10/12/2000 Liquidity *

Just another historic week, with stunning swings in the prices for individual stocks and leading indices. For the week, the Dow dropped 4% and the S&P500 declined 2%. The economically sensitive issues were pounded, with the Transports and Morgan Stanley Cyclical index dropping 4%. The defensive stocks outperformed, with the Morgan Stanley Consumer index unchanged and the Utilities adding 4%. The NASDAQ100 dropped 4% Tuesday, and three percent both Wednesday and Thursday, before exploding for a 9% gain today. For the week, the NASDAQ100 declined 1%, while the Morgan Stanley High Tech index actually posted a slight advance. The NASDAQ Telecommunications index dropped almost 3%, and The Street.com Internet index sank 8%. The Biotech index added 1%, while the small cap Russell 2000 and the S&P400 Mid-cap indices dropped 2%. The financial stocks were weak, with the S&P Bank index declining 7% and the AMEX Broker/Dealer index sinking 3%. Gold shares were largely unchanged.

Unsettled conditions dominated the credit market as well, as unfolding financial dislocation and a crisis in the Middle East fostered a major stampede into Treasury securities. For the week, 2-year Treasury yields sunk 12 basis points, as the 5-year collapsed 16 basis points. Ten-year yields dropped 10 basis points, while the long-bond underperformed with yields declining 4 basis points. Mortgage-backs and agency securities underperformed as yields declined about 7 basis points. The benchmark 10-year dollar swap spread jumped four basis points to 119. The corporate debt market continues to falter, with liquidity all but disappearing in the tattered junk bond universe. The dollar generally added about 1% this week, while crude oil surged 10% and gold added $2.

Broad money supply expanded by $11 billion last week as retail money market funds increased $5 billion. M3 has increased at an 8.8% rate during the past three months and 10% rate for the previous year. Commercial paper outstanding increased $15 billion last week, with $12 billion of additional borrowings from the financial sector. We do note an interesting stagnation in bank credit over the past few weeks. Total bank credit has contracted by $13 billion during the past three weeks, with security holdings declining $20 billion, Commercial and Industrial loans flat, and Real Estate loans rising only marginally.

Fannie Mae reported third-quarter earnings this week. For the period, Fannie increased assets by more than $29 billion, only slightly below its record balance sheet expansion during 1998’s historic fourth quarter “reliquefication.” For comparison, Fannie Mae increased assets by $13 billion during 1997’s third quarter. For the just completed quarter, total assets increased at a 19% annualized rate, up from 15% during the second-quarter. Interestingly, (non-mortgage loan) “investments” have surged $17 billion to $55 billion (43%) during the past six months. Fannie Mae ended the quarter with total assets of $638 billion. During the past 11 quarters, Fannie Mae has expanded total assets by an astounding $246 billion, or 63%. Fannie Mae Chairman Franklin Raines was quick to appear on CNBC to trumpet Fannie’s earnings and the health of the U.S. housing market.

Well, all we can say is that housing inflation (“health”) will continue as long such egregious mortgage credit excess continues. But make no mistake; it is a massive bubble and Fannie Mae is the leading instigator of reckless credit excess.

Paralleling mortgage finance, consumer credit excess runs unabated. After a huge month of issuance ($30 billion), the asset-backed market is on track for total issuance of almost $230 billion for the full year. This compares to $217 billion last year. Year to date, 27% of issuance has been for home-equity loans, 19% for credit cards, 20% auto loans, and 34% for “other.” The “other” category includes manufactured housing, aircraft leases, student loans and equipment leases. Only time will tell as to the quality of these loans, particularly in the “other” category. Obviously, the asset-backed market is a key source of funding for the continuing consumption binge. With its earnings release, we see a 26% year on year increase in managed receivables from credit card powerhouse MBNA. Capital One experienced 30% loan growth during the third quarter, up from 23% during the second-quarter and 13% growth during last year’s third quarter. There is little mystery behind today’s stronger than expected report on retail sales – it’s all about credit.

