If the Disease is Misdiagnosed, the Cure Won’t Help
In July 2006 I gave a lecture on the “House of Cards” in which I discussed the certainty of bank failures in 2008
[1] and in a subsequent speech in 2007 identified the failure of Washington Mutual and the rest of the TARP recipient banks.
[2] In these speeches I discussed the certainty of systemic failures which, barring immediate intervention would lead to certain catastrophes. The forecast was based on data, not hunches and the data was right. Ironically, as recently as this weekend, the Obama Administration continues to parrot the Bush Administration’s error in proposing the purchase of “toxic mortgages” without acknowledging the fact that it is consumer credit defaults on home equity loans – NOT Real Estate – that has created the precipitating event and the Congressional and Administration belief that consumer debt will save us this time is as wrong now as it was in 2001.
As the one voice countering the “no-one-could-see-this-coming” years before the banking collapse I am in the unenviable position of pointing out a bigger crisis on the horizon – one from which we will have greater difficulty in recovering. A number of corporate and municipal bonds and other credit facilities are going to start defaulting in the next three quarters based on the convergence of a new perfect storm. I’ve been encouraged by many dear friends to try to make this understandable and accessible as some of my earlier warnings were “inaccessible”. So here goes.
From 2001 to 2005, the market response to the dot com bubble burst was to migrate investment funds from venture capital for launching new enterprises to private equity and hedge funds to finance merger and acquisition activity so that by 2005, over $8 trillion was being bet against enterprise value. What I mean is that, in the absence of IPOs, “liquidity events” came in either consolidations in public and private firms (out-sourcing costs and labor and gaining market efficiencies) or short-selling in public equities and commodities. Value investing meant finding ways where the market could generate short term gains by extracting longer term infrastructure investment – betting, if you will, against the future.
Unfortunately, from GE and AOL TimeWarner to Quantum and Millennium Pharmaceuticals, large and small companies with access to artificially low cost debt vastly over paid for acquisitions. In June 2001, the Financial Accounting Standards Board (FASB) changed accounting rules to require companies to charge off the goodwill premiums they paid in acquisitions. This meant that a company could debt-finance an acquisition for $500 million and, while holding onto the bond or debt instrument used for the purchase, have little or no collateral backing the purchase it just made. Not to worry, regulated banks, investment banks, and hedge funds were more than happy to provide the capital (typically with 5 to 10 year maturing terms) and fueled speculative pricing that kept the merger and acquisition premiums going up.
So part one of the perfect storm is that beginning in 2009, many of the first generation balloon maturities hit precisely at a moment when few companies can refinance or repay their obligations and, they have no collateral to attract new capital.Thinking that private investors shouldn’t have all the fun, many regulated banks were more than happy to provide capital to enter this lucrative but increasingly competitive market. A regulated bank, unlike a hedge fund, included in its financing package a “general intangible lien” or “UCC Article 9 lien” which said that all of the intangible assets (patents, brands, copyrights, trademarks, franchise rights, etc) belonged to the senior secured creditor. This means that the only asset retained in the post-outsourcing world, the innovation and brand, belongs to the bank until the note is repaid. What few people considered is the fact that when banks have to assess their reserve adequacy, they are required to look to their borrower’s collateral position. If there is no collateral – or at least none that can be valued – the bank must set aside up to 5 times the reserve funds that would be required if the borrower was appropriately collateralized. To date (save present company), no method exists to value these liens and, as such, banks seeking to stabilize their balance sheets, can create technical defaults requiring their borrowers to accelerate their loan payments or call them en masse. In short, because there is no consensus on how to recognize or value the intangibles, the only collateral that could save borrowers or creditor’s balance sheets, has been written off (due to the FASB rule) and does not exist for all intents and purposes.
So part two of the perfect storm is that beginning with annual reports in this quarter (first quarter 2009), record impairments and charge-offs of goodwill will lower creditor collateral adequacy forcing borrowers into default risks well beyond any historical period. At the same time, banks will have no flexibility to have forbearance due to their own balance sheet scarcity.
The safety net behind corporate and municipal debt for the past 5 years has been credit insurance in a variety of forms. Much of this insurance is provided by – you guessed it – insurance companies. Both life insurers and re-insurers (sorry, I can’t make this understandable in this brief) have seen their premium income fall precipitously over the past six quarters both weakening their own business capacity but also rapidly shrinking their ability to guarantee the credits that they’ve insured. Moody’s, S&P, and Fitch – the largest rating agencies – have presumed that credit insurance has intrinsic value but have not been providing adequate risk assessment on the credit insurance providers setting up a calamitous event made worse by recent events. While the market can already see the strain on household names like Ambac and MBIA, what it hasn’t seen is the profound instability in the insurance market in part due to the Federal Government’s intervention in AIG which has preserved the opacity of the firm’s exposures and the collateral damage arising therefrom which reaches deep into the re-insurance markets around the world. And tragically, at the same time when the FDIC is running for cover with growing banking collapses, the Federal Reserve has audaciously suggested creating Term Asset-Backed Lending Facility or TALF which would serve as a quasi-insurance facility to restart securitization. By creating the illusion of insurance – goes the theory – the private sector will buy what they otherwise wouldn’t. Well, the bad news is the TALF may be dead before it ever really lived.
So part three of the perfect storm is the imminent failure of credit insurance – either the actual collapse of one or more of the major players or the withdrawal of credit insurance providers from offering guarantees leading to the down-grading of investment grade assets.
Now, that’s the storm. Where’s the levee breach?
The answer is where we’re least prepared to deal with it. If you have a 401(k), you know that you’re retirement fantasies have been pressure tested lately. The sailboat has become a kayak, the trip to far off lands has become TiVo of the Travel Channel, and so forth. However, many people are counting on pensions and other ERISA-styled managed funds. Unfortunately, a number of pension funds have a dual exposure to the coming storm. First, the equity market value erosion of the last four quarters has erased much of the value of managed pension funds. Second, the “secure” investments in corporate and municipal bonds are now about to be severely impaired forcing many pensions into a distressed position where the obligations they have to pay benefits will have insufficient liquidity to meet those obligations. Municipalities and corporate balloon maturities are coming due over the next 6 quarters at a rate as much as three times historical precedent and no one is talking about how to deal with this. These, after all, were supposed to be the safe investments. When President Bush signed the Pension Protection Act of 2006, he did so on the eve of one of the most grievous times for pension security while the equity market was still generally bullish. However, one of the key figures in this legislation – a name that most of us don’t know now but we will soon – is the Pension Benefit Guaranty Corporation or PBGC. By the end of 2008, the top 1,500 companies who have administered pension benefit funds were over $400 billion in the hole. The PBGC is absolutely incapable, at present, of filling this hole and the number is growing. And regrettably, to stave off present capital shortfalls, many corporations (including insurance companies) have actually borrowed from their pension funds to meet current cash-flow obligations. This levy is going to breach and Congress – fresh off of a $800 billion dollar stimulus package – is going to be faced with more staggering liability – and this says nothing about entitlements of Medicare and Medicaid in case you were wondering.
So, what’s an average citizen to do? First, be informed. At present the Congress and Administration have allowed unconscionable opacity to persist within the FDIC, the PBGC. These programs are not adequately funded and you, the American public must stand up and demand accountability. Second, prepare for significant adjustments in standards of living. There is no question that 2008 was the opening act on a much longer show. This one is a bit more tragedy than comedy in the first couple acts. Remember that we got here based on the belief that we could out-source our manufacturing, kill off growing enterprises to get rid of their inefficiencies (also known as employees) through merger and acquisition consolidation, and, use our homes as ATMs. Well, none of these messages were true. And now, when we have to pay for the excesses, we need to take stock in what future we wish to have. We must be creative in how we move, how we power our lives, how we consume what is necessary rather than what is excessive, and how we engage with each other. And third, we must be creative. There is a world of opportunity that was passed over in our last eight years of ignoring the innovative front line while we let the colossal get bigger. Your neighbor has a great idea and while you might not be able to invest cash, you may be able to invest your time, creativity, contacts and talents. See yourself as a part of the next solution rather than a victim of the failure of excess. And, if you want to invest in these challenging times, help clean a highway, mow a park, or invest more of your scarce resources in your local grocery store or restaurant. By seeing yourself choosing a destiny, you will be empowered to see the calm after the storm.
[1] http://archive.arlingtoninstitute.org/library/ArlingtonInstituteAddressTranscript_eng.pdf[2] http://www.arlingtoninstitute.org/tai-alert-11-major-financial-disruption_______
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