The Year of the Junk Bond

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It was the “Year of the Junk Bond,” says Forbes. Lenders lent to marginal
enterprises as if they were the last borrowers on earth.

But wait – so did lenders lend to marginal homebuyers. Junk mortgages –
where buyers borrow more money than they can pay back to buy houses they
can’t really afford at prices that are higher than the houses are worth,
promising to pay back the loan only when – and if – they can get around to
it – also hit record numbers.

So many records were broken in 2006, we could barely keep up with them.
Private equity was on a roll by year end – with twice as many deals as the
year before…financed, of course, by record lending on the part of
recordly reckless lenders with a record amount of loose change in their
pockets.

Mergers and acquisitions, too, hit record levels. Corporate profits
reached record levels. Real estate deals in New York City hit noteworthy
records. And of course, so did derivatives. And the Dow itself, as
everyone knows, was at record levels.

Everything was hot in 2006, not just Wall Street. January through June was
the warmest first half of any year in the continental United States since
records began in 1895. The average January-June temperature was 51.8
degrees Fahrenheit – 3.4 degrees above the 20th century average.

It was so hot that both Britney and the hedge funds forgot to put on their
shorts. The former Mrs. Federline set a record for celebrity
buffoonishness…but the hedge funds set a record too.

 

The great guru, Joe
Granville, once walked onto stage to give a speech and immediately dropped
his pants. “This is just to show you the importance of shorts,” he told
the audience. But in 2006, hedge funds forgot the lesson. They stopped
hedging in order to attract more money. Everyone seems to think he can get
rich by speculating…but you can’t get rich speculating on the down side
while the bubble is still hitting new records. So, the hedge funds dropped
their shorts and started speculating on the long side…along with every
other addled gambler with a drink in his hand and a dollar in his pocket.
There were records set in politics too. It was the first time ever, so as
we can recall, that a Vice President of the United States of America
mistook a middle-aged hunter for a duck and blasted him with buckshot. And
the Bush administration must have broken all records for spending
money…as well as for overseas military misadventures. But who bothers to
keep track?

Records are meant to be broken, but we didn’t realize that so many of them
had to be broken in such a short period. Housing properties all over the
world hit record levels. Even in places like Bombay, India, you can pay as
much for an apartment as you would in New York. House prices in England
rushed up 10%…even though they began the year already at extraordinarily
high levels.

All over the world, stocks hit new highs…with the Chinese leading the
way. Chinese stocks doubled in the last year, hitting – naturally – a new
record. So did commodities. Tin reached a 17-year high by year-end. Corn
is at a 10-year high. And uranium is near an all-time record high last
month, closing at nearly twice the level at which it began the year.

Many consumer prices, too, reached record highs. Housing, of course. Gas
prices rose nearly two cents over the past two weeks, to a record high of
$3.02 per gallon of self-serve regular, a national survey reported Sunday.
But health care, transportation (largely because of record oil prices),
and education rose too!

But the record we find most intriguing is in the art market. Overall, the
Mei-Moses art index rose a record 22%. In the summer, a Gustav Klimt sold
for a record $135 million. No one had ever paid that much for a painting.
And then, a few months later in the year, along came someone with more
money to spend. He laid out $140 million for a Jackson Pollack.

And here, we have to sit down and compose ourselves, our pulse races so.
The buyer chose to remain anonymous. What a shame. Anyone who would spend
$140 million on a dreadful painting deserves notoriety. In fact, more than
that…he deserves clinical study. That amount of money would produce
about $7 million in income each year, if invested at 5%. What kind of
person could get $7 million dollars worth of pleasure from looking at a
Jackson Pollack painting each year? What kind of person would be willing
to look at it at all? We need to know more. Is this person normal? Is he
allowed out in public? Is he human? Obviously, he has a lot more money
than we do. But if he is so rich, how come he’s not smart? Or are we the
dumb ones?

If he cannot get $7 million in annual satisfaction from the painting,
perhaps he can rent it out. Yes, dear reader, maybe you will have the
opportunity to rent it. Let’s see, the daily rate should be something like
$20,000. Surely you’d pay $20,000 to have an oeuvre of Jackson Pollack’s
on your wall for 24 hours. Who wouldn’t?

Unless the owner can get a return of $7 million…he must be counting on
something other than yield. He must be counting on capital gains! He must
be counting on an even higher price…and an even greater record! He’s
probably betting that there is an even greater fool.

And he may be right.

