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Generational Dynamics Web Log for 29-Mar-08
Investment bank UBS is now "writing down" clients' auction rate securities

Web Log - March, 2008

Investment bank UBS is now "writing down" clients' auction rate securities

From individual investors to tech firms, people are losing their money.

Last month, investors were told that they couldn't get their money out of funds that they'd invested in -- funds backed by auction-rate securities (ARSs) that they'd been told were as "good as cash," but which paid slightly higher interest rates than standard money market funds.

Now, UBS AG is telling investors that it's marking down the values of those investments. On Friday, according to an article in the Wall Street Journal, UBS began notifying investors that it will begin marking down the values of the securities in investors' accounts.

The markdowns will range from about 5% to more than 20% of the principal, depending on the securities.

Oh wait, there's good news: "The losses won't be realized immediately, as investors are currently unable to sell the securities for lack of a market," according to the article.

So, your investments have been marked down, but that's OK because you still can't get your money out anyway.

High-tech firms

In related news, high tech firms such as hand-held-device maker Palm Inc., internet-service provider EarthLink Inc. and internet job-search company Monster Worldwide Inc. are being forced to acknowledge substantial asset writedowns.

High-tech firms are particularly vulnerable, because they often keep a lot of cash on hand to make deals with. Auction-rate securities have been an attractive investment vehicle because they pay better interest rates than cash and because they're "as liquid as cash," a claim that's now turning out to be false. Starting next month, the list of companies disclosing large ARS holdings "is going to grow pretty quickly," according to an analyst, and many of these firms are going to be forced to write down significant portions of their assets.

If this prediction is true, then we'll see a huge ominous new twist in the credit crisis. For months we've been seeing large asset writedowns by numerous financial institutions. A spate of writedowns from high-tech firms would show that the "subprime virus" is now spreading rapidly outside of the financial community into the larger corporate arena, as well as to individual investors. From the point of view of Generational Dynamics, this change must come sooner or later anyway, but it will be a shock to the public when it happens.

Auction-rate securities (ARSs)

Interestingly, these assets being written down are not always CDOs or other mortgage-backed securities. More and more, the problems are with auction-rate securities (ARSs), which are "a whole nother thing."

Generally speaking, when you make a long-term investment, you can expect a higher yield (interest rate) than with a short-term investment, since a long-term investment carries a higher risk of default.

In the 1980s, investment brokers started using a trick. A municipality or a corporation would issue long-term bonds, and normally would have to pay high interest rates to investors in the bonds. But investment brokers converted the long-term bond into a series of short-term securities. Thus, a 10-year bond might be split up into 120 one-month securities. Since one-month securities normally pay much lower yields than 10-year bonds, the municipality or corporation would have much lower interest rates.

The only problem is that while a 10-year bond has to be sold only once, the one-month securities have to be sold over and over again, each month. So the investment brokers would hold monthly auctions, allowing investors to bid on the short-term securities. (In actual practice, these auctions might be held every 7 days, every 28 days, or every 35 days.) Since the yield (interest rate) on these short-term securities can change every time there's an auction, they're called "auction rate securities," or ARSs.

You know, I heard of this scheme some years ago, but I never paid much attention to it because it's so hare-brained that I thought it was a scam. It wouldn't be so bad if it were used sparingly, but like every other conceivable form of credit, it was abused during the credit bubble. It now turns out that hundreds of billions and perhaps trillions of dollars have been invested in ARSs. This hare-brained scheme has become the norm, much to my surprise.

I will say this for ARSs: They aren't based on massive fraud and corruption, the way that CDOs and mortgage-based securities are. The auction-rate securities are based on sheer, utter stupidity, the stupidity of people in the Boomer generation and Generation-X who think that if something makes money today, then it will make money forever. The stupidity is monumental, but it's just stupidity, not fraud. (However, it IS fraud if the broker tells the investor that they're "as good as cash.")

As long as the credit bubble was expanding, and there was plenty of money around, the investment banks were willing to guarantee the weekly or monthly auctions, in the sense that if there were no bidders for the ARSs, then banks would purchase them. But now with the deflating credit bubble and the credit crunch, investment banks are hoarding money and are unwilling to guarantee ARSs when the auctions fail. With most of these auctions failing nowadays, the ARSs can't be sold for cash, and so investors in ARS-backed funds can't get their money out.

This is affecting a LOT of people. If you'd like to get a feel for it, take a look at this February 27 BloggingStocks blog entry. It had over 800 comments, mostly from people telling their sad stories. Here's the first of the comments, from someone named Mike Rubin:

"I have a substantial amount of cash in Morgan Stanley and at my broker's suggestion put a lot of it in various Muni ARS. When things started looking dicey I called and was assured that none of my holdings were insured my AMBAC or MBIA or in student loan instruments so not to worry. Two days later things froze up. I was told that the senior partners were meeting to figure out what to advise or do. My broker tried to be helpful. I was offered a loan against my holdings if needed. Happily I did not need the cash and actually got higher rates as many of the instruments reset to penalty rates. I then was asked if I would be willing to buy some of the instruments from other of their clients who needed the cash. Things have evened out now but from this episode one should definitely take away a sense of how tenuous our security in general really is and just how much of it is based on simply confidence in the system."

Mike Rubin was lucky -- at least at that time (Feb. 28) -- because he hadn't really lost anything -- yet. But I'll bet that he's in a lot worse trouble today, unless he's been able to sell his ARSs in the meantime to some "greater fool."

The worsening deflationary spiral

This auction-rate security crisis is just the latest manifestation of the growing deflationary spiral. The credit bubble, which created hundreds of trillions of dollars in new "money" (mostly in the form of credit derivatives), is now deflating. Consumer and commercial credit is disappearing, as the deflationary spiral accelerates, and the credit crunch worsens.

Banks are hoarding cash, because they're hiding the fact that more asset writedowns are coming, and they'll need that cash when the writedowns actually occur. In a scenario laid out by Oppenheimer analyst Meredith Whitney, this could trigger a forced selling panic, as the market is flooded with near worthless CDOs and other mortgage-backed securities. And now we have to add ARSs to that mix of worthless securities.

The Fed can see this coming as well, and has been launching one new program after another to inject liquidity into the places in the system where it's needed most.

The Fed has provided some $260 billion in short-term loans to banks through a series of auctions beginning in December, and will hold two more auctions in April, offering another $100 billion. These measures, along with its hand in saving Bear Stearns from bankruptcy, have been getting increasingly desperate. Each new intervention requires more ammunition than the last one, and each has a diminishing salutary effect.

The climax of my "bloated mansion" analogy appears to be getting closer and closer each day. Here's how I described it in November:

"Think of the world economy as a huge, enormous bloated mansion made of wood, with all kinds of additions tacked on all over the place. Think of the CDOs as millions of termites that are eating away at the insides, so that another piece of the mansion falls off into the ravine almost every day.

The Fed and other central banks have been running around the mansion with hammers and glue and nails, patching things up as fast as they can, trying to keep ahead of termites. They've been pretty successful with their hammers and glue and nails in postponing the inevitable, even bloating the mansion up a little more, but they can't keep up with the termites.

[What's happening] is that the hammers and glue and nails aren't working, and it won't be long now before the entire mansion collapses into the ravine."

As each week goes by, you can just feel that Fed chairman Ben Bernanke is running around the mansion faster and faster, using up his supply of nails and glue, in the hope that that internal rot can be "contained," but it never can because the credit bubble engulfed the entire world when it was growing.

The credit bubble created hundreds of trillions of dollars in new money, mostly in the form of credit derivatives, in a huge Ponzi scheme or pyramid scheme. Now that the bubble is deflating, all that money is unwinding, and there's less money in the world each month than there was the month before.

The Fed has a few hundred billion dollars at its disposal. It does not have anything close to the hundreds of trillions of dollars that would be required to reflate the credit bubble, or avoid a huge financial crisis.

All in all, the Fed has been using its available assets very cleverly. It's managed to keep the mansion together with nails and glue at the the most critical structures, but it's a losing battle. I'm amazed that the Fed has been so successful thus far.

Corporate earnings estimates plummet again

As regular readers know, we've been keeping a running track of the analysts' estimates of corporate earnings. For the fourth quarter, analysts estimated 11.5% growth at the beginning of the quarter, but that became a -25.2% (i.e., a 25.2% fall) when actual earnings were announced.

Now we're seeing the same thing in the first quarter. Here's the latest summary from CNBC Earnings Central:

"As of Friday, March 28th:

23 companies in the S&P 500 have reported earnings for Q1, 73.91% have beaten estimates, 13.04% were in-line, and 13.04% have missed. (Data provided by Reuters Estimates)

The blended earnings growth rate for the S&P 500 in first-quarter 2008, combining actual numbers for companies that have reported, and estimates for companies yet to report, fell to -9.3% from -7.9%, mostly due to downwared revisions in the Financials sector.

On January 1st, the estimated growth rate for Q1 was 5.7%. (Data provided by Thomson Financial)"

So we can update our tracking table as follows:

  Date    1Q Earnings estimate as of that date
  ------- ------------------------------------
  Oct 23:             +10.0%
  Jan  1:              +5.7%
  Feb  6:              +2.6%
  Feb 29:              -1.1%
  Mar  7:              -4.3%
  Mar 14:              -7.8%
  Mar 21:              -7.9%
  Mar 28:              -9.3%

And we can expect further reductions when the first quarter ends next week.

The public mood

I'm hearing all kinds of ridiculous things these days.

Long time readers may recall that in 2006, former Fed chairman Alan Greenspan blamed the housing bubble on the fall of the Berlin Wall.

Greenspan, who is trying to save his own legacy, has just written a commentary in Financial Times blaming the credit crisis on "animal spirits."

He says that existing macroeconomic models are simply failing -- which is exactly what I've been saying for years. But instead of trying to work "animal spirits" into the macroeconomics models, it would work better if they worked System Dynamics into the models, as I described in "System Dynamics and the Failure of Macroeconomics Theory."

If you're looking around for more silliness beyond "animal spirits," it's hard to beat the two "investment advisors" that I quoted in January as saying that people with brain disorders make better investors.

Here's some more silliness in the public mood:

On Friday morning, I was listening to a BBC financial report on how there are far fewer mergers and acquisitions this year than in previous years, and I was startled to hear the following statement:

"As the credit crunch takes hold, there's an inevitable slide in the number of mergers and acquisitions, the fuel of the financial markets."

This is an incredible statement. Mergers and acquisitions don't actually PRODUCE anything. They're simply financial transactions that generate enormous fees for investment brokers. Since most of these deals were leveraged, they were a big part of the "creation" of money during the credit bubble.

We've actually gotten to the point where financial reporters are putting forth the view that financial transactions are the "fuel of the financial markets."

Hey, folks, the fuel of the financial markets are businesses that produce things. JP Morgan doesn't produce things, but General Motors does.

This once again shows how different generational attitudes are. The generations of people who lived through the Great Depression would not have thought that financial paperwork was the fuel of the financial markets. People born after WW II have little understanding of the connection between production and income.

What's funny is that all of this will be "obvious" once the financial crisis begins. "Of COURSE companies like General Motors, not mergers and acquisitions, are the fuel of the financial markets. Of COURSE auction-rate securities violate the rules of the universe, and can't work forever. Of COURSE there was a huge stock market bubble based on credit. It's so OBVIOUS, why on earth didn't we see all this before???"

You'll be hearing that a lot.

You'll also be hearing this a lot: "Why oh why didn't I just save a few hundred dollars instead of spending everything. If I had, then I'd be OK now."

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (29-Mar-08) Permanent Link
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