Category Archives: Macro Viewpoints

Georgia and Iraq – New President’s Nightmare

The following is from a weekly newsletter I read. I think they do a wonderful job of taking the “spin” off of the media’s issue of the moment. They also provide possible strategic reasons for actions taken around the world. This article has nothing to do with trading. However, it does provide some context for my job as a commodity broker and the issues our next President is going to face.


By George Friedman

The United States has been fighting a war in the Islamic world since 2001.
Its main theaters of operation are in Afghanistan and Iraq, but its
politico-military focus spreads throughout the Islamic world, from Mindanao to
Morocco. The situation on Aug. 7, 2008, was as follows:

  1. The
    war in Iraq
    was moving toward an acceptable but not optimal solution.
    The government in Baghdad was not pro-American, but neither was it an
    Iranian puppet, and that was the best that could be hoped for. The United
    States anticipated pulling out troops, but not in a disorderly fashion.
  2. The
    war in Afghanistan
    was deteriorating for the United States and NATO
    forces. The Taliban was increasingly effective, and large areas of the
    country were falling to its control. Force in Afghanistan was
    insufficient, and any troops withdrawn from Iraq would have to be deployed
    to Afghanistan to stabilize the situation. Political
    conditions in neighboring Pakistan
    were deteriorating, and that
    deterioration inevitably affected Afghanistan.
  3. The United
    States had been locked in a confrontation with Iran over its nuclear
    , demanding that Tehran halt enrichment of uranium or face U.S.
    action. The United States had assembled a group of six countries (the
    permanent members of the U.N. Security Council plus Germany) that agreed
    with the U.S. goal, was engaged in negotiations with Iran, and had agreed
    at some point to impose sanctions on Iran if Tehran failed to comply. The
    United States was also leaking stories about impending
    air attacks on Iran by Israel or the United States
    if Tehran didn’t
    abandon its enrichment program. The United States had the implicit
    agreement of the group of six not to sell arms to Tehran, creating a real
    sense of isolation in Iran.

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In short, the United States remained heavily committed to a region
stretching from Iraq to Pakistan, with main force committed to Iraq and
Afghanistan, and the possibility of commitments to Pakistan (and
above all to Iran
) on the table. U.S. ground forces were stretched to the
limit, and U.S. airpower, naval and land-based forces had to stand by for the
possibility of an air campaign in Iran — regardless of whether the U.S. planned
an attack, since the credibility of a bluff depended on the availability of

The situation in this region actually was improving, but the United States
had to remain committed there. It was therefore no accident that the Russians
invaded Georgia on Aug. 8
following a Georgian attack on South Ossetia.
Forgetting the details of who did what to whom, the United States had created a
massive window of opportunity for the Russians: For the foreseeable future, the
United States had no significant forces to spare to deploy elsewhere in the
world, nor the ability to sustain them in extended combat. Moreover, the United
States was relying on Russian cooperation both against Iran and potentially in
Afghanistan, where Moscow’s influence with some factions remains substantial.
The United States needed the Russians and couldn’t block the Russians.
Therefore, the Russians inevitably chose this moment to strike.

On Sunday, Russian Prime Minister Dmitri Medvedev in effect ran
up the Jolly Roger
. Whatever the United States thought it was dealing with
in Russia, Medvedev made the Russian position very clear. He stated Russian
foreign policy in five succinct points, which we can think of as the Medvedev
Doctrine (and which we see fit to quote here):

  • First, Russia recognizes the primacy of the fundamental
    principles of international law, which define the relations between
    civilized peoples. We will build our relations with other countries within
    the framework of these principles and this concept of international law.
  • Second, the world should be multipolar. A single-pole
    world is unacceptable. Domination is something we cannot allow. We cannot
    accept a world order in which one country makes all the decisions, even as
    serious and influential a country as the United States of America. Such a
    world is unstable and threatened by conflict.
  • Third, Russia does not want confrontation with any
    other country. Russia has no intention of isolating itself. We will
    develop friendly relations with Europe, the United States, and other
    countries, as much as is possible.
  • Fourth, protecting the lives and dignity of our
    citizens, wherever they may be, is an unquestionable priority for our
    country. Our foreign policy decisions will be based on this need. We will
    also protect the interests of our business community abroad. It should be
    clear to all that we will respond to any aggressive acts committed against
  • Finally, fifth, as is the case of other countries,
    there are regions in which Russia has privileged interests. These regions
    are home to countries with which we share special historical relations and
    are bound together as friends and good neighbors. We will pay particular
    attention to our work in these regions and build friendly ties with these
    countries, our close neighbors.

Medvedev concluded, “These are the principles I will follow in carrying out
our foreign policy. As for the future, it depends not only on us but also on our
friends and partners in the international community. They have a choice.”

The second point in this doctrine states that Russia does not accept the
primacy of the United States in the international system. According to the
third point, while Russia wants good relations with the United States and
Europe, this depends on their behavior toward Russia and not just on Russia’s
behavior. The fourth point states that Russia will protect the interests of
Russians wherever they are — even if they live in the Baltic states or in
Georgia, for example. This provides a doctrinal basis for intervention in such
countries if Russia finds it necessary.

