The Great Credit Contraction of 2007

What is the inter-relationship between Housing, LBOs & Stock Buybacks?

Last month, I noted 6 reasons why rising yields were a threat to equity prices:

Valuation
The M&A/LBO Put
Competition
Profits
Share buybacks
Consumer spending

As of late, we have seen the threat of two of these issues increase dramatically: The M&A/LBO Put and
Share buybacks are being pressured by the increasingly expensive credit. 

Much of this is derived from the mess in Housing: As many of the ARM/liar loans in the Sub-prime and Alt-A mortgage group increase their default rates, the residential mortgae backed securities (RMBS) that were packaged into CDOs have begun to unravel (See WTF is going on in the ABX Markets?). All told, the many variations of these were a prime source of cheap financing. This was what has been driving private equity buying frenzy and many share buybacks. That financing source is rapidly fading. 

How much is the credit drying up?  According Merrill’s Richard Bernstein:

"Bloomberg Radio reported this morning that the monthly issuance of Collateralized Debt Obligations (CDOs), or packages of debt instruments bundled together to form a "portfolio" of debt, dropped from $42 billion to $3 billion in the latest month. That 93% drop represents a significant tightening of liquidity that is starting to ripple throughout the credit markets. The fixed-income markets appear to be starting to understand that the days of free-flowing liquidity are likely to be behind us. Most credit spreads are widening."

See Bill Gross latest for further discussion of the great credit contraction of 2007. 

Lastly, for those hoping this marks the bottom of the Housing derived credit crunch, according to the UK Telegraph, "some $2 trillion of subprime and ‘Alt A’  mortgage debt is falsely priced on the books of banks and funds worldwide.” 

And to imagine: Some tv pundits — cretins of the lowest order — actually have been insisting that the Housing market would have absolutely zero impact on credit, the economy, markets and retail.   What a bunch of tools . . .

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UPDATE July 25, 2007 10:47am

Both CNN/Money and Reuters are confirming what the WSJ reported this morning, that Chrysler’s bankers could not sell the $12B in loans for the auto business and they are getting stuck with $10B of it with Daimler and Cerberus likely responsible for the balance.

The expectation is that the finance unit will eventually get done — but at terms that are considerably more attractive to investors. Bloomie is reporting that KKR was forced to accept much higher loan costs on the Alliance Boots deal.

Expect more term deals to falter like this in the near future . . .

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Kansas City Shadow Fed / Maine Fishing Trip Recap

I am back home, rested and refreshed after a wonderful few days on the lakes of Maine (and a grueling weather impaired return trip).

I wanted to give y’all a recap of the "Kansas City Shadow Fed Meeting" up in Grand Stream Lake, Maine. This is an invitation only  gathering that David Kotok of Cumberland Advisors has been running for the past few years. We all stayed at Leen’s Lodge on Grand Lake Stream, ME. Economists, strategists, fund managers, Fed employees, traders, journalists all mingle on the water and in the lodge. The participant who traveled the furthest came from Chile. A certain Scotsman regaled us with tales in that charming brogue, frequently punctuated with exclamations of "Crrrappp!" and "Foook!"

The entire event was under "Chatham House Rule" — meaning, I can not quote anyone by name or tell you which economist got drunk and danced until midnight (but one did).

But I can say that this is a very fine group of folk. The weekend was filled with good conversation, lots of wine, fine cigars, too much scotch, and outstanding fishing. we fished all three days — it rained on Friday, cleared on Saturday, was gorgeous on Sunday. I caught more freshwater fish than I ever have (and I spent the summers of my youth fishing in upstate New York). My canoe mate was hedge fund manager Scott Frew. Most days we pulled in 30-40+ fish — everything from Bass to Pickerel to the especially delicious White Perch. We released most of the Bass, and ate most of the Perch. On my last cast of the weekend, I pulled in the biggest freshwater fish I have ever caught — a fat 19" Bass that must have weighed 4 – 5 pound. Simply outstanding.

The weekend’s second biggest highlight — the first being that 19-incher — was the Saturday evening betting. Wagers are made by the group on S&P, 10 year, Fed Funds, Oil, Gold, Dollar/Euro, and CPI exactly one year hence. I made all bets, except CPI, choosing to boycott any BLS data. It was lots of fun.

David and I started an interesting side bet on the price of oil — over/under $66 — which attracted a lot of attention, and quite a few participants.

Here’s a bit of quirkiness: My outlook on the US economy was probably the most bearish of the entire group; at the same time, I probably had the most fully invested investment posture in terms of our managed accounts versus the rest of the fund managers. Kinda weird . . .

A few other interesting items worth relating:

Economics: The general consensus seems to be that the economy is middling, with some expecting it to slow further, and a few of the economists expecting a 2H re-acceleration. No one really thinks housing has bottomed, and I got the sense that I was the most moderate person in terms of how much further real estate prices will fall.

Politics: An interesting split between the two most esteemed political observers in the group: Both expected Mitt Romney to be the GOP nominee, while Obama/Clinton as the Dem nominee.

Markets: There was general caution amongst the group, with the expectation that a 5% correction is very probable. The range of other bets covered whether the markets run much further or get hit much harder  in the future.

The Fed: Likely to be on hold for the foreseeable future. The inside line is that Bernanke is a much bigger inflation hawk than Greenspan ever was. 

BLS: Clear consensus is there is no vast conspiracy manipulating there data. They have models, all models are biased, therefore their model is biased. I was surprised to hear a very experienced, highly placed participant mention in passing that he thought the Fed paid little attention to BLS data. Rather interesting.

If you have never spent an afternoon gently rocking in a small canoe on an northern glacial-formed lake, surrounded by pristine forests, with Loons crying in the distance as Bald Eagles wheel in the skies overhead, I highly recommend it.

Bottom line is that I expect to be back in Maine next summer . . .

~~~

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