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THE BEAR BUST
The bear bust was a watershed event. In late June Bear Stearns was forced to bail out one of its subprime-mortgage-laden funds with $1.6 billion, and now says that fund and another are nearly worthless. That ended the era when most investors dismissed the cesspool of putrid debt as tiny and isolated.
Now they realize the subprime slime is spreading. From July through the end of the year $220 billion in subprime adjustable-rate mortgages will reset upward from low teaser rates, with many monthly payments increasing by 40% to 50%. Since subprime borrowers already spend 40% of aftertax income on housing, they cannot afford the resets. Plus, with house prices falling, they have negative equity and can no longer sell or refinance. So delinquencies and foreclosures, already leaping, will get worse and dump more houses on the market.
But wait, there is more. Speculators are walking away from tiny down payments on new houses and condos, forcing builders to ax prices and offer huge concessions. So home builder stocks are about to drop below book values. The supply of existing homes on the market, now equal to 8.9 months of transaction volume, is headed still higher. With 2 million excess homes built during the 1995-2005 realty boom, the forecast I made in my June 19, 2006 column of a 20% decline in the nationwide median sale price for single-family houses is probably optimistic, and would not even bring prices back to norms.
After the Bear Bust junk bonds sank, fear began to overshadow the factors that had propelled the high-yield market – the oceans of liquidity, zeal for yield and low volatility that produced minuscule spreads to Treasurys. The average junk bond fund lost 1.5% in June when investors reversed gears and pulled $1.6 billion from high-yield mutual and exchange-traded funds. Junk bond buyers forced Thomson Learning to slash its buyout-related offering from $2.1 billion to $1.6 billion and to drop its payment-in-kind toggle provision that would let Thomson replace cash interest payments with more IOUs if things went wrong. U.S. Foodservice twice restructured its takeover-linked financing plans and left its banks with $3.6 billion in potentially lethal bridge loans. Look for a big private equity financing, maybe for Chrysler or First Data, to fail and end the latest leveraged-buyout era.
Junk financing is necessary for buyouts, and buyouts were necessary for the stock market surge we have had in the past year. Buyouts put cash in equity owners’ hands and push up stocks as they anticipate the next takeover. But the game is ending. Junk often finances stock buybacks as well. The bull market cannot depend on earnings, now decelerating.
The biggest jolt from the Bear Bust is the realization that collateralized debt obligations (CDOs) – pools of debt instruments, especially mortgage-backed securities – are illiquid, trade infrequently and are carried on hedge fund books at what charitably can be called fuzzy prices. When Merrill Lynch tried to sell $850 million in CDO collateral for loans to Bear Stearns’s troubled funds, some pieces fetched bids of only 30 cents on the dollar. Highly prized on Wall Street until recently, CDOs, of which $500 billion were issued last year, are supposed to reduce risk. But they have been vastly overvalued by highly subjective and sometimes self-serving models. This approach is anathema to the S.E.C., which is investigating CDO prices and Bear’s troubled hedge funds. Meanwhile, investors are fleeing, the CDO market is drying up, and their yields are jumping as rating downgrades multiply.
Speculation has run rampant in recent years in real estate, commodities, private equity, farmland, the carry trade (borrowing in a low-yield currency, lending in a high-yield currency), emerging market equities and debt, junk bonds and leveraged loans. Subprime mortgages are the first category to collapse. Others will follow. Great pools of hot money in the last decade ended up on the same side of the same trade at the same time. When problems unfold in one area, speculators quickly retreat from others to preserve capital.
Look for U.S. consumers to retrench and precipitate a big recession, perhaps by year’s end, as the home equity that has supported their spending evaporates. Weakness will spread globally as they slash their purchases of imported goods. It is not too late to sell or short housing-related and consumer-discretionary stocks. Equities in general are vulnerable, as are industrial commodities, commercial real estate, emerging market stocks and bonds, junk and CDO-related securities and highly leveraged companies. And it is not too early to buy my longstanding favorite, Treasurys, in anticipation of recession, Federal Reserve ease and deflation.Link here.
Subprime pain spreads into office market.
The scrupulously groomed office buildings that blanket Schaumburg, the economic engine for Chicago’s northwest suburbs, boast abundant amenities such as parking, views, cafes and health clubs. But behind the gleaming glass and manicured lawns one critical element is becoming increasingly scarce. Tenants.
Signaling the seepage of residential real estate woes into the office market and perhaps other economic sectors, many housing-related businesses that for years have buoyed this slice of suburban offices have been giving back space they leased, industry experts said. “The downturn in the residential sector has spilled over into the commercial side as the mortgage lenders, title companies, real estate and mortgage brokers shut down or downsize,” said Doug Shehan, a senior director at Cushman & Wakefield Illinois.
Over the past several months the contraction of these firms has kept vacancy rates high, rents modest and building sales uncertain, he said. “It’s changed the landscape of the suburban markets dramatically,” Shehan said. “Now, what will be the next industry to absorb the space?” With job growth slowing in the metropolitan region, the answer might be a long time coming.
Clearly, the contagion of the housing sector’s ailments – defaults on home loans, Wall Street losses on real estate-backed securities and the tightening debt market – is to be expected because capital markets are interconnected, said Mark “Sam” Davis, senior managing director of real estate for Northbrook-based Allstate Corp. “The biggest source of capital for real estate now comes from Wall Street, with the same hedge funds that invested in subprime mortgages also investing in commercial property,” he explained. As a result, turmoil in the housing and debt markets has led “to the most volatile period we’ve seen in commercial real estate since the tech bust of 2001.”
How much this will hurt Main Street is another big question. “If enough companies vacate offices and put people out of work, the problem moves from a technical to a fundamental one for the regional or national economy,” Davis said.
Throughout metropolitan Chicago, job growth fell for the 12-month period that ended in May, to 44,200 jobs from 61,000 a year earlier, according to the Federal Reserve Bank of Chicago. But the pain is not restricted to companies in real estate. Businesses that provide their technology, accounting and marketing also might be feeling the pinch, said Faith Ramsour, Cushman’s research director. “Business service companies are signing fewer, smaller deals than in the past,” she said. This mix of dynamics will eventually lower office sale prices. Meanwhile, as fewer people buy lunch at noon or shop after work near suburban office buildings, the community as a whole could suffer. “The ripple effect could be very deleterious because no other industry is growing enough to fill the space,” said Geoffrey Hewings, an economics professor and regional job market expert at the University of Illinois.
For Schaumburg, which raises substantial revenue from local retail sales and Cook County property tax receipts, “this could be a great loss, and it still has to provide public services like police and lighting,” Hewings explained. Already, the problem is all too real for suburban landlords, especially those who borrowed heavily to buy buildings that were supposed to be filled with rent-paying tenants.Link here.
Hedge fund manager’s fun sailing away.
A hedge fund manager whose fund ran into trouble from the sell-off in securities backed by subprime mortgages is having to put his huge yacht up for sale, seeking $23.5 million. John Devaney, the CEO of United Capital Markets, a fund that specializes in buying and selling bonds that are backed by the mortgage payments, particularly adjustable rate subprime mortgages, has put his 142-foot yacht “Positive Carry” up for sale, according to a yacht broker’s Web site.
Devaney’s fund has run into trouble lately. A spokesman for the firm told Reuters on July 3 that it had stopped honoring request from some of its investors for redemptions, or withdrawal, of investments. The market for assets backed by subprime mortgages has taken a huge hit over the last two months, causing large losses by some top Wall Street firms, including Bear Stearns. Devaney told Money magazine this spring that despite problems that the loans cause for borrowers, the assets backed by them provided a good return for his fund. “The consumer has to be an idiot to take on those loans,” he said. “But it has been one of our best-performing investments.”
But with rising delinquency and default rates in the sector, investors have been scared away from the assets lately, hitting those like Devaney who made a big bet on the investment. According to the yacht broker’s listing, the yacht has accommodations for 10 passengers in its five staterooms, along with space for a crew of seven. The New York Post reported Monday that Devaney is also seeking to sell a home in Aspen for $16.5 million. But the sale of the yacht and the Aspen vacation home will not leave Devaney without any high-priced holdings. Money reported in May that he also owned a Rolls-Royce, a Gulfstream Jet, a 12,000-square-foot mansion in Key Biscayne, Florida, as well as a few Renoirs and a valuable 1823 reproduction of the Declaration of Independence.Link here.
Mr. John Devaney is an idiot. But without idiots, the graveyards and barrooms would be empty. And what kind of a world would that be? Thank god for them all. And so, we sympathize when an idiot runs into trouble ... fully aware that we could be the next ones to do so!
Poor Mr. Devaney is selling his 142-foot yacht for $23.5 million. But that is not the source of the discomfort. There are only two happy moments in a boat-owner’s life, or so it is said – the day he buys his boat, and the day he sells it. So, may Mr. Devaney will probably enjoy getting rid of the thing. Especially since the boat’s name is “Positive Carry”, and therein lies a tale. For the reason that Mr. Devaney is in the news is precisely because his carry went negative and his hedge fund, United Capital Markets, went into losses.
This is not the first time the man has made the news. He was quoted in the papers as describing people who took out subprime mortgages as “big idiots”. A moment’s reflection might have brought the opprobrium closer to home, for Mr. Devaney’s fund was buying up these big idiots’ subprime mortgages, on a grand scale.