The fifth point is the critical one: “As is the case of other countries,
there are regions in which Russia has privileged interests.” In other words,
the Russians have special interests in the former Soviet Union and in friendly
relations with these states. Intrusions by others into these regions that
undermine pro-Russian regimes will be regarded as a threat to Russia’s “special

Thus, the Georgian
conflict was not an isolated event
— rather, Medvedev is saying that Russia
is engaged in a general redefinition of the regional and global system.
Locally, it would not be correct to say that Russia is trying to resurrect the
Soviet Union or the Russian empire. It would be correct to say that Russia
is creating a new structure of relations
in the geography of its predecessors,
with a new institutional structure with Moscow at its center. Globally, the
Russians want to use this new regional power — and substantial Russian nuclear
assets — to be part of a global system in which the United States loses its

These are ambitious goals, to say the least. But the Russians believe that
the United States is off balance in the Islamic world and that there is an
opportunity here, if they move quickly, to create a new reality before the
United States is ready to respond. Europe
has neither the military weight nor the will to actively resist Russia.
Moreover, the Europeans are heavily dependent on Russian natural gas supplies
over the coming years, and Russia can survive without selling it to them far
better than the Europeans can survive without buying it. The Europeans are not
a substantial factor in the equation, nor are they likely to become

This leaves the United States in an extremely difficult strategic position.
The United States opposed the Soviet Union after 1945 not only for ideological
reasons but also for geopolitical ones. If the Soviet Union had broken out of
its encirclement and dominated all of Europe, the total economic power at its
disposal, coupled with its population, would have allowed the Soviets to
construct a navy that could challenge U.S. maritime hegemony and put the
continental United States in jeopardy. It was U.S. policy during World Wars I
and II and the Cold War to act militarily to prevent any power from dominating
the Eurasian landmass. For the United States, this was the most important task
throughout the 20th century.

The U.S.-jihadist war was waged in a strategic framework that assumed that
the question of hegemony over Eurasia was closed. Germany’s defeat in World War
II and the Soviet Union’s defeat in the Cold War meant that there was no
claimant to Eurasia, and the United States was free to focus on what appeared
to be the current priority — the defeat of radical Islamism. It appeared that
the main threat to this strategy was the patience of the American public, not
an attempt to resurrect a major Eurasian power.

The United States now faces a massive strategic dilemma, and it has limited
military options against the Russians. It could choose a naval
, in which it would block the four Russian maritime outlets, the Sea
of Japan and the Black,
Baltic and Barents seas. The United States has ample military force with which
to do this and could potentially do so without allied cooperation, which it
would lack. It is extremely unlikely that the NATO council would unanimously
support a blockade of Russia, which would be an act of war.

But while a blockade like this would certainly hurt the Russians, Russia is
ultimately a land power. It is also capable of shipping and importing through
third parties, meaning it could potentially acquire and ship key goods through
European or Turkish ports (or Iranian ports, for that matter). The blockade
option is thus more attractive on first glance than on deeper analysis.

More important, any overt U.S. action against Russia would result in
counteractions. During the Cold War, the Soviets attacked American global
interest not by sending Soviet troops, but by supporting regimes and factions
with weapons and economic aid. Vietnam was the classic example: The Russians tied
down 500,000 U.S. troops without placing major Russian forces at risk.
Throughout the world, the Soviets implemented programs of subversion and aid to
friendly regimes, forcing the United States either to accept pro-Soviet
regimes, as with Cuba, or fight them at disproportionate cost.

In the present situation, the Russian response would strike at the heart of
American strategy in the Islamic world. In the long run, the Russians have
little interest in strengthening the Islamic world — but for the moment, they
have substantial interest in maintaining American imbalance and sapping U.S.
forces. The Russians have a long history of supporting Middle Eastern regimes
with weapons shipments, and it is no accident that the first world leader they
met with after invading Georgia was Syrian
President Bashar al Assad
. This was a clear signal that if the U.S.
responded aggressively to Russia’s actions in Georgia, Moscow would ship a
range of weapons to Syria — and far worse, to Iran. Indeed, Russia could
conceivably send weapons to factions in Iraq that do not support the current
regime, as well as to groups like Hezbollah. Moscow also could encourage the
Iranians to withdraw their support for the Iraqi government and plunge Iraq
back into conflict. Finally, Russia could ship weapons to the Taliban and work
to further destabilize Pakistan.

At the moment, the United States faces the strategic problem that the
Russians have options while the United States does not. Not only does the U.S.
commitment of ground forces in the Islamic world leave the United States
without strategic reserve, but the political arrangements under which these
troops operate make them highly vulnerable to Russian manipulation — with few
satisfactory U.S. counters.

The U.S. government is trying to think through how it can maintain its
commitment in the Islamic world and resist the Russian reassertion of hegemony
in the former Soviet Union. If the United States could very rapidly win its
wars in the region, this would be possible. But the Russians are in a position
to prolong these wars, and even without such agitation, the American ability to
close off the conflicts is severely limited. The United States could massively
increase the size of its army and make deployments into the Baltics, Ukraine
and Central Asia to thwart Russian plans, but it would take years to build up
these forces and the active cooperation of Europe to deploy them. Logistically,
European support would be essential — but the Europeans in general, and the
Germans in particular, have no appetite for this war. Expanding the U.S. Army
is necessary, but it does not affect the current strategic reality.

This logistical issue might be manageable, but the real heart of this
problem is not merely the deployment of U.S. forces in the Islamic world — it
is the Russians’ ability to use weapons sales and covert means to deteriorate
conditions dramatically. With active Russian hostility added to the current
reality, the strategic situation in the Islamic world could rapidly spin out of

The United States is therefore trapped by its commitment to the Islamic
world. It does not have sufficient forces to block Russian hegemony in the
former Soviet Union, and if it tries to block the Russians with naval or air
forces, it faces a dangerous riposte from the Russians in the Islamic world. If
it does nothing, it creates a strategic threat that potentially towers over the
threat in the Islamic world.

The United States now has to make a fundamental strategic decision. If it
remains committed to its current strategy, it cannot respond to the Russians.
If it does not respond to the Russians for five or 10 years, the world will
look very much like it did from 1945 to 1992. There will be another Cold War at
the very least, with a peer power much poorer than the United States but prepared
to devote huge amounts of money to national defense.