What is the source of all this record-breaking activity, you might ask? A
“Wave of Liquidity,” says the Financial Times. Bank Credit Analyst, in
Montreal, picked up the idea, predicting that the ‘wave of liquidity’
would continue in 2007. The Wall Street Journal, meanwhile, modified the
idea slightly, referring to investors riding ‘rapids’ of cash.

Rapids, waves, swells, tsunamis…no matter what you call it, there is a
huge amount of liquidity in the world. And at of the close of 2006, it was
still pushing up asset prices and setting new records just about
everywhere.

And more predictions:

*** The big question is this: When will this ‘wave of liquidity’ finally
begin to ebb? We don’t know, of course. It is not given to man to know his
fate. So we have to make our guesses and take our chances.

And our guess now is that too many people are betting too heavily that
this wave of liquidity will continue…and some that it is not temporary,
but permanent. Whenever too many people crowd onto one side of a trade –
like piling onto one end of a teeter-totter – we want to take the other
side; it is almost sure to pay off.

So let us imagine what might happen from this contrarian perspective:

1. First, we could see major weaknesses – even crashes – in several areas.
The dollar remains extremely vulnerable. More and more central banks have
announced that they are moving away from it. The euro edges up. Sooner or
later, a panic could set in…in which case, the dollar could fall
10%…20% or 30% in a matter of days. Will it happen? We don’t know, but
dear readers are advised to hedge against it, just in case.

2. A severe downturn could also come in the stock market. Not likely, but
very possible. At this point, stocks are doing well…but our guess is
that corporate profits will stagnate in 2007…and then turn down. There
is very little real upside left in this market – or so it appears to us.
We would want to get out of it before the exits get too crowded.

3. Less dramatic, but more certain, should be the decline of the housing
market,
which has already thrown up a few records this past year: The
National Association of Realtors said that the median price of a home sold
in October was $221,000, the same as in September, but down 3.5% from
October 2005. The previous record drop was a 2.1% decline in November
1990.

There were record numbers of foreclosures too. Nearly 90,000 homes entered
foreclosure in June…17% above the previous year. “Housing Market In
Free-Fall As Foreclosures Eclipse Record,” say the local papers in Denver.
Foreclosures overtook the peak set during the oil industry collapse in
1988.

In the first part of this year, we are likely to hear that housing has
stabilized. It will look that way for a while – as sellers become
reluctant to take any more price cuts…and house seekers take advantage
of what they see as a buying opportunity. This illusion may be aided by a
cut in Fed rates later in the year – caused by general weakening or local
panics.

Gradually though, the fundamentals of the market will take over. One
trillion dollars worth of mortgages are reportedly going to be reset in
the year ahead. Many homeowners won’t be able to afford the new payments.
Foreclosures will rise. Many of the absurd mortgages written in the last
two years will go bad. Inventories of unsold houses will rise. Sellers
will become more desperate. The whole thing will begin to sink.

Remember, the ‘wave of liquidity’ doesn’t help the marginal homeowner –
except by making it easier for him to get himself deeper into debt. But
once he and the lenders realize that he can’t continue servicing his debt,
the credit dries up. Liquidity may still force up prices for Klimts and
Picassos…and Chinese stocks…but it does little to help the poor
householder who can’t pay his bills.

4.Gradually, too, problems at the bottom of the debt pyramid work their
way up
. Lenders will begin to realize that many of their credits aren’t
worth what they thought they were. Then, the packaged, securitized,
leveraged loan, debt Spam begins to lose its flavor. Look for a few major
blow-ups in the financial industry – in derivatives and hedge funds
particularly. Amaranth was not the end of the story, but just a prelude.
Hedge funds will wish they had not forgotten to hedge.

5. The hedge fund industry itself is due for a correction. There are said
to be about 8,000 funds in operation. Over the next two or three years,
that number should be cut down to less than half that number. That is what
happened to the mutual fund industry, following the bear market downturn
after 1968. It will surely happen in hedge funds too.

Another development in the hedge fund industry is likely to be a reduction
in charges. The industry is bound to become more competitive…and less
profitable. Returns are already below those an investor could get by
throwing darts at the stock pages. Our guess is that hedge fund managers
have had their day of glory. It’s time for them to step back…and take in
more normal earnings.

Most of the records for 2006 reflected record levels of hope, faith and
recklessness. We don’t know what is ahead for 2007, but we warn readers
that for every high there’s a record low. For every year of hope and
expectation there’s a year of helplessness and desperation. And for every
fool…there’s some wise guy waiting to take advantage of him.

———————

Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
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