That is the problem with today’s markets. It is so hard to figure out who is the biggest idiot. Surely, the fellow who buys a trashy barrack in a bad part of town using a subprime ARM is an idiot. Buying more of a house than he can afford, he is just asking for trouble. But so is the fellow who buys a whole inventory of these packaged mortgages – CDOs – asking for trouble. If they were bad for the borrower, sooner or later they are going to be bad for the lender. Making a loan to a guy who cannot pay you back has never been good business. But then, in order to buy more CDOs than he can afford, the hedge fund sharpie borrows money. Often, he will get even more leverage by means of the carry trade – borrowing yen or Swiss francs at a low rate and using the money to buy high-yielding subprime debt. As long as everything works out as planned, he will have “positive carry”.
And then, along comes an investor who puts his money in the hedge fund! And, get this, he pays the manager fees of “2 and 20” for the privilege of taking part. Is this guy an idiot, or what? Everyone is passing the blame buck. Rating agencies are now in the cross hairs of populist politicians seeking targets to blame for all of society’s woes. This pits “greedy Wall Street financiers” against the constituents whom they argue are the victims of the “predatory” lending business, including all of its key enablers, like the rating agencies. But nearly everyone lauded the glories of the great housing bubble, thinking that everyone could get something for nothing and we could all get rich by selling houses to each other. But now that it is payback time, few want to admit that we are still in the early stages of a prolonged housing recession.
The mathematician, Daniel Bernoulli, described why he was sure to be a loser, hundreds of years ago. On even odds, 50/50, if you keep betting you will win sometimes and lose sometimes, and go double or nothing each time, sooner or later you will be wiped out. If the hedge fund manager were merely making 50/50 wagers, he would win some, lose some. Each time he won, he would join you in the winnings. Each time he lost, you would be alone. Eventually, you would have nothing left. But hedge fund managers have an incentive to take much bigger gambles. Because, the bigger the bet, the more he stands to win ... and you stand to lose. If it goes right, he will get 20% of the pot. If it goes wrong – which it will, sooner or later – you will take all the loss.
We do not know exactly what went wrong with poor Mr. Devaney. Sounds like he was a bigger idiot than most. He seems to have invested in his own preposterous fund. Word is, he has put his house in Aspen up for sale too. For only $16.25 million, all 16,000 square feet of it can be yours.
What happens to these guys? Our friend, Nassim Taleb, took up the question. “Don’t worry about them,” he said. “A hedge fund manager who blows up his fund isn’t out of work for long. He just takes a vacation. The bigger the blow-up, the longer the vacation. Maybe he goes for a hike in the Alps if it is a small fund. A medium fund manager who blows up goes to climb Kilimanjaro. And a really big fund manager has to go to the Himalayas. But he has already sent out his resume, telling of all the great success he has had ... blemished by only one mistake. Usually, he gets a call to come back to work at another fund before he ever leaves the base camp.”
So do not worry about the idiots. As long as the credit boom is still going on Mr. Devaney will be all right. But don’t worry, dear reader. It’s only money.Link here.
9th largest U.S. mortgage lender to make “very major changes” to mortgage lending.
IndyMac Bancorp is making “very major changes” to its lending standards and may raise interest rates it offers on home loans because of a slump in mortgage securities, according to an e-mail to employees. The market for mortgage bonds has become “very panicked and illiquid,” CEO Michael Perry said in the e-mail. The Pasadena, California-based company will stop making certain types of mortgages completely, he wrote. “Unlike past private secondary mortgage market disruptions, which have lasted a few weeks or so, our industry and Indymac have to be prudent and assume that this present disruption, which appears broader and more serious, might take longer to correct itself.”
The additional credit tightening by IndyMac, the 9th largest U.S. mortgage lender, comes in a period when it is “difficult” to trade even AAA-rated mortgage bonds that are not guaranteed by Fannie Mae and Freddie Mac, or federal agency Ginnie Mae, Perry wrote. “The private secondary market is not functioning.”
Non-guaranteed securities linked to subprime mortgages to borrowers with poor credit have caused losses among hedge funds, insurers and banks from the U.K. and France to Taiwan and Australia. Other “major” mortgage lenders are taking similar steps this week, with “some leaving subprime, Alt-A, and other products altogether or restricting some products to only their own retail channel,” Perry wrote.
One area of product change is so-called piggyback mortgages, said David Stevens, head of a home-lending venture for Fairfax, Virginia-based realty firm Long & Foster Cos. “There’s just no market for” the second mortgages used in lieu of down payments or mortgage insurance, he said. “Nobody is taking them. They’re radioactive.”Link here.
A hedge fund stalks subprime’s next potential victim.
As America’s subprime-mortgage tempest spreads, Wall Street’s latest parlor game is to bet on who will be next to get caught in the storm. A fair few have placed their chips on the so-called monoline insurers, an obscure but important bunch who guarantee the timely repayment of bond principal and interest when the issuer defaults.
The two largest monolines, MBIA and Ambac, both started out in the 1970s as insurers of municipal bonds. In recent years, much of their growth has come in structured products, such as asset-backed bonds and the now infamous collateralized debt obligations (CDOs). The total outstanding amount of paper insured by monolines reached $3.3 trillion last year.
André Cappon of CBM Group, a financial consultancy, describes monolines as “rating agencies that put their money where their mouth is.” Arguably the keenest of credit-market observers, they extend their gold-plated credit ratings to paper they deem worthy of their protection, in return for a premium. The monolines’ share prices have tumbled this year as the depth of the subprime crisis has sunk in (see chart). The cost of insuring against their own default has shot up, prompting talk of a “monoline meltdown”. This week Ambac’s second-quarter profit missed forecasts due to a $57 million write-down on credit derivatives.
The industry’s tormentor-in-chief is William Ackman, who runs Pershing Square, a hedge fund. Mr. Ackman has spent the last five years, no less, telling anyone who will listen that the monolines are doomed, with MBIA particularly vulnerable. He points to their massive leverage: outstanding guarantees amount to 150 times capital. He also questions MBIA’s “aggressive” accounting techniques. Earlier this year the company paid $75 million to settle allegations that it used reinsurance contracts to conceal losses.
Amid the market’s jitters, other hedge funds are readily buying into this message. That may be all Mr. Ackman, who holds a short (bearish) position in MBIA shares, wants. But most analysts think his analysis is based on a misunderstanding. Monolines may be highly geared compared with traditional insurers. But, as Rob Haines of CreditSights points out, they are highly conservative in other ways. They model each transaction under a variety of high-stress situations and only accept those that show no losses in all scenarios. This may explain why they had little exposure to New Century, the biggest mortgage lender to go bust so far. Subprime makes up only 1-3% of their direct exposure.
To wipe out the monolines’ capital cushion, it would take a loss 20 times bigger than the hit they took last year. Even in today’s febrile markets that is hard to imagine, especially since the insurers are at the back of the queue when it comes to taking losses on CDOs. So, though losses may run into the hundreds of millions, they are unlikely to be big enough to deprive the biggest monolines of their cherished triple-A rating.
The monolines may lose business as investors turn their back on CDOs and other structured products. But MBIA’s finance chief, Chuck Chaplin, thinks the general confusion over credit risk may even help them, as more debt issuers seek comfort in guarantees. It remains to be seen if that optimism is, like Mr. Ackman’s pessimism, somewhat overdone.Link here.
Wall Street often shelved damaging subprime reports.
Investment banks that bundle and sell home mortgages often commissioned reports showing growing risks in subprime loans to less creditworthy borrowers but did not pass on much of the information to credit rating agencies or investors, according to some of those who prepared the reports. The mortgage consultants, known as due-diligence firms, were hired by investment banks to make sure blocks of mortgages conformed to the mortgage seller’s own standards. The studies provided a first glimpse of loan quality for ratings agencies and investors who do not normally see the full reports.
As the U.S. housing boom reached its crescendo in 2006 and investors showed a strong appetite for mortgages, lenders relaxed their underwriting standards, and millions of borrowers with poor credit records were able to obtain subprime mortgages as a result. Default rates on many of those subprime mortgages are now rising, some borrowers face foreclosure on their homes, and investors in the mortgages face losses.
“If all the information about these investments was properly disclosed, our client would have made different decisions,” said Dale Ledbetter, a Florida attorney suing Credit Suisse Group on behalf of an insurer that lost money on mortgage bond investments. “Specifically,” they would have “not bought these investments.”
Now some of the firms that prepared those damaging due-diligence reports say their work should be turned over to investors so they understand the underlying assets better. “I am sure there is a value in those reports,” said Joe Andrea, a partner with Opus Capital Markets Consultants of Chicago. But due-diligence firms like his are not empowered to release the reports, he said. While subprime mortgage security prospectuses warned about the perils of such loans in recent years, they did not enumerate the findings of due-diligence reports.
Ledbetter’s suit, filed on behalf of Bankers Life Insurance, claims that the investment bank failed to perform or disclose proper due diligence on the mortgages it sold to investors. One of those investments was downgraded five times from early 2005 to late 2006.
Several executives of due-diligence firms said they had reported a slide in loan quality to their investment bank clients but that those mortgages still had been bought up and passed on to investors. “In some cases we felt that we were potted plants,” said Keith Johnson, president of Clayton Holdings, a large due-diligence firm based in Connecticut.
During the housing frenzy, many Wall Street firms appear to have overlooked due-diligence warnings about problem mortgages in order to keep up with the market, due diligence executives said. As lenders relaxed their underwriting standards during the recent housing boom, Wall Street firms followed suit by easing the guidelines that due diligence companies followed, several executives said. “We got away from where we were in the late ‘90s,” Johnson said, referring to a time when due diligence firms were expected to give full-throated opinions on the safety of mortgage loans.