There are four broad U.S. options:

  1. Attempt to make a settlement
    with Iran
    that would guarantee the neutral stability of Iraq and
    permit the rapid withdrawal of U.S. forces there. Iran is the key here.
    The Iranians might also mistrust a re-emergent Russia, and while Tehran
    might be tempted to work with the Russians against the Americans, Iran
    might consider an arrangement with the United States — particularly if the
    United States refocuses its attentions elsewhere. On the upside, this
    would free the U.S. from Iraq. On the downside, the Iranians might not
    want —or honor — such a deal.
  2. Enter into negotiations with the Russians, granting
    them the sphere of influence they want in the former Soviet Union in
    return for guarantees not to project Russian power into Europe proper. The
    Russians will be busy consolidating their position for years, giving the U.S.
    time to re-energize NATO
    . On the upside, this would free the United
    States to continue its war in the Islamic world. On the downside, it would
    create a framework for the re-emergence of a powerful Russian empire that
    would be as difficult to contain as the Soviet Union.
  3. Refuse to engage the Russians and leave
    the problem to the Europeans
    . On the upside, this would allow the
    United States to continue war in the Islamic world and force the Europeans
    to act. On the downside, the Europeans are too divided, dependent on
    Russia and dispirited to resist the Russians. This strategy could speed up
    Russia’s re-emergence.
  4. Rapidly disengage from Iraq, leaving a residual force
    there and in Afghanistan. The upside is that this creates
    a reserve force
    to reinforce the Baltics and Ukraine that might
    restrain Russia in the former Soviet Union. The downside is that it would
    create chaos in the Islamic world, threatening regimes that have sided
    with the United States and potentially reviving effective intercontinental
    terrorism. The trade-off is between a hegemonic threat from Eurasia and
    instability and a terror threat from the Islamic world.

We are pointing to very stark strategic choices. Continuing the war in the
Islamic world has a much higher cost now than it did when it began, and Russia
potentially poses a far greater threat to the United States than the Islamic
world does. What might have been a rational policy in 2001 or 2003 has now
turned into a very dangerous enterprise, because a hostile major power now has
the option of making the U.S. position in the Middle East enormously more

If a U.S.
settlement with Iran
is impossible, and a diplomatic solution with the
Russians that would keep them from taking a hegemonic position in the former
Soviet Union cannot be reached, then the United States must consider rapidly
abandoning its wars in Iraq and Afghanistan and redeploying its forces to block
Russian expansion. The threat posed by the Soviet Union during the Cold War was
far graver than the threat posed now by the fragmented Islamic world. In the
end, the nations there will cancel each other out, and militant organizations
will be something the United States simply has to deal with. This is not an
ideal solution by any means, but the clock appears to have run out on the
American war in the Islamic world.

We do not expect the United States to take this option. It is difficult to
abandon a conflict that has gone on this long when it is not yet crystal clear
that the Russians will actually be a threat later. (It is far easier for an
analyst to make such suggestions than it is for a president to act on them.)
Instead, the United States will attempt to bridge the Russian situation with
gestures and half measures.

Nevertheless, American national strategy is in crisis. The United States has
insufficient power to cope with two threats and must choose between the two.
Continuing the current strategy means choosing to deal with the Islamic threat
rather than the Russian one, and that is reasonable only if the Islamic threat
represents a greater danger to American interests than the Russian threat does.
It is difficult to see how the chaos of the Islamic world will cohere to form a
global threat. But it is not difficult to imagine a Russia guided by the
Medvedev Doctrine rapidly becoming a global threat and a direct danger to
American interests.

We expect no immediate change in American strategic deployments — and we
expect this to be regretted later. However, given U.S. Vice President Dick
Cheney’s trip to the Caucasus region, now would be the time to see some
movement in U.S. foreign policy. If Cheney isn’t going to be talking to the
Russians, he needs to be talking to the Iranians. Otherwise, he will be writing
checks in the region that the U.S. is in no position to cash.

National City, Key or, Iraqi Govt. Bonds?

As it relates to continually tightening credit, we need only look at the current credit spreads to see just how tough it is to procure operating cash in corporate America. Currently, according to the Merrill Lynch US Financial Index, the typical cost to borrow money has increased from 70 basis points over Treasuries to over 390 basis points over Treasuries. A 500% increase in borrowing costs will put the clamps on any new business spending. Now, to put this into perspective, please note the following from John Mauldin.<![endif]–>

it can get much worse for some banks. In the “for what it’s worth”
department, Iraq’s bonds are now considered safer than those of many US banks.
The country’s $2.7 billion of 5.8% bonds due 2028 have gained 45% since August
2007, according to Merrill Lynch & Co. indexes. Investors demand 4.84
percentage points more in yield to own the debt instead of Treasuries, down
from 7.26 percentage points a year ago. The spread is narrower than for notes
of Ohio banks National City Corp. and KeyCorp, suggesting Baghdad may be safer
for bond investors than Cleveland. National City and KeyCorp, based in
Cleveland, have debt ratings of A and spreads of 959 basis points (9.59%) and
7.55 basis points (7.55%), respectively. Iraq debt has no ratings. Clearly the
market is ignoring the rating agencies which give the banks an “A&quo
t; rating. Their debt is priced at the junk level. Go figure. (Source: Bloomberg)”

For those of us here in Ohio, like myself, that light puts a whole new spin on where WE are in this economic cycle.

When it looks too cheap……(stocks)

The following article is by Bennet Sedacca of Atlantic Advisors in Winterpark Florida. Some companies within the banking sector have been beaten up to the point of attractive yields. However, those yields are only attractive if the entity is around to pay them. As a commodity broker I believe there is a place for direct commodity investment in one’s portfolio, so too is there a aproper allocation to dividend yielding stocks. The point is a stock that has declined from $70 to $15 is no better a deal than a barrell of oil declining from $145 to $110 if the fundamentals, like the commitment of traders reports call for lower prices, yet.

Dead Men Walkingby Bennet Sedacca

Dead Man Walking – Originally, a phrase in a poem by Thomas Hardy in 1909, but later in a work of non-fiction by Sister Helen Prejean, A Roman catholic nun and one of the Sisters of Saint Joseph of Medaille. Prejean later wrote ‘Dead Man Walking’, which became a hit movie in 1995. The title comes from the traditional exclamation “dead man walking, dead man walking here” used by prison guards as the condemned are led to their execution.

Death Row – A term that refers to the section of a prison that houses individuals awaiting execution. It is also used to refer to the state of awaiting execution, even in places where a special section does not exist. As of 2008, there were 3,263 prisoners awaiting execution in the United States.

The Last Mile – “I guess sometimes the past just catches up to you, whether you want it to or not. Usually death row is called ‘The Last Mile’. We call ours ‘The Green Mile’-the floor was the color of faded limes.” – Tom Hanks as Paul Edgecomb in ‘The Green Mile’.

Are There Corporations that are “Dead Men Walking”?

The title of this piece sums up how I feel about the current credit markets. When I first started in the industry in 1981 we were worried, but only about one company -the Chrysler Corporation. Prior to that, Continental Illinois was in the forefront. Later in my career, in 1998, it was Long Term Capital Management, the hedge fund founded by John Meriwether that captured our attention. Then we had Enron/WorldCom, and by early 2008 Bear Stearns became a worry and then a problem that needed fixing.

All of these events were isolated, dealt with, often with either direct assistance from Uncle Sam or an effort coordinated by our benevolent/socialist government financial authorities. Markets would become unnerved, fear would grow, and then the Government would step in to make sure that the systemic risk that had finally come to the surface didn’t melt the entire planet.

But this is where it is “different this time”. Not only is it different, I think it may be unprecedented in nature. When I look at my Bloomberg monitor each day that contains my 100 most important indices, companies, commodities, bonds, bond spreads, preferred shares, etc, I shudder. The reason I shudder is that my screen doesn’t have just one “problem child”. It looks like a screen that contains many “dead men walking”.

The Failed Fannie Mae/Freddie Mac Experiment

I recently wrote a piece entitled The Tale of Two Markets, where I talked about the “Fannie Mae/Freddie Mac Experiment”. That experiment has now clearly failed and a bailout/privatization/nationalization of Fannie and Freddie is now being planned. While I have been expecting nationalization for quite a while, I am intrigued along with my peers and colleagues as to why the bailout is taking so long to accomplish. This is where it gets interesting and dangerous from a systemic point of view. My hunch is that the reason for the delay is that the Treasury Department is “peeling back the onion” on Fannie/Freddie and finding out just how much of a mess the two of them are in.

At last count, Freddie had Level 3 Assets of $151 billion while Fannie had $65 billion, for a not-so-paltry sum of $216 billion. When Freddie announced their results a couple of quarters back, they disclosed that most of their Level 3 Assets were of the “sub-prime” variety (the type of assets that started the whole Credit Crisis in the first place). They are also littered with Alt-A mortgages and are leveraged to the hilt.

Just how bad is the news at Fannie/Freddie? On Friday morning, Moody’s downgraded their outstanding preferred stock 5 notches from A1 to Baa3 (a slight gradation above junk) and their Bank Financial Strength Ratings (BSFR) to D+ from B- (one/half notch above D, which is reserved for companies in default). According to Moody’s, “the downgrade of the BFSR reflects Moody’s view that Fannie Mae and Freddie Mac’s financial flexibility to manage potential volatility in its mortgage risk exposures is constricted… particular, given recent market movement, Moody’s believe these companies currently have limited access to common and preferred equity capital at economically attractive terms.” “Dead men walking” defined.

Moody’s went on to say, The GSE’s more limited financial flexibility also restricts their ability to pursue their public mission of providing liquidity, stability and affordability to the US housing Market. Fannie Mae and Freddie Mac currently make up approximately 75% of the mortgage market in the US. A reduction in the capacity of these companies to support the US mortgage market could have significant repercussions for the US economy. In an effort to thwart broader economic effects, Moody’s believes the likelihood of direct support from the United States Treasury has increased.”

Let me put it this way. “We the people” are about to become owners in Fannie and Freddie, whether we like it or not. The capital markets have shut on them both as their stocks trade in the $2-5 range, down from the $70-80 level just a year ago. And the yield on the outstanding preferred shares hovers in the 18-23% range, quite the bargain if they keep paying, but also it is the market’s way of saying “beware the value trap”, as the preferred shares may pay another dividend or two, but that is about it.

When the Treasury peels back the onion, I believe they will find a hornet’s nest. I think we will see an initial bailout of $100 billion or so, with 2/3-3/4 going to Fannie (as it is a larger organization). The scenario I foresee however, just as happened at Merrill Lynch, Lehman Brothers and Morgan Stanley, is that they came to the financing window expecting to have borrowed enough, but then find they have to keep coming back repeatedly until the buyers go away or until “We The People” have thrown at least $500 billion at Fannie/Freddie to get them back on their feet again. This will also likely take an Act of Congress to raise the Treasury’s Debt ceiling quite dramatically.

I will now identify who might be the other “Dead Men Walking”.

More Dead Men Walking-Is There a Pattern?

What strikes me the most about impaired companies, whether they are automakers, airline companies, banks, brokers or GSE’s, is that they seem to sing the same tune, or have the same pattern of behavior. This is how I have attempted in the past to identify what would be in trouble in the future (whether that was just to avoid their stocks and bonds from the long side or to try to profit from their missteps on the short side). It is a pattern that is not terribly dissimilar from the emotion charts I like to focus on so much. In the graphic below, I will offer my “recipe for disaster” for a bank or brokerage firm. I would like this cycle to be called, “The Dead Man Walking Cycle”.

The first tip-off or “tell” is when a company releases earnings or some sort of positive announcement and the stock falls. Another important tell is the credit spreads of the debt as the company begins to widen. Then, the
company will usually announce that “all is well” and is so great that they will buy back stock and not “cut the common dividend”. After this comes the “acceptance” phase and write-offs/write-downs are announced and then some Sovereign Wealth Fund or Private Equity firm will inject capital or that a company within the same group will buy a “strategic stake”. After a brief pop in the stock and short covering rally, the stock begins to fall further and credit spreads begin to blow out and preferred shares get hammered. Then, uh-oh, more write-downs and more write-offs and yes, another capital raise and finally a dividend cut to ‘preserve capital’.

Sound familiar yet…?

All of this goes on for quite some time, until your stock price is so low that you would have to issue so many shares in a secondary offering that you dilute your shareholder base until it is unrecognizable. With this new share offering your credit, while still rated investment grade, trades like junk, and your preferred shares rise to double digit yields. Further, the former strategic buyers, Sovereign Wealth Funds and Private Equity firms have taken such a beating that there are no further buyers.

Yet the write-downs and write-offs continue unmercifully as the economy slows and credit is all but cut off. Eventually, dividends go to zero and you are a “Dead Man Walking”.

There are only a few things that can happen to the companies that are walking “The Green Mile”. Either you make it to the electric chair (in the movie “The Green Mile” it was called “Old Sparky”) and cease to exist or you are eventually forced into the arms of a better capitalized institution. Over time, I expect a bit of both but mostly of the latter.

Keep in mind that if too many are allowed into the arms of Big Sparky”, it will have a systemic effect as all the institutions are so intertwined because when one group of institutions are forced to mark their bonds to market, others are forced to do the same, ending in an ugly daisy chain. I think the chain has formed and that many are about to “walk the mile”.

In the end, perhaps years from now, many banks and brokers will be merged into an international list of “good banks” or “Live Men Walking”. Who are the Live Men Walking? They are likely Bank of America, Bank of New York, JP Morgan Chase, Northern Trust, State Street, US Bancorp, ABN Amro, Deutsche Bank, BNP Paribas, Royal Bank of Scotland, Barclays, Allianz and a few others. The following cycle is how the cycle goes from good bank to ‘Dead Man Walking’.

The “Dead Man Walking” Cycle

Who Are the Dead Men Walking?

Above, the cycle begins with denial, and ultimately ends up in despair. At first, the company denounces that anything is wrong, but Mr. Market has a way of sniffing out who is imitating Pinocchio. Ultimately, the company ends up in despair when they need/want to raise capital to just be able to function normally, but alas, they cannot because the window of opportunity to raise capital has shut.

Let’s use Lehman Brothers as the poster child of this sort of behavior. I wrote a piece last week that singled out National City, Washington Mutual and Lehman Brothers. Before the credit crisis started, Lehman, at the time known for its savvy timing, suddenly came to market for $5 billion of long-term bonds when they didn’t need capital-or did they know something was awry as I suspect? Last year, with the Credit Crisis in its infancy, Lehman announced a $100,000,000 stock buyback. The shares, as you would expect, popped on the news, but of course no stock was ever re-purchased. As the stock began to sell off, they kept saying that capital was not needed.

Then, on June 9, 2008 they sold 143,000,000 shares at $28 per share. As hedge fund manager David Einhorn said, “They’ve raised billions of dollars they said they didn’t need to replace losses they said they didn’t have.” In between was an enormous preferred stock deal-75,900,000 shares at $25 per share at a rate of 7.95%. Those shares now change hands at $15 per share for a yield of 13.1%. Its pretty hard to turn a profit when your cost of capital is greater than 10%.

During this time, in January, the company actually raised its common dividend by 15% year-over-year. They have written off north of $8 billion since the Credit Crisis began and when they release earnings (or lack thereof) next month, estimates are for another round of $2-4 billion of write-downs. They have reportedly been trying to shop $40 billion of impaired real estate and they are mired in all sorts of Alt A, sub-prime, CMBS and CDO’s and CLO’s.

The best part is that they said they “shrank their balance sheet” when in fact they were sold to an “off balance sheet subsidiary” that they own part of. The bonds weren’t sold, they were just “relocated”. I sure wish I could do that when I make a mistake. And lets not forget that the Federal Reserve opened up the discount window to primary/dealers so that they could off-load a bunch of nuclear waste on to the Fed’s balance sheet, which now looks like one big hedge fund in drag. And then the SEC temporarily changed short selling rules for ‘the Group of 19’ (the GSE’s and Primary Dealers) for a few weeks, resulting in a short squeeze, but their shares still hobble along at recent lows.

On Friday, there was a rumor that the Korean Development Bank would buy Lehman, but again that turned out to be hogwash. And if they wanted to raise debt, like they say, “lotsa luck”. Their bonds trade around +500 basis points to treasuries but my guess is that even if they could get deal done, they would have to come in the 10% range, again, uneconomic.

So now we have the recipe and an example for “Dead Men Walking”:

  • Common stock too low to issue new shares.
  • Preferred stock yield too high to issue new shares economically.
  • Issuing debt is uneconomic.
  • More write-offs coming in days to come.
  • Business trends are awful.
  • Denial.

Now that we have identified the “poster child”, let’s find a few more… Or sadly, more than a few.

Zions Bancorp

  • Equity has traded down from $75 to $25.
  • Tried to issue a $200 million preferred stock offering at 9.5% but only was able to sell $47 million.
  • Their debt trades in the open market approximately 1,000 basis points above Treasuries, IF you can sell them, or 13 14%.
  • They are geographically in Utah, but spread out to Florida, Nevada and Arizona at the top of housing to take advantage of great opportunities.
  • They say they need $200-300 million capital. Good luck.
  • They maintained their common dividend.


  • Common Stock has traded down from $40 to $11.
  • Preferred Stock trades at 13%.
  • Debt trades in the market at 10-11% dividend.
  • Cut dividend in half in July, still yields 6.5% even while they lose money.

Fifth Third Bank

  • Equity has traded down from $60 to $14.
  • There are no preferred issues outstanding.
  • Debt trades in 10-11% range if you can sell it.
  • Cut dividend by 75%.

Washington Mutual

  • Equity has traded from $40 to $3.
  • No preferred outstanding except convertible preferred.
  • Debt trades in the 20-25% range.
  • Cut the dividend to $0.01 per share in April.
  • Has admitted they will lose money for the next several years.

National City

  • Equity has traded from $40 to $5.
  • Preferred stock trades at 13-15%.
  • Sold a huge amount of shares at $5 per share in April.
  • Cut dividend to $0.01 per share in April.

Regions Financial

  • Equity down from $40 to $8.
  • Preferred Stock Trading at 10%.
  • Debt trades in the 10-11% range, if you can sell it.
  • Cut dividend by 75% in June.
  • Needs to raise $2 billion, according to Sanford Bernstein.

ral Motor/GMAC

  • Equity has traded from $80 to $10.
  • Preferred stock trades in 18% area.
  • Short-term debt trades in 25-30% range.
  • Long-term debt trades in 17% range.
  • Eliminated common dividend in July.

Ford/Ford Motor Credit Co

  • Equity has traded from $60 to $4.
  • Preferred stock trades in 16-17% range.
  • Long term debt trades in the 18-20% range.
  • Eliminated common dividend in September.


  • Equity has traded from $60 to $14.
  • Issued a $3.5 billion “hybrid security” in February that now trades at 11%.
  • S&P has stated they cannot issue any more hybrids.
  • Sold 92,000,000 shars of a preferred stock in December at 8% that now trades $18 or 11%.
  • Cut common dividend twice since February to $.05 a share or 90%.
  • Debt trades at 9.5-10.5%.


  • Equity has traded from 60 to 9.
  • Preferred Stock trades in 12% range.
  • Outstanding debt trades in 12-14% range.
  • Cut common dividend by 66%.
  • Sold 91,000,000 shares of common at $11 in April 2008.

Who are in the “Limping but Not Dead Man Walking Crowd”?

These companies would include those that may be ‘too big to fail’, have enough quality assets to sell, a franchise that is worth something to an acquirer or could just be broken up into pieces. They include:

  • Citi
  • Merrill Lynch
  • Morgan Stanley
  • Suntrust
  • Legg Mason
  • Capital One
  • AIG
  • MetLife
  • Prudential

Summary – This is NOT Shaping Up to be a Pretty Couple of Years

I am certain that I have missed a bunch of names on the “Dead man Walking List”, but the pattern is rather easy to discern. As I stated early on, when we have one or two firms in trouble, we can deal with it. But when we add rising unemployment, explosive debt growth in recent years and non-performing assets to many hobbled financial institutions with trillions of dollars of exposure, it is hard not to be concerned.

For this reason, we remain cautious towards credit, expect a hard sell-off in stocks into 2010, consolidation in the financial services industry and some pain, like it or not. I am just not sure where the capital will come from to bail everyone out simultaneously. And even if the capital showed up, it would likely come at a cost that is uneconomic and would likely be dilutive for many years to come.

It is why we expect much lower than consensus earnings across the board and lower stock prices ahead. In the meantime, we sit with our historically cheap GNMA’s at the widest spreads in 20 years and continue to add to that position. In the meantime we position our portfolios so that if we are wrong, the most we can lose is opportunity, not precious capital.

Dollar’s Strength an Anomaly?

The U.S. Dollar surged through its daily resistance and is well on its way into the overhead weekly resistance between 75.88 and 77.24. Although the rally has been impressive, it’s important to maintain the perspective that the Dollar is in a bear market. Even if we were able to rally another 300 points, that would only bring us back to the 38% retracement level from the ’06 highs.

Of recent interest in the Dollar’s surge are the factors that television commentators claim are fueling it. The major factors receiving notice are, the decline in energy prices and commodities in general, the European Central Bank’s deflationary comments and finally, the worse than expected jobless claims number. The following factors are deflationary and the U.S. equity markets are rejoicing.

I would ask the question, “Have the preceding factors created a bottom in the economic cycle or, are we seeing a more general global slowdown?” I believe that the domestic economic issues have not been addressed and that a globally deflationary environment will create more problems for the U.S. Dollar than it will solve.

First, examine the chart on import prices. The double top may have proven to be the limit. Clearly, it has already begun to turn down. This index includes oil which, when priced separately, is 5% higher than imports in general. Oil is germaine to the topic because the $25+ decline has NOT been priced in and will contribute greatly to the establishment of this chart’s double top.

If, in fact, overall commodity prices are topping out then, this will also reduce demand for U.S. commodity exports. Exports have helped to offset the declining Dollar over the last two years as global demand and globally anomalous weather patterns have made the U.S. the supply center for the world. Dollar strength and, or a global slowdown will curb the primary growth engine for the U.S. economy. What effect will this have on a sluggish employment picture?

Obviously, the unemployment pressure is still to the upside. Will global commodity deflation offset the cost of a declining employment base? According to many pundits, the tax refund checks have gone to cover current expenses, rather than paying down debt. That leaves many people still looking for meaningful employment opportunities. This is most clearly illustrated in this week’s jobless claims.

The past two weeks’ claims have surpassed the historically significant 450,000 threshold. As you can see from the chart, this threshold is frequently accompanied by a recession. Based on the previous factors, I fail to see continued strength in the U.S. Dollar or, the U.S. economy. While the equity markets have broached the 20% bear market threshold and, recently bounced, I still view this as a selling opportunity in both equities and the Dollar.

