Thursday, July 26, 2007
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%.
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.
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.
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.