Of Bailouts, Hedge Funds and Energy

September 10, 2008 at 7:09 pm
Contributed by: Chris

My Energy and Capital article for this week takes a closer look at the health of the US economy, taking the Fannie and Freddie bailout into account.

–C

Of Bailouts, Hedge Funds and Energy

An Unsustainable Course

2008-09-10
By Chris Nelder

Hooray! Fannie and Freddie have been rescued! With the US Treasury as a "backstop," the mortgage crisis is over, and it’s safe to jump back into tech and finance, right?

Not so fast…

The bailout won’t help the homeowners at risk of foreclosure, and the stimulus it might give to the mortgage market will be limited to those with the very best credit.

Nor does the bailout remove the risk of the perhaps $500 billion more in writeoff candidates that still remain on the books of the banks.

In fact all it did was preserve for a little while longer the faith of international bankers in the US financial system.

It assuaged the global credit markets sufficiently to keep them from freezing up entirely—a scenario no one wanted to see. It assured the foreign bankers who are holding and buying our federal debt that their investments weren’t going to evaporate. It meant that our lender of first resort, the Chinese, might continue to buy Treasury bonds, and keep this charade going a little longer.

At least, until just after the election.

So while we awoke with a hangover on Monday morning, realizing that what we really did the night before was increase the federal debt exposure by half…and while we watched huge financial institutions like Washington Mutual and Lehman brothers going down in flames, just like Bear Stearns did…and then when we got the news on Tuesday from the Congressional Budget Office (CBO) that this year’s budget deficit will jump by (ahem) 153% to $407 billion…

…In other words, while the news about the health of the US financial system could not possibly have been worse, what happened?

The dollar rallied.

It’s the kind of action that could drive any rational person insane. That is, until you realize that it was really a global exhalation by thousands of bankers who had been holding their breaths, and could now wipe their brows and live to fight another day.

A Giant Sucking Sound

Naturally, with the rallying of the dollar, energy and commodities were sold off. In a huge way.

In the first two trading days of this week, after the emergency measure was announced (again, on a Sunday) by Treasury Secretary Henry Paulson, some of my favorite positions got slaughtered: Arch Coal (NYSE: ACI) down 19%; Southwestern Energy (NYSE: SWN) down 19%; BHP Billiton (NYSE: BHP) down 8%.

That’s just from the close on Friday to the close yesterday (Tuesday). The carnage was widespread, covering the whole sectors and indeed, pretty much the entire market.

Such insane moves are never about the fundamentals of the businesses; they’re always about market sentiment.

In fact this one was about more than just the health of the US financial system. It was also about the role of hedge funds in the markets. I would go so far as to call it a referendum.

Most hedge funds were deeply invested in energy and commodities in the first half of the year, because that’s the only part of the market that was making any money while oil made an historic run. Bloomberg estimates that assets linked to commodity indexes exploded 20-fold from $13 billion at the end of 2003 to $260 billion by March of this year.

The massive selloff that began in July—which has now whacked roughly 25% off the entire energy and commodity complex— absolutely killed many of the funds, as they had to unwind highly leveraged investments at the worst possible time.

The amount of leverage can’t be known, since private funds aren’t required to disclose it. We do know that via a process called Joint Bank Office (JBO), hedge funds can act as though they are prime brokers, and leverage as much as 200-to-1. Under such tension, even a slight selloff in the core assets of a fund can have a massive effect on the markets.

So that giant sucking sound you hear is coming from hundreds of billions of dollars quickly disappearing from the market, as fund managers try to exit their positions. Some are just trying to limit their risk and preserve their remaining capital, but others are forced into selling to pay for redemptions.

Some of the top names in hedge funds have suffered losses as high as 60% in the last two months, while others, like Osprarie last week, are simply closing their doors.

After about a decade of massive excesses in hedge fund investing, which made huge piles of cash for some, it looks as though the game may be up now.

Ah well. What goes up must come down.

This means that for a short while, at least, there will be these periods of sharp selling in perfectly good energy and commodity stocks. This is another phase of the bottoming out in those sectors, as the last of the big speculative money is squeezed out.

The action has also made it clear that I have underestimated the effect of speculative money on oil, and on energy and commodities in general. Perhaps it had less to do with the fundamentals than I thought.

