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The Great Deleveraging will take a while

History offers little comfort for the “great deleveraging” process we are experiencing right now. (source: WSJ)

The Great D(eleveraging)

Leveraging Took Awhile,
And So May the Unwinding;
Little Comfort in History

The specter of deleveraging still haunts the financial markets. Rightly so, for the removal of credit from the global economy is a process that feeds on itself. That means that the credit crunch could easily turn into something much nastier.

Before the deleveraging came the leveraging. Take the U.S. The ratio of all sorts of debt to gross domestic product rose to 342% at the end of September 2007 from 160% in 1975. Through 2000, debt increased by 2.4 percentage points a year faster than GDP. But after the turn of the millennium, the rate accelerated almost to 3.7 percentage points a year.

SNOWBALL EFFECTS

When Debt Was Good: People bid more for a house because banks were willing to lend more. That helped house prices rise and gave the bank more confidence about lending yet more. So people borrowed even more and built an addition or bought a new car.
When Debt Becomes Bad: Banks decide they need to call in lines of credit. As some borrowers are forced to sell assets, prices fall. Banks get spooked by the falling value of collateral and cut back even more on lending.
How Bad is Bad? In Japan, despite massive government borrowing and five years of a near-zero interest rate on overnight borrowing, the prices of shares and real estate declined by 40% to 70%. In the U.K., house prices dropped by 40% in the early 1990s, after taking inflation into account, but share prices rose.

While it was happening, only a few sourpusses complained. Increasing debt was seen as a natural trend. As economies get richer, they have more need for debt-financed investments and inventories. But lending grew much faster after 2000 than even the most gifted apologist could explain away. It was a bubble, which has now been popped.

In a credit bubble, one thing leads to another. You can bid more for a house because banks are willing to lend more. So house prices rise, giving the banks more confidence about lending yet more. So you build an addition or buy a new car.

Multiply that by a few hundred million borrowers and presto, asset prices go up and economic growth is high. Banks rejoiced. They set up off-balance-sheet vehicles that piled on debt. Leveraged-buyout groups borrowed to take companies private; hedge funds borrowed to invest in assets. And so on.

In deleveraging, too, one thing leads to another. Start with a bank that has lost a few billion dollars on subprime mortgages. The bosses are likely to decide that troubled times call for higher capital ratios. That means calling in lines of credit. Some borrowers are forced to sell assets, pulling down prices. The banks then look at the value of their collateral and think: “Oh my god, it’s not worth what we thought.” They then cut their credit again — giving another turn of the deleveraging screw.

The housing market was just the start. A series of debt mountains — credit cards, car loans, LBO loans — risk being leveled. The credit contraction strikes down financial arrangements that once looked solid — from structured investment vehicles to auction-rate securities.

If the original debt helped fuel consumption, deleveraging will feed into lower economic activity. If the original debt fueled asset purchases, the consequence will be lower asset prices. There could be a dual effect because lower asset prices can make people feel poorer and less willing to spend money. This is especially the case with people’s homes.

How far can this go? Historical parallels aren’t terribly comforting. In Japan, a boom in the 1980s was followed by a painful deleveraging. Despite massive government borrowing and five years of a near-zero interest rate on overnight borrowing, the prices of shares and real estate declined by 40% to 70%. The U.K. did better in its deleveraging after 1990 — house prices dropped by 40%, after taking inflation into account, but share prices rose.

Politicians and central bankers are alarmed by the rapid shift to deleveraging. There are limits to what they can do. Sharp interest-rate cuts may not be enough to make banks abandon their newfound caution in lending, especially if loan losses are rising. Higher government deficits may not help either. In a deleveraging world, the government may borrow so much it crowds out private borrowers seeking funds.

The deleveraging snowball will eventually reach the bottom of the mountain. Banks will start to see opportunities, and borrowers will become more courageous. But it could be a long and painful wait.

Global Macro, the come-back kid

Global macro strategy, which has been out of favor for years, is coming back strong in current turbulent time.
 
 

'Global Macro,' the Strategic Sequel 

As Wall Street firms hunger for dependable trading profits, an out-of-favor strategy is making a comeback.

Now that volatility has returned and interest rates are moving, some traders using a so-called global macro strategy are thriving. By betting on economic trends in currencies, interest rates and other instruments around the world, these traders have been scoring big gains.

[Hedged Bet]

Last year, global macro funds rose more than 17% on average, according to Credit Suisse/Tremont Hedge Fund Index. These funds gained 1.7% on average in January, according to Hedge Fund Research, a Chicago-based research firm.

One of the funds with the biggest gains is Alan Howard's $20 billion Brevan Howard Asset Management LLP. The London-based fund racked up winnings of about 10% last month, even as many hedge funds sputtered and global stock markets tumbled. Mr. Howard's profits come on the heels of gains of 25% in 2007 for his firm's flagship hedge fund.

Other winners include GLG Partners Inc.'s macro fund, managed by Greg Coffey, which was up 51% last year, and Peter Thiel's Clarium Capital Management, which jumped more than 24% in January and more than 40% in 2007.

These kinds of funds can include a variety of styles — and returns vary wildly. Paul Tudor Jones's Tudor Investment Corp., one of the largest and most respected macro funds, gained less than 1% in January, investors say, while Goldman Sachs Group Inc.'s Global Alpha fund has been struggling.

The bond market's volatility, falling interest rates and a steep yield curve in the U.S. — or a difference in yields between short- and long-term debt — is causing the "sort of environment that is very good for macro managers," says Gary Vaughan-Smith, a partner at London-based SilverStreet Capital LLP, which has about $700 million under management.

[George Soros]

That is advantageous for someone like the 44-year-old Mr. Howard. His firm is blossoming, soaring from $12.5 billion at the beginning of 2007 to become one of the largest hedge funds in the world. Other macro-oriented hedge funds have become hot tickets, too, investors say. Popularized by billionaire investor George Soros, macro trading was widely practiced two decades ago. But its popularity waned as the global economies turned calm, rising in unison.

The macro strategy "seems to be the only thing that is performing in this current period of market upheaval," says Omar Kodmani, senior executive officer in London at Permal Group, a fund of hedge funds that is a unit of Baltimore investment company Legg Mason Inc. It is among investors that have been adding money to macro funds like Brevan Howard over the past year.

In recent years, Brevan Howard's annual gains weren't particularly extraordinary — about 10.5% on average. But Brevin Howard specializes in short-term trades that generally profit as interest rates in developed nations fall, a stance that has helped lately. The fund also has profited from a series of currency investments. It does a bit of stock trading, too, in recent months sticking with consumer staples.

Brevan Howard steers clear of so-called credit wagers, or investments that depend on the improving or deteriorating quality of a company's credit, difficult terrain in the past year. Mr. Howard's traders work independently, judged on their performance. That strategy creates a competitive environment that rewards top performers, say people close to the firm.

As chief investment officer, as well as chief executive, Mr. Howard is responsible for 20% of the flagship fund's investment portfolio, as of October 2006, according to regulatory filings. Mr. Howard, who sits in the middle of the firm's trading room surveying his traders, contributes to Israeli and other charities, such as Holocaust education. He lives near several of his firm's senior partners in Hampstead, an affluent, leafy London neighborhood.

He received a master's degree in chemical engineering in 1986 from London's Imperial College of Science and Technology. Working as a trader for Credit Suisse, Mr. Howard itched to start his own hedge fund as the firm became more conservative under then-head John Mack. But he told an acquaintance that he wouldn't quit the bank unless he could raise $500 million to $1 billion.

He did exactly that, leaving Credit Suisse in 2002 and starting Brevan Howard with $870 million, increasing it to $1.2 billion in its first month. Brevan Howard now invests money for Credit Suisse and the bank acts as a broker for the fund.

Last spring, Mr. Howard raised about €770 million ($1.13 billion) from listing a fund called BH Macro on the London Stock Exchange, falling short of the €1 billion he had hoped to raise, as some investors weren't impressed, at the time, by the firm's returns. Proceeds of the listing were invested in the flagship Master Fund, which is otherwise closed to new investors.

Brevan Howard executives are upbeat that the recent big gains will continue, anticipating that interest rates in a number of countries will head even lower. In a recent shareholder letter, they said they expect the European Central Bank to hold rates steady, that the U.S. is likely to slip into a recession and that the economy of the United Kingdom will continue to slow.

The firm also expects the problems in the banking sector to continue and the "punishing recession" in residential investment to spill into other sectors, it says in the shareholder letter. "In short, [Brevan Howard] sees anemic growth in 2008 with downside risks," the letter adds.

 
 

Same old credit problem

A nice piece from wall street journal that looks into similarities of many different credit problems.
 
 
When Nerves Get Short, Credit Gets Tight
 
One aspect of this credit crisis has a familiar ring to it. All around, investors and lenders are getting squeezed because they depended on short-term borrowing to finance long-term holdings. When their lenders get nervous, once-cheap short-term borrowing becomes dangerously expensive or disappears altogether.

Think about the Americans with sketchy credit backgrounds who depended on adjustable-rate mortgages to finance home purchases. Many thought they would refinance into fixed-rate mortgages if their adjustable rates reset much higher. Instead, their rates shot up and their banks wouldn't refinance. For many it suddenly becomes impossible to finance the most essential of long-term investments — a home. Nearly 16% of risky, subprime mortgages with adjustable rates were at least 90 days delinquent as of Sept. 30, compared with 6% for subprime mortgages with fixed rates.

[Chart]

Wall Street is getting trapped by short-term borrowing in different ways. Two prime examples from last year were investments known as asset-backed commercial paper and structured investment vehicles. In both cases, banks and their clients went to the short-term commercial-paper markets to raise money. They used the money to acquire long-term investments, such as mortgage debt, or to make long-term loans. When commercial-paper markets seized up, the short-term borrowing rates soured and the strategy imploded.

An old-fashioned bank run works the same way. Depositors put their money in a bank, understanding they can pull it out at a moment's notice. Banks use the money to make long-term loans to businesses or homeowners. When depositors get skittish and demand their money back, the bank has a problem: the funds are tied up for decades with customers. That is what happened to a British mortgage lender called Northern Rock last year. Now, the bank has been nationalized.

Something with similar contours is happening in the auction-rate-securities market. Municipalities, museums, student lenders and others issue these securities, which have interest rates that reset every week to 35 days. They use the money to finance projects or make student loans with long repayment periods. Investors have fled the market, and the municipalities that issue the notes have had to digest soaring interest costs.

There is nothing new about any of this. It was an ingredient in the financial crises that plagued emerging markets in the 1990s. Countries that depended on short-term debt got squeezed when investors became skittish about the miracle stories of emerging-market growth. The savings-and-loan crisis of the 1980s had its roots in a mismatch between the maturities of thrifts' long-term assets and their short-term liabilities.

The U.S. government does the same thing. Much of its debt rolls over within a few months or years, even though its obligations to retirees look out as far as the eye can see.

Borrowing short term works most of the time. In the past 26 years, yields on three-month Treasury bills have been higher than yields on 10-year Treasury notes in only 22 months out of 313, or about 7% of the time.

The trouble is even the most sophisticated bankers have very short-term memories. Because when the strategy doesn't work, the consequences can be dire.