In the last two weeks, major ratings agencies have downgraded subprime mortgage investments and said they expected more such loans to borrowers with shaky credit would fail. Moody’s customarily receives summaries of due-diligence studies but not the full reports, which might have helped the ratings agency evaluate now-troubled mortgage securities, said Nicolas Weill, chief credit officer for Moody’s asset finance team. “It’s difficult to know what would have happened if we had gotten that information,” he said. Weill said that Moody’s would have welcomed due diligence reports if they had helped them learn something new about the mortgages.
Lehman Brothers and Bear Stearns, two major underwriters of mortgage bonds, declined to comment on how they handled due diligence reports. However, while due diligence reports may contain facts that ratings agencies seek, they might not be interested in seeing the reports, said Josh Rosner, a housing analyst with Graham Fisher, an independent research firm in New York. “The International Organization of Securities Commissions code of conduct requires that they use all available information in their ratings process,” he said. “To require them to look at due diligence would move them to another level of responsibility.”
Mortgage securitizers relaxed their due diligence tests during the housing boom just as lenders loosened their loan standards during that time, but all sectors of the market are retrenching now, Johnson said. “We are in a correction process right now,” he said. Deutsche Bank and Morgan Stanley accounted for nearly a quarter of Clayton revenue in 2006, according to the company annual report. Both firms declined to comment on what they do with due-diligence reports.Link here.
THE COSTS OF MODERN FINANCIAL THEORY
In the past week, a number of leveraged buyout transactions have fallen apart, whether temporarily or permanently one cannot yet say. The Alliance/Boots buyout in Britain, Cadbury Schweppes’ sale of its U.S. drinks business and the Chrysler buyout in the U.S. are just the best-known examples of multi-billion dollar transactions that cannot currently get completed. Naturally, these and other failures impose costs on the participants, but they raise a more fundamental question: How great are the costs imposed on the world by modern financial theory, in which debt financing is preferable to equity?
The 1958 Modigliani-Miller theorem (MM), one of the fundamentals of modern corporate finance, states that corporations should be indifferent as to whether they issue debt or equity. Of course MM rests on a number of assumptions about perfect markets and rational investors which are twaddle in the real world, but that does not stop professors from teaching it, and greedy corporate managers, investment bankers and buyout artists from using it to justify their nefarious schemes. The Theorem has a further pernicious effect in treating managers as impartial arbiters of capital structure, rather than the representatives of shareholders they are paid to be. By treating debt and equity capital equally, it divorces equity capital from its true function of ownership and management from its true function of stewardship on behalf of the owners.
It follows from MM that in an environment such as the U.S. in which corporations are taxed but debt interest is tax deductible, it is optimal to load up the balance sheet with as much leverage as the banks and the capital markets will give you. That maximum in recent years of mild steady economic growth and over-liquid capital markets has in practice been pretty close to 100% of your capital employed, plus a bit extra for management stock options and investment banker fees.
The result of MM has been to leverage up corporate balance sheets far beyond the point at which operations are damaged and the costs ignored by the Theorem exceed any putative benefits. The beneficiaries of this are of course corporate management, who by indulging in unnecessary and expensive share buybacks can minimize the earnings dilution caused by their own excessive stock options grants. Cisco, the doyen of the tech sector in the late 1990s, has cleaned up its act since the millennium, but even so in the year to June 2006 it spent $8.3 billion, more than its net income of $5.6 billion or its operating cash flow of $7.9 billion, to repurchase 435 million shares. At the same time it issued 230 million shares through management stock options and allowed the exercise of 136 million stock options at an average price of $10 per share. Thus Cisco’s entire operations for that year, employing many thousands of highly skilled employees, were as far as its shareholders were concerned more or less futile.
In my business school days, after MM had been promulgated but before it became ubiquitous, we spent a great deal of time trying to determine the optimal capital structure for a company. This was done by examining the company’s expected profitability and cash flow in a moderate sized recession, and then determining the level of debt which could be serviced by the company in that recession, given the need to keep banks and capital markets open to the company for necessary capital spending and possible expansion. (Generally, it was thought that except in brief moments of panic a ratio of 2 to 1 between the company’s pretax income and its interest payments was sufficient to maintain civilized relationships with financing sources.) We all recognized that debt was cheaper than equity, particularly after tax was taken into account, so the optimal structure was that which maximized the amount of relatively cheap debt, while maintaining financial flexibility in a recession – generally with a margin of safety which varied with the conservatism of the person doing the calculation. In principle quite simple, likely to preserve companies through all but the worst recessions and prevent bankruptcies unless something went severely wrong on the operating side.
Post-MM, this has all gone horribly wrong. Management does not care too much whether the company survives the next recession. It wants to maximize its own returns before that recession hits. Private equity owners care still less. They want to asset-strip the company, cut costs as far as they dare and sell it, before the recession hits. (Incidentally, one can indulge in hollow laughter when reading in the Wall Street Journal that private equity funds are now trying to speed up the process of cutting costs and selling companies.)
Private equity owners and corporate management now prefer debt, even in jurisdictions where the tax treatment of debt interest does not give it an advantage, e.g., Britain, where only retained earnings are taxed more heavily. In a well adjusted financial system, that would encourage corporations to pay out 100% of their earnings as dividends. In an MM world, management loads up with debt anyway.
So what of the deals which are falling apart? To what extent has the Theorem imposed additional costs on the economy, by leading buyouts to be attempted that should have been left alone? In the case of Chrysler, it is not surprising that the buyers cannot get the financing deal done. Automobile manufacturing is an extremely risky business, particularly for a company which is a laggard in its home market. Chrysler would only be viable if financed entirely by equity, probably as part of a much larger group, but its pension liabilities made it unattractive for any such group to invest in. The LBO deal was thus a complete waste of money, transferring fees unnecessarily to investment bankers and eventually causing losses to the providers of bridge financing, but beyond that it did not significantly alter the company’s likely destiny.
In the case of Cadbury Schweppes, there is a race against time before the onset of tighter money hits. Many business situations face this race against time, for example real estate projects which need to be financed and leased before the next downturn. In Cadbury Schweppes’s case however the impending downturn is the company’s friend not its enemy. If conditions in the debt markets remain favorable, the company will be forced by the fringe operator Nelson Peltz to split its Cadbury chocolate and Schweppes drinks businesses, product of a 1969 merger that made excellent operating sense then and subsequently. Doubtless the Cadbury business itself would then be subjected to a leveraged buyout, which might create value for shareholders but would certainly destroy a company founded in 1824. If on the other hand the debt markets close, so that the spin-off of beverage businesses is not merely postponed but canceled, then the company will be safe from predators and will be able to resume its centuries-long history of high-quality and ethical business. MM’s cost in the latter case will be modest – just a few unnecessary legal bills and maybe some investment banking fees. If Cadbury Schweppes is broken up, the Theorem’s long term cost will be far higher than any possible saving from cheaper financing.
In the case of Alliance Boots, the acquired company was a highly profitable pharmacy and retailing operation, established in 1849 and probably good for another 158 years if the leveraged takeover and buyout industries had not intervened. It had already merged with Alliance Unichem in 2005, to the benefit of nobody very much beyond the managements concerned, so was a vulnerable target when the private equity industry came looking for assets to buy. Since the financing has run into difficulties and much of the Boots operating top management has opted to leave the company, notwithstanding the immensely attractive remuneration packages being dangled before them, it is likely that this buyout will turn into a disaster, particularly if as seems likely a recession intervenes. Boots will be transformed from a huge and profitable retailing company into a husk of its former self and large numbers of British high streets and shopping centers will be landed with the problem of a large “anchor” space for which the occupant has gone out of business. The damage to real estate values, employment and community coherence from Boots’s disappearance will be very substantial indeed. THAT, not a percentage point or two on debt financing costs, is the true and ultimately hidden cost of the Theorem. Like most such second-order effects, it is ignored by simplistic academic nostrums.
As a final example, the Sainsbury and Bancroft families, founders and controlling owners of Sainsbury’s and Dow Jones respectively are being advised loudly and persistently by Wall Street and its friends in the media that they should stop resisting the “raider” bids for their family companies and devote the cash proceeds from a sale to the usual wasteful if not destructive charitable activities. Can there be any doubt that the unique positions in their industries of both the British supermarket chain Sainsbury’s (founded in 1869) and Dow Jones, publishers of the Wall Street Journal (founded in 1882) would be severely damaged if not destroyed by the fast-buck operators, ignorant of the acquired operations’ traditions, who would be put in to manage them by the new owners? It currently seems likely that only family recalcitrance, hopefully accompanied by the emergence of unexpected financing difficulties, can stop these deals going through. As before, MM’s views on capital structure and its elevation of theoretical return over all other considerations are likely to prove hugely damaging and costly to real-world businesses of enormous value.
Blackstone’s shares are now trading at over 20% below the private equity fund’s IPO price, and it is rumored that the IPO for KKR, the granddaddy of all buyout titans, will be canceled. Thus if the current difficulties in the financing market are extended we may see the end of the insane fashion for leverage and quick profits that has been so damaging to both the British and U.S. economies.
Roll on, recession!Link here.
THE FIRST AND THE BEST
With this column I pass Joseph D. Goodman to become the fourth-longest-running financial columnist in Forbes’s 90-year history. Joe wrote for a 23-year stretch that ended in 1958. For me, this lap on the track is sweet and bitter. Sweet because I relish a quest to become Forbes’s longest-running columnist. Bitter because I have always believed Joe was the best Forbes columnist, ever. He was also the first. He made and broke the mold.