Importantly, the asset-backed market has held up exceedingly well throughout this period of enormous issuance, as investors and speculators alike have flocked to this “safe haven” as heightened stress engulfs the corporate debt market. Now, however, faltering financial system liquidity is making its way to this key market as well. During the past week, top-rated credit card spreads have widened 6 to 12 basis points. Not surprisingly, spreads for equipment lease paper have performed poorly, widening as much as 7 basis points. The home-equity sector has seen spreads widen as much as 9 basis points during the past week. We will keep a keen eye focused on what we see as a vulnerable asset-backed marketplace over the coming days and weeks.

We are extremely concerned and saddened by the possibility of war in the Middle East, and very much hope that peace can somehow be restored as quickly as possible. The potential for great hardship and catastrophic loss of human life certainly makes the flashing prices on my Bloomberg machine seem almost inconsequential.

What had been an unfolding financial dislocation took a dramatic turn for the worst earlier this week. And despite today’s wild rally, it is my view that we are now in the midst of a full-fledged financial crisis. Further, for the U.S. financial system and economy, the Middle East crisis could not have come to a head at a more inopportune time. In numerous commentaries, we have written extensively on the issue of financial fragility and we do not think one can overstate the critical importance of this concept. Unfortunately, over this protracted boom cycle the U.S. financial system has developed acute vulnerability to the point that it hangs in a truly fragile balance – there is absolutely no room for error. There is going to be an accident, it is only a matter of time and under what circumstances. The amount of leveraged speculation is unprecedented.

There has been considerable marketplace speculation with respect to losses suffered by U.S. financial institutions. Clearly, there are problems associated with a near breakdown in the junk bond market - with the plethora of downgrades, earnings disappointments, defaults and now a self-feeding credit crunch. Morgan Stanley Dean Witter denied the most heated rumor of a billion dollar hit. There are, however, serious losses out there somewhere, and we suspect that the entire leveraged speculating community is desperately hoping for a recovery. According to MarketNews International, the spread between Treasuries and the S&P Speculative grade credit index widened 17 basis points yesterday, indicative of a virtual panic.

This week, Moody’s announced that it expects corporate bond defaults to rise to a staggering 8.4% during the next twelve months. During the third-quarter, Moody’s downgraded $44.3 billion of junk debt, compared to upgrades of $19 billion. There were 82 junk downgrades versus 29 upgrades. Also during the quarter, Moody’s placed 62 US corporate issues under review for downgrade, compared to 37 for possible upgrade, and 50 for downgrade during the second quarter. Dow Jones quoted Moody’s John Lonski, “we ought not to be quick to assume that the worst is over for the high-yield bond market.” There should also be no mystery why junk bond yields are at the highest in 10 years and why they will not be narrowing any time soon.

A Los Angeles Times headline caught our attention Wednesday: “Xerox Goes to Banks, Not Commercial Paper.” As investors, and apparently the commercial paper market in particular, continue to shun Xerox debt, the heavily leveraged company resorts to its credit line from a group of 58 lending banks. We would not expect, however, that prudent bankers are all too excited to lend to such a rapidly deteriorating credit. But then again, that is precisely why companies are willing to pay the fees during the “good times” – to ensure that the banks are there to provide liquidity protection if things turn nasty. The bankers, on the other hand, take the fees during the “good times” because they love such revenues that flow directly to the bottom line. When things turn sour, as they are presently, unsuspecting bankers quickly find themselves in deep trouble with faltering credits in their own loan and securities portfolios. The last thing they need is to take on additional risk lending to faltering credits losing access to the commercial paper and capital markets. And as the banking system is forced to become the liquidity backdrop to a growing list of troubled companies (industries), it should not be difficult to envision an increasingly risk-averse marketplace turning against the banks and the credit system generally. As such, the Xerox situation provides a good example of how during periods of rapidly rising systemic risk liquidity becomes a very precious commodity. As fears mount, both companies and bankers are apt to move simultaneously to increase their own liquidity. We suspect this is already in play. Corporations would rationally like to tap their credit lines in preparation for continued market turbulence, much to the detriment of banking system liquidity. Banks likely desire to rein in risk. Xerox’s predicament and reliance on commercial paper and bank lines highlights what will be a critical issue going forward – the rush to liquidity. Keep in mind that there is almost $1.6 trillion of commercial paper outstanding.

