bizzXceleration: Performance, Value and Profit

Some correspondents said "what other asset classes" but really meant what are you talking about ? For some reason that triggered off a long response compressing our best understanding into a longish note. But before we post that response it turns out to make sense to build up a slightly better picture of the rocks & pond(s) credit contagion model (somwhere in there is an acronym and I'll even bet that with a little cleverness we could get to PUKE or something else perjoratively appropriate - suggestions welcome). Meanwhile let us share some of the diagrams that "inspired" our own terrible and non-analytical chart work.

And oh, yeah and BTW - the two prior posts have a recent collection of readings on the Credit Crisis and the Fed's strategic outlook but are just the tip of the iceberg since we've been collecting this stuff for a couple of years now. If you think our apprehensions were building up exponentially to match the curve of articles you're right :) ! 

Below the line you'll find various chart collections that have led us down this thought process and are worth reviewing. Given the range of sample we don't point to the source in all cases but you'll find a bunch of them in the prior postings suggested readings. In any case the bottomlines here are that a) we didn't make this stuff up and b) a bunch of folks who're a lot smarter and more knowledgeable did. All we're trying to do is compress it into one central organizing framework to try and put a filter on all the chaotic data flowing over us (think of it like a whale's plankton screening filters :) ).

Let's start with the basic construction of a collateralized debt instrument, for which we've all likely seen a large number of pictures. We'd also like to note that, to the best of our understanding the basic construction processes, math models and statistical analysis are applied to other asset classes besides mortgages, e.g. buyout loans, etc. And broadly speaking the whole apparatus of speculative debt modeling that we got rudely introduced to during the Asian crisis of the late 90s applies here. So when we walk thru the CDO chart just substitue, say, a business and voila' there's another whole structured debt market.

Now the next little stream of thought that occurred to us once the "build a leveraged debt instrument" picture was a tad clearer was the one Bill Gross introduced us to in his essay "Ten Little Assets". As you can see from his picture his list of candidate assets that are going to go thru a de-leveraging workout is a tad different from the one we used to build our pond picture. We focused on ones that have experienced recent troubles and that are related so we could point to those readings. But here's an interesting thought - what if Gross is entirely correct and all these other classes will be subject to some similar pressures ? And if the only thing different will be some of the structural characterisitcs and timing ? In other words you could make our "pond" much....much bigger. Or build a bunch more ponds. Scary ain't it. Obviously for Bill's assessment it'd pay to read his column.

The next question is where do the ripples and waves come from - that is what rocks are being thrown in what ponds and how are the ripples spreading around. Well a great article by Greg Ip in the WSJ put up some wonderful charts we are pleased to reproduce here that pretty well walk you thru. What you see is the historical breakdown in housing investment spending relative to normal housing patterns as measured by the spread over many years between buying vs renting costs. If you think that chart looks a lot like the stock market bubble charts we'd sure tend to agree with you. As it's gotten increasingly difficult for folks to pay back the mortgages or maintain their payments what you've seen is an increasing spread between low-risk, high-quality debt instruments and riskier ones. When Uncle Alan and others talke about risk premia being arbitraged away there talking about this phenomenon - which is now in the process of reverseing. In particular if you look at the accelerating spread between various classes of commercial paper you get that ripple. And if you look at the terrible drop in the indices for credit instruments based on various tranches (splits) of mortgage-debt related instruments the Ebola-like character of the contagion is perhaps a little clearer.

The final spike in the coffin (and the reason that Jan Hartzius of Goldman-Saches has cogentely - and correctly IMHO - argued that a $150B+ credit problem results in a $1T or more of credit shortfall) is that these various debt instrument breakdowns were heavily built of borrowed money, that's Leverage my friends and there's gonna be trouble here in River City.

The bundling process is shown in the first sub-chart while the second shows the de-leveraging process. That is what happens when the value of the underlying asset, whether it's houses, mortgages, or CDO derivatives, is reduced/impaired and the instrument owner has to start selling off lower-rated chunks to pay off the higher-rated. This is the thing that scares the Bejesus out of the banks because the "margin" calls on their debt instruments/SIVs meant they'd have to be spending real money, of their own, and taking the writedowns back on their own balances sheets. Can you spell capital impairment ?

The final sub-chart shows how borrowed funds were used to build up the so-called assets of these instruments as they were crafted and how leverage was built up from, say, 3X to 30X. I've even heard some knowledgeable insiders mention 70X...whew. When that engine starts running in reverse the original real equity/asset gets written down to zero pretty rapidly.

By the way - one of the sadder things about this other than being a poster child for out-of-control greed and cleverness exceeding wisdome (as when doesn't it) is that these problems were first being seriously investigated, judging from my files, beginning in early '05.