It appears that this is beginning to be priced into the interest rate markets as well. Inflationary pressures are easing. This is taking the pressure off of the Federal Reserve Board to tighten rates at the next meeting on September 6th. Furthermore, the declining employment picture will add pressure to hold or, LOWER, rates at meetings through the end of the year. This stance is contrary to the hawkish inflationary stance that has been their premise for much of this year. Finally, the combination of a declining equity market in an election year would also add to the shift in the FOMC’s position from hawkish to dovish. The last chart is beginning to tip the market’s hand as it points to lower rates ahead……once again leading to a lower Dollar.


The Epitome of Fair Trade

The CME Group has modified their allocation method for distributing electronic order executions. This is simply the most fair and equitable marketplace in the world.

How many times have you bought the high or, sold the low on a stop or market order? My guess is that it’s happened to you far more often than you’ve been able to buy the low or, sell the high. In the past, the reason for this has been the manual execution of orders in the open outcry markets on the trading floors of the various exchanges. Here’s the way this process used to work:1) Your order is placed with your broker on the phone.2) Your commodity broker places the order with a phone clerk on the floor of the appropriate exchange.3) The phone clerk sends the order to the pit broker’s clerk.4) The pit broker’s clerk gives the order to the broker…………….That’s the order placement part of the process………………….1) The broker determines how many contracts he needs to buy or sell.2) The broker looks into the pit of 400+ traders to see where the market is trading.3) He rapidly deciphers the hand signals and noises to ascertain the best bids and offers at the prevailing moment.4) The broker decides that the best offer is coming from one guy—across the pit and looking the other way.5) Deciding that he is unable to get the opposite trader’s attention, the broker sees a small trader near him willing to make the same offer.6) The broker makes the trade with the guy in front of him. The small trader waits for the guy across the pit to make his offer one tick better then buys the offer of the guy across the pit and pockets the profit of one tick X the number of contracts traded…………….That’s the execution process…………………….The broker tells his clerk who tells your broker’s clerk so, your broker can then report the fill back to you.

Now, I ask the following questions:1) Is it fair that the small trader got to pocket the free money without taking the risk of actually “making a market?”2) Is it fair that the large trader got his trade done at a worse price while taking the risk of making the market?3) Is it fair that the customer got a worse fill because his clearing firm’s broker couldn’t get the attention of the large trader?4) Is it fair that the customer got a worse price and a delayed notification because the many links in the execution process?

Welcome to the Era of FREE TRADE!!!

The single greatest benefit of the electronic markets has been the equalization of customers, traders and brokers. The second greatest benefit of electronic markets has been the ELIMINATION of floor traders unwilling to make a market or forecast market direction or, in any other way earn a living through their intellectual abilities. ……….The electronic process…………1) Anyone places a bid or offer at a specified price and number of contracts.2) The first bids and offers at a given price are the first ones executed. FIFO.3) Your computer tells you instantly that you have an execution.

If you would like to know the details of how the CME Group makes allowances for partial fills at a given price or, how it justifies a single contract’s importance over a thousand lot, please read their announcement. Otherwise, take my word for it. We have the best system ever devised for true commodity trading price discovery. This is the epitome of fair trade!

CME Group’s modified FIFO allocation method.

Govt. Legislation in Free Markets

By David Goldman,
staff writer

NEW YORK ( — Some of the Democratic lawmakers leading the campaign to crack down on oil traders appeared Wednesday
before the House Committee on Agriculture to explain their proposals.

A dozen or so bills have been introduced on the subject of oil speculators,
and Democratic leaders in the House have promised to address the issue by
tackling what they call “excessive” speculation.

But some Congressmen are skeptical that the legislation will do any good –
and could even cost consumers more by driving up the price of other commodities
such as corn and soybeans.

“Given that charges against speculators have historically been more wrong
than right, it is important that we have the facts, data and analysis that
demonstrate the validity of this contention before we take action,” said
committee chairman Collin Peterson, D-Minn. “Any legislative remedy that seeks
to remove speculative interests from futures markets could result in more
volatile markets, as the role of speculators has always been vital for price
discovery and liquidity.”

The slew of speculation-tackling bills that have not yet faced a vote address
a variety of issues.

Some have bipartisan support, such as one increasing the Commodity Futures
Trading Commission’s (CFTC) budget, and some are more contentious, such as
limiting over-the-counter trades to producers and boosting traders’ margin

If applied to all commodity traders, some lawmakers say the propositions may
have unintended consequences on other markets.

“Increasing margin requirements, for example, would be very problematic, as
volatility in the futures prices of the grains … has already made it tough for
elevators in farm country to meet margin calls,” Peterson said. “Such
instability can have serious effects on the prices we pay at the

Legislation necessary to combat high oil prices

But other lawmakers are convinced that curbing excessive speculation by
expanding the role of CFTC will help reduce oil and fuel prices for

“While some have advocated for doing nothing and others believe that we
should simply bar index investors and others from the energy commodity markets
altogether, I believe what we really need is a level playing field that is
transparent and accountable,” said Rep. Jim Matheson, D-Utah. “Our goal should
be to make sure that the regulator – the CFTC – has the ability to ensure undue
manipulation isn’t taking place in the markets.”

Though many lawmakers are still unconvinced that speculation plays a role in
higher gas prices due to a lack of concrete evidence, other Congressmen say the
circumstantial evidence is enough reason to act.

“In light of the dramatically increased speculative inflows into the energy
futures markets … coinciding with a staggering 1,000% jump in the price of a
barrel of oil, I believe the burden is on those who would argue for maintaining
the status quo,” said Rep. Chris Van Hollen, D-Md.

“Proponents of maintaining current law must definitively demonstrate that the
exceptions we have thus far permitted to persist in the Commodities Exchange Act
do in fact support the primary functions of price discovery and offsetting price
risk necessary for a healthy energy futures marketplace,” Van Hollen added.

