Shawn Baldwin from CMG(Chicago) for the 2009 Critical Capital Management Series




March 30 2009 Market Commentary


The Dow fell 254 points after a semi-convincing run in the equities market during a 3 week period in March–although this rally was never reflected in the credit markets, many heralded this as the return of the bull market. I wasn’t so swayed. In the March 18th “Preparing for Re-Entry” commentary, I clearly stated that this was a bear rally and I re-emphasized this point again on March 23rd in Pulling the Trigger(s). Retail sales, Housing permits, durable goods and re-financings all seem to outline positive possibilities. The market drop today was due mainly to concerns about the banking industry fueled by concerns over automakers as we saw Mr. Wagoner hit the pavement. Bull markets are not built on rampant optimism fueled by good news. The question of when the market begins a strong trek into positive territory is primarily a function of “what” occurs– the when is a tertiary concern. The acceleration of the market is predicated by a number of factors and we have seen a number of them fall in place. This makes the question of “When will the market go up?” very rudimentary. The real question is what will make prices rise —rising prices attract investment.


What is it that drives prices and spreads in securities in the first place? What is it exactly that makes prices and perceived valuation go up or down? The answer to that while seemingly complex is very simple: Information. When information is coupled with experience and knowledge on a trading desk the by product is action in the form of a position made for the basis of a trade. Money moves the market but the force behind that movement is information. Information courses through electronic pathways pushing critical data points to market participants who use this intelligence to make decisions to buy or sell. That is why traders rely so heavily on Bloomberg and other information delivery tools. The information pressure formed behind capital is similar to the mean arterial pressure that moves the blood through our bodies—information controls the flow and pressure of capital in the financial marketplace. It is the lack of information –or uncertainty– that stagnates investment and causes capital to sit idly by on the sideline. This is what we are viewing in the markets presently, something commonly called investor fatigue, which I personally believe is a misnomer. I believe what we have is a “Dearth of Buyers” due to uncertainty and therefore is no one to counter aggressive short-selling. I will cover that topic in another commentary, for now we will focus on the uncertainty.



A practical case in point for uncertainty in the markets is the venerable GE, which was to the chagrin of any long time participant of the markets recently downgraded. GE’s price has dropped over 72%. Unbelievable! What caused this precipitous drop in the stock price and its credit rating? Uncertainty. In GE Capital, the asset management arm of GE, over 81% of $55B of equipment leases is with entities that are below investment grade. GE has been dealing with these types of financing arrangements deftly and profitably throughout the years—but now with the crisis others have been alerted to these activities. They are UNCERTAIN about the non-rated entities ability to pay so GE’s stock is being punished—that is certain. There are certainly other mitigating factors that are assisting in dropping the price, but you can be assured that they are also tied to uncertainty in a very large way as well. This particular example helps to illustrate my point quite nicely though.


Uncertainty of Solvency


The drop in the market to day was primarily over banking concerns, banks and real estate are the inextricable factors in the equation of our markets financial health. These two components comprise both product and measure of our wealth and stability. 65% of commercial banks business is lending for real estate whether for commercial or residential purposes. Prices for real estate are still in flux causing the core assets of the banks and by induction the respective value of the banks themselves to be unknown. The banks through their assets and securities comprise a significant (until the crisis the majority) of the value of the S+P 500. This has been fairly problematic for our country and the main reason for the creation of the TARP fund which I likened in my Capitulation commentary in October as the United States answer to a sovereign wealth fund.



The United States was no longer certain that the normal investors who happily invested in and with many of our investment companies would go along for the ride this time. For the first time ever, the funds simply sat back and waited to see what happened. The U.S. was uncertain if our normal co-investors would come along for the ride so we created our own pool of investment capital so that we could create certainty of investment, capital and financial guarantees.


Uncertainty of Regulation


I will not explain the TARP/TALF functions in micro-detail as has been done in every major finance publication in existence. There has been more than enough of that. It will suffice to say that the plan simply provides low cost leverage and non-recourse capital to effectively aid in reducing the cost of an asset acquisition by private capital. The second  effect of this scheme is to ease –and possibly force by the regulators– write downs in the banks that would otherwise be reluctant to do so at less than wholesale prices. On the surface this would seem to be a very elegant solution and method to “fire sale” assets right under everyone’s noses without causing too much price impact. Hank is very clever.



So why hasn’t the second Gold Rush started? Uncertainty. The worst kind of uncertainty there is for a finance person, the uncertainty of regulatory risk. As a market professional I went my entire career without any marks on my track record—the moment I started to make too much money in my own entity—Here come the regulators! By the way, they don’t like your briefcase, shoes or the car you drive. So you can rest assure that they will cause you problems. Believe it. These guys make between $45 to $75k a year and they don’t believe that you have earned your money. FINRA literally spent hundreds of thousands of dollars on regulatory proceedings (complete with them lying under oath in those proceedings) not based on theft or deceptive practices—but on the reception of a document that the SEC had in their possession. Why? I raised my voice at one of the guys who lied under oath. People in finance believe that nothing gives a regulator more pleasure than to stick it to Wall Street guys who they feel aren’t any smarter than they are—whether they deserve it or not. FINRA has over 5000 broker-dealers and at any time almost 10% of those members were attempting to sue the organization if you read the transcripts of the blogs you will alternate from laughing to states of shock about their treatment by the regulators. Securities professionals know that accountants who haven’t performed securities transactions seldom are reasonable and in this environment it’s 100 times worse. In an environment where Bernard Madoff stole billions (right under the regulators noses) they are given license to be unreasonable under the guise of “championing” the little guy. They pursue this with zeal and relish the idea of their power.


Well, at least that’s how we feel. J


That uncertainty might seem laughable to others outside of our world, but you can best believe that Goldman wants to hand the $10B back for a reason and the reason isn’t to compete with a higher cost of capital than its competitors. It’s to reduce any newfound, discovered or created regulatory laws that might encumber its business due to an over- politicized environment populated with testosterone induced regulators. The concept itself gives me frightmares.



This concept is magnified exponentially with Private Equity firms and Hedge Funds who have chosen these professions so that they wouldn’t have to register and deal with over zealous regulators.  Public Private Investment Partnerships will be a wave in the future and create tremendous investment opportunities in infrastructure throughout the world. I outlined this topic as a separate commentary in the “Trigger(s)” and I will expound on it in detail later. The premise of the low cost, non-recourse capital is very appealing but you will find most private capital very reticent because they are uncertain about regulatory risk. The AIG bonus shenanigans by Congress and the previous actions and history of regulators don’t exactly assuage any fears the President Obama and Treasurer Geithner try to address—Private Capital is uncertain.




There have been a number of positive trading and investing information points that shows that pent up capital is ready to invest. They are the following:



Positive data:


A. CDS clearing has been effectively put in place, so we now have an orderly and systematic way to sell, clear and regulate these opaque instruments. This will reduce a tremendous amount of uncertainty. ( I mentioned this instrument and its market in September as a key component in the sell off, but I got one thing wrong—I thought that the CME-Citadel joint venture would dominate, it would seem the Sprecher of the ICE took umbrage at that statement—ICE has been killing the CME-Citadel group in terms of volume. My bad!)


B. Oil output has been steady and therefore not sparking energy concerns from production. Oil going to $50 will be a positive for trading and volatility.



C. G20-concentrated efforts to coordinate (to a degree)-Global Trade


D. Repo market is showing life and that bodes well for the moribund debt market


E. Real Estate/ Banks-Mortgages originating 2.7B new home loans, reducing payments freeing up more cash for consumer spend. Wells Fargo, JP Morgan and B of A  will all benefit from this boom. The re-financing surge represented the 4th highest level.



F. Almost half of the HNW ( as defined 1mm to 10mm) will purchase Real Estate and specifically named it as their focus for acquisition. This will help to determine the strike for real estate and set prices.


G. Gold has been rising over $900 for fear of a currency war and uncertainty about equities and values in the marketplace, oil hit $50 this will generate arbitrage and market neutral positions will become vogue again-will draw away from the recapitalization of banks sparking more investing.


H. Bond issuance accelerated and smaller bridge loans are being populated with covenants to encourage refinancing in the bond market-this bodes well for the debt market and insures supply.



There are also a number of negative drag factors which are question marks and create uncertainty in the minds of institutional investors. They are the following:


Negative Data:


1) Potential Insurance bailout-insurance companies are amongst the largest holders of the nation’s debt. 18% of all corporate bonds are held by insurance companies. Insurance companies have to buy or the markets will not recover/ Insurance companies bought 3.3B in stocks and bonds—this was down 63% from the previous quarter. I’m not clear if insurers are eligible for the TARP. Since they only have state regulators and zero federal regulation this will be highly unlikely. The insurance companies will most likely form specialized investment units to participate.



2) CDO’s failure rate-nearly half of asset backed securities (collateralized debt obligations) have failed—47.6% to be exact. Look for higher numbers in the very near term as more bonds are defaulted on. Bet on it.


3) Emerging Market Ops MSCI up 10.6%-this will surely draw capital away from the uncertainty of the United States. Emerging markets always carry high returns—the previously carried the stigma of risk due to uncertainty….that whole paradigm is now changed. Investors will definitively pile on this attractive return set. I will explore how to profit from this trend in a separate thesis called the “Global Trade”.


4) Corporate Bond Defaults are poised at a record high-junk Bonds defaults will rise and as many as 300 corporate bonds are expected to default versus 104 in 2008 and 18 in 2007. Default rates are up to 4.8 percent that was 1.1 percent a year ago.



5) Hedge fund redemptions will increase. I started my thesis on market collapse predicated on redemptions for hedge funds and CDS trades. On September 30 of 2008 the hedge fund industry had redemptions taking the total assets from $2.7T to $1.8T, most estimates are expecting another drop of 15% to 30% as consolidation in the industry continues. This will have a dramatic effect on securities prices as the firms are forced to sell positions to meet investor redemptions. That’s right, another potential crater.


It remains to be seen how effectively these schemes will assist banking and housing to settle into their new pricing and valuation schemes. Even if they do work positively, earnings won’t really start increasing until 2010. The IMF forecasts the global economy declining by 1 percent in 2009-the first contraction in 60 years, this is not good news. There are also liquidity issues in UK banks making western finance everywhere absolutely and the jobless rate went up in January.


This has been the longest recession since the Great Depression, it formally started in December 2007 and it will be 17 months old in April –close to its Terrible Two’s. Continue to watch the unemployment number; it is currently at 8.1% the highest it has been in 25 years. Most economists believe that unemployment will probably hit 10.1% in 2010. This would normally be a very negative sign but in this case it would indicate a bottoming in April –May with a reversal most likely in the fall.



I will examine the Dearth of Buyers and the Global Trade opportunities next for opportunities to generate positive returns while we wait on the cycle to revert in the equities markets.


About the author

Shawn D. Baldwin is Chairman of the AIA Group (AIA), an alternative investment and advisory firm based in Chicago.