Stock columnists were not common when he began writing here, three years away from the bottom of the 1929-32 market crash. Joe was way ahead of his time. Handpicked by his friend and this magazine’s founder, B.C. Forbes, he kept up the column for four years after B.C.’s death, in 1954, until his own death, at the age of 64. Joe was stunning with market direction, sector picks, stocks – and words. He called the 1937 peak. He envisioned World War II well before it was in the market. He was bullish in 1949, at a time when stocks were very out of favor but poised to quintuple in the space of seven years. In the June 15, 1956 issue of forbes he nailed the top almost perfectly, just a few months after its peak. By early 1958, as the market was bottoming, he was bullish again. When he died he went out on top, riding high.
He created lines that became famous in finance:
He had his own way of seeing things. He said that you should buy a stock that will not go down in a bear market because it will probably lead the next rise. Just so, he feared stocks that would not rise in a bull market. They did not look like bargains to him. They looked like trouble.
Some pros go by the adage, “I get rich selling too soon.” He worked the other side of the price chart, aiming to sell two or three months after a bull market was over. I learned from reading Joe not to precall market peaks. Those who do are often run over. There is always plenty of time to get out. For two decades I have seen Joe Goodman as a virtual mentor, even though I never met him (and was 8 when he died). As I now outlast him, I offer five stocks I hope he would have liked now.Link here.
INTEREST RATE BLUES
Income investors worry about two things. One is interest rates. The other is defaults. Keep these two risks separate in your thinking and you can decrease the volatility of a fixed-income portfolio. The first risk is that interest rates rise after you buy a bond. That sends the market value of the bond down.
This risk is greater on long-term bonds than on bonds due in just a few years, greater on noncallable bonds like Treasurys than on bonds that can be called in early by the borrowers, and greater on bonds with small or zero coupons than on bonds with big coupons. It is a palpable risk. Since January the rate on the 10-year Treasury has climbed from 4.7% to 5.2%, with investment-grade corporate bonds falling in lockstep. Someone who bought a 10-year Treasury six months ago has witnessed a 4% decline in its value. The interest payments in the meantime have not been enough to make up that loss. The total return on this security is negative.
Worth losing sleep over? If you bought the bond for income, you do not have any out-of-pocket loss at all. You will get all the coupons and your full principal back in 2017. You might have regrets when you realize you could have bought the same bond cheaper. But yours is not quite the loss of a copper speculator who buys a future at $3 and gets closed out six months later at $2. This fellow has indeed suffered a permanent loss.
If you typically buy a bond for its income stream and hold until maturity, you do not need to sell into a bear market, as mutual funds do – especially the junk bond funds. For now keep your spare cash in money market funds until the yield curve steepens. I think that a further rise on the 10-year rate from 5.2% is likelier than a return to 4.7%. So I would shorten my bond maturities. But do not let rate risk scare you out of fixed-income investing altogether. Learn to live with rate fluctuations.
Defaults are something else to think about. The risk in junk bonds is worth taking if you are selective. If the coupon yields on a junk portfolio are high enough, they will make up for an occasional loss of principal. At the moment, however, junk yields are not high enough. The spread between yields on CCC corporate issues and 10-year Treasurys dropped from 7.73 percentage points in December 2005 to 5.2 in mid-July. For that reason I advise you not to buy junk now. Investors are going to be fleeing this sector, not least because of a spillover effect from defaulting subprime mortgages. Prices will be under pressure even before corporate borrowers start defaulting.
Where do you go when rates on Treasurys are inching up and prices on conventional junk bonds are likely to fall? My strategy at a time like this is to look for high-yield income vehicles linked to the stock market or to energy prices as the income drivers. For stock-oriented exposure, go for convertibles, which are bonds and preferreds that can switch into company stock at a set price, paying interest in the meantime. Two issues I like are convertible preferreds, both of them below investment grade: General Motors 6.25% and Ford 6.5%. Both issues offer a high current yield: 6.5% for the GM preferred and 8.3% for the Ford. Both offer an opportunity to share in a likely stock-price surge once labor negotiations are concluded this September. Note that Ford is trying to buy-in this $5 billion issue by offering $40 in stock. This offer is way too low. Ford will have to sweeten the pot for it to work.
Another income driver, which I have been advocating here since 2004, is Canadian oil and gas trusts. The Canadian government moved to tax them starting in 2011, and it appears that this threat will be realized. The impact should be minimal, given the tax offsets most trusts are building up. Oil prices recently crossed the $70-per-barrel line. The consensus is that as long as oil stays above $60, the trusts’ monthly dividends will continue to flow nicely.Link here.
SERIOUS IMPROVEMENTS IN AUTO FUEL ECONOMY SOON
The car companies are beginning to make fuel-saving technology a standard feature. They are also pushing more-radical projects that could change our world. But even if those radical dreams fail, we are going to see serious improvements in fuel economy soon, from things like these:
Slicker transmissions. Most of us have 4- or 5-speed automatics in our cars. The higher the number, the better the fuel economy and the smoother the shifting. Well, 6-speeds are becoming common – saving probably 4% to 7% over a four-speed – and I expect to see transmissions with 7 and 8 speeds moving out of the luxury class. Better, there is another transmission, using a so-called dual clutch, now found in Volkswagens and soon to come to Chrysler cars. It acts like a manual in saving 5% to 10% in fuel, but it works like an automatic as far as drivers are concerned.
Start/stop systems. These cut off the engine when you are stopped at a traffic signal. Saves fuel in city driving. I predict these will be common in a few years.
Cylinder cutoffs. These enable a V-8 to run on four cylinders when it does not need to deliver a lot of power. That saves fuel in highway cruising. Cutoffs are on a few vehicles now, but will become common, especially on V-6 engines that will cruise on three cylinders. Chrysler says they will save 6% to 8% in fuel. Computer controls that monitor fuel use, the variable valve systems, are becoming more sophisticated, and new engines are being designed for these systems. They were developed by the Germans and Japanese but are now coming into our Detroit cars.
Hybrids. GM and Chrysler will have hybrid engines on some of their biggest SUVs this fall, and the use of hybrids will spread. They are expensive, but prices will come down with manufacturing experience. More likely, higher gasoline prices will be their sales strength.
Diesel engines. These, common in European cars, slice around 13% off your carbon footprint. GM, Ford and Chrysler all promise to start using diesels by 2010 on large pickups. American consumers bought next to no diesel vehicles last year. The diesel is an expensive engine – I am guessing $3,000 to $5,000 more. Honda says it will have a diesel for small cars in a couple years that will meet our pollution rules without costly add-ons. That would be a breakthrough.
It takes years to get production up on new transmissions and engine modifications for millions of cars. They start on a few models and spread. That is the way the auto industry works.
There are efforts to give gasoline engines diesel-like fuel economy (25% to 30% better). Ford says it will have such an engine, with two turbochargers, on a new Lincoln at the end of this year. The more far-off dreams include efforts to build a plug-in hybrid, which could let you do your commuting and shopping without consuming any gas while still having the gasoline engine for long trips. Hydrogen fuel cell cars might be practical in a few decades. If the hydrogen came from a nuclear plant or windmill, it would spare the atmosphere.
What about putting today’s cars on the South Beach diet, lightening them by hundreds of pounds and going to smaller engines? That would work, but no one goes that way – not in Detroit, Wolfsburg or Toyota City. Buyers will not accept a smaller version of the car they have. If a car is going to be smaller, it must be something new. Thus Honda brings in a small model called the Fit instead of making its Civic smaller. GM seems happy getting its smallest cars from Korea, and Chrysler talks about building one in China.
Detroit needs to do a better job of trumpeting its environmental successes. Does anyone remember the Mobil Economy Run? It was a race, sponsored by the old oil company, in which the winner was the vehicle that got the most miles per gallon. It was last seen in 1967. Maybe it is time to start it up again.Link here.
HYDROGEN POWER ON THE GO
Think of it as a briefcase for electricity. Houston-based Trulite is developing a portable hydrogen-powered generator, the KH4. Pour water into the unit, and it will crank out 150 watts of power, and 200 watts at its peak. While that will not run your house, it is enough to recharge power tools or a laptop or run a small appliance, according to company CEO John Goodshall.
A target audience for the device will be contractors, particularly ones who work on downtown skyscrapers. Power tools regularly sap their batteries. To get around the problem, contractors either carry spare batteries, which can be expensive, or recharge them with gas generators. The fumes and noise of the gas generators, however, are often incompatible with downtown building requirements. Thus, Trulite hopes that contractors will opt to carry its unit instead. And for those people who bring a generator to a campsite to watch TV? A portable hydrogen generator will eliminate the noise.
The active ingredient in the fuel cell is sodium borohydride. The material splits water molecules into hydrogen and oxygen. The hydrogen is then pushed through a membrane that extracts electrons. The sodium borohydride also stores hydrogen safely. Others are also working on similar solid storage systems for hydrogen. Once the fuel of the future, hydrogen now gets regularly panned by critics as being expensive and impractical. Advocates, however, say it could become an important green fuel when batteries or solar electricity are not practical.
Hydrogen may be a niche, but its advocates are not giving up. Horizon Fuel Cell Technologies, for instance, is promoting hydrogen fuel cells as a way to power boats on Swiss lakes. Others have speculated that offshore platforms – decades from now – could harvest wave and tidal energy, turn it into hydrogen, and then ship it to shore. Toyota and Daimler-Chrysler continue to research hydrogen cars.
