Monday, July 02, 2007

When Phil was Up-Looking ‘Un-Restrained,’ and other Tales from the Federal Reserve

The credit derivatives market is imploding. There is no overstating the issue: it’s imploding as you read this.

A phenomenon that was supposed to have been contained inside the definitional boundaries of “sub-prime” mortgages is spreading across all classes of debt, now that the formerly gluttonous consumers of dubious paper have reached their limit.

Stuffed to the proverbial gills, the former buyers have pushed away the scrap-filled mortgage plate on the table before them and are refusing offers of all sorts of paper, sub-prime or not.

Thus we read about the suspension of debt offerings by not just highly leveraged buyouts such as U.S. Foodservice and Myers Industries, but also proper corporate debt-issuers, such as steel giant Mittal's newest acquisition, Arcelor.

Even companies you’ve never heard of are having a hard time accessing capital.

One such is Magnum Coal, a West Virginia company about which we have no facts to report owing to the fact that the company has the least informative corporate website in the industry, hands down.

What we do know is that Magnum is a large Central Appalachian coal producer, and while Central Appalachian coal is wonderfully low in sulfur and high in BTUs, it also tends to be found underground. Thus, Magnum's key asset is only recovered by union workers toiling in dangerous environments.

The company recently delayed a third-of-a-billion junk bond deal.

Another lesser-known victim of the credit seize-up is Catalyst Paper, a Canadian company whose business has been in something of a down-cycle lately—last quarter’s $14 million (Canadian) EBITDA being less than the $18 million of interest expense reported on page 22 of a very lengthy press release.

Catalyst recently pulled a fifth-of-a-billion junk bond deal.

What happened in sub-prime has most indisputably not stayed in sub-prime.

Of course, nobody wants to shout ‘fire’ in a crowded movie theater, least of all the Federal Reserve Board, which, like Hitler in his bunker, appears to believe it is still in control of the forces unleashed by Alan Greenspan’s free-money policy of some years back, which triggered the whole you-too-can-afford-this-house mortgage mess now showing up on the balance sheets of major Wall Street brokerage houses..

Nevertheless, you might expect a bit more of a reaction out of the Federal Reserve Board than merely eliminating the word “elevated” from its interest rate policy statement.

Yes, while the Chinese call on natural resources takes commodities to new highs, and Russian oligarchs and Middle East sheiks bid up all manner of assets, both hard and soft, leaving U.S. consumers fully employed but tightly squeezed, the members of the Fed are literally tinkering with adjectives.

Herewith my reconstruction of the dialogue among Fed policy bigs as they prepared their most recent missive to the outside world:

Chairman: “Last month we said ