Credit Crisis 'Only Now Beginning' - Bloomberg

Summary:
David Goldman, a portfolio strategist at Asteri Capital, talks about the outlook for the U.S. financial-services industry, the impact of the hedge-fund model on market volatility and his investment advice. This is not a mere recession, it's a change in the lives of Americans. We're still in the credit bubble, because of contractual obligations the banks have. The credit crunch hasn't started yet, merely a mild indisposition so far. The credit crunch is what comes next, and it will be brutal. The hedge fund business is very vulnerable. All in the same trade all the time and every turn is like a stampede out of a crowded theater. Only the big funds that have a lock on capital may do well. If you marked everyone to market now, the banks would be in very bad shape, many insolvent. Isn't going to happen and banks will try to generate enough earnings in order to bring in the capital back while they pretend that they're still solvent. But losses from consumer lending may pile up faster. We may have a deflationary outcome, destroying huge amounts of wealth in the form of homes and equities and companies is in principle inflationary. (Published: 14/08/08)

Notes:

• not a recession, not a blip: it's a change in the lives of Americans who've spent the last 10 years in the delusion that they'd fund their retirement by selling homes back and forth to eachother at higher prices
• the financial industry enabled them by sustaining this delusion
• delusion is now coming unravelled
• no one is going to retire, entire neighborhoods will turn into slums and financials will trade at 50% of book
  

• a year from now we're still going to have a very weak economy;
  
• that may be long enough to find the bottom;
• but it's going to take a rebuilding of household balance sheets, ie a lot of saving
• what we have now is a lot of dis-saving
• Mr Market is going to have to kick their teeth down their throats to change their behaviour

• hedge fund business now (compared to 1998) is much bigger and much more vulnerable
• with everyone forced to take the same trade, volatility intra-month so great that those investors who are committed to a month by month sharp ratio low volatility strategy will be forced to redeem and you get wild swings and illiquidity and inability to liquidate positions
• we're going to have a serial catastrophe of hedge funds
• particularly the type of fund that thought it was a great idea to buy loans at 90 cents to the dollar and won't be able to sell them at 80 later this year
  

• private equity can make money in this kind of market, if you're right and you willing to take massive volatility intra-month, and hang on for a year or two; you can do extremely well
  
• but if you have to grind out returns month by month, which is the conventional hedge fund model, you end up creating volatility because you're all in the same trade all the time and every turn is like a stampede out of a crowded theatre
  

• hedge funds are one of the major sources of volatility, and have become one of the major sources of risk
  

• the most important thing to keep in mind is: we have not had a credit crunch yet; we've had a 20% annual rate of increase of bank lending to corporations, and an even faster rate of securities purchases; we've had a credit bubble continuing
• this is because banks are contractually locked into make loans, largely revolving credits, which they can't get out of
• so the credit crunch is only begining to start
• we're now seeing banks cut off home equity lines to consumers, we're seeing the beginning of cut off credit card lines;
  
• but we had a spike in credit card usage because since the home equity lines were cut off, consumers used their credit cards
• the credit crunch is only now beginning because bank capital is so restricted by losses to date that they will have to begin shutting of credit to households and corporations
• and that's when we're going to get the defaults
• what we have had in aggregate is a credit bubble till today; a credit crunch is technically the wrong expression;
  
• the credit crunch is what comes next, and will be brutal compared to the mild indisposition we've had for the past 12 months
  

• financial institutions would be well-advised to try and clear their books as quickly as possible
• take the pain now because it will be more painful later
  

• SIVs are essentially a corpse waiting to be buried;
• you now have a highly ambiguous situations regarding all of the off-balance sheet assets of banks;
  
• the Federal Accounting Standards Board (FASB) was supposed to have ruled in a way that would force banks to take several billion dollars of asset-backed securities and take them out of off-balance sheet structures and consolidate them back on their books, which would increase the capital demands on the banks
• that was one of the reasons that financial stocks were in such hot water during May and June;
  
• the FASB turned around and postponed that ruling;
  
• obviously they looked at the distressed state of the banks and decided that it was a bad time to stress their capital base again;
  
• so a great deal of this remains under negotiation or in complete unclarity because the regulators, the FASB and the SEC, have not decided what to do about it
  

• if you marked everyone to market now, the banks would be in very bad shape;
  
• they certainly would have inadequate tier one capital, many of them would be insolvent
• wouldn't be the first time, the banking system might have been insolvent in 1990, also might have been in 1981
• so no one is going to mark the stuff to market;
  
• the question is can they generate enough earnings in order to bring in the capital back while they pretend that they're still solvent;
  
• but the problem is, as the rot gets into the consumer sector and the losses pile up from consumer loans and high yield loans, my view is their capital is going to be decreasing; instead of earning their way out of it, they're going to be piling up fresh losses
  

• the only hedge fund model that will work now is to be huge and have a lock on money for a long period of time;
  
• if you can take the courage of your convictions and ignore 10 or 20 or 30% down months in order to get 50% up years, then this is a good thing to do;
  
• and if you want to invest in hedge funds, find managers whose convictions you believe in, who are willing to swing for the fences, and will insist on taking your money for a period of time and have the courage to do it
• or keep it in treasury bills

• I believe that we're going to have an enormous taxpayer bailout for the GSEs and for a number of banks; i think it will look like the 80s, when we had a $700b bill for the S&Ls, but it will be larger

• in an economy where there aren't enough hedges, the price of hedges can be arbitrarily high
• what's the price of a last ticket on the Paris-Marseille express on the night of that the Germans march into Paris? The answer is how much do you have in your pocket;
  
• we may have a deflationary outcome, destroying huge amounts of wealth in the form of homes and equities and companies is in principle inflationary;
  
• the hedge against this in the form of commodity investing has turned out not to work that well in the last several weeks,
  
• and the signals that we're getting from the TIPS market - the break-even inflation rate between TIPS and coupons - has actually come in to the lowest in years;
  
• so we may have an inflationary environment