Commentary 10 October

Commentary 10 October

By Bill Cara | 10 October 2007

Every market cycle is set apart by unique drivers (ie, influences on price).

Sometimes, the primary driver is a matter of real economic growth (ie, Gross Domestic Product that exceed true levels of inflation), sometimes wage and/or price inflation, sometimes commodity prices, sometimes interest rates, or international currency rates, or international earnings, and so forth.

But at the end of the day, we can usually look back and make an accurate assessment of what happened to push and pull prices in a rising or falling trend.

It was June of 2006 that US Treasury Secretary Henry Paulson stepped into the chair, and within four weeks a sagging equity market was sent soaring. Why? In a word it was leverage. Balance sheet leverage. Corporations were encouraged to pick up the slack from individuals who were getting maxed out on credit and losing sight of their price gains on real estate.

Corporations were flush with cash because they weren’t spending it. With Paulson at the helm they were encouraged to dividend more to individuals and investment funds that would plow it back into markets, driving prices higher. That changed their balance sheet structures.

At the same time, Humungous Private Equity Corp (HPEC) was induced to borrow huge sums from the banks in order to complete what were until then unimaginably big deals.

Wiki has a good definition of an HPEC fund.

A fund that invests in companies and/or entire business units with the intention of obtaining a controlling interest (usually by becoming a majority shareholder, sometimes by becoming the largest plurality shareholder) so as to be in the position of restructuring the target company's reserve capital, management, and organizational infrastructure. Once one or more of theses objectives are accomplished, the target companies are delisted from public exchanges (unless already unlisted), held private, and restructured over a period of 3–7 years, and then, again, relisted through an IPO.

Wiki also lists the major investors in this industry: Goldman Sachs Private Equity Group, KKR (Kohlberg, Kravis, Roberts & Co.), Apollo Management, Bain Capital, Blackstone Group, Hellman & Friedman, Carlyle, and Texas Pacific Group. Cerberus Capital Management is another.

The distinguishing features of HPEC are (i) close ties to both the US Administration and (ii) Humungous Bank & Broker (HB&B). These groups do not work independently. For instance, after former Treasury Secretary John Snow suddenly resigned in favor of Paulson, he popped up as CEO of Cerberus Capital Management, an industry in which he had no experience. But he did have a friend in former US Vice President Dan Quayle, who served under Pres. George HW Bush, who was tied to Cerberus.

In any event, HPEC raised at least $1 trillion from institutional investors and in debt securities that they sold to HB&B in the past two years, and they used that capital to acquire companies where they could leverage up the balance sheet with additional debt. They paid humungous prices.

So now we have a situation where (i) share prices in the market have been driven beyond the normal economic basis (eg, Price to earnings ratio, and revenue and earnings growth ratio, and the like), and (ii) the banks that bought this securitized debt from HPEC have to sell it back to investors [[this 'lingering' debt on their books is like the proverbial monkey on their backs; they will do (almost) anything to offload it, as it threatens their very solvency: normxxx]].

The latter will take some doing, as a story in today’s Wall St. Journal says. To do so the banks are taking major losses, and to clear the rest of this inventory, they will need rates to fall, which is why Wall Street and Friends have been screaming at central banks, and why the Fed has complied.

The situation is that the US Administration and the Fed have the biggest problem, and the only way out is to print more money, cook the inflation books to lead us to think that inflation is no longer a problem, and to make borrowing easier by investors who will purchase all that inventory of debt that HB&B holds.

Therein lies the seeds of the next great problem for capital markets. The falling USD and the resultant commodity price bubble [[and those EMs that are in the 'miners' camp: normxxx]].

So, it is not for traders to help the US Administration, the Fed or HB&B here; it is our job to manage portfolios by laying off risk (ie, selling shares of financial lenders and companies that rely on debt) and participating in the commodity boom cycle as long as it exists.

Normxxx    
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