I'm officially scared



Over the last few weeks I have been wondering whether I was drinking too much from the Black Swan fountain and being overly pessimistic.  After all, when everyone turns negative has go to be a time to be buying, right ?  But just as I am getting tired of myself of as angel of doom, I come across this little column on the back of the Financial Times on my way to London (View from the Markets, December 1).

Chris Flanagan is head of asset-backed research at JP Morgan.  You may be less immediately in awe of JPM than a Goldman Sachs, but when it comes to complex derivatives and asset backed innovation these guys are at the top of the league tables.  Here are a few snippets from Mr Flanagan (loose editing applies):

  • Q: it seems that virtually every mortage-backed security could be classified as toxic or distressed ? A: that is correct
  • You have losses […] up the triple A part of the capital structure.  Prices on Triple A are down to 30, 40, 50 cents on the dollar.
  • A large, large portion of the asset-backed investor base, anywhere from 65 to 75 percent, is gone.   It’s going to be gone for a very long time.
  • Q: Should people buy asset-backed right now A: I think the sectors people invest in really will be very dependent on […] the affiliation or the linkage to government support, such as student loans or credit cards issued by government-backed banks.  Mortgage-backed securities are still much more of an open question.

Let’s just recap: mainstream triple AAA securities are trading at 30-50 cents on the dollar and the head of asset-backed is recommending investing only in non-mortage related, government-backed programs ???  Wow.  Of course the guy is probably chastised from pushing in the other direction for the last 5 years, but still…

So here is my contribution to shaping your view on the world economy:

  • Post crisis we saw a strong $ rush as investors literally did not know where to put their money, but the US is on an unsustainable borrowing path (and has been for a while) which means its paper will need to yield more at some point — except that interest rates essentially cannot go down further –>  The US dollar is likely to take a deep dive in the next 12 months
  • It is also clear from the above that fundamental economic programs (such as student lending) are on government life support already, leaving the US government little additional room for maneuver in boosting the real economy, and that the all-important stabilisation of the mortgage market will be very, very costly to achieve –> Any drop in confidence in the US economy will leave the government stranded with high borrowing costs and a “snowball” effect on repayments.

The countries that have suffered snowball effects on their national debt, such as Belgium or Japan, took a long time to recover, marked by sustained fiscal austerity.  As much as I am astonished by Merkel’s decision to go hawkish, I am increasingly concerned about the likelihood of a dollar fall and what that is likely to do to the world economy.  Even aggressive Keynesian economics may not be enough to save the day for us. 

This explains the rumoured $700bn package; it will need to be communicated with extraordinary and strength to have a chance of being successful.  The goal: nothing less than convincing the world’s investors that US government paper is still the best place to park their money.  A daunting task for the new US economic staff, no doubt.

Image:Morgan, Sam.jpg<— Once it was JP Morgan who bailed out the US Treasury

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4 Responses to I'm officially scared

  1. Joe Cohen says:

    Fred
    It’s never great to be scared but I have to take lot’s of issue here:

    1. There is no such thing as AAA anymore. The ratings agencies stopped doing their jobs sometimes in the past ten years so we should assume all assets are BBB unless proven otherwise.

    2. Your expert has no, exactly zero, credibility. These are the same guys who told us ‘everything is great’ in asset backed securities for the past five years so why should we believe a word he has to say? These folks burned their own house down.

    3. Which leads to the contrarian view, money needs to go somewhere and it will (under mattresses). Maybe not the places that drive markets and generate fees but that’s a reality we all have to live with.

    Believe any financial services intermediaries at your peril. Trust your instinct and observe what real people do in their real lives – maybe not pretty either but certainly less doom and gloom.

  2. Ivan O'Dwyer says:

    If 65% of the investment base is gone, what is going to happen to that handy side effect of investment – innovation?
    If VC investment is slowing, entrepeneurship is curtailed, and if entrepeneurship is curtailed, the pace of innovation slows accordingly.
    Where is it going to come from? If as I’m hearing , the Angels have spread their wings and flown away- and the VC’s are worried about getting more capital..What is going to sustain innovation?
    Is the Environmental Crises enough to create it? We used to have World Wars, Cold Wars and Space Races for this kind of thing…..whats going to fill the void?
    Is The Green Imperative enough by itself to fill it?…The cruel irony is that innovation may stall right at the point we need it most..

  3. Disclaimer: I profited from the USD on the way down, on the way up and I plan to do so again once it’s peaking, which it may be (or not, I ain’t going to start picking bottoms here). But point well taken on the US economy.

    I think many things look oversold. Lots of highly cash generative businesses out there trading at low low fcf multiples. But again, let’s not pick bottoms.

    What a great time to have cash – it’s what everyone wants these days. And what a great time the next three years will be to build companies. Less competition. More talent. More time. Better prices. Fundamentals stronger than ever. And the big boys just blinked.

    Illegitimi non carborundum, etc.

  4. Fred Destin says:

    @Joe:

    1/ The point on AAA tranches in asset-backed securities is that upon initial structuring they sit at the top of the securitisation structure in terms of quality. Below them are typically a equity piece (really toxic and not sellable), a BBB piece, a A and a AA piece (for example). So for the AAA tranches of “high quality” asset backed to be suffering significant losses is a strong proxy indicator of the depth of the trouble in these portfolios. Whilst we have been focused on subprime this seems to be hitting the mainstream MBS and CDO assets, which I do find scary. that points to very deep underlying asset issues and it’s a leading indicator of what is to come.

    2/ I won’t disagree there but senior classes trading at 30-50 cents on the $ is a fact (and not a good fact).

    3/ Mmmmh. If Chinese money stops flowing into US government securities, who is going to fund a stimulus package worth 7% of GDP ? It’s quite perverse that rich economies rely on emerging market money that would be best employed at home, which is why I think a USD deval is in the works. For us (Atlas) being a USD fund this is not good news, although the current weakness of GBP does make our lives easier in the UK.