Printer Friendly

eMail Article

November 29, 2007

Welcome to the World of Dr. FrankenFinance!
by Reggie Middleton

Many of the large institutions that are the bellwethers of industry (certain industries, at least) are the victims of Dr. FrankenFinance. Due to the machinations of Doctorates of Philosophy (PhDs), who are much smarter than I am (academically at least), there has been an explosion of financial activity in the past decade. From off balance sheet structures to insured debt, to the securitization and sale of balance sheet liabilities, these doctors (known in today's parlance as financial engineers) have enabled companies to do what just a decade or two before had been considered impossible and just the stuff of fantasy. But wait, did they truly weave magic? Or was it the result of financial alchemy? Or was it just pure, old fashioned math? Well, whatever it was considered in its creation, it can now be now considered... A Monster!

Why a monster, you ask? Well, The Doctors' FrankenFinance have enabled corporate America (and corporate Europe and Asia as well, I just don't have the time to cover them in this blog piece), to bring to life certain aspects of the profit cycle that were heretofore non-existent. Examples of which are:

• profiting from assets that do not drag down ROA and ROI metrics (i.e., holding business assets off balance sheet);
• funding operations with "disappearing" liabilities (i.e., holding liabilities off balance sheet);
• creating the unlimited balance sheet by writing loans off of someone else's balance sheet (i.e., loan securitization otherwise known as OPM - other people's money); and
• using allegedly 3rd party opinions from companies with highly conflicted interests in conjunction with insurance and guarantees from companies levered over 100x to sell junk bonds as AAA .

Yet, you see, these distortions of financial nature have truly indeed created monsters. Let's take a look:

• Off balance sheet accounting: When Dr. FrankenFinance takes things past the alchemical and into the mysticism of Voodoo, we get ... Zombies. Lennar, the nation's largest homebuilder, is borderline insolvent. Click the zombie link to see my analysis. Long story, short - this would not be the case if they were not allowed to sock half of their debt away from investors' eyes. Or at least, investors would have had a chance to value the company accordingly. To make matters even worse, up until yesterday, the nation's largest bank (and itself a prime benefactor/recipient cum victim of FrankenFinance science, see below) has been issuing bullish buy reports on this company and its entire sector for months.
• More off balance sheet accounting: Citigroup, BofA, HSBC, JP Morgan Chase and all of the other major SIV (structured investment vehicle) vendors. The monster behind the madness of these guys' creations have come home to roost.
• Using other peoples money: The problem with this aspect of FrankenFinance is that it breeds irresponsibility. If you make loans and it ain't your money, you really don't give a damn who pays it back and who doesn't. These geniuses only considered the short term ramifications of such actions though. In the intermediate term, we get companies like... American Home Lending, Countrywide and Washington Mutual.
• Using allegedly 3rd party opinions from companies with highly conflicted interests in conjunction with insurance and guarantees from companies levered over 90x to sell junk bonds as AAA: Here we have the Scary Halloween Tale of 104 Basis Points where we delved into the inner machinations and secrets of MBIA, and the subject of my next dark missive - Ambac Financial (which should be online in an hour or two).

I want to be clear on my perspective - the current credit malaise was not caused by subprime mortgages, it was caused by lax underwriting due to banks being able to write loans through securitizations in lieu of through their balance sheet (which would have forced accountability). Since it was not their money they were lending, prudence was thrown to the wind. The easy money of the credit bubble (which enabled imprudent amounts of leverage in both consumers and corporations) led to a real estate bubble, all topped with lax underwriting of exotic and poorly understood instruments sold to consumers (corporate and household) who were far from equipped to understand the ramifications of such products (not to mention greedy and imprudent themselves).

Thus, this is not a subprime contagion, but a poor underwriting contagion - and as such will not be contained in any single credit area. Consumer finance, residential mortgage, commercial mortgage, corporate lending - all are showing the signs of the "other people's money" or OPM phenomena - and it has NOTHING to do with subprime! Despite what the media pundits would have you believe. To take you through the quick timeline of how we got to where we are today:

