June 4. Collateral Damage

From 1999 until 2005 I worked at Refco, a global futures firm.  For me, it was a great place to be.  While notorious for its freewheeling style in the early days  -for example, when Hillary Clinton, completely of her own accord, decided to trade cattle futures through the firm- when I was there it was becoming more corporate.  There were long term, knowledgeable professionals throughout the firm in every department, however, there were also legendary stories of  -ahem- less than professional behavior that are much more amusing to relate.  But I am not going to tell those stories today, I am just going to touch upon the meteoric crash shortly after the IPO.

Refco went public in August of 2005.  It was a successful IPO.  By October 2005, the company was bankrupt.  The reason for the bankruptcy was an undisclosed debt that was being transferred around internal entities like a hot potato.  From Wikipedia [link below]:

Apparently, [CEO, Phil] Bennett had been buying bad debts from Refco in order to prevent the company from needing to write them off, and was paying for the bad loans with money borrowed by Refco itself.

…anonymous sources cited by the WSJ and other publications have stated that the debt stemmed from losses in as many as 10 customer trading accounts, including that of Ross Capital, and the widely reported October 27, 1997, trading losses of hedge fund manager Victor Niederhoffer.

Now I don’t want to go into detailed fact checking regarding this event, though I think I saw that the amount of the ‘bad asset’ in question was about $430 million.  Now considered an almost “quaint” sum of money.  What I’d like to consider are aspects of this episode that relate to our current environment.

Take a look at a chart of SP500 in the late 1990’s. From 1995 to 2000 SPX went from 500 to 1500. On a long term chart it’s sort of difficult to even see the blip related to October 27, 1997.  It was the year of the Asian crisis, twenty years ago.  From one article: “The tipping point was the realization by Thailand’s investors that its property market was unsustainable, which was confirmed by Somprasong Land’s default and Finance One’s bankruptcy in early 1997.” There were runs on the Thai Baht, Malaysian Ringgit, etc.  And on October 27, the DJIA fell 7.18%.

So, according to the Wikipedia story, the hole in Refco’s books was a direct result of that day.  However, it took EIGHT years for this bad debt to sink Refco.  Good things and bad things can all be happening at the same time, but it usually comes down to collateral, to asset values.  The timing of the last straw regarding overvaluation and the subsequent realization that asset values didn’t provide the same level of cushion in terms of collateral that was modelled at the outset is extraordinarily hard to anticipate.


It should be noted that the Fed will release stress test results related to Dodd-Frank on June 22nd, and will follow that with its own stress test results for the banking sector on June 28th.  The outcome of these reports will almost certainly reveal rather minor (if any) concerns.  Even Kashkari has been muted recently.  The Fed has mostly been a cheerleader for stocks, with Harker last week doing his utmost to assure the market that nothing bad will come from balance sheet reduction: “…it will be slow, steady, incredibly boring, and essentially on autopilot.”

So with regard to asset values, here are a few back of the cocktail napkin calculations, and snippets from news stories [linked at the bottom].  First, total market cap of the ‘five horsemen’ Alphabet, Apple, Amazon, Facebook and Microsoft, is about $3T, “…not far from the market value of all the other components of the Nasdaq 100.”  These five have added $612 billion in value to the stock market this year. (Reuters).  Now, total stock market cap to GDP is about 133%.  So if GDP is $19T, then total cap is about $25T.  Subtract out the five mentioned above and it leaves $22T.  The same Reuters article notes that “investors are currently paying $18.50 for every $1 in earnings expected over the next twelve months in the [tech] sector….compared to $20-plus seen during the most recent market peak in 2007.”  So, that’s about 5.4% (1/18.50).  Probably not that bad in comparison to ten year treasuries yielding 2.16%.  Now here’s where the math gets a little fuzzy (on the third napkin).  The St Louis Fed has a chart showing that Total Credit to Non-Financial Sector is at [a record] 255.7% of GDP (includes household, business and govt).   From the Z.1 Fed report, total business debt is $13.47T.  Obviously, there are many private businesses that are not a part of stock mkt cap.  But when one looks at growth in GDP of, let’s optimistically say 2%, that’s growth of about $380 billion.  Now let’s call the interest rate on the business debt 3.5% (BBB corp sprd is 1.51).  So the interest cost is $471B. Excluding the 5 big guys, market cap is $22T…just a bit bigger than GDP.  Probably hard (or maybe even mathematically impossible) to see growth in all companies better than GDP.  At best, running in place, and at worst, not keeping pace.  ZeroHedge ran a great article highlighting SocGen research from Andrew Lapthorne.  http://www.zerohedge.com/news/2017-06-01/one-banks-surprising-discovery-debt-party-finally-over

Lapthorne calculates that S&P1500 ex financial net debt has risen by almost $2 trillion in five years, a 150% increase, but this mild in comparison to the tripling of the debt pile in the Russell 2000 in six years. He also notes, as shown previously, that as a result of this debt surge, interest payments cost the smallest 50% of stocks in the US fully 30% of their EBIT compared with just 10% of profits for the largest 10% and states that “clearly the sensitivity to higher interest rates is then going to be with this smallest 50%, while the dominance and financial strength of the largest 10% disguises this problem in the aggregate index measures.”

So we see that large cap tech outperforms, because smaller companies are saddled with debt that is chewing into the bottom line, even at these very low rates.  But with total GDP growing slowly, it’s hard to make up ground.  And then we have pension funds penciling in 7% returns.  Is it any wonder the Fed is so preoccupied with ramping up inflation?

OK, what else is going on?  Two weeks ago, China and Brazil were downgraded.  Last week Illinois was cut to within a notch of junk. There are constant articles about bad debts in China.  In the US, bank warnings started last week with JPM CFO Marianne Lake indicating trading revenue was down about 15% in Q2, echoed by other major banks. https://www.bloomberg.com/news/articles/2017-05-31/jpmorgan-bofa-trading-revenue-on-pace-to-drop-at-least-10   The growth rate of C&I loans has plunged from 12% in 2015 to 2.6% now.

So (of course) stock indices in the US continue to reach new highs.  This, against a backdrop of a yield curve that reflects anything but robust growth and inflation.  Crude oil is near the year’s low and down over 15% from the start of the year.   With Friday’s weaker than expected employment data many curve measures hit new lows.  The 2/10 treasury spread ended the week at 87 bps.  All ED one-year calendar spreads made new lows.  The peak is still EDZ7/EDZ8, now at only 29 bps, down 5.5 bps on the week.    Red/gold euro$ pack spread closed at 56.5bps, down 8 on the week and barely above ½% for the three years between 2018 and 2021.  The dollar index made a new low.  All of these are at pre-Trump levels.

And that’s the tie-in between Refco, asset values, and collateral underlying loans.  It’s the hope that Trump would be able to hide or overcome the bad stuff.  And the bad stuff is record debt which is stifling growth.  All the markets besides stocks appear to have shed that hope.

Economic data this week pretty sparse.  However, Comey testimony is scheduled for Thursday and the House is slated to vote on the repeal of Dodd-Frank, also on Thursday.

Posted on June 4, 2017 at 4:42 pm by alexmanzara · Permalink
In: Eurodollar Options

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