Speculation debate continues

Since 2003, the volume of investment funds in commodity markets – especially
oil – has risen from about $15 billion to $260 billion, according to the
International Energy Agency (IEA), an influential oil-policy group.

But the IEA released a report last week arguing that the increase in
oil-market speculation is not driving up crude prices.

“There is little evidence that large investment flows into the futures market
are causing an imbalance between supply and demand, and are therefore
contributing to high oil prices,” the report said.

But the study far from ends the debate.

“A growing chorus of congressional testimony and market commentary from a
wide range of credible and authoritative sources has concluded that the run-up
in today’s price of oil cannot be explained by the forces of supply and demand
alone,” said Van Hollen.

Even analysts who concede that the laws of supply and demand are the main
contributors to record oil prices say that speculation can make price swings
more volatile.

The House Agriculture panel has planned hearings Thursday and Friday to
further discuss the issue of amending the Commodity Exchange Act. To top of page

Defending the $ and Popping the Bubble

Yesterday, Bernanke stated that a weak Dollar was not in America’s best interest. Typically, this statement would be argued against based on a weak Dollar’s contribution to exports helping to grow a weakened domestic economy. Bernanke’s point, I think, is that inflation is a bigger worry than recession. Dollar based commodities, primarily grains and energy are having a greater negative impact on our economy than can be offset through higher exports. Inflation in these primary goods is acting as a tax on the American consumer. Right now, the economy cannot create enough high quality jobs fast enough to offset the economic pain that is felt at the gas pump and grocery store.Further more, Bernanke also stated that he will work with Secretary Paulson to defend the Dollar’s decline. This is important because the Federal Reserve and the Treasury are separate entities. It is a big deal that Bernanke used language such as, “In collaboration with our colleagues at the Treasury…” as well as, “…ensuring that the Dollar remains a strong and stable currency.”

These are strong words from the chairman of the Federal Reserve. The perfect storm could be brewing……strengthening Dollar combined with regulatory action, via the CFTC closing the “swap loophole” on Commodity Index Traders could bring liquidation across the commodity spectrum. It will be important to check the Commitment of Traders Reports for position changes.

Commodity Index Funds & Investment Banks

This is from John Mauldin at http://www.frontlinethoughts.comI think he does a wonderful job of explaining how the Commodity Index Funds stay off of the CFTC’s radar in their weekly Commitment of Traders reports.

Swapping out Commodities

The Commodity Futures Trading Commission announced yesterday that they are
looking very hard at possibly closing a regulatory loophole that allowed some
extremely large commodity index funds to get around position limits. For those
not familiar with the concept of limits, it basically works like this. No trader
or fund is allowed to own more than a specific amount of a commodity traded on
the futures exchange. This limit varies from commodity to commodity and exchange
to exchange. The point is to keep one group from manipulating the price of a
commodity, as the Hunts did with silver in the early 80s.

The loophole is one where large investment banks can sell a “swap” for a
specific commodity like corn and then hedge their position in the futures
markets. There is no limit on the amount of the commodity that can be hedged.
So, a fund can accumulate sizeable positions far in excess of what they could do
directly by working with an investment bank. In essence, the swap is a
derivative issued by a bank which acts just like a futures trade, but it is with
the bank as guarantor and not an exchange. Swaps are not regulated as such. And
up until now, the banks were seen as legitimate hedgers so there were no limits
on what they could buy in the futures markets.

This works for very large commodity index funds which try to mirror a
particular commodity index and need to be able to buy very large positions in
excess of the normal limits (and there are scores of them), and for the banks
that make the commissions and profits on the swaps. Remember, the fund gets a
management fee, so growing the size of the fund grows their fees.

These indexes typically have about 26 commodities, with the largest
allocation to oil, but almost anything that is traded has some small portion of
the allocation. As I noted last week, there are some who believe this is working
to drive up the price of commodities beyond the simply supply and demand
principles. Whether or not you believe this to be the case, the CFTC is looking
at the loophole.

The key word in the announcement yesterday was the word “classification.” Their classification can be tracked in the Commitment of Traders Report classified as hedgers and as such have no limits. But
they are not rea lly hedging the actual physical commodity as a farmer or
General Mills might do, but the hedge is their financial position.

CFTC vs. Commodity Index Traders

High grain and energy costs have finally generated enough momentum for the politicians to get involved. This past week, a paper was presented to Congress by Michael Masters of Masters Capital Management. He attributes the current price levels to creating an artificially high floor price due to the asset class categorization of commodities. The long only money that has poured into the markets is creating, “demand shock from a new category of speculators: institutional investors like
corporate and government pension funds, university endowments, and sovereign
wealth funds. He also, matter of factly states, “Index speculators are the primary cause of the recent price
spikes in commodities.”

One statistic that is being roughly, though widely, quoted, is the assumption that demand for exchange traded commodities over the last five years has increased equally between China and Commodity Index Funds. The CFTC is prepared to overhaul its system of reportable trading categories and players to try and pinpoint who is trading what and how much. The purpose is to differentiate between true physical price discovery and speculative froth.

Congress is prepared to assist the CFTC in outing the institutional speculative money by closing the swaps loophole that has allowed the billion dollar funds to enact futures transactions as swaps through their securities brokers (Merril, Goldman, etc.) who then hedge the swap in the futures market. This is how every individual fund has managed to stay off of the CFTC’s Commitment of Traders reports. The commodities are held assets with their broker while the broker executes the hedge and reports the position as their own.

The CFTC and Congress working hand in hand could bring an end to this bubble far quicker than peace in the Middle East or a bountiful global harvest.

Please, feel free to comment or, question. This is a small picture painted in broad brush strokes.

Have a wonderful weekend, Andy.