It is our strong belief that the epicenter of the unfolding crisis is not necessarily to be found in junk bonds, but much more likely involves a general dislocation in the derivatives marketplace. As we have highlighted previously, it has been our view that derivative-related dislocations were contributing to turbulent trading in global currency, energy, equity, and credit markets. As such, any disturbance that tended to exacerbate these dislocations would be quite problematic. Accordingly, the possibility of war in the Middle East is particularly problematic as it creates safe-haven buying of the U.S. dollar and Treasury securities as well as liquidation of equity positions and panic buying in the energy markets. During 1998, it was panic buying of Treasuries that blew out many derivative trades and led to the infamous “seizing up” of the credit market. Despite today’s episode of panic buying, we do see this as truly a worst-case scenario in the making.

And while we haven’t come across any recent estimates, last year it was estimated that an equivalent of 4 billion shares of stock/stock options had been granted - worth $220 billion or 9% of total stock value at the time – for the NASDAQ100 alone. Estimates also had the market value of stock options issued by S&P500 companies at $543 billion. A year ago August, New York Times’ Gretchen Morgenson wrote an article titled “Rumbling of an Avalanche” where she quoted Baruch Lev, professor of accounting and finance at New York University, “This is an avalanche-in-waiting. And this avalanche may fall at the worst time of all.” We see this as a most prescient quote.

A truly unprecedented mountain of employee stock and options was created, and the timing of this avalanche is terrible. For quite some time, I have been bothered by a nagging unanswered question in my mind: With the proliferation of sophisticated Wall Street derivative programs providing corporate insiders the ability to “cash out” of stock and option positions, where was the source for all the liquidity? What was the source for all the money that flowed to the insiders for the purchase of expensive cars and homes and such? I have a hunch that the answer to this question could lead us directly to a key focal point of the unfolding financial crisis.

Last August we wrote a commentary titled “90% Stock Loan - The Magic of Credit & Financial Engineering.” The piece highlighted an advertisement that had caught my attention in Investor’s Business Daily: “First Security Capital’s 90% Stock Loan – the proprietary financial instrument that provides liquidity without triggering a taxable event, protection from a market downturn, and unlimited upside potential.”

I want to clearly underscore this product as this type of structure has significant ramifications presently for our financial system. Continuing from their website: “With capital gains in your portfolio or vested options, you would be subject to capital gains taxes should you decide to sell – taxes that would be especially significant if you have shares with a low relative cost basis, or have employee stock options with a low relative exercise price. Loans, however, are not taxable events. So in many cases you could actually net more cash by borrowing 90% of the current value of your stocks with our 90% Stock Loan than if you were to sell. And because you still own your stocks, you retain the ability to realize future growth in the value of your portfolio. The loan is also non-recourse, so you have no personal liability for your loan, and your maximum downside is capped at 10% for your entire loan term. Ultimately the 90% Stock Loan can help you net more cash, get long-term downside protection, and keep your stocks. “

“Diversify into real estate or other ventures by leveraging your stock portfolio – without the risk of a margin call if your stock declines in value. You can access standard margin loans when it comes to leveraging your stock portfolio, but these leave you exposed to downside risk if your holdings drop in value. Our 90% Stock Loan is non-callable and it has no margin maintenance requirements, so it enables you to leverage 90% of the value of your stock portfolio without the risk of a cash squeeze from a margin call. And unlike margin loans, with the 90% Stock Loan you are not required to make any interest payments until the end of your loan term. Than means you get 90% of the current value of your stock portfolio in cash and you have long-term downside protection – without negative cash flow. So you can leverage your stock portfolio and diversify into real estate and other ventures without worrying about making monthly payments or meeting margin calls.”

