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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