Trulite will release beta units soon, and the company hopes to start selling the KH4 in the second quarter of next year. The unit will cost about $2,000, which is far more expensive than a gas generator. A more powerful gas generator can be bought for $300.Link here.
GENERATING ELECTRICITY FROM BACTERIA
Wired reports that as part of a school science project, a high school student has conceived a new way of generating electricity. It is so simple anyone could have done it. It is tiny, yet may have big applications. Montreal high school student Kartik Madiraju reasoned that since some bacteria are magnetic, they should be able to serve as a source of electricity. His experiment generated half the power of a normal AA battery with 1/5 oz. of bacteria. The “battery” kept producing for two days before wearing out. Amazingly, no one had ever thought to do this before.
Magnetic bacteria are distinguished by the fact that they include magnetite. They were discovered just a quarter century ago and are naturally occurring in all kinds of water. (The fact that such a widely dispersed class of organisms could have just been discovered recently should also give us pause.) Future Dr. Madiraju devised an experiment in which he placed water filled with bacteria into tiny boxes. Each box is surrounded by electrically conductive metal strips on two sides. The metal strips interact with the “magnets” between them, causing the box to spin. This generates the electric current. The experiment was vetted by professor John Sheppard, a bioresource engineer at McGill University. “I am optimistic about the practical applications,” said Sheppard. He expects it to eventually serve as a power source for nanotechnology devices with limited life and in biosensors.
As a practical matter, this is rich with potential. The bacteria used were selected almost randomly from the widely available types. Now that the phenomenon has been proven to work, it is a safe bet that researchers such as Dr. Sheppard will actively seek to identify the best naturally occurring bacteria for these “batteries”. Following that, the next logical step is to genetically engineer optimized organisms. There is almost certainly an ideal percentage of magnetite in each bacterium, and it is improbable that nature happened to provide it – since these creatures did not evolve to be batteries. Such optimization should at least double the power output. While a single AA battery may not sound like much, the “real estate” required is only a cube about 1/5 cubic inches in size. Such cubes may or may not be the optimal configuration, representing a further opportunity for optimization.
An additional opportunity lies in researching the “shelf life”. It may well be true that the bacteria died due to lack of continuing nutrition. A colony supplied with ambient food might be self-replicating and effectively immortal. Regardless, the energy density is clearly comparable with that of commercially available alkaline batteries, potentially at far lower cost. Also, the “batteries” can be stacked and the power output added together for far greater power needs. I can envision a scenario in which they are housed in lattices by the thousands, with special nutrient water continually washing all of the cubes to keep the bacteria healthy and productive.
In addition, it may be desirable that the bacteria die after a short time. This could make them an ideal power source for tomorrow’s implantable nanotechnology devices, causing the nanites to shut off after a few days. The era of microscopic machines is coming. It will be interesting to see the mix of technologies that wind up powering these tiny devices.Link here.
SOUTHERN CALIFORNIA’S REAL-ESTATE TAILSPIN
If Wall Street wants to get even more worried about the real estate market, it need look no further than southern California. There, the culprits are not just the bad-credit borrowers whom banks and lenders loaded up with ballooning debt to purchase their dream homes. The well-to-do have partaken of those treacherous loans as well. And now everyone is hard-pressed to pay as interest rates rise.
Up to now, the booming housing markets in Los Angeles, San Diego and Orange counties had barely felt the chill that hit Miami and Denver from rising inventories, declining prices and slowing sales. But this week’s spate of gloomy housing data included ominous reports from the West Coast. Led by an astonishing 799% rise in Los Angeles County, foreclosures in southern California jumped 725% in the second quarter, to a record 9,504, from 1,152 a year ago. The spectacularly bad trend was coupled with news from mega-mortgage lender Countrywide Financial that homeowners with good credit are starting to fall behind on mortgage payments. It has all contributed to a contagiously pessimistic mood. “We thought the upper end of the market was immune,” says Steve Johnson, of real estate consulting firm Metrostudy. “But this is now like kudzu in the South, spreading into all product types in the southern California housing market.”
The statistics show that subprime-caliber borrowers were not the only takers for those notorious no-money-down, interest-only, adjustable-rate mortgages. Purchasers with high credit scores, who could have qualified for the standard 30-year mortgages, were also enticed by the exotic loans because they offered substantial initial tax deductions and freed up cash for other big-ticket purchases. “Why pull your money out of the bank for a down payment when someone is willing to give you all the money and structure payments that initially are significantly lower?” asks Johnson. With home values increasing by double digits annually, “people began buying houses they couldn’t afford under the theory that the more house you buy, the more wealth you have once it appreciates,” he says. “It’s kind of a Ponzi scheme on a mass scale. But there has to be an end at some point.”
Bill Santoro, a broker with National Realty Group, has watched the end come for many clients, and it is not pretty. “Once those introductory rates end, all of a sudden between the mortgage, the new car note and the big charge card payments, there’s not enough money in the pot,” he says. “It throws them into a complete tailspin.” Santoro’s territory, known as the Inland Empire, lies some 60 miles east of downtown Los Angeles. Migrant Angelenos found bigger homes on bigger lots in brand new subdivisions for as much as $100,000 less. Johnson says that in some of those developments, as many as 80% of the buyers were subprime borrowers and many of them first-time homeowners. Consequently, when interest rates started to rise, they were squeezed hard. Now the region is a symbol of the real estate slump.
Foreclosures in San Bernardino shot up 987% to 1,489 in the second quarter. In Riverside they jumped 793% to 2,509. That stock will soon be competing with a 13-month supply of unsold inventory that is already on the market. Santoro is braced for the worst. “There’s a tsunami coming and we’re going to get slammed,” he says. And while economics is always local, economic nervousness can go national – even global – in a matter of hours, as recent financial events have shown.
Could the Inland Empire’s contagion debilitate L.A. and areas beyond? So far, property experts are still trying to put a positive spin to it. John Karevoll of DataQuick, a company that compiles real estate information, points out that the Los Angeles County foreclosure figure is still well off that region’s previous peak of 11,494 recorded in the third quarter of 1996, during southern California’s last real estate collapse. And he is encouraged that activity at the very high end of the L.A. market hasn’t fallen off, that home prices in the county overall continue to rise and that job growth is “pretty good”. Still, even he admits that the subprime crash has plunged the entire real estate sector into uncharted territory. “Will it create a flood of foreclosures that drags down values in the rest of the market? So far it hasn’t, but at some point, it might.”Link here.
S&P PAINTS A GLOOMY PICTURE FOR BIG BANKS
Global banks are well-placed to withstand the weakening in credit markets but could face a squeeze on revenues if the situation worsens, according to a report by Standard & Poor’s, the ratings agency. S&P warns there is “no room for complacency” and says ratings will come under pressure if there is a harder landing in the leveraged finance market. The “golden age of leveraged finance volumes and returns” is now at an end, it adds.
Several takeover deals have hit problems recently as investors avoid leveraged buy-outs in the wake of the collapse of the US subprime mortgage market. Banks suddenly find it harder to syndicate tens of billions of dollars of debt for deals such as the takeovers of Chrysler and Alliance-Boots. Cadbury -Schweppes has delayed the sale of its U.S. drinks arm.
S&P says an upturn in defaults “cannot be far away”. Banks could – if the situation worsens – see “sizeable losses” relative to earnings and capital. In terms of revenues, they will no longer receive such substantial underwriting fees from leveraged finance activity. Banks may also face litigation from investors, according to Richard Barnes, author of the S&P report. His comments follow a warning by Peter Wuffli, former chief executive of UBS, that the leveraged finance boom could drag banks into litigation if the cycle turned.
S&P says the leveraged finance market had been “ripe for a correction” with “frothy” underwriting criteria, and new issuance skewed towards higher-risk assets. But the jury is out on whether the correction marks a return to rational pricing or a downturn.Link here.
THE SILVER ROAD
Two years ago, I was strolling along cobblestone roads of Lijiang, a little city in China that is poised at the southernmost end of the Himalayas. The cobblestones of Lijiang form part of the ancient Silk Road. But it dawned on me that day that “Silk Road” is a misnomer. Its proper name should be the “Silver Road”. For if you view this famous trade route from an Asian perspective, Silver Road is exactly what it was.
Let us envision this mysterious part of the world as Marco Polo would have found it, in 1280 AD, at the age of 20, when he arrived in China with his father and uncle, both Venetian traders on their second trip to the Middle Kingdom. We think of silk and tea when we think of the China of that era, but the Polos also encountered a magical cleaning cloth that could be itself cleaned by throwing it on the fire for a bit – asbestos. And that was not all. China had an iron manufacturing industry whose output would not be equaled by Europe for another 500 years; an Imperial Post Office, with second-class, first-class and Royal Priority Mail services; a complex, canal-based transportation system; and a prodigious salt-manufacturing industry. (Salt, before the invention of refrigeration, was a commodity almost as precious as gold.)
Over the Silk Road, the Chinese shipped goods and technologies like silk, gunpowder, spaghetti, ceramics and tea. The Europeans – still largely feudal, agrarian and caught up in internecine warfare – had neither the will nor the skill to produce these goods. But mercantile China was not giving this stuff away! The accepted means of payment was, of course, gold or silver. Particularly silver.
China’s love-affair with silver as money predates recorded history. Silver was informally monetized by 475 BC, and was officially declared the currency of the land by the Yuan Dynasty, which commenced in 1279. Silver remained China’s official money until well into the 1930s, when the Middle Kingdom became the last great civilization to cave into the seductions of fiat money. Over the ensuing centuries, commerce between East and West was so intense that by the year 1800, China wound up with half of the world’s silver! Even with Europe’s new-found silver and gold in the New World, they could not keep up with their payments.
This situation was the source of considerable pain to European pride and solvency. So the British decided to get into the dope-peddling business. The famed tea trade between Britain and China, and China and the Americas, those great Clipper ships, were not built just to haul tea. No, they were introducing sweet, addictive, stupefying opium from India and Pakistan to the population of China in order to get their silver back. It had devastating results. Hence China was unable to enforce its ban against opium trafficking.
Its money and its youth threatened, an infuriated China outlawed opium in the early 1800s. But mercantile China, used to thriving on peaceful trade and innovation, rather than war and conquest, was at a total loss to confront the Royal Navy, which sailed and later steamed to Chinese ports escorting boatloads of British merchantmen larded with the dreaded drug. By the 1830s, writes historian Richard Hooker, “[T]he English had become the major drug-trafficking criminal organization in the world; very few drug cartels of the twentieth century can even touch the England of the early nineteenth century in sheer size of criminality. Growing opium in India, the East India Company shipped tons of opium into Canton [now Guangzhau] which it traded for Chinese manufactured goods and for tea. This trade had produced, quite literally, a country filled with drug addicts ... The effects on Chinese society were devastating.”
The imperial government made opium illegal in 1836 and began to aggressively close down the opium dens. To enforce its prohibition (and its sovereignty) China sent a rag-tag fleet of junks out to intercept a British opium shipment in Canton in November 1839. An indignant Queen Victoria dispatched the Royal Navy to exact revenge. For two years the Royal Navy mercilessly hammered China’s shore batteries, ultimately prevailing. Humiliated by this defeat, China signed the Treaty of Nanking in 1842, followed a year later by the British Supplementary Treaty of the Bogue. These provided that the ports of Guangzhou, Jinmen, Fuzhou, Ningbo, and Shanghai should be open to British opium trade and British residence. In addition Hong Kong was ceded to the British. Sensing blood, France, Russia and the U.S. all piled in with similar treaties granting similar access. In essence, the West subdivided the Middle Kingdom.
It took China nearly 100 years to shake itself from the stupor of the opium trade, during which period China endured the hideous predations of the Japanese during the 1930s and 1940s, and later the savagery of Mao Zedong, both of which served virtually to wipe out China’s cultural and intellectual best.
Yet here we are, a mere 31 years after Mao’s death, confronted with a new China, vigorous and increasingly prosperous – teaching the West once again, as it has for two millennia, how to play the trade game. And once again, we Westerners are not learning very well. The U.S. annual trade deficit is now running at a rate of more than $750 billion annually, or 6.3% of GDP. The U.S. depend on foreign bond buyers to finance domestic consumption. Asian countries produce low-cost goods which are shipped to the U.S., the U.S. ships dollars back to Asia, and then the Asians purchase U.S. treasuries. Anthony Fell, formerly vice-chairman of the Royal Bank of Canada, had this to say about this:
“One could say this is a giant international Ponzi scheme. I don’t think this model is viable or sustainable. Asian central banks will not want to accumulate U.S. dollars at the current rate forever. There is no free lunch. Virtuous circles like this, where everyone appears a winner, always come to an unhappy ending.”
But an unhappy ending for the U.S. dollar could produce a very happy ending for silver. A comment one often hears from people returning from their first visit to China is, “Better teach your grandchildren how to speak Chinese.” I submit that there is an alternative to having to learn all the multiple dialects of Chinese: Learn to speak Silver, the ancient and modern money of China. If you are in possession of real money, silver, then that is all the Chinese you will ever need to learn.Link here (scroll down to piece by David Bond).
LET THE BUYER BEWARE
“Cheap money policies have allowed us to continue to borrow. We have taken this money and maintained or increased our rate of consumption and purchased assets. The swell in dollars has created a swell in demand. While consumption prices have stayed low because of globalization, asset prices have inflated greatly. The primary effect of asset inflation can be seen most clearly in real estate prices, yet the stock and commodity markets reveal this as well. As our borrowing capacity begins to tap out, who will keep inflating these asset prices? If we are forced to pay down debt and thus have less money to buy assets and consume, is the next major obstacle inflation or deflation? Every investor will witness the answer to these questions. Our history, and that of Japan’s, teaches that asset classes and investment strategies work very differently in long-term deflationary cycles. The real question is whether we, as individuals, will prepare now or be caught off guard at some point in the future.” ~~ From “The Great Inflation Illusion: A Historic Perspective”, Doug Wakefield
When I produced this article in May 2005, the Dow had moved down almost 1,000 points in six weeks. The retracement fit a nice ABC pattern, and everything looked as though we had seen the final top. With two years passing since, this obviously was not the U.S. equity market’s top, but it was the top for the housing sector of U.S. equity markets. This was the first warning that a long-term, deflationary trend was beginning to set in. [The housing chart can be found on page 6 of our July 2005 newsletter.]
In the last several weeks the reason that equity markets have floated higher has started to surface. The parabolic rises that we have been seen in most of our major markets the world over has come from maniacal growth in the money supplies of the same. The price of which has been a deflating U.S. dollar and Japanese Yen. Though the BIS 77th Annual Report, which was released on June 24th of this year, does not pinpoint the reason, they do note the effect this has had on many of the world’s stock markets:
“It could be suggested that the market reaction to good news might have become irrationally exuberant. There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral, and in turn, more risk-taking.”
The recent reaction of various equity markets should have come as no surprise. Yet, since the major equity indices have been disconnected from reality for sometime, many were likely caught off guard. Still, those who took note of the weakening trend in the brokerage or banking sectors over the last few months would have known that when this is the case and the headlines read, “Dow at All Time High”, something is indeed wrong.
Undoubtedly, many buy-and-hold investors and advisors have been struggling to explain this recent “dip”. And as they sit, waiting for the next rally which is surely just around the corner, we remind the reader that “buying on the dip” this go ‘round could prove to be as costly as it was for the 2 1/2 years that the Dow fell from 11,750 to 7,197.
If after watching the Dow drop more than 500 points in 5 trading days, after hitting its all time high, you are beginning to think critically about what the markets may do next, consider these comments from previous commentaries.
Dr. Benoit Mandelbrot, known as “the father of fractal geometry”, authored a book called The (Mis) Behavior of Markets (PDF), which we used as a resource in our September 2006 issue, “Too Costly to Bear”:
“‘The size of the price changes clearly cluster together. Big changes often come together in rapid succession, like a fusillade of cannon fire; then come long stretches of minor changes, like the pop of toy guns.’”
Those receiving conventional buy-and-hold advice from their brokers and advisors should be leery. We referenced Barton Biggs’s, former Chief Global Strategist with Morgan Stanley, book Hedgehogging in our April 2006 issue, “Losers: Why We Invest with Them”:
Secular cycles, both in markets and sectors of the market, make a big investment management firm a very conflicting enterprise to manage if you are a businessperson, because the rational things to do to maximize short-term profitability are exactly the wrong things from both an investment and a long-term profitability point of view. For example, during 2000, even as the bubble was bursting, Morgan Stanley Investment Management, which has a business-dominated management, acted like businessmen: they heavily promoted the underwriting of technology and aggressive growth stock funds because those were the funds the salespeople could sell and that the public would buy. Management was not evil; they were doing what they thought was right. Large amounts of public money were being raised and very quickly lost. Short-term sales profits were collected at the expense of, not only the public, but the firm’s long-term credibility and profitability.
Those who are looking for warnings from our “trusted” government officials should consider their track record. On July 12th of this year, U.S. Treasury Secretary Paulson declared, “This is far and away the strongest business economy that I have seen in my lifetime.” Several days prior, on July 2nd, he stated, “In terms of housing, most of us believe that we are at or near the bottom.”
If the truth is not already obvious to us, history can be instructive. One need not look far to find examples of misleading statements at major market and economic turning points. Paul Warburg, an early advocate of the Federal Reserve, was on the Federal Reserve Board when he made this statement in January of 1930: “Happily, we have now turned our backs upon the events of this unfortunate event.”
As a final word of warning, we leave you with the words of Dr. Carroll Quigley, a noted historian, former professor of history at Georgetown University, and consultant to the U.S. Defense Department, the Smithsonian Institute, and NASA. His tome, Tragedy and Hope: A History of the World in Our Time was used as a resource in our December 2006 issue, “Mind Games”:
“The so-called ‘surprises’ of history have emerged not because other countries did not have the information, but because they refused to believe it. The date of Hitler’s attack on the West in May 1940 had been given to the Netherlands by the German Counterintelligence Office as soon as it was decided; the Western countries refused to believe it. The same was true of every one of Hitler’s surprises. Stalin was given the date of the German attack on the Soviet Union by a number of informants, including the United States Department of State, but he refused to believe. Both the Germans and Russians had the date of D-Day, but ignored it. The United States had available all the Japanese coded messages, knew that war was about to begin, and that a Japanese fleet with at least four large carriers was loose (and lost) in the Pacific, yet Pearl Harbor was a total surprise.”
While the evidence of trouble has just begun to surface in U.S. equity prices, the love affair with credit, as demonstrated by record profits in the banking and brokerage industries, has only made investors, especially large institutional investors, more attached to this bullish run than ever. But, with the continuing contraction in the housing sector, and its impact on borrowing, the early warning signals are blowing.