1. It started with the invention of financially engineered methods of extending one's balance sheet past the confines of any individual company or lender, via securitizations and off balance sheet vehicles. This was thought to be a wonderful invention, for it allowed for nearly limitless loan making amongst other activities, as well as the wide dispersion of risk to avoid risk concentration and supposedly lower the risk of insolvency. Oh yeah, I forgot one other thing - it marshaled in the era of EXTREME leverage for companies and institutional investors alike (read Ambac, MBIA, Lennar, LTCM, etc.);
2. Next up, and seeming unrelated was the media induced, yet actually productivity supported Internet boom/bubble, which caused a mania in equity investing and startups as a result of the first paradigm shift (i.e, internet), since the one caused by the personal computer some 35- 40 odd years earlier.
3. This mania was quelled by the requisite popping of said bubble. This popping was also the start of the greatest financial experiment in the history of this country, "The Great Global Macro Experiment".
4. This aforementioned experiment appeared to work well at the time, apparently lifting the US economy out of recession and sparking a globally risky asset bull market, but there were hints of problems, primarily when the alchemist at the helm noticed that he totally lost control of market interest rates.
5. The global bull market turned into a global bubble market, with risky assets soaring up to, past, and then astronomically beyond anything that could be considered fundamentally sound. The kicker in this part of the timeline is that the riskier (aka, the more illiquid) the asset, the more it seemed to soar. This in, and of itself should have been a red flag to many, albeit hindsight is always 20/20.
6. This global bubble, like the one that preceded it just a year or two earlier, pops (as all bubbles do, from tulips to gold dust)! It brings with the bursting, much more than the previous bubble did for it encompasses something that nearly all people have and need - not stocks, but a place to live. This burst bubble pierces finance, real estate development, holding and investment, ancillary services, retail and wholesale, and reaches around the globe. Unlike the tech stock bubble, this bubble held real assets and arcane, untraded derivatives - assets or at least simulacrums thereof, that are very hard to trade with very high spreads and transaction costs - and that is in good times.
7. As a reaction to this mess, our new Alchemist at the Helm, Mr. Bernanke, has dropped rates again and will probably drop rates significantly further. Even if he doesn't, rates are already very close to historical lows. This is being done to accomplish what the previous Alchemist at the Helm valiantly tried to accomplish, that is prevent recession. We are trading recessions for bubbles, on what seems like a regular basis. Will this experiment work for the recession fighters this time around? I am not smart enough to answer that question, but I do know one thing for a fact. As a professional investor, I need to be on the lookout for the next Experimental bubble!

Reggie Middleton
Reggie Middleton, LLC
Perpetual Interests, LLCTM
http://boombustblog.com/

Who am I?

Well, I fancy myself the personification of the free thinking maverick, the ultimate non-conformist as it applies to investment and analysis. I am definitively outside the box - not your typical or stereotypical Wall Street investor. I work out of my home, not a Manhattan office. I build my own technology and perform my own research - in lieu of buying it or following the crowd. I create and follow my own macro strategies and am by definition, a contrarian to the nth degree.

Since I use my research as a tool for my own investing to actually put food on my table, I can stand behind it as doing what it is supposed too - educate, illustrate and elucidate. I do not sell advice, I am not a reporter hence do not sell stories, and I do not sell research. I am an entrepreneur who exists just outside of mainstream corporate America and Wall Street. This allows me freedom to do things that many can not. For instance, I pride myself on developing some of the highest quality research available, regardless of price. No conflicts of interest, no corporate politics, no special favors. Just the hard truth as I have found it - and believe me, my team and I do find it! I welcome any and all to peruse my blog, use my custom hacked collaborative social tools, read the articles, download the files, and make a critical comparison of the opinion referencing the situation at hand and the time stamp on the blog post to the reality both at the time of the post and the present. Hopefully, you will be as impressed with the Boom Bust as I am and our constituency.

I pay for significant information and data, and am well aware of the value of quality research. I find most currently available research lacking, in both quality and quantity. The reason why I had to create my own research staff was due to my dissatisfaction with what was currently available - to both individuals and institutions.

So here I am, creating my own research for my own investment activity. What really sets my actions apart is that I offer much of what I produce to the public without charge - free to distribute and redistribute, as long as it is left unaltered and full attribution is given to the author and owner. Why would I do such a thing when others easily charge 5 and 6 digits annually for what some may consider a lesser product? It is akin to open source analysis! My ideas and implementations are actually improved and fine tuned when bounced off of the collective intellect of the many, in lieu of that of the few - no matter how smart those few may believe themselves to be.

Very recently, I have started charging for the forensics portion of my work, which has freed up the resources to develop the site to deliver even more research for free, particularly on the global macro and opinion front. This move has allowed me to serve an more diverse constituency, which now includes the institutional consumer (ie., investment turned consumer banks, hedge funds, pensions, etc,) as well as the newbie individual investor who is just getting started - basically the two polar opposites of the investing spectrum. I am proud to announce major banks as paying clients, and brand new investors who take my book recommendations and opinions on true wealth and success to heart.

So, this is how I use my background and knowledge in new media, distributed computing, risk management, insurance, financial engineering, real estate, corporate valuation and financial analysis to pursue, analyze and capitalize on global macroeconomic opportunities. I have included a more in depth bio at the bottom of the page for those who really, really need to know more about me.

Visit his blog Boom Bust Blog.

Copyright © 2007-2009 Reggie Middleton

Image rendition and html coding Copyright © 2000-2009 SafeHaven.com

« BullionVault.com -- Buy gold online - quickly, safely and at low prices »
« Honest Money: A History of U.S. Gold & Silver Currency -- by Douglas V. Gnazzo »

« Opinions expressed at SafeHaven are those of the individual authors and do not necessarily represent the opinion of SafeHaven or its management. Articles are available via RSS/XML. Please visit RSSHelp for instructions. »