A new report released today by Masters Capital Management cites "clear evidence" that the flow of large institutional money became "the primary source of the dramatic and damaging volatility seen in oil prices" this year. Masters estimates that $60 billion flowed into the oil futures markets in the first five months of the year as oil soared from $95 to $145, but that $39 billion has since flowed back out, taking oil down to $103 today.

A report expected later this week by the Commodities Futures Trading Commission may confirm the Masters conclusion, but in any case, we expect further regulation of the oil futures market going forward, and a consequent reduction in volatility.

The Python Plan

Ultimately, what must happen now is a massive deleveraging of the hedge funds, and a gradual deflation of the dollar. But it could be painful.

I think we’re only about halfway through the total losses stemming from the mortgage industry. And the rest of the economy looks absolutely abysmal. In round numbers, here’s what I’m seeing.

On the asset side: Our official GDP is about $12 trillion, but about $4 trillion of that is just accounting tricks like "imputations" and "hedonics." (I won’t get into all that nonsense now, but you can learn more about it from Chapter 16 of Chris Martenson’s excellent Crash Course, which I highly recommend to your attention.) So our real GDP is closer to $8 trillion.

On the debit side, the numbers really beggar belief.

The official US national debt now stands at nearly $10 trillion.

Total federal debt obligations (including Social Security and other unfunded mandates) are closer to $53 – $85 trillion, depending on whose numbers you use.

This year’s expected budget deficit of $407 billion includes $168 billion for the economic stimulus checks. Most of the remaining $240 billion went to pay for the wars, for tax cuts, and for imported oil.

Add to that the $200 billion that we may expect to take on in Fannie and Freddie debt, and we’ve got over a half-trillion dollar hole in our pocket, every year. Divide a $600 billion deficit by an $8 trillion GDP, and we’re losing roughly 8% per year-enough to make anyone shudder. (Even those numbers are probably on the optimistic side.)

And all of that money is either being printed or borrowed from abroad. Either way, it means our economy is getting progressively sicker.

Consider this: Total credit market debt now stands at a record 342% of the GDP…a level far above the last all-time peak in 1929.

On a balance sheet, we look like a banana republic.

I don’t know how else to put it. Our economy is teetering on the edge of the abyss. And the path it’s on is completely and utterly insane and unsustainable.

Peter Orszag, director of the CBO, put it plainly: "The nation is on an unsustainable fiscal course."

The only reason we’re still breathing at all is that our creditors, primarily Japan, China and countries of the Middle East, are holding so much of our debt, they really can’t afford to let us fail too hard, or too fast.

What the Treasury is to Fannie and Freddie, Asia and the Middle East are to the US.

But that game can’t go on for much longer, and we’re already seeing the signs that they are losing their appetite for more US debt.

Instead of letting us crawl still further out on that limb, I think we’re seeing a change in tactics. Credit will contract, which will drive up interest rates, and our creditors will slowly shed their dollars, preciptating deflation and shrinking the economy. Instead of T-bills, they will buy large chunks of our assets on the cheap: an airline here, a big stake in a bank there; a vault full of gold today, and a port tomorrow.

Call it the Python Plan: We will be slowly strangled and then eaten.

But they have to keep the markets from seizing up entirely in order to do that, and the bankers of the world will work together to keep the money flowing. Hence, this week’s bailout, which was clearly necessary. Hence the seizure of 11 banks this year by the FDIC, with more undoubtedly to come. And hence the liquidations of firms like Bear Stearns, which isn’t over yet either.

Get Ready for the Next Bounce in Energy Stocks

So when do we see the end of this latest bounce of confidence?

I think it might have been today. Monday morning’s exuberance in the major averages quickly faded away, and all ended yesterday with losses. Then we had a follow through with a sharp rally in energy and commodity shares today.

Likewise, I expect the dollar rally to turn around here. The dollar is now up about two standard deviations over the past 60 trading days, a condition that has only occurred six times this decade, and should be ripe for another plunge.

So what does it all mean to you?

I know I’m beginning to sound like a broken record, but this is where you want to be adding to your positions in energy and commodities. (If you need some suggestions, see my past articles listed below.) And if you’re holding underwater positions, this is your chance to average down your cost by buying a little more.

But I will certainly understand if you want to stay out of the water and wait until there are fewer sharks around.

Until next time,

Chris

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