The following is an excerpt from the July 19th email we sent our subscribers: “We are releasing this month’s Investor’s Mind early because a variety of technical indicators are pointing to an end to the bull market run that began in the fall of 2002. I thought it important to release this piece on three high-level financial meetings that have taken place over the last few months, which I believe make it clear that those at the top of the money game have known for some time that the end of this period will bring massive shifts to the global capital markets.”Link here.
Dow 14,000 ... we barely knew ye.
July was the worst month for U.S. stocks in three years. But now, we are in a new month. Stocks are dropping. Will they continue to drop? Oh, dear reader, you know better than to ask us that. If we knew the answer we would be borrowing millions in yen in order to speculate. Heck, we would start our own hedge fund and charge 2 & 20 ... no, 3 & 30. We might even be tempted to charge for The Daily Reckoning! But no, we continue to offer these humble insights and reflection at the price they deserve. Because, alas, we are mortal too – just like you. And it is not given to man to know his fate. ... Or the fate of his Dow Jones Industrials.
Besides, it does not matter to us whether stocks go up or down. We are not speculators. We are moral philosophers and kibitzers. We believe you never get what you hope to get. Nor even what you expect to get. You get what you deserve. And even if you do not get it, you ought to. And you ought to believe you will get it, even if you don’t. In the words of Doug Casey, “Whatever is going to happen will happen ... just don’t let it happen to you.” In other words, position yourself in a way that you are protected from whatever is around the bend.
Well? What is it? The beginning of a correction? The end of a bull market? The end of a rally in a bear market? Over the long run, investors have judged stocks to be worth about 20 times earnings, on the high side, and about five times earnings on the low. This implies an earnings yield between 5% on the low side, and 20% on the high side. People have traditionally wanted yields (or, implied yields ... investors do not normally receive 100% of a company’s earnings in dividends) from stocks higher than what they would get from bonds or from current accounts. Why? Because stocks are inherently risky. Most people nowadays would say that they are inherently “volatile”, but that is not the same thing.
Volatility is a type of risk. Stock prices go up and down, depending on what mood the voters are in. Sometimes they are fearful and will not pay more than 5 to 10 times earnings. Sometimes, they are greedy and hopeful, and willing to pay 20 times – and more – for a stock (because they think it will go up). This movement in prices makes stocks unreliable. If you need to pay your child’s college tuition and the stock market has just corrected 30%, it is small comfort to know that in 5, 10, or 20 years stock prices might be back to where you got in. In the past, investors demanded a little extra compensation from stocks to make up for this inconvenience and uncertainty.
But then, after a period in which stocks have been stable and rising, the voters forget about the premium. They begin to think that stocks have been underpriced in the past, because past generations of investors were not very smart. They run up stocks to the point where bond yields are actually higher than earnings yields – the risk premium disappears. Then, in Mr. Market’s own sweet way, stock prices suddenly go down, and investors wish they had not been so bullish.
There is also risk of another sort. Real risk. The real risk is not a feature of the voting machine. It is the harsh judgment of the weighing machine. Sometimes stocks go up. Sometimes they go down. Sometimes they go away.
A stream of interest earnings from a bank, or a bond, or the Treasury is not guaranteed. But it is usually much more sure than a stream of income from a business. In the short run, anything could happen that could affect business earnings. In the long run, everything does. Businesses go bankrupt, lose their competitive edge, miss important innovations, mis-invest, run out of money, are embezzled and mismanaged, become obsolete, and fail. Some fail every day. All fail eventually.
A reader writes: “The American people and the people of the world stand behind the dollar. So do not say the dollar has no backing.”
Oh? Americans are not all sinners. But neither are they all saints. Like every other race, they will support their paper money as it suits them to do so.
One of the most remarkable trends of the past 30-odd years has been the build up of dollar credits overseas. That is, people who live in foreign countries and who speak foreign languages and who often worship foreign gods, control trillions worth of dollar assets. These dollars – whether dollar bills or U.S. Treasuries – are essentially claims against U.S. wealth. For these last 30 years foreigners have been eager collectors of these claims. They pile them up in central bank vaults and stuff them into mattresses. Drug dealers use them. The oil industry uses them. People selling houses in South America quote prices in them. Year after year, foreigners have taken in more dollars than they have spent.
But imagine that the foreigners should become net sellers of their dollar positions. Or, to put it another way: suppose they want to cash in all those dollar I.O.U.s they have collected. From memory, net foreign claims against U.S. assets now total something like $3 trillion – equal to about a third of U.S. GDP. What will Americans do? Give the foreigners a quarter of their entire national output? Will the yanks and yahoos stand firmly behind their currency ... cutting back on their own standards of living so they can pay off the foreigners? Or will they simply react in the time-honored tradition of scoundrels – by creating more dollars out of thin air?
What do you think?Link here.
PERMA-BULLS AND DEAD CATS
Remember that the stock market is also a market of stocks.
The stock market’s sudden, sharp selloff is paralyzing investors with fear. Even the “perma-bulls” are terrified. The recent declines are breathtaking in speed, but not particularly large, as far as corrections go. At least not yet.
In the short term, the market’s movements can be explained entirely by the collective appetite for risk. Up until a few weeks ago, this appetite was strong, but it has weakened significantly. The aggressive indiscriminate buying of everything from junk stocks to blue chips during the first half of 2007 is likely over.
Last Monday, I wrote: “The market is long overdue for a nasty correction, and you can hedge your overall position by buying a bit of UltraShort Financials ProShares (SKF), the August recommendation.” SKF has performed brilliantly, thanks to the stock market’s sharp selloff.
I expect that the price-discovery process currently underway in the CDO and leveraged loan markets will continue in the coming months, and perhaps lead to a few more high-profile hedge fund blowups. But eventually, cooler heads will prevail. We must always keep in mind the global economy’s highly inflationary monetary backdrop. If you look at out-of-control money and credit creation emanating from all parts of the globe, it is hard to believe that any asset price can decline in nominal value over the long term.
Sovereign wealth funds – from Asia, the Middle East, and any country where exporters earn more U.S. dollars than they can handle – will likely increase the buying pressure under U.S. assets. In a future environment in which the supply of paper money is virtually limitless, it makes sense for these funds to shift their focus away from bonds and toward stocks, especially stocks of companies that provide what they demand: energy, commodities, and other key components of infrastructure.
This week’s issue of The Economist describes the recent shift in the behavior of sovereign wealth funds worldwide: “Many emerging markets, notably China, have built up vast reserves of foreign exchange. Such reserves are traditionally invested in liquid assets like Treasury bonds, which could be sold quickly if the central bank had to prop up the currency. But many countries have far more reserves than they need for this purpose. ... That leaves the government free to buy more exciting things where it might make a better return.”
The shift from bonds to stocks should only grow over time as these funds slowly realize that holding U.S. dollar-denominated bonds until maturity means holding the bag in the U.S. dollar’s inflationary endgame. The rest of the world already has far too many U.S. dollars. They are constantly getting flooded with more of them, and they are certainly going to take action that is in their best interests. Keep in mind that the stock market is first and foremost a “market of stocks.” Rather than get distracted by the day-to-day movements in the Dow, concentrate on the sectors and stocks that remain entrenched in strategic positions.
Oil and oil services remains at the top of that list, and we were reminded of this industry’s importance in Petroleos Mexicanos’s (Pemex’s) recently published 2006 annual report. If the status quo is maintained, Mexico will face a crisis, as all of its proved oil reserves will be exhausted within seven years. Mainstream economists continue to focus almost entirely on the drivers of U.S. demand for oil, when the real factor at the margin is demand from rapidly growing Asian economies. China’s oil imports are currently growing at a rate of 20% year over year.
Longer term, I expect that global oil demand will be constrained by global oil supply, and the key variable in the equation will be price (volatile, but upward-trending). Supply will go to the highest bidder, since the rest of the world is now on an equal playing field with the U.S. when it comes to bidding for shipments of oil on international markets. Higher oil prices usually prompt producers to produce as much supply as possible. Yet we are not seeing this response. Last week’s earnings report from Exxon clearly indicates that it is not investing enough in future production growth. Also, looking at entire oil-producing regions shows that many are having a hard time maintaining production despite high prices. The Alaska Department of Revenue just published a report concluding that North Slope oil and gas production declined 12% last year.
The long-term investment picture for energy remains positive despite the credit market turmoil that is currently rattling financial markets.Link here (scroll down to piece by Dan Amoss).
HEDGE FUNDS FACE BITTER DIFFERENCES ABOUT VALUE
Bitter disputes are developing behind the scenes in the hedge fund industry about the way funds are valuing some assets for their end-of-month performance reports. In particular, the recent violent swings in the credit markets are making it unusually hard for some funds to agree the value of these assets with their administrators, particularly in sectors linked to assets such as subprime mortgages.
That may mean investors will be forced to wait longer than usual for performance reports about the net asset value (NAV) of hedge funds’ portfolios in July. It may even form fertile ground for future lawsuits, since sharp differences in the perceived value of hedge fund portfolios could influence investor confidence. “There is a lot of wrangling going on behind the scenes, because it is getting hard to agree [about] how to value a lot of stuff,” says one US banking official. “The bid-offer spreads can be incredibly wide – and that can really affect the NAV.”
The data on funds’ NAV for the end of July is currently awaited with particular eagerness by many credit funds, since some are believed to have suffered painful losses as a result of the recent market turmoil – not only in the subprime sector but corporate credit markets in general. Indeed, many bankers assume there will be further hedge fund implosions during coming weeks, adding to the list of those already forced to close their doors, or to take extreme measures such as banning investor redemptions.