“With the 90% Stock Loan you receive 90% of the current value of your portfolio in cash, and still keep your stocks. Even if your stocks go down significantly in value over the course of your loan term, you have no obligation to repay either the original loan or the accrued interest at maturity – yet you continue to realize future growth in the value of your portfolio if it keeps going up.”

And while this sounds “too good to be true,” this company was set up to do basically what Wall Street derivative groups have been doing for some time: providing liquidity to corporate insiders and other wealthy clients. It has been, not surprisingly, a popular product. And with the Internet and technology mania, particularly since the 1998 “reliquefication,” derivative structures that would allow scores of new Internet and technology million and billionaires to “cash out” or lock in gains became the hottest, most sought after product anywhere. In an interesting aside, I am told that Internet Billionaire (and owner of the Dallas Mavricks) Mark Cuban, responding to a question on talk radio as to what he would do if his huge holdings of Yahoo stock tanked, stated something to the effect that “its no problem, Goldman Sachs has taken care of that.” And while Wall Street firms had in the past dominated this market, the banks increasingly had a hankering to get into the action. This was particularly the case for the money center banks moving aggressively into the securities and leveraged lending business. What better way to get a deal than to provide “wealth-enhancing” products to insiders? Anyway, at June 30th, Chase Manhattan had $38 billion of notional equity derivative positions, JPMorgan $183 billion, Bank of America $122 billion and Citibank $44 billion.

But, you may ask, how can a company provide a non-recourse loan, or protect against loss, while still providing the insider the upside to higher stock prices? The answer lies in “financial engineering.” Through hedging – “dynamic hedging” – the issuers of these derivative products are theoretically able to protect themselves against a decline in stock prices with sophisticated computerized trading programs – often by shorting the underlying stock into declines. Of course, this is the same type of strategy that failed miserably with the “portfolio insurance” debacle in 1987 and with LTCM in 1998. However, these products are so popular that the myth that they actually work as prescribed is perpetuated. Basically, there are two key erroneous assumptions built into these dynamic hedging strategies: liquidity and continuous markets. Bear markets provide neither.

When stocks collapse quickly, there is a big problem as it becomes impossible to implement the necessary hedges. Apple is certainly a good example, as its stock gapped down almost 50% after its earnings disappointment. In such a situation, dynamic hedging not only doesn’t work, it can lead to quick disaster. Think of an example where a company provides 90% non-recourse loans to Apple executives while holding stock and options as collateral. One day everything is fine. The next day, the news breaks, the stock collapses, and there is absolutely no chance to get “hedged.” It is not difficult to see how a lender caught in this predicament could quickly face insolvency. Indeed, with the collapse of stocks throughout the Internet and technology sector, it is a certainty that the operators of these strategies have suffered huge losses. While such a strategy can work well on a limited basis, it becomes an impossibility when a large numbers of employees and insiders from a pool controlling over $1 trillion of stock market value want into the game. Quite simply, there was absolutely no way adequate liquidity would be available to hedge this amount of perceived wealth when the bubble burst.

And, back to my question, where did all the liquidity come from in the first place to make these loans and provide the opportunity to “cash out”? Well, perhaps it was bank loans or perhaps Wall Street has been using sophisticated vehicles such as asset-backed commercial paper or other securitizations. Why is this important? Because there are almost certainly massive losses involved in the equity derivatives marketplace that have greatly impaired the value of financial assets, either on the books of the banks, the Wall Street firms, the securities marketplace or “all of the above.” This is most definitely a systemic issue today, and may be the “big problem” “behind the scenes.”

This situation becomes even more critical as it is my belief that derivative players are also impaired by losses in the credit and currency markets, and likely the energy markets. Many derivatives players “write” volatility (sell both put and call options) in various markets and, like 1998, destabilized market conditions have impacted markets across the board. As I wrote last week, I think it is increasingly important to think of this as an unfolding crisis in derivative markets generally. And with the derivative players – the leveraged speculating community - increasingly impaired, we see faltering liquidity conditions likely impacting markets generally. And with virtual technology/Internet meltdown in progress, especially for firms that have aggressively played in equity derivatives themselves such as Intel, Dell, and Microsoft, the equity derivative players were in desperate need of a major rally. They got it today, but the issue has in no way been resolved.

