Time to start loading up on those sovereign CDS. Today Michael Milken provided some insight into what the five key reasons for our current predicament are, which, courtesy of absolutely no real reform, double as even greater future risks for the global financial system. These include: i) that corporate credit is not the same as leverage, especially not 100x debt/EBITDA, ii) mortgages in real estate are never an investment-grade asset, iii) interest rates are volatile and unpredictable [the JPM-GS IR swap complex will not be too happy to hear this], iv) The US AAA rating is misleading and, and most important, v) sovereign debt is a big, if not the biggest, risk.
Full highlights of Milken's presentation, courtesy of Deal Journal:
Credit rather than leverage
When I was on Wall Street , I rarely had ratio higher than 3:1 or 4:1, I have never heard of any leverage ratios higher than 10:1. But in the United States of America, there were companies that leveraged 100:1. To me, it is not a business.
Mortgages in real estate are never an investment-grade asset
Real estate values go up 70 years and in certain period of time, it has been going down for five years in a row. If you are an investor that buying real estate assets that are backed by mortgages, assuming the only way to get your money back is hoping the price keeps to go up, then it is hard to understand what the asset category is. The debt depends on the asset value that the company who sells the debt doesn’t guarantee.
Why aren’t other countries having this problem? Because in most countries, people don’t borrow on their homes. The shocking thing for America is that this occurred before. In 1980s, we went through 5-6 painful years that caused failures or mergers of almost every single financial institution in Texas, Colorado, Oklahoma, Louisiana and Arkansas. In Houston, house prices fell 40% in five years.
Interest rates are volatile and unpredictable
I have never met anyone of significant wealth who made money guessing which way interest rates are going over a long period of time. In 1981, when short-term rates were 20%, almost every single financial institution, including the most conservative, was underwater on their government portfolio, when the U.S. government bond was sold at 50 cents on the dollar.
Rating is misleading
I guess none of the financial crisis would have happened without rating. There are now only four AAA-rated companies left in the America now: Microsoft, ADP, ExxonMobil and Johnson & Johnson.
Yet, S&P alone, in the first eight years of this century, has rated 17,000 securities AAA. How do you lose a 100% on a triple A investment? Well, first, those weren’t AAA companies. Second, you can borrow against it and create a security that is against the mortgage portfolio that is still rated as triple A. That is nothing new. If you read the rating history you will see that a double-A railroad has a 200% higher default rate than a B-rated industrials.
Sometimes, companies were not getting downgraded after they actually defaulted. Even for GM, there was an uptick in its ratings in last May from B- to B.
So if you are relying on rating, then I am not sure why, as a money manager, you should be paid a fee because there isn’t too much value-added you are providing. Besides, people who provide ratings are just human beings. Maybe if they are the most talented in the world, you would have already hired them.
Sovereign Debt is a big risk
It isn’t a major issue in the market today and was not a main reason that caused this crisis , but historically, it is among the worst credit assets in the world.
In 1980s, people constantly told investors “No one ever lost money by loaning money to a country.” But the U.S. only got 30 cents on the dollar from a sovereign loan to Poland. The loss in sovereign loan totaled $1 trillion in those years, but investors continued to believe these assets aren’t risky. This dramatic example tells us that people in senior positions, such as those in the Fed and run major banks, make statements that are just 100% false.
One extreme example is Argentina. The country, in the past century, has issued loans that borrowed at 100 cents on the dollar and paid 30 cents on the dollar back. In 1980s, Bank of America lent almost all its capital, $700 billion, to Argentina. Eventually, that debt was restructured at 30 cents a dollar.
American investors vowed not to loan money to Argentina ever again . Years later, the U.S. loaned $100 billion to Argentina. History repeats itself. That is why investors need to base their work on research, not on conventional thinking.