Although these pressures make July’s NAV data particularly important, it is often difficult to ascribe precise values to many complex financial instruments even in calm markets, because these markets are illiquid. As a result, funds have often relied on models to value these instruments. However, there is growing unease these days about the quality of some of these models, given that conditions in the subprime sector, for example, are turning out to be much worse than models have assumed.
“You are getting a distressed subprime asset which one person values at 20 cents in the dollar, and someone else values at 40 cents. There is a lot of scope for argument,” said one banker.Link here.
DOW JONES INDUSTRIALS SKATING ON THIN ICE
Perhaps the most important market in the world today is the vast network of foreign currencies, where total trading volume, including derivatives and futures, average around $2.9 trillion a day. This is 10 times the size of the combined daily turnover on all the world’s equity markets. And as world’s economies have become increasingly integrated, so have the foreign exchange and global capital markets.
But the foreign exchange market is only one piece, albeit a very important one, of a bigger puzzle. Turnover of interest rate, currency and stock index derivative contracts rose 24%, to a mind boggling $533 trillion, in the first quarter versus the previous quarter, underscoring the enormous leverage in the global markets. Thus, any major unexpected event in the currency markets can touch off a panic and violent market reactions in the global bond and stock markets, or gold.
In the “brave new world” of global investing, sentiment can often turn on a dime, and at a moment’s notice. For instance, the Dow Jones Industrials (DJI-30) lost 4.2% last week to key horizontal support at 13,250, its worst performance in five years. In the background, the U.S. dollar was sliding from 122-yen to as low as 118-yen, triggering the unwinding of the “yen carry” trades that wiped out $2.1 trillion of global stock market value.
But a new headache has emerged beyond the U.S. dollar’s woes. Many high yield “junk” bond funds lost 10% to 15% of their value over the past six weeks, amid concerns that defaults in securities backed by sub-prime mortgages may spread across the credit markets. Interest rates for leveraged buy-out artists, who issue junk bonds to finance acquisitions soared 120 basis points, and more than 40 junk bond offerings were canceled or restructured worldwide in the past five weeks.
The second wave down for risky sub-prime BBB- mortgage securities, from the 70-level towards the 40-area, since May 1st, has spread to the U.S. junk bond sector, knocking Van Kampen’s High Yield Bond fund about 10% lower. Sharply higher junk bond yields could slow down leveraged buy-outs by private equity firms, removing a key prop for the U.S. stock market, and drying up liquidity in a market priced for perfection.
Also spooking the DJI-30 is the escalating cost of crude oil, which has topped $78 per barrel, just shy of the record high of $78.40 per barrel. Higher oil prices fuel inflation, crimps disposable income of consumers, and dents corporate profits. Goldman Sachs predicted crude price could top $90 a barrel this autumn and hit $95 by the end of the year, if OPEC keeps oil production capped at current levels, of 26.6 million barrels per day. The increase in global demand could outstrip the increase in new supplies, so OPEC finds itself firmly in the driver’s seat.
Interestingly enough, the energy sector has been swept lower by selling contagion from the broad market’s weakness. The energy sector was a top performer in the S&P 500 index last quarter, so when a leader of the bull market tumbles 10% from its record highs, it begins to rattle the broad market. Still, if one must be invested in the stock market, the Amex Oil Index (XOI) could be a relative “safe haven”, with crude oil prices aiming for the $80 per barrel mark.
With the DJJI-30 tumbling 146 points to close below key support to the 13,200 level, U.S. Treasury chief, Henry Paulson is desperately trying to head-off a trade war between the U.S. Congress and China. The U.S. Congress is passing “veto proof” legislation aimed at punishing China for its currency policy. “At a time when U.S. exports are growing globally, such legislation also exposes the United States to the risk of mirror legislation abroad and could trigger a global cycle of protectionist legislation,” Paulson warned.
However, U.S. legislators argue the undervalued yuan is fuelling the trade deficit with China. To mollify Wall Street, Beijing said it would allow approved international investors to purchase up to $30 billion of stocks usually reserved for domestic buyers, compared with the $10 billion quota before. But Sen. Charles Grassley, an Iowa Republican who crafted a bipartisan bill that passed the Senate Finance Committee by a margin of 20 to 1, is fed-up with the Bush administration’s secret dealings with Beijing, and mounting trade deficits, that have been blamed for the loss of more than 3 million U.S. manufacturing jobs since 2000. Beijing is starting to get the message, and was a net seller of U.S. bonds for the first time in four years, dumping $5.8 billion of U.S. T-bonds in April, and $7 billion in May.
So far, Shanghai red-chip traders have shrugged off the brewing protectionist storm. The world’s hottest market sprinted 14% higher in 8 trading days to an all-time high of 4,500, up 67% so far this year, after climbing 130% in 2006. Hundreds of billions of dollars unrelated to trade or foreign direct investment (FDI) have evaded China’s capital controls and poured into the country in anticipation of high returns on stocks and yuan appreciation.
The Chinese central bank is scheduled to sell roughly $203 billion of special T-bonds in the second half of 2007 to mop-up excess cash floating in the banking system, and on July 30th, raised the level of deposits that banks must hold in reserve to 12%, the 9th increase in 13 months, the latest step in its campaign to keep the world’s 4th-largest economy from overheating. But so far, all tightening measures by Beijing have failed to put a lid on the Shanghai red-chip market. China’s M2 money supply grew at an annualized clip of 17.1% in the year to June, above the central bank’s 2007 target of 16%. The tightening measures by Beijing have lifted 7-year T-bond yields 120 basis points higher to 4.00%, but are less than the country’s consumer inflation rate of 4.4 percent. Negative interest rates adjusted for inflation have kept Shanghai red chips bubbling.
The red-hot Shanghai stock market did run into a stiff roadblock at the 4500-level however, after the DJI-30 futures market extended its latest string of losses to 1000-points, from its record high reached on July 19th. Shanghai tumbled nearly 4% to close at 4,300 on August 1st, when jittery mutual fund traders turned huge paper profits into hard cash, following sharp falls in Hong Kong’s market. The interplay between the Dow Jones Industrials and the Shanghai stock market has psychological importance, because the two countries have accounted for roughly 60% of global economic growth over the past five years.
So with the DJI-30 sliding below key horizontal support at 13,250, it would become very worrisome if the powerful locomotives in the Hong Kong and Shanghai stock markets, suddenly took a turn for the worse, due to contagion sales from sliding stock markets in Australia, Japan, Europe, and South America. At that point, the U.S. Treasury’s “Plunge Protection Team” would have more on its hands than it can handle. The story gets more interesting by the day.Link here.
A FIRE IN THE PROJECTION ROOM
Many people in high places continue to assert that problems with hedge funds and subprime lending do not pose a systemic risk to the financial system. If these important people did think the entire financial system was threatened, do you think they would tell us?
Why would they tell us? Would that not be like the projection room crew yelling “FIRE!” in a crowded theater as they attempt to suppress the flames from something that was ablaze upstairs? Maybe some patrons already got a whiff of something foul smelling, but not enough to compel them to make for the exits while the movie plays on. Hopeful that the flames could be beaten back, the theater staff would probably delay notifying the audience until they were sure their patrons were threatened – otherwise life and limb may be risked as panicked movie-goers all made a hasty retreat from the building at the same time.
Inciting a panic would only make things worse. Unless, of course, the small fire turned into a much bigger fire and, in the end, no one survived because no one yelled “FIRE!” Is that what is happening in financial markets today? A fire in the projection room?
A week ago, a report from ratings giant Moody’s claimed there were “serious reasons to worry” but that systemic risk was not among them since “financial institutions retain a high capacity for withstanding shocks.” Last month, Fed Governor Kevin Warsh testified before the House Financial Services Committee stating that there may be more downside to go in the current credit market tumult, but, “We don’t see any immediate systemic risk issues.” At the same hearing, Treasury undersecretary Robert Steel said that the recent sell-off in subprime securities “does not seem to be a systemic issue.”
Earlier this year, current Fed chief Ben Bernanke noted there were indeed systemic risks from the GSEs (Fannie Mae and Freddie Mac), referencing former Fed chief Alan Greenspan’s successful effort to reduce the role of GSEs in the financial system – in this case the systemic risk was clearly identifiable, derived from the GSE’s implied government guarantee. Other than that, there is nary a systemic risk to be found.
Over a year ago, Ben Bernanke spoke on the subject of hedge funds and systemic risk, ultimately rejecting the idea of somehow making hedge funds less opaque to “allow authorities to monitor this possible source of systemic risk and to address the buildup of risk as it occurs.” Maybe that would have been a good project to undertake in early 2006 rather than watching things unfold as they are now with no tools and no data at their disposal.
Almost 10 years ago, former Fed chief Alan Greenspan noted that when banks “are undercapitalized, have lax lending standards, and are subjected to weak supervision and regulation, they become a source of systemic risk both domestically and internationally.” Lax lending standards and weak regulation leading to systemic risk ... Hmmm ...
This week, it was revealed that another hedge fund from Bear Stearns is in deep doo-doo. According to the report, they have “blocked investors from pulling money out of a third fund as losses in the credit markets expand beyond securities related to subprime mortgages.” Unlike the two Bear Stearns funds that went belly-up last month, this $850 million asset-backed fund had no leverage and virtually no exposure to subprime mortgages.
Call it systemic risk, call it what you want. Whatever it is, it is spreading.Link here.
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