Enthusiastic kudos to Christine Richard, a very talented journalist from Dow Jones, for her excellent article this week, “Lucent Sells Vendor Loans To Money Market As Risks Rise.” We will include excerpts:

“Through the creation of an asset-backed commercial paper program, Lucent will transfer $1.1 billion in loans and trade receivables financing for the sale of telecommunications, data networking and other equipment products off its balance sheet and into the money market.

The Lucent receivables will be credit enhanced by an insurance policy issued by National Union Fire Insurance Co. which is a subsidiary of American International Group. This credit enhancement will protect holders of the commercial paper - including the millions of small investors who keep a portion of their savings in money market funds - against losses.

Additionally, Citibank N.A. will lead a group of banks in providing liquidity support for the paper. Should money market funds and other investors refuse to buy the paper, then, the banks will step in and purchase it.

Asset-backed commercial paper conduits need continual access to funds as they must roll-over short-term paper to fund the purchase of longer-term obligations such as trade receivables.

Many companies sell their trade receivables into the asset-backed commercial paper market. Typically, however, those companies sell their receivables to a bank which combines them with the receivables of hundreds of other companies to set up a multi-seller conduit.

In this case, however, it is Lucent, rather than a bank, that is the sole sponsor of Insured Asset Funding. And only loans and trade receivables extended by Lucent and its affiliates are included as assets of the conduit.

The lack of diversification might appear to increase the risk on the notes. But James McDonald, a vice president in the asset-backed commercial paper group at Moody's Investors Service which assigned the conduit it top rating of Prime-1, doesn't see it that way.

"The rating is primarily based upon the insurance policy because it is a fully supported program," said McDonald. "The fact that the assets are all Lucent originated assets is not a factor in the rating."

According to McDonald, AIG's National Union Fire Insurance Co. bears the risk that Lucent's customers won't pay their bills and the insurer has agreed to step in to make up any shortfall in the payments. Therefore, the credit risk on the notes is really the insurance company's top-rated risk, explained McDonald.

Furthermore, should the market for some reason reject the Lucent notes even though payments are being made, Citibank, along with a syndicate of banks, would step in to buy the paper to assure that the conduit remains funded. The banks are required to fund the notes unless National Union and Lucent were bankrupt, McDonald said.

The asset-backed commercial paper market has grown rapidly in recent years and now makes up around one third of the $1.5 trillion commercial paper market.

The market is used mainly by banks and finance companies looking to take debt off their balance sheets. Whether the offloading of vendor financing risk into the super conservative money market raises questions of systematic risk to the insurance and banking system or even to money market investors is a subject of some disagreement.

Bruce Bent, Chief Executive Officer of the Reserve Funds in New York and the creator of the first money market in early 70s says securitized debt has no place in the money market.

"Sure the risk gets spread far and wide with asset-backed commercial paper but the risk is totally inappropriate to start with in a money market fund," said Bent.

Bent says most people invest in the money market under the assumption that it is a reasonable alternative to a bank deposit but with a slightly better return, and they rarely question what is in the fund.

For that reason, investors simply aren't compensated for the level of risk they take, he says. "People don't have the slightest idea what's in their money market fund," said Bent."

Another news release from Moodys caught our eye this week. “The number of downgrades in the U.S. asset-backed securities market significantly exceeded the number of upgrades by 122 to 23 during the first six month of 2000.” We continue to see cracks in the foundation of Wall Street “structured finance,” with the highest probability of a serious break in US and global financial markets since 1998. An acute liquidity crisis has developed in at least the equity derivatives and junk bond markets, with quite negative implications for liquidity throughout the US financial system generally. Again, the focus is on the impairment of the leveraged speculating community and the inevitability of forced liquidations. It’s all about liquidity, or the lack thereof…