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As we look at today’s set up for the S&P 500, the range is 34 points or 1.4% (1,064) downside and 1.7% (1,098) upside.

  • ADVANCE/DECLINE LINE: 790 (+1068) Breadth turned positive on a flat day for the S&P
  • VOLUME: NYSE - 788.90 (-9.49%) - 35% below the average for the last 12 months!
  • SECTOR PERFORMANCE: Two sectors positive - XLB and XLK
  • MARKET LEADING/LOOSING STOCKS: Apollo +5.2%, Cliffs natural +3.3% and Devry -8.7% and Washington Post -8.1%


  • VIX - 26.10 0.53% - The VIX remains elevated.
  • SPX PUT/CALL RATIO - 1.55 down from 1.83 (low on 07/15/10 of 0.87)


  • TED SPREAD - 20.21 -0.969 (-4.577%)
  •  3-MONTH T-BILL YIELD .16% up from .15% yesterday
  • YIELD CURVE - 2.0802 to 2.0981


  • CRB: 269.36 -0.47%
  • Oil: 75.96 +0.96%
  • COPPER: 334.80 +1.44%
  • GOLD: 1,225 +0.13%


  • EURO: 1.2886 +0.38%
  • DOLLAR: 82.257 -0.33%


  • ASIA - Markets closed mixed; China closed up and Japan closed down.
  • EUROPE - Major indices are trading close to session highs.
  •  EASTERN EUROPE - Trading higher - Slovakia, Hungary and Romania leading the way.
  • MIDDLE EAST/AFRICA - Trading higher - Egypt and Israel up over 1%.
Howard Penney
Managing Director

THE DAILY OUTLOOK - levels and trends













COMPLIANCE: All That Glitters

Matt Taibbi’s latest anti-Goldman polemic was posted on line this last week (Rolling Stone, 11 August) under the poetic title “Goldman: New Reform Law Can Kiss Our Ass.”  In it Taibbi makes the point – long obvious to readers of this Screed – that Goldman executives “don’t expect the new financial regulations to cut into their profits in any meaningful way.”



COMPLIANCE: All That Glitters - chart1



As with so much current anti-Wall Street invective, Taibbi aims his gonzo prose at a paper tiger.  For if the Goldmans of the world have nothing to fear, it is thanks to those who make the laws.
Case in point: the tempest in the backroom beer keg over death benefits for survivors of military personnel who die in action.  This story was broken by Bloomberg (29 July, “Veterans Agency To Probe Insurers On Soldier Benefits”).  (Full disclosure: our CEO, Keith McCullough, is a Bloomberg TV Contributing Editor and regular guest and co-host.)  Suddenly, everyone from the New York State Insurance Department, to the Senate Veterans Affairs Committee, to the White House is calling for “the VA’s immediate investigation into these unacceptable insurance companies’ practices.”
The “unacceptable” practice is, life insurers retaining these death benefits in their own corporate accounts, rather than sending lump-sum checks to the beneficiaries.  The company keeps the interest earned on the balance, and until the balance has been withdrawn by the survivors, pays what the Bloomberg story calls an “uncompetitive interest rate,” pocketing the spread.  The beneficiaries receive a book of drafts which they can use to withdraw all, or any part of the death benefit at any time.  Complaints about this practice have already been thrown out of court (Wall Street Journal, 6 August, “Courts Often Back Insurers’ Death-Benefit Practices”).  Not only is the practice legal, it is embedded in current insurance industry regulations.
Let’s ask a different question.  “Unacceptable” to whom?   Prudential, the company in the Bloomberg story, is the second largest insurer.  You can bet that every state regulator knows about this practice.  As well as every Senator and Member of Congress who has any dealings with the insurance industry.  The task of protecting the public, you see, is tempered by the awareness of which side of the pork-roll is larded.
Now those who make the laws and regulations that have long encouraged this practice are attacking the companies that do it.  And by the way, if this practice looks Structured Notes, it is because the insurance company, rather than segregating the death benefit in a separate account in the name of the beneficiaries, makes an accounting entry, making the death benefit an IOU of the insurance company.  But unlike the “guaranteed” structured notes, the benefit is protected by state insurance authority guarantees.  In fact, states have paid out on such guarantees when the insurers could not come up with the funds.  Guess the regulators were aware of this “unacceptable” practice all along.
Prudential, whose stock trades on the NYSE, has a market cap of over $26 billion.  Its current dividend yield of 1.2% makes it a more attractive income instrument than many money market funds – including, apparently, the rate of interest it pays to survivors.  Let’s face it, insurance companies don’t make money by paying out claims.
According to the website opensecrets.org, “in 2007 and 2008, the insurance industry contributed a record $46.7 million to federal parties and candidates…”  The industry spent $164.4 million on lobbying in 2009, and $85.9 million so far this year.  Prudential, the third-largest lobbying client, has spent almost $4.7 million year to date.
“Unacceptable”?  We think “ungrateful” is more like it.  Legislators and regulators have a fine line to tread in going after the insurers.  It is only a question of time before the industry will tire of feeding the hand that bites it.
Moshe Silver
Managing Director / Chief Compliance Officer

R3: Top-Line Deceleration


August 17, 2010


In an effort to ensure that we deliver the R3 to you, our valued subscribers, on a consistent timely basis each and every morning we are removing the Call Out section of this product. Instead, what you typically find in our Call Outs will be posted as separate stand alone posts.



This morning’s confluence of earnings events confirms broad-based top-line shortfalls, a gnarly setup in light of the headlines we expect out of the Housing Finance Conference today.





- This morning’s confluence of earnings events confirms what we wrote yesterday in our WMT: Our Tone is Changing note.  First, a light topline and little to suggest that merchandising efforts are going to move the needle in the near-term at the discounter.  Inventories also coming in at 4% growth against sales up 2.8%.  Perhaps some apparel markdowns are on the horizon?  Second and as expected, HD comes in with light sales but EPS slightly better.  Guidance goes up slightly and you again have another quarter in which HD controls its own destiny while LOW looks a little worse on a relative basis.  Finally, ANF comes in with the surprise of the morning.  Inventories up 47%, sales up 17%.  Not good.


- Lowe’s noted that extreme summer heat had both it’s positives and negatives for the quarter. On the positive side, sales were strong in appliances (primarily air conditioning), dehumidifiers, and seasonal cooling. On the negative side, consumers were hesitant to spend on nursery and related items. Yard work was one of the first items the consumer gave up on when it became too hot to be outside.


- Canada continues to benefit from limited growth opportunities in the U.S for large retailers. Today marked the opening of the first Victoria’s Secret in Canada, which had approximately three hundred customers waiting in line prior to the doors opening for the first time.


- Keep an eye on Metail, a website plugin that allows the user to enter their specific measurements and ultimately get a realistic 3D model of their body. The model is then used to show how a specific piece of apparel or outfit would look without having to try it on or go to a store. If successful, this adds yet another reason why ordering online is becoming more and more like shopping in the “real” world.




Chinese Footwear Exports Increase 27% - Despite rising labor and sourcing costs, China’s export of footwear to the U.S. continued to grow in double digits in June. Imports from China increased 27% over last year to 179 mm, according to data from the Commerce Department’s Office of Textiles and Apparel. The import value increased 26%. Vietnam, the next largest supplier, increased its footwear shipments 10% to 13.4 million pairs. Indonesia increased shipments 22% to 4.7 million pairs and  Mexico’s shipments rose 46%. <wwd.com/footwear-news>

Hedgeye Retail’s Take: While China’s continued growth isn’t surprising – Mexico’s outperformance is. Over the last decade, Mexico has lost share within the U.S. import mix both in footwear and apparel to far east competitors – this may be a byproduct of more “localized” sourcing given the advent of higher shipping costs of late.


India Under Scrutiny Over Child Labor Issues and Fearful of Potential Boycotts - Apparel manufacturers in India are increasingly anxious about a boycott because of child labor abuses. The U.S. Department of Labor’s Bureau of International Affairs last month included India’s textiles and apparel industry on a list of countries and industries that use forced or indentured child labor. With the U.S. market receiving about one-third of India’s textiles exports, which last year totaled $22.4 bn, Indian manufacturers have a right to be concerned. More than 12 mm Indian children under the age of 14 are thought to work in a wide range of jobs — from cloth weaving to cleaning up in restaurants and homes. Since India increased its use of genetically modified cotton, there have been reports that children are employed to harvest bacillus thuringiensis (or Bt) cotton because it is smaller than normal cotton and easier for small hands to pick. <wwd.com/business-news>

Hedgeye Retail’s Take: India is certainly not the only country under such scrutiny, but it might just be the largest behind only China. Swift and comprehensive action by the Indian government will be needed to ease global scrutiny.


Retailers Plan for the Road Ahead - Retailers continue to keep inventories lean and reduce buying for spring until the economic situation stabilizes. But at the same time, they need to scour the market for interesting new products and categories to lure a reluctant shopper to the cash register. Among the categories primed for growth, many stores believe, are men's woven and plaid shirts and non-denim bottoms, flat-front shorts, striped v-necks or polo shirts, military-inspired jackets and novelty swimwear. In women's, long, lean dresses; tubular knits; retro tropical prints and florals; skinny-ankle pants; head-to-toe white, and American Indian influences are expected to be key to the season for spring, according to the Doneger Group. <wwd.com/business-news>

Hedgeye Retail’s Take: Sounds like “Bill & Ted’s” meets “Austin Powers” come spring 2011…can’t wait. Anyhow, the key is that retailers remain hesitant to ramp inventories heading into the holiday season. We will be keeping an close eye on those that will inevitably “hope” to capture any potential uptick in consumer demand by building supply prematurely.


Retail Footwear Prices Rise 0.6%, But Children's Footwear Drops 4% - Retail footwear prices rose 0.2% in July and advanced 0.6% compared with a year earlier, the Labor Department said Friday in its Consumer Price Index. Women’s footwear prices rose 0.4% in July compared with June and increased 2% compared with a year earlier. Men’s footwear prices fell 0.4% month-to-month and rose 1% in 12-month comparisons. Boys’ and girls’ footwear prices fell 1% compared with a month earlier, and declined 4% year-over-year. <wwd.com/footwear-news>

Hedgeye Retail’s Take: Men’s footwear continues to lag, not a surprise given persistent economic weakness. Either way, declining ASPs are likely an indication of heightened promotional activity given lighter than expected demand.


Pakistan Floods May Drive Cotton Even Higher - The worst floods in Pakistan’s history have disrupted the lives of 20 million people, with much of the devastation in smaller towns and villages near rivers, including the standing cotton crop. The crop, at the point of being harvested, has taken a substantial hit with 10% to 30% ravaged by the floodwaters. An estimated 700,000 acres of cotton cropland is under water and from 1 to 3 million bales out of an estimated 2010 harvest of 14 million bales of cotton, has been laid waste. This includes about 5 percent of the crop in Punjab and 20 percent in the harder hit province of Sindh. Pakistan is the world’s fourth largest cotton producer after China, India and the U.S. There are mixed messages of how severe of an impact this may be, but some officials claim that since it was a bumper cotton crop to begin with, and most of the flooding occurred in the reclaimed land of riverbeds the impact shouldn't be too severe. <wwd.com/business-news>

Hedgeye Retail’s Take: As we noted yesterday, on the heels of the USDA’s crop report last Thursday, this floods continues to be one of the key drivers pushing cotton higher – stay tuned.


Data Confirms Holiday Shopping Pushed Forward Earlier - In 2009, holiday shoppers were on their marks and ready to go long before the traditional Black Friday start to the season, and some retailers were behind the curve. Evidence is coming in to suggest this year will be no different. According to a May 2010 survey by Google and OTX, 35% of US internet users have already begun their holiday shopping and research as of August. That proportion is equal to the 35% who said they planned to start in November or later.  <emarketer.com>

Hedgeye Retail’s Take: As we highlighted in yesterday’s anecdotes, retailers stand ready pushing promotional activity for holiday shopping earlier as well blurring the lines between which is the chicken and the egg.


R3: Top-Line Deceleration   - 1


Shopkick: Retailers Embrace Mobile Commerce App Used in Retail Stores - Shopkick is a mobile device that allows the shopper to enter a participating retailer equipped with a transmitter and instantly learn of deals at the store. In addition, there are opportunities to earn “kickbucks,” Shopkick’s currency, which can be redeemed for rewards or donated to charity.In a move that merges mobile commerce with retail’s brick-and-mortar, American Eagle Outfitters is launching the Shopkick application today in 52 stores in NYC, Chicago, San Francisco, and LA and the form of the rewards is a gift card. Macy’s launched the app Monday in New York, San Francisco and Los Angeles. In two weeks, it will launch in Chicago as well, bringing the total number to 157 stores in four cities for the initial test run. Best Buy has already launched the app. <wwd.com/retail-news>

Hedgeye Retail’s Take: This is only the beginning – let the period of best practice discovery begin…


R3: Top-Line Deceleration   - 2


COLM's Mountain Hardwear Launches E-commerce -  Mountain Hardwear officially launched www.MountainHardwear.com, a new e-commerce site where consumers can buy Mountain Hardwear products online directly from the company for the first time. <sportsonesource.com>

Hedgeye Retail’s Take: Buried among bigger headlines re its new OmniHeat technology and related product, dot-com will only provide an added boost to the top-line.


Simon Doonan to Design Halloween Apparel and Costumes For Target - Asking Simon Doonan to design Halloween costumes is like giving a sugarholic the keys to Dylan’s Candy Bar. Costume Couture by Simon Doonan for Target, is a more sophisticated approach to playing dress-up. Doonan approached the assignment “through the prism of fashion and popular culture. No one wants to look supergoofy. Halloween is the time for people to dabble in the more crazy aspects of popular culture that they don’t normally participate in the rest of the year. They get to be a little hedonistic.” <wwd.com/retail-news>

Hedgeye Retail’s Take: Let the battle between the homemade marvels and Target styles begin…you be the judge come October.


Charlotte Russe Seeks to Entice Twentysomethings and Teens - Charlotte Russe has generated a store prototype that is intended to simplify the shopping experience. New management has retooled the 515-store chain, opened creative offices in San Francisco, updated the logo and assembled an in-house design team. The fresh look for the stores made its debut this month in the revamped Southern California shopping center Santa Monica Place. <wwd.com/retail-news>

Hedgeye Retail’s Take: There’s a reason to chase this market – it’s HUGE, but it doesn’t happen overnight. The results will such efforts will take time to come in, but it’s a start.

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The outlook for replacement demand is better than investor sentiment. We’ll tell you why.



The slow recovery of replacement slot demand is clearly frustrating investors.  The fact is, replacement demand is getting better and we can see pass this perfect storm of impediments.


The replacement market discussion has dominated the price action of the suppliers for quite some time.  On the upside, server based gaming (SBG) was supposed to spur a huge IGT-led replacement cycle in late 2006.  More recently, fears of a permanent 50k annual replacement cycle has pressured the stocks.  Well, 50k in annual replacement units would imply a 19 year cycle.  Knowing that the age of the average North American slot floor is actually not old will go a long way to understanding that the cycle duration will probably normalize close to half that.


Before we can predict better replacement demand we have to understand why it was weak in the first place.  So the slot floors aren’t that old.  What else?  First, the more permanent changes:  a) the average life of a slot machine is longer than pre-TITO (ticket in/ticket out) since there is less wear and tear on the equipment and b) the ease of converting content on existing video slots is also extending the shelf life of slots.  Second and less permanent (we hope) relates to the dynamics of the casino markets:  a) economic malaise impacting casino patrons, b) overleveraged casino operator balance sheets, and c) little new casino competition the last 2 years. 


The Current Replacement Market

The unit shipment trends we’ve been observing also suggest that replacements hit a bottom of 40k units in 2008 and crept up to 43.5k units in 2009.  For 2010, we estimate units will grow modestly to 49k.  However, the heightened competition in the slot space has masked some of this ‘modest recovery’ in replacements that’s already ongoing.  The top 4 suppliers' share of NA shipments dropped from approximately 92% in 2007 to approximately 84% in 2009.  This loss of ship-share by the public companies makes the overall market appear less healthy to the public investor who is only following the top 4.

Young Slot Floors Will Age Quickly


Over the last decade, equipment suppliers have shipped over a million new slots to North America. The total number of slot machines in North America has grown from 580,000 in 2000 to over 921,000 units at the end of 2009.  We believe that an instructive way to look at replacements is as a % of the casino floor that’s been depreciated.  Most casino operators depreciate their slots over 5 years. While the decision to replace slot machines isn’t solely based on age, operators are more likely to order a conversion kit for an underperforming ‘new’ game than replace it and lose their depreciation tax shield.


When we began this project we assumed – like most – that slot floors were old.  We were wrong.  At the end of 2009, 52% of slots in NA had been refreshed over the last 5 years and 80% had been refreshed over the last 7 years.   Despite the fact that only 10% of the depreciated slot floor base was replaced last year, the average age of the floors in North America isn’t that old currently.  However, if replacements persist at the current pace - 21 year replacement cycle or a 10 year cycle of replacing depreciated slots -, the slot floors will ‘get old’ very quickly.  Assuming a replacement pace of 50,000 per year, by 2012, almost 60% of floors will be older than 5 years old and over 37% will be over 7 years old.  This compares to over 67% of slot floors having refreshes within 5 years in 2005. We think that this scenario is highly unlikely.




The Turn

Several factors negatively impacting the slot market should turn in the next 24 months:

  • Given the low level of replacements, slot floors – while still young - are aging fast
  • The economy isn’t booming but most operators would describe the environment as “stable”
  • Many operators have recently refinanced with balance sheets and some are emerging from bankruptcy
  • New competition is about to pick up with many new markets coming online:  Illinois, Maryland, Ohio, and Kansas – so a lot of pressure building to refresh slot floors

Our Estimates Probably Exceed the “Whispers”

In our base case scenario, we assume that replacements grow to 60k in 2011 and 75k in 2012.  In this scenario, by 2012, over 55% of slot floors will be fully depreciated and the implied replacement pace of depreciated units will be 7 years - 12 years for total units.  In our bull case scenario, - 65k shipments in 2011 and 90k in 2012 - we assume that 18.5k units ship to Canada to fulfill orders of ongoing RFPs in several provinces.  Even our bull case scenario suggests a 6 year replacement cycle for fully depreciated units (10 year replacement for total units) and implies approximately a third of slots floors will comprise of units more than 7 years old.  These don’t seem aggressive to us.




We understand the investor pessimism, but we also think some are misinformed about the current age of the slot floor.  We too would be much more pessimistic if we thought that the slot floors were old AND the casinos weren’t replacing machines.  The takeaway here is that replacement demand is getting better and growth has the potential to be explosive.  Demand should normalize significantly higher than current trough-like levels which implies the slot suppliers have significant built-in growth even before we consider the bull new market thesis. 

Exorbitant Privilege

“The US is not a superpower. The US is a financially dependent country that foreign lenders can close down at will. Washington still hasn’t learned this. American hubris can lead the administration and Congress into a bailout solution that the rest of the world, which has to finance it, might not accept.”

-Paul Craig Roberts


I read this quote just a few minutes ago from a respected American who has served his country well.  As an American, it’s painful and embarrassing at the same time to get up each morning and read sentiments like this.  It makes me want to move to Canada (kidding).


Valéry Giscard d’Estaing, a French Minister of Finance in the 1960’s referred to the benefits the United States had in the US Dollar being the international reserve currency as an “exorbitant privilege”.


Yesterday the S&P 500 closed flat on the day on anemic volume; it feels like everyone is on summer vacation.  We learned yesterday that the Chinese are selling their holding of US Treasuries in favor of Europe and Japan.  We are financially dependent on foreign lenders and our biggest creditor is saying “no mas” - on this news the S&P 500 traded flat on the day.   


The dollar sent the right message yesterday, declining 0.50% and it is headed lower.   The actions of the Chinese are telling the rest of the world to flee dollar-denominated paper assets.  This is a problem for the dollar as the Federal Reserve appears to be a lender of last resort for the U.S. Treasury.  While the selling of foreign-held dollar-denominated debt has been orderly so far, the inflow of foreign-held dollars into the U.S. will debase the dollar and lead to higher inflation.  Despite what the FED sees (it’s focused on the “core” figure), the signs of inflation abound in the economy. 


(1)    Gold traded higher yesterday (looking to gain for a fourth day in a row) and has rallied 3.1% in the past month.

(2)    Copper traded up 0.8% yesterday and is up 13.3% over the past month.

(3)    Last Friday, the US CPI number crept higher and will again in August.

(4)    Today’s UK inflation reading is above the BOE target rate

(5)    The US PPI number will also post an upside surprise


Since the US does not have the balance sheet to execute on any creditable plan and the world has little faith in our political leaders, it’s hard to see a way out.  The “Fiat Fools” in Washington have already done everything in their power to spend or to create whatever money was needed to prevent systemic collapse in 2008. 


Yet, today we seem to find ourselves in a precarious position.  While the situation is not overly similar to 2008 (yet); Lehman Brothers’ collapse is one important difference that shocked markets. Many facets of the economy are on a knife edge: housing is once more coming to the center of people’s attention as a concern and unemployment remains at elevated levels. 


Should inflation meaningfully take hold, it would be a death knell for the margin story embedded in the current estimates for the S&P 500.  The only action that will expeditiously calm the markets is more spending or creating of U.S. cash (which creates inflation).  Daryl Jones has written extensively on this; our economy is addicted to foreign financing just as acutely as it is addicted to foreign oil. 


The futures are rallying today on the back of China rising for the third day (up 0.4%) on signs that the Chinese economy is maintaining some momentum in June.  But this is not the case in the US.  The surging trade deficit and anemic retail sales (plus the Fed’s own admission) suggest that 2Q GDP will be revised downward and that 2H10 GDP will be even slower. 


With consumer credit continuing to contract and confidence readings trending downward, downward sequential movement in GDP growth rhymes with what the data is indicating.  We estimate that personal consumption growth will slow to less than 1% in 4Q10 and discretionary spending growth will slow to a rate close to what we experienced in 1Q09. 


The unease with which Valéry Giscard d’Estaing viewed a US Dollar denominated world reserve currency is not a relic of the 1960’s.   In 2009, Luo Ping, director general at China’s Banking Regulatory Commission, said in New York, “Once you start issuing $1 trillion-$2 trillion…we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do”.  Yesterday, we saw this sentiment manifest itself in action.  Keith highlighted Ping’s comment in real-time back in early 2009, and the selling of U.S. Treasuries by the Chinese is indicating that the turn in 10 year US Treasury yields is coming.


Function in disaster; finish in style

Howard Penney


Exorbitant Privilege - hpel

COMPLIANCE: The Birthday Boy of Last Resort

We can share what we got of yours, ‘cause we done shared all of mine…
-         Grateful Dead, “Jack Straw”



It’s Friday the 13th, and Fed Chairman Bernanke is baaaaack, astride his battle-scarred helicopter.  Where foreign central bank officials used to suffer Chopper Envy, the measly purchases the Fed will be able to undertake going forward, as announced by a distinctly half-hearted Chairman Bernanke, make it clear the Chairman’s whirly-bird has been chopped down to size.
And while we’re on the subject, Happy Birthday to Secretary Geithner (born August 18, 1961).  In the spirit of the times, we wish the Secretary many extraordinary and extended returns of the day.
What will be the next shoe to drop?  And will it turn the perpetually youthful Secretary Geithner from a lean and mean 49 year-old into a suddenly decrepit semi-centenarian, or will he continue to tough it out?  His deluded and tenacious clinging to what are generally called “Keynesian” principles notwithstanding, we like Secretary Geithner and wish he were on our side.  (“If only he had used his genius for good…!”)



COMPLIANCE: The Birthday Boy of Last Resort - chart1



John Maynard Keynes was a highly successful currency trader, a self-made millionaire in a day when a million was actually… well… a million, and a man who honed his intestinal fortitude and grasp of human nature where it most counts: in the arena of putting one’s own money at risk.
We do not pretend to speak for Mr. Keynes, but we think his trader’s acumen would temper a bureaucrat’s blind urge to shovel good money after bad in the current scenario.  Indeed, as a currency trader, Keynes would no doubt recognize that today’s money is no longer so Good.  (Tim, maybe you should tell you friend Ben?)
One of the ways in which the yawing Helicopter is trying to stave off the Inevitable is by buying everything that is not bolted down.  And while it has become popular political sport to attack the likes of Congressman Barney Frank, he appears not to be to blame.
It is “Common Knowledge” today that Frank single-handedly trashed the American economy by “rolling the dice” on housing, letting Fannie and Freddie run wild with the public checkbook.  But while Freddie and Fannie enjoy “Most Favored Too Big To Fail” status, the fact is that the private sector issued far much paper, of far lower quality, than Fannie and Freddie combined.  Perhaps the biggest issuer of the worst paper was Lehman Brothers – probably the reason it was subjected to involuntary assisted suicide at the hands of the former Treasury Secretary while the Birthday Boy looked on.
The “real problem” with Fannie and Freddie, as everyone will tell you (but really… everyone.  We hear it from our barber, the guy at the pizzeria and half the cab drivers in town.) is that the government remains on the hook for its debts, but will not acknowledge it.  Indeed, even the steely-eyed Secretary Geithner had occasion to balk when asked outright whether GSE debt is sovereign debt of the United States.
Let’s get it straight: debt incurred by the government on behalf of poor citizens is not sovereign debt.  Debt incurred by powerful private corporations in the process of scamming poor citizens, and foreign investors – that is sovereign debt.  If you don’t think so, look at how much subprime paper has made it onto the Fed’s balance sheet.  TARP was designed to wall off toxic debt by buying it from the banks – a process which would have driven down prices to a less mythical level – but ended up giving money to the banks outright, while allowing them to not write down the worthless paper they continue to hold.  Now where does that paper go?  Behold Helicopter Ben, spinning his blades in reverse, sucking up all that nasty stuff, putting it on the public balance sheet.
Since it’s your birthday, Tim, we thought we’d show you the next tranche of toxic waste to grace the Fed’s balance sheet.  Call it our present to you.
With the ink on Dodd-Frankenstein barely dry, we read (Bloomberg, 9 August, “Structured Notes Are Wall Street’s Next Bubble, Whalen Says”) about the opaque and unregulated market in “structured notes.”  Christopher Whalen, of Institutional Risk Analytics, is credited with predicting the collapse of the mortgage backed market as early as March of 2007, so his insights may bear examination.
Whalen says the banks are using the same loophole that permitted the over-the-counter CDO and auction-rate securities markets to metastasize, and selling illiquid structured notes – one-off private contracts – often with little disclosure, and promising “enhanced yields that go well into double digits.”
The firms originating these contracts have no obligation to make markets in them.  Indeed, it is not clear what regulatory regime they may be brought under.  A spokesman for the Structured Products Association says they are “used by sophisticated investors to make tailored bets,” and “while it’s true that firms make clear in the prospectuses that they are under no legal obligation to provide liquidity, they have provided it over the last two decades without a single hiccup.”  But as we saw in the Goldman / Abacus hearings, “sophistication” is a concept open to a broad range of interpretations, and every new instrument created by Wall Street always worked fine – until it didn’t.  Retail sales of structured notes hit almost $30 billion this year, a 72% increase over last year.  Are all those people “sophisticated,” or are they blinded by nominal double-digit returns?  We can just hear Fabrice Toure saying “Dat’s de deal!”
Whalen writes that these investments are being packaged by the same firms now making an elaborate public show of the burden Dodd-Frankenstein represents for their business.  He says there are no standards for what must be contained in such a package, and that often they are “pure derivatives,” meaning no actual security underlies the projected return.  A bank could issue a note and make an offsetting bet.  Or it could just hope the market will trade in its favor, and that it can fill its own order to make payments to the investor when the time is right.  In short, an IOU.  Whalen says he is aware of two hedge funds being created “specifically to buy this crap from distressed retail investors” who will see the value of their holdings crushed when Treasury rates finally turn up.
For reasons beyond our meager ability to comprehend, structured notes are available to retail buyers, apparently without any regulatory requirement or standards of minimal disclosure, or a sophistication test.  Writes JP Morgan, “a principal protected note is backed by the firm that issued the note.”  They explain that the notes are not FDIC insured.  If an issuer goes bankrupt, the “principal protected” note is unsecured debt of the issuer.  Which means that the instruments underlying the note could be profitable, but the holder of the note might still receive nothing – exactly what happened to holders of notes issued by Lehman Bros.
JPM also clarifies that there is no aftermarket for the notes, that “will generally trade at a discount to their value at issuance” because of something called “distribution and hedging fees embedded in the original issue price.”
Allow us to point to two troubling usages here.  First, the instruments trade at a discount to their issue price, not to their value.  “Value,” as Marx points out in the early pages of Das Kapital, is a moral and spiritual concept, not to be confused with market price.  Second, the reason these notes trade at a discount is that the issuer takes hefty sales commissions (“distribution fees”) and banking and trading commissions (“hedging fees”) and builds them into the price to the buyer.  Like the structured derivatives offered to the likes of Jefferson County and the government of Greece, since there is no market quote for these notes, only the seller knows what price they should trade at.  What price is that?  How much can I get you to pay?
To JPM’s credit, they say the notes are “not intended to be actively traded instruments and are intended to be held to maturity.”  In common parlance, they are what we call “To who?” securities.  When the customer calls demanding to sell out a position, the broker asks, “Sell?  To who???”
When the debacle in unsecured structured notes hits, how many will end up on the Fed’s balance sheet?  The notes are unsecured obligations of the issuer, which will need to make a reserve based on their own internal calculation of the percentage likelihood of having to pay a projected dollar amount at maturity.  But this is an unregulated contract, so there appear to be no set standards for reserve computation.  This tips us off to two things.  First, when the “perfect storm” in these notes hits, the banks will not have the funds to pay out.  Bloomberg reported last month (16 July, “Bank of America Leads Sales of Structured Notes in What May Be Record Year”) “banks have sold $22 billion of structured notes to individual investors in the US this year,” with B of A accounting for $4.7 billion.  We sincerely doubt B of A has reserved $4.7 billion to pay off these notes.  Who is going to haul B of A’s chestnuts out of the fire if these IOUs actually come due?  Unlike Lehman, B of A has a huge percentage of Americans’ wealth in its deposit accounts.  And unlike Lehman, it is FDIC insured.
So our first question is answered: there is a good likelihood that a Perfect Storm will hit structured notes.  When it does, they will have to be sucked onto the Fed balance sheet, because FDIC insurance will not go far enough to cover the face amount outstanding.
So Happy Birthday, Tim!  Your BFF over at the Fed has launched a new party game called Pin the Tail on the Administration, where every toxic piece of financial excrement that no one has the political will to flush down the tube gets bought at inflated prices with the taxpayers’ money and socked away in the Secret Stash.  This game proceeds with all the players blindfolded and will only end when someone removes the blindfold and says out loud, “But these numbers are way overvalued!”  So, Tim, your Secret Birthday Question is: who’s going to buy from the Buyer of Last Resort?  In God we trust, indeed!
But here’s a better question.  The reason the banks have so little capital reserved against these notes is that they believe they will never have to pay out on them.  Buyer beware?  How about, buyer, be an idiot?



Moshe Silver

Chief Compliance Officer

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