Thursday, July 26, 2007

Bid to old Boots (...or not, as the case may be)

Poor Henry Kravis. One day he snaps up AllianceBoots, operator of the UK's hegemonic chain of pharmacies, and is feted with an appearance on the cover of this month's Bloomberg Markets and a panegyric within the pages of the magazine. The next thing you know, he's actually being asked to improve the terms of his financing (in the lenders' favour, of all things!) while his debt underwriters get stuffed with the bulk of the Boots debt. Meanwhile, Cerberus Capital has been caught in the crossfire and failed to dispense with another $10 billion worth of debt required to finance its Chrysler purchase.

Left holding the bag, of course, are the underwriting syndicates, which now have billions and billion of dollars of undesirable debt on their books. Should such an environment persist, we will eventually see what economists refer to as an "inventory unwind". And when that happens, we'll finally get the dip that you don't want to buy immediately. On a more medium term horizon, meanwhile, it could be that the PE bid for equities is more price sensitive than has been the case; of course, the PE bid could well be replaced with a healthy dose of VIG (a.k.a. the Voldemort Investment Group, a.k.a. sovereign wealth funds.)

Another example of an institution assuming the risk of unhappy clients is AXA, proprietor of the horribly-performing cash-plus fund highlighted in this space on Tuesday. Macro Man's industry spies suggest that AXA is now meeting redemptions out of its own capital base, such is their aversion to selling more securities and embarking upon another unpleasant voyage of price discovery. When institutions begin to warehouse substantial amounts of dodgy inventory, as is happening now, the "systemic risk" warning signal begins flashing amber.

Lest you think that AXA was the only institution impacted by subprime, or that only dollar-based investors are taking the hit, consider the fund below. The chart, Macro Man is sure you'll agree, bears an uncanny resemblance to that of the AXA fund. However, the chart below shows the price of the Oddo Cash Arbitrage Fund, a euro-denominated cash-plus fund domiciled in France. It would certainly appear as if the 'cash arbitrage' in question involves buying short-term subrpime paper in the US, hedging the currency back into euros, and collecting the yield difference between LIBOR (used in the currency hedge) and the subprime notes. It looks like the fund might need to be re-christened as the "Oh-no Cash Abritrage Fund"...
Elsewhere, Macro Man was blown away by a piece written by Jim Cramer yesterday comparing the current environment to October 3, 1998, a scant few days before the Fed engineered an emergency rate cut in the midst of the LTCM crisis. Although Cramer does state that he expects things to get worse (and specifically suggests sectors to short), the underlying theme of the piece appears to we are entering the sphere where Fed easing enters the equation, and boy you don't wanna be short when they do cut rates.

Macro Man had to shake his head when he read this. Has volatility really fallen so low that the current blip prompts comparisons to October '98? Not that that scenario couldn't eventually unfold, but there would have to be a lot (and Macro Man means a LOT) more pain before the environment resembles October of '98. Let's take a ride in the way-back machine:


THEN: On October 2, 1998, the S&P 500 closed 17.1% below its closing high of a few months before.

NOW: Yesterday's SPX close was a scant 2.25% below its prior closing high.

Investment Grade Credit

THEN: The spread between Moody's BAA index and 30 year Treasury yields widened from 1.43% in July to 2.07% on October 2. Swap spreads widened to 0.89%.

NOW: The Moody's BAA spread has widened from 1.43% to 1.56%, and swap spreads, while wider, are still at 0.72%.

Emerging Markets

THEN: A year after the Asian crisis, Russia took the unprecedented step of defaulting on local currency debt; the rouble got crushed.

NOW: EM central banks are flush with FX reserves and many, many currencies are at their strongest level versus the dollar since 1998-99.

Yen Carry

THEN: USD/JPY had already fallen 9.6% from its high, vols were at 18%. The 17.8% peak-to-trough crash in USD/JPY the following week was part of the rate cut calculus.

NOW: USD/JPY has fallen 3.5% from its peak and vols are at 7.5%. If positions were as large as they were in 1998, both implied and realized volatility would be higher.

Real Economy

THEN: The NAPM fell from 52.2 to 48.7 in the six months leading up to October 2.

NOW: The ISM has risen from 51.4 to 56 over the last six months

None of this means that a crisis cannot unfold, of course. Indeed, it looks increasingly likely that the resolve of the DOTW will be tested in equities. Bear in mind, though, that it will need to get a lot worse before an emergency rate cut balm can make it better.

To paraphrase Winston Churchill: we're not at the beginning of the end; if anything, this is only the end of the beginning. Macro Man will therefore write a check to protect against disaster:

He buys 1200 August DAX 7600 puts at 135.


Anonymous said...

If mother VIG can be price sensitive to a single bond auction, can’t family VIG be the same with equities?

Macro Man said...

Sure. However, SAFE is coming from a position of owning more than a trillion dollars' worth of govvy or quasi-govvy bonds. VIG currently has $10 billion worth of equity on its books. I suspect they'll need to get positioned up before they become terribly price sensitive.

In any case, buying the public stock of a private equity company (which many suggested was the top of that particular market; recent financing issues suggest that analysis may be spot on) at IPO doesn't suggest that 'buying cheap' is high on the agenda at the moment...

tmcgee said...

when it comes to equity, i can't imagine why VIG (and with all due respect i still think there's a better, more nefarious acronym awaiting) is all that sensitive to equity moves, or buying at the top. after all, $1.3 trillion buys you a LOT of long term. and certainly the impact on interest rates has meant a fair bit of seemingly indiscriminate purchases with wide-ranging ripple effects (i still think SAFE has, ironically, played a role in the private equity craze by holding down (seemingly) risk-free interest rates.

i also totally agree with those 2007/1998 comparisons. why are people getting so shrill? i swear, it's like people are wishing for a repeat, or are lacking in similes. i suppose low volatility breeds a desire for volatility by invoking the wackiest vol moments of all.

Macro Man said...

Oh, I've got plenty of acronyms in mind. Sadly, most of them have four letters and are not fit for a family-friendly website like this one....

Anonymous said...

Their strategic timing may not be so bad at all.

Given US market risk, would you rather have a $ trillion in cash or a $ trillion in equities right now?

And $ 3 billion to start at the peak is neglible in terms of eventual market timing overall - plus it gives them an unusual market window.

They won't be too desperate to load up quickly - can always start parking money in short term bank deposits in addition to treasuries, and have lots of portfolio equity flexibility in addition to private ventures.

They've taken a while to get to where they are and can afford to be patient in broadening out their $ 1.3 trillion.

It's almost as if they planned it this way.

"Cassandra" said...

A month-or-so ago, over at Brad's on an SWF discussion, I had mused that IF one (say for example, SAFE) was interested in doing a trillion-dollar debt to equity portfolio rebalance, the optimal strategy would indeed be to use the old trader's ruse of first slamming prices with the marginal dollar, thereby creating a credit cascade and bear market in asset prices, after which they would find themselves able to execute the trade at far better prices, in far larger quantity than otherwise, and perhaps even find themselves in the most enviable PR position of partaking in "a JP Morgan moment" by being the heroic buyer of last resort. Buying USD assets at 20%++ discounts would be some consolation for the FX loss, and costly difficulties of converting them into real USD and both real and paper non-USD assets.

Macro Man said...

Yes it isn't hard to imagine that SAFE/VIG stepped away from bonds a few weeks ago to help engineer lower risky asset prices, if one is sufficiently Machiavellian.

I was commenting to someone yesterday that I had a sneaky suspicion that the current credit crisis ends with VIG buying some of this stuff for 10 cents on the true dollar value. An exaggeration, maybe, but perhaps not hyperbole...

Charles Butler said...

The direct effect of an environment of doubts concerning credit and the like will be a return to a stock picker's market (if not a generalized rush for the exits, which I don't think is in the cards), rather than this vaguely upward trend fuelled by LBO's and such. A brief cruise through the S&P component carnage list today shows AAPL up 7+% - on earnings! Merely positive would have grabbed my eye. Straight long major market index plays are probably dead in the water.

Also, an observation on the DAX..

It's huge run this year testifies as to what good news is capable of doing in this context. And I wholeheartedly agree with your purchase of the puts on the same.

Macro Man said...

Well, it all feels terribly ugly, doesn't it? Anyone long equities or NZDJPY must feel like Cramer was right...price action in high quality EM like Brazil is reminiscent of last May.

I think it's safe to say, Charles, that those DAX puts may have preserved my pork-based breakfast food!

Anonymous said...

Couldn't agree more about how far done the Fed put lies, Ben has to amend for the 'helicopter' speech, or else he'd have a hell of problem.
Thing is, housing here in the US is just starting to really get into that self-reinforcing downward spiral and the bond market knows do the DOTW I suspect.
Funny thing is, if the bulls want equities here to really run, they need them first to fall out of bed, really fall out of bed, then the bearded one can ride in.
PS. I nominate VIG as the acronym of the year. In fact, viewers of CNBC were treated to one Ms. Bartiromo almost cheering (I paraphrase) "VIG will save us! VIG will save us!"

James said...

I doubt VIG has anything to do with it. If the Chinese were smart enough to engineer something like a credit crunch they would have never ended up with 1.2 trillion dollars. Thats what mismangement gets you. Conspiracy theories are fun to think about.
"unstable, unbalanced, uncoordinated and unsustainable"

Anonymous said...

Cramer "unstable, unbalanced, uncoordinated and unsustainable"

Every time US markets fall (market jawboning) a couple of points we get pundit and admin. jawboning

Compare yesterday with March 1st yadayadayadayada....

Wonder why?

Macro Man said...

Believe it or not, I probably mind Cramer less than most. I have respect for what he has done with TSCM and for the fact that he has been at the coalface of risk taking.

That said, he's clearly turned into a caricature of himself and, frankly, a buffoon.

Moaning about futures market manipulation is frankly pretty weak- as indeed it is from those with a bearish slant when futures go bid.

ilanit said...

Much of the original work on Los Angeles private equity fund performance comes from seminal work of Steve Kaplan and Antoinette Schoar who reported that the performance of 746 private equity funds in their sample was close to that of the S&P 500, net of fees. Subsequent work by Phalippou and Gottschalg (PG)found the performance of private equity funds was below that of public stock markets.

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