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Dear Lord!
By RANDALL W. FORSYTH, Saturday June 30th, 2007
IT'S A MIRACLE!
The long wait by the patient faithful has been rewarded by the arrival of the Jesus Phone, as the flock of Apple's true believers has come to call the iPhone. They already had been queueing up for days in front of their shrines, aka the Apple stores, just for the chance to receive their own Jesus Phones when they first were offered to Apple's acolytes Friday evening.

But why have the digerati dubbed it the Jesus Phone? Because the iPhone has inspired such religious fervor? Because the iPhone can perform miracles, combining a cell phone, music player and an Internet device in a single gizmo? Because waiting for its arrival required the patience of Jobs?

To an agnostic, when it comes to Apple and the ardent worship its many works seem to inspire, the deafening buzz about the Jesus Phone is a mystery, not least because the name relates to a product from a company whose logo depicts (and seems to celebrate) Original Sin.

But the real miracle would seem to be the 30-odd billion-dollar increase in Apple's stock-market capitalization since the iPhone's creator (with a lower-case "c"), CEO Steve Jobs, unveiled the prototype earlier this year.

Even at $599 a pop, Apple supposedly will sell 10 million iPhones by 2009. (OK, there's a $499 version but it's doubtful many buyers won't spring for the extra C-note to get the higher-memory version.) And that doesn't include the hefty monthly charges AT&T will be collecting from each of those eager iPhoners.

Even taking into consideration the burgeoning population of that fictional land of Richistan, you've got to wonder if there really are enough kids of private-equity and hedge-fund managers to scoop up all those pricey iPhones. (It's hard to imagine that the grownups who are raking in the big bucks needed to pay for all the little urchins' indulgences will abandon their CrackBerries, however.)

Then there is the real world, where the unpleasant reality of $3-a-gallon-plus gasoline and milk intrudes, along with falling home values and rising mortgage costs and taxes. With the housing ATM pretty well tapped out, there might be less left over for expensive toys, no matter how miraculous.

Connecting the dots of the housing downturn, Merrill Lynch's chief domestic economist, David Rosenberg, spies a marked slowing in consumer spending. In May, real consumption rose only 0.06%, which gets rounded up to 0.1%, he notes. "On a three-month basis, real consumer-spending growth has throttled back to a mere 0.9% annual rate, which is a far cry from the 5% pace at the turn of the year, and outside of the Katrina disruption in the fall of 2005, this represents the softest trend in three years," Rosenberg wrote in a research note.

Then again, Apple may find that the iPhone is immune to these pocketbook pressures. Or that American consumers can continue on their merry spending ways unimpeded by rising prices and slowing real income growth. That would be the greatest miracle of all.

AS A MODERN MIRACLE, THE IPHONE DOESN'T come close to the true blessings of our age. Even a gadget geek would gladly give up his laptop, cellphone, MP3 and flat screen for antibiotics or the polio vaccine, which were genuine miracles a half-century ago.

But as marvels of imaginative engineering, none of Steve Jobs' creations can come close to financial derivatives.

In the beginning, there were mortgage-backed securities that turned ordinary home loans into bonds. Then came collateralized mortgage obligations, or CMOs, which sliced and diced the mortgage securities according to when they'd get paid off, which is uncertain, especially given homeowners' proclivity to refinance when it suited them.

The next step was the collateralized debt obligation and its cousin, the collateralized loan obligation. CDOs and CLOs represent pools of corporate bonds or other loans -- including subprime mortgages -- that are split up into tranches of varying risk and return. The first in line to get paid get the highest credit rating and the lowest yield, and so on down the line.

Here's where the real alchemy comes in: The top tier of CDOs and CLOs can be backed by a pool of junky credits and still get a triple-A rating. The pawns at the lower tiers absorb the losses to protect the kings and queens at the top. And so these derivatives have exploded in just a few years, to as much as $1 trillion by some estimates.

Pimco's Bill Gross wrote on his Website last week that the ratings agencies were bedazzled into giving triple-A ratings to these fancy derivatives by their "makeup, those six-inch hooker heels and a 'tramp stamp.' Many of these good-looking girls are not high-class assets worth 100 cents on the dollar," the Bond King observed. I'd say it was more a case of dressing up trashy assets in prim-and-proper attire to pass off to good families as having pedigrees.

While the ratings agencies have granted their imprimatur to this sleight of hand, skepticism about a triple-A carved out of junk is in order. According to a Bloomberg news story, about 65% of the bonds in indexes that track subprime-mortgage debt don't meet the rating criteria at the time they were issued. That means Moody's, Standard & Poor's and Fitch are masking mounting losses by failing to downgrade these securities, according to the Bloomberg analysis. Were those downgrades to take place, it would force selling that would further roil the subprime and CDO markets, it added.

This suggests the travails that befell Bear Stearns' hedge funds aren't one-off events. "This is not an isolated LTCM-type complex trade that has gone wrong," writes Albert Edwards, Dresdner Kleinwort's global strategist, referring to the famous meltdown of hedge fund Long Term Capital Management in 1998. "These 'financial weapons of mass destruction' are widely owned. And the housing market is still sinking...."

While Bear had to put up $1.6 billion to bail out one of its namesake funds, the CDO market remained back on its heels. CDOs trade rarely, if at all, in a thin market. As a result, these exotica aren't marked to market, like most securities, but "marked to model," quips Barry Ritholtz, chief market strategist of Ritholtz Research & Analytics. Indeed, various reports indicate the high-quality CDOs that Bear tried to sell fetched bids as low as 85 cents on the dollar. And without the support of the derivatives market and a rising queasiness about risk, a whole parade of leveraged financings were either postponed, restructured or left on underwriters' shelves.

Indeed, says Martin Fridson, the veteran observer and chronicler of the high-yield market, a "turning point in leveraged finance has been reached." Writing in his authoritative Leverage World letter, he lists a litany of woes, among them: Dealers reportedly are cutting back on making markets in high-yield paper because of the capital they have tied up in bridge loans and problematic mortgage paper. Meanwhile, securities in the secondary market may face markdowns if new issues have to be priced at concessions to draw buyers.

Private-equity firms have been slow to face up to the deterioration in the financing environment for leveraged buyouts, he adds. Dealers who have been unable to persuade deal sponsors to adjust terms to the new reality instead are leaning on investors.

"They warn that portfolio managers who refuse to take their 'fair share' of the troubled deals will face reduced allocations on good deals in the future," Fridson writes, recalling similar tactics employed by Drexel Burnham Lambert in the latter days of its reign over the junk market in 1989.

A pickup in default rates could slow the creation of CLOs, he continues, cutting off a key financing source for new LBOs. Already, lenders increasingly are balking at aggressive deals featuring debt that exceeds seven times earnings before interest, taxes, depreciation and amortization. In addition, says Fridson, private-equity firms' affiliated asset-management companies are said to be showing less enthusiasm for LBO paper created by their associated LBO funds.

All these capital-market machinations ultimately will cut back on financing for deals.

"Reduced aggressiveness by private-equity firms, in turn, could remove the buyout premium from stock prices," Fridson concludes with a bit of understatement. Bob Prince and Fred Post, in Bridgewater Associates' Daily Observations, write that an array of factors has "conspired to produce at least a short-term turning point in perceptions of risk." In addition to the subprime-mortgage and CDO woes hitting hedge funds, they see "overextended carry bets by naive players," combined with hawkish comments on monetary policy and emerging-market central banks shifting from dollar bonds, pushing volatilities higher.

That would mark a key reversal. Since the bursting of the dot-com bubble, central banks have tamped down volatility by flooding the global financial system with liquidity. China's currency peg adds to the flood by massive printing of yuan to buy up dollars that are recycled into U.S. assets, keeping a lid on American interest rates and providing cheap financing for U.S. home buyers. Japan, by holding its interest rates at just 0.5%, provides fuel for global speculation in high-yielding assets via the carry trade.

In essence, this cycle has seen a massive arbitrage, using cheap debt financing to buy up equity and property assets all over the globe. It has been the source of mind- boggling fortunes, as the Blackstone Group flotation amply demonstrates. The key question now is when, not if, the credit flows end. Then the movie will be rewound. Besides the impact on equities, that would mean other processes could go into reverse, notably the yen carry trade.

As borrowings in cheap yen are paid back to meet margin calls, the carry traders will have to buy back the Japanese currency they sold in exchange for higher-yielding assets. So far, that hasn't happened. But when the yen-carry trade unwinds, you'll know the global margin call is on.

E-mail: randall.forsyth@barrons.com

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