Birth of the Credit Monster

Monday, May 4th, 2009

Gillian Tett, of FT.com has written an in-depth exposé about the birth of innovative securities that gave rise to the markets’ abuse of leverage finance and ultimately, the catastrophic rise of debt. Here is the first excerpt from Tett’s new book, Fool’s Gold provided by FT.com, Genesis of the Debt Disaster, May 1, 2009.

In the 1990s, a young team at Wall Street investment bank JP Morgan pioneered a new way of making money – credit derivatives. Within a decade, the market for these exotic securities had exploded to more than $12,000bn – and some people later blamed them for fuelling the global financial fiasco. In the first of two extracts from her book, Fool’s Gold, the FT’s Gillian Tett reveals how the innovation genie was first let out of the bottle – and eventually devoured the system, to the horror of its creators.

The first sign that there might be a structural problem with the innovative bundles of credit derivatives that bankers at JP Morgan had dreamed up emerged in the second half of 1998. In the preceding months, Blythe Masters and Bill Demchak – key members of JP Morgan’s credit derivatives team – had been pestering financial regulators. They believed that by using the new credit derivative products they had helped create, JP Morgan could better manage the risks in its portfolio of loans to companies, and thereby reduce the amount of capital it needed to put aside to cover possible defaults. The question was by how much. (Though these bundles of credit derivatives later went under other names, such as collateralised debt obligations [CDOs], at that time these pioneering structures were known as “Bistro” deals, short for Broad Index Secured Trust Offering). Masters and Demchak had done the first couple of Bistro deals on behalf of their own bank without knowing the answer to their question for sure. But when they were doing these deals for other banks, the question of reserve capital became more important – the others were mainly interested in cutting their reserve requirements.

The regulators weren’t sure. When officials at the Office of the Comptroller of the Currency and the Federal Reserve had first heard about credit derivatives and CDOs, they had warmed to the idea that banks were trying to manage their risk. But they were also uneasy because the new derivatives didn’t fit neatly under any existing regulations. And they were particularly uncertain over what to make of the unusually low level of capital available to cover losses on the derivatives.

When the team did their first Bistro deal, they pooled more than 300 of JP Morgan’s loans, worth a total of $9.7bn, and issued securities based on the income streams from these loans. The lure of the idea was clear: the team had calculated that they only needed to set aside $700m - a strikingly small sum - against the risk of defaults among the 300-plus loans. After much debate, the credit rating agencies had agreed with the team’s assessment of the risks, and the deal had gone ahead on the basis that if financial Armageddon wiped out the $700m funding cushion, JP Morgan would absorb the additional losses itself. To Masters and Demchak, the chance that losses would ever eat through $700m were minuscule…

Read the entire article here, or PDF version here.

Tags: 1990s, Catastrophic Rise, Collateralised Debt Obligations, Creators, Credit Derivatives, Derivative Products, Excerpt, Excerpt From, Extracts, Fiasco, Financial Regulators, Fool S Gold, Genesis 1, Genie, Gillian Tett, Investment Bank, Jp Morgan, Leverage Finance, May 1, Monster, Reser, Wall Street, Wall Street Investment
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Big money poll - the long view (Barron’s)

Monday, May 4th, 2009

Barrron’s magazine has published the results of its Big Money Poll of sentiment among money managers. Here is an excerpt and some and a summary of the results:

“After the worst stretch for stocks in decades, America’s money managers say they’re bullish. But do they really believe it? Based on the results of our latest Big Money poll, the pros are hoping for the best, but … hold on! Aren’t those fresh bear tracks in the mud?

“Nearly 60% of our respondents call themselves bullish or very bullish about the stock market’s prospects through the end of 2009, a significant increase from the 50% who proclaimed themselves bulls last fall. Yet, signs of unease abound. For one, just 56% of today’s poll participants think the stock market is undervalued, down from 62% last fall. Thirteen percent say stocks are overvalued, up from a prior 7%. And an alarming 58% say the market hasn’t bottomed yet, even though the Dow Jones industrials hit a low of 6,469 in March, before recovering to a recent 8,100.

“The managers are similarly wary about the outlook for the economy, at least through the end of this year. And they are downright doubtful that the government’s first stimulus package, announced with fanfare shortly after the Obama administration moved into the White House, will be the last.

“Given these and other concerns, only 26% of the Big Money men and women expect to be net buyers of stocks in the next six months, although 66% say they will be putting more money to work in the 12-month span. But don’t look for fresh dough to flow solely to US equities. Just 44% of our respondents think the US will be the strongest market in the next year; 42% expect emerging markets to take the baton and lead. As Keith Wibel, a money manager at Foothills Asset Management in Scottsdale, Ariz., put it, ‘Confidence has been fractured. The psyche is slow to heal.’

“The market isn’t much faster. Big Money’s bullish cohort expects the Dow to end 2009 at 8,676, about 7% above current levels but flat for the year. Things, or at least stocks, will pick up thereafter, with the blue chips rising another 10% or so, to 9,488, by mid-2010. In concert with their short-term-skittish, long-term-sunny stance, more than 40% of bulls predict the Dow industrials will reach or breach 10,000 by the middle of next year.

“The optimists see the Standard & Poor’s 500 jogging to 906 by December 30, en route to 1,003 next June. The popular benchmark closed Friday at 866. Their mean predictions for the Nasdaq Composite: 1,683 by year end, and 1,841 by mid-2010, up from last week’s 1,694.

“Some big money managers are notably upbeat even - or especially - after a global financial meltdown has cut most stock indexes in half. ‘They don’t ring a bell when they announce a sale on Wall Street, but prices are as good as I’ve seen them in my entire career,’ says David Corbin, president of Corbin & Co. in Fort Worth, Texas.”

Additional notes from Seeking Alpha:

59% of the money managers it polled are bullish on the market through year end. But, as Barron’s notes, it’s unclear how much of that bullishness is only in theory. To wit, 58% concede we’ve yet to see the bottom, and only 26% of them expect to be net buyers of equities over the next six months.

Below are a range of selected comments.

David Corbin - Corbin & Co.

“They don’t ring a bell when they announce a sale on Wall Street, but prices are as good as I’ve seen them in my entire career.” He sees Dow 11,000 by year end, fueled by “a mountain of cash on the sidelines,” high dividend yields, and M&A. His favorite stocks: UPS (UPS), Pfizer (PFE) and Medtronic (MDT). “These companies have low price/earnings ratios and decent yields, and franchises that are unlikely to be damaged in a downturn.”

Steve Ethridge - Stewart & Patten

“We’re nibbling here and there, but we still feel there might be some hiccups around the corner.” Normally, his firm is 60% invested in stocks, but for now he’s at a more conservative 50%.

David Ware - Barrington Capital

Presciently, Ware went almost all cash last September. He’s still 65% cash, awaiting another downdraft and a better entry point.

Peter Scholtz - Scholtz & Co.

“They will be walking a tightrope. If they don’t get it right, there is going to be a big inflationary problem. We are at a turning point, and I don’t think the Fed has the dexterity to handle it.” Scholtz, and most of his peers, think inflation, not deflation, poses the greater short-term risk to the U.S. economy. He sees oil regaining $100/barrel.

David C. Hartzell - Cornell Capital Management

“Five years from now, people are going to look back and find it hard to believe GE (GE) sold for $5 or $6 a share.” Despite the recent controversy, GE is Big Money’s favorite stock. Other favorites include Berkshire Hathaway (BRK.A), Wells Fargo (WFC), Apple (AAPL), Chesapeake Energy (CHK), Monsanto (MON) and Loews (L). Most overvalued stocks include Amazon.com (AMZN), Google (GOOG), Netflix (NFLX), Goldman Sachs (GS) and Citigroup (C).

Other tidbits

• 99% see unemployment rising. 56% expect a peak rate of 10%.
• 74% expect another stimulus package.
• 55% believe the government’s PPIP toxic asset purchase plan will stabilize banks and spur lending.
• 44% peg the U.S. as the top global performer over the next 6-12 months. 42% like emerging markets. 13% chose developed Asia.
• 43% foresee GDP going positive again by Q4.
• 34% think we’ll see signs of a housing recovery within six months.
• 32% favor large-cap growth stocks over the next 6-12 months. 15% like large-cap value. 9% prefer mid-cap growth.

Source: Jack Willoughby, Barron’s, April 27, 2009.

Tags: Asset Management, Barron, Bear Tracks, Cohort, Dow Jones, Dow Jones Industrials, Emerging Markets, ETF, Fanfare, Money Manager, Money Managers, Money Men, Money Poll, Psyche, Respondents, S Poll, Scottsdale Ariz, Sentiment, Stimulus Package, Stock Market, Unease
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