on the StrategicOutlook to indicators of current deals slowing and/or going bad. To my favorite section on the Mid-Markets. Now there'snot a lot ever covered in the MSM on the mid-markets. So what you'll read there are the excerpts from various newslettersand seminar announcements which have come to my attention. Which aside from their intrinsic merits also are greatindicators of the outlook - and they all are focused, one way or another, on the situation as we've sketched it. Life is aboutto get interesting indeed for the Private Equity industry.

June 16, 2008

Markets and Financials:4 Year Crunch, Broken BizzMods

http://llinlithgow.com/bizzX/2008/06/markets_and_financials4_year_c.html

In this collection of readings excerpts we combine Markets and Financials because the underlying issues are so inter-twined. As usual the same talking head debate continues - is the worst over ? And what would trigger an uptick in themarket ? But the game has changed on several fronts and two of the critical things we've talking about for months are now

common currency memes and being reflected in almost everydiscussion we read or hear. The two ?

Credit Crisis to Broken BizzMod

1) The Credit Crisis has morphed into an on-going creditcrunch where key players are now talking about seeing thingstake the next 2-4 years to work out. We refer you to theaccompanying graphic charting the propagation of thecontagion that we've used before. ( Finance Ind(Readings):Barbarians, Fixes and Outlooks ) Interestingly one of the chiefnew naysayers is Bob Doll, CIO of Blackrock, who's earlierassessments that the worst was over has changed to the mostpessimistic 2-4 estimate. It turns out that what he meant to saywas that the breakdown was over and now we're into thelonger-running de-leveraging and risk re-pricing. Oh...now you tellme. :)

2) Which leads to the new key issue/meme - the broken businessmodel of the financial industry.( Finance Ind II(Readings):Fundamental Breakage in the BM ) In the excerpts we've collected abunch of key CNBC vidclips that talk about Investment Banks,Private Equity, the re-structuring of the LBO business, a burstingHedge Fund bubble and some of the consequences.( Finance Ind III


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(Readings): Private Equity Futures - from Golden(Gilt) to Iron Age ) The interview with James Stewart on long-term businessmodel breakage is especially worth listening to IOHO. But the one you should/must listen to is Meredith Whitney's - who'sassessment, based as it is on deep industry analysis, wide familiarities with the key companies and players and very deepanalysis still, strangely enough, sounds a lot like ours.

Market Assessment

How this is playing out in the markets is fascinating. The "will we

go, will we stay, Jimmy Durante" theme remains with us...all basedaround an apparent lack of clarity with regard to the economicoutlook. A surge in Unemployment took out the market week beforelast and good news on Retail Sales brought it back this last Fri.Good news which, when you parse it out, is anything but.( HFIndicators (Sales, Rates, Money, Inflation, Oil, Dollar): UnscheduledInterruption ) We've highlighted four key technical indicators in the chart and you'll notice that despite Fri's surge that we

didn't recover all that much ground.Just for fun here's the 1-year weekly and 5-year monthly chartspresented as simply as possible with a little trading trend stuff thrown in.Continuing our usual interpretation we don't see any signs in either ofthese that the markets are pricing in anything serious in our economicfuture. If you do please let us know. A point, btw, made in several of theexcerpts. Notice on both that we got back essentially to the 200-day MAafter correcting a mild 10% correction and that we're still barely bustingthe long-term lower bound on the trend.

Sector Comparisons

When you de-compose the overall market into sectors (having covered the int'lsituation and emerging economies jointly in the prior post) an interesting pictureemerges in the short/intermediate-terms and the longer-run. Here we've dividedthe SP sector ETFs into the worse and better performers. As you can see theonly real pain is in Financials (XLF) - what a surprise - with Con. Discretionary(XLY) doing poorly and Healthcare (XLV) not feeling the love while Con. Staple(XLP) is holding up reasonably well considering what the economic numbers are

telling us. On the other hand the vaunted strong performers aren't, over a year,doing that well either whether it's Technology (XLK), Industrials (XLI) or Materials(XLB). Only Energy (XLE) is still going gang-busters. If any theme emerges it's

that Energy still has a good story and nobody else does but nobody'sadmitting it as yet.

Then when you shift your perspectives to the longer-term it gets evenmore interesting. Over the long-term the story's consistent but still not"pronounced" - that is we haven't seen the clear emergence of a strongdirection, let alone one that matches up with our views on the economicoutlook. Over five years Finance has essentially given up all it's gains -and if you belive the BM discussion (puns intended) there's a lot worse tocome. Of the Weak group nobody's done particularly well. Of the Strong

group only Energy has truly been an outstanding performer while the resthave done decently well. In the last five years we had, perhaps, three-fivedominant investing themes. Real Estate that went bust but made money.Emerging Markets which are shifting rapidly. Energy and Commodities - still rolling along. The New World Economy -while true that would appear to be shifting somewhat as well. And then what ?

July 25, 2008

Bad Times, Bad Companies: More Finance Industry


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http://llinlithgow.com/bizzX/2008/07/bad_times_bad_companies_more_f.html

Time to re-visit some confessionals. In case you didn't notice the recent marketrally was driven by the Financials ! Of all things. And they were driven by betterthan expected earnings, i.e. smaller than disastrous write-offs and terrible butnot catastrophic impacts to their bottomlines. Unfortunately when you actuallystart parsing the news instead of reading the newswires PR announcements aslightly different set of pictures emerges. But let's start with this "simple", by ourstandards, little chart of the Finance ETF, XLF. On the "since Oct" chart therecent runup was huge IOHO - more even than the April surprise when it wasall over. When you look at the 10-day chart you get the more granular anatomyand that it's starting to fade. Hopefully as some semblance of reality fades in. Ithardly took a day, or less than, for the talking heads to get trotted out to talkabout "worst is over" again and the time to be investigating putting money towork in the financials was now. One of the readings you'll see excerpted isabout Bill Miller - the most exemplary fund manager of legend of the last twodecades - who got completely trimmed up by large and bad bets on just that thesis. What happened ? Well for one thinglet's remind ourselves of the arguments from the last post about what constitutes a good company ( Bad Times, GoodCompanies: Who's Swimming Naked ). And then suggest that we're looking at bad times for bad companies.

Economic Consequences

But, before pursuing that, you need to think about the consequences which arecomplex, convoluted but ultimately not surprising. When banks start writing offbig numbers they take big hits on their capital and have less to loan. When theythink the economic situation isn't good they tighten up lending standards. Theend results is that credit gets scarcer and the economy experiences moredown-pressure. Which gets reflected in interest rates and the money supply.Which is worsened in a credit crisis by elevated rates as risks are re-priced. Allof which you see in this chart. On the top the 3Mo spread between Treasuriesand Financial commercial paper remain at elevated levels while the spreadbetween higher quality and more risky corporate bonds does as well. The reallyfascinating, puzzling and scary thing is that the spread between very short-termFed Funds and 10Yr Treasuries has widened out enormously. That usually onlyhappens when the economy is booming, there's a serious fear of inflation orrates are getting driven up by exchange rate pressures. Almost none of thatseems to be the problem right now though. The middle chart shows the YoY%growth in the inflation-adjusted monetary base - and it's approx. 3.5% and returning to a downtrend. In other wordsdespite a slowing economy, very low Fed rates and everything else that should be mitigating things credit is drying up at aserious rate. And it's NOT inflation as you can see on the bottom which compares core CPI to the spread between TIPsand 10YRs. The biggest, most astute and biggest bettors in the world don't see inflation as a problem. After parsing all theputs and takes we end up with a metastasizing credit crunch slowly oozing its' way/weight thru the economy. And youwondered why mortgage rates were jumping !

Business Implications & Inferences

Returning to contemplate the XLF jump leaves one more than a bit puzzled. Here's a set of hypothesis that you mightwant to kick around.1. The Fed thru magic, innovation and cojones has created enough instruments to provide technical tools to address thecredit crisis but we're still faced with the consequences of bad business decisions and a slowing economy. At least we'renot facing collapse as we were in March.2. The Financials have "merely" worked their way thru the immediate consequences of the crisis, not the crunch. As theeconomy slows the "credit death spiral" we've talked about before will start working it's way on their balance sheets,losses and loss provisions. With attendant impacts on profit and credit availability. IN other words this still has a long wayto go. AmExp's results should be reviewed for the reality check.3. None of this is/was being factored into the market's thinking on the financials....otherwise we shouldn't have seen abounce.4. Another thing we've talked about is broken business models, the strategic consequences of de-leveraging and the needto fundamental re-think all the major banking/finance segments for future prospects when leverage gets driven to a morerational 10X or less from the 20-30X that many were depending on for profits.


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As you can see it's a little complicated and we didn't try and show everything. But we've shown the status as best we canby color coding and line thickness. You can see where the accelerating collapse of the Housing Markets has created abreakdown in the Credit Markets while also weakening the Economy. The breakdown in the Credit Markets led to majorweakness in the broader Markets which in turn fed back with declining investment values to put further pressure on theCredit Markets. Unfortunately the Economy, both here and abroad, hasn't yet shown or felt the full effects, nor weakenedas much as we anticipated from its' own internal, organic weaknesses. When that happens that will establish a 2-wayfeedback between the Economies (Domestic, Int'l), each of them and their respective Markets and also with the CreditMarket. So we anticipate having to revise some of these to heavier and redder some time soon. Let's hope not, though.

September 06, 2008

Frannie From Pan to Fire (Update2): Rescue Me...Us...the System ?

http://llinlithgow.com/bizzX/2008/09/frannie_from_pan_to_fire_rescu.html

A little earlier this evening an interesting and very major story just came out on the WSJ online that Fannie and Freddieare about to have the Treasury impose a "rescue" plan of some sort or another. We'll see what happens over theweekend but it looks like the long-delayed other boot (Paul Bunyan's spare) is about to be dropped. This is good newsand bad news. You might want to review a little history ( Bad Times, Really Bad Behavior, Bad Trouble: Fannie/Freddie and PerditionRoad ). This is ironic since the markets, after reacting in what we consider a properly rational way to an abysmal employment report, rallied back today toclose in positive territory for the non-tech businesses. Guess what - it was the Financials, the Homebuilders and Consumer Discretionary that were up.All the things that a metastasizing credit credit crisis and an accelerating slowdown are going to hurt the worst. The continued triumph of delusion overanalysis IOHO. Ironically in the after-hours markets the Frannie Twins were down about -20%+ ! Though to be fair, if very confused, XLF was up almost5% and XHB up almost 3%. Clearly the weekenders think Frannie is toast but it bodes well for the financials and the homebuilders. BtW Barry Ritholzhas obviously been up and reading as his excellent summary of the news is here:

Roundup: Fannie & Freddie Bailout . His opinions aboutsocialist bailouts are another thing IOHO.Weekend Updates and Summaries: BigPicture, CalculatedRisk and Matt Trivvsanno & crew have come thru withsummaries analysis and consequences that you should have in you reading lists.BigPicture: Fannie & Freddie Weekend Wrap Up/Linkfest ,Treasury Takeover of GSEs: 10 Key Points CalculatedRisk: Fannie & Freddie Thoughts Matt Trivisonno: The Fan-Fred Short-Squeeze Rally Update2: More interesting news below in the readings section detailing the behind the scenes on the Frannie rescue ANDthe impact on the Housing markets. Plus an assessment of widespread the problems with banking capital shortfalls are.Confirm our themes and "worsen" them in essence.Let us try and disabuse everyone of those notions that a) a Frannie bailout is pork-barrel politics, b) that the Financials are /will be in good shape and c)it's safe to get back in. And do so by complementing all the news roundups with our usual focus on the structural context and consequences. In otherwords , what's the lay of the land and what's the weather therein.


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State of the Credit Markets

Starting by looking at the state of the credit markets using some of ourstandard indicators. What you see here are three differentcredit/money market measures the can tell us quite a bit about what'sgoing on. First up is the spread between FedFunds and 10YrTreasuries - which mixes instruments a bit - but is still telling us thatthe Yield Curve is "market favorable". That is short-term money ischeap, which generally encourages investing because borrowing is

inexpensive. And longer-term money ain't that expensive at around 4%and dropping. But the really interesting thing about that spread is theabrupt switch around Nov. from no spread, indicating a flat/invertedyield curve and tight short-term money, to now. In this puzzle-palaceworld the short-term drop was Fed policy at work but why the long-term rates are staying up is....dollar ?More interesting though is the spread between 3Mo Treasures and corporate commercial paper, which is still veryelevated over last year and appears to be rising. An indicator that there's still a lot of fear and uncertainty in the market.Finally is the inflation-adjusted monetary base which tells us the effective supply of money is growing or shrinking.Normally it shrinks during downturns and this time is no exception ...except it's been shrinking longer and farther than theeconomy's been downturning so far ! The reason - it's called credit tightening. In other words the credit markets areworking but under enormous pressures. If you'd like to see a really cool and implicitly informative history of how the yieldcurve works and relates to the markets try this: Dynamic Yield Curve . And in case you're wondering why you careWikipedia has a decent, thorough and balanced description .

Frannie's Failures and Consequences

After the break you'll find a largish collection of readings that bear onall this from the news that the Chinese banks have backed awayfrom Frannie, for what now seem like sound, rational reasons. Whichmakes the rates they have to pay to borrow higher, funding harder toget and so on. Which leads us to one of the gray-headed potentialtriggers - though it's been months/years in the making. Bill Gross'slatest newsletter talked about a financial tsunami freezing up andthen collapsing the markets and specifically the need to rescueFrannie on Thur. But he wasn't alone - Paul Volcker, perhaps themost respected central banker in seven decades, came out flatly the

same day and said the system is broken, more write-offs are comingand we need to re-engineer it. He further added he's never seen acrisis this complex or painful.

Our fear is that once we move beyond the perennial Pollyannas andinto more realistic territory there's still a limited grasp of what abreakdown in Frannie, let alone the whole system, would mean forthe economy. Shucks...:) We're not even sure we get it and we'vebeen flapping our gums for months. Certainly if the XLF keepsgetting run up like this though our fears of a major breakdown arevery far afield from the common understanding. In other wordsthere's still a lot of piping to pay for and Bill and Paul are telling usthe bill's coming due.

There's a bunch of other readings we think are worth your timeincluding some more on the lingering after-effects and some very good discussion, similar to questions we've raised butnow done in a wider venue by somebody who's very knowledgeable, about the future down-sizing of the industry. Plussome interesting stories of folks who have been or are navigating these storms thru what we'd call business acumen, gutsand discipline.

The one story though we really urge you to click thru, read, download think about is Robert Solow's review of KevinPhillips book on "Bad Money". His shrill polemic against the Finance Industry. While there's a lot wrong he apparentlydidn't bother to figure out what worked but dug up some 100 year old anti-capitalist conspiracy theory stuff from WilliamJennings Bryan and his "cross of gold" speeches and re-furbished them. Now we're not denying there's a lot broken and alot of malfeasant behavior since we've been arguing that as well. What Solow - btw, one of the best 100 economists of the


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the broken finance industry: credit, crisis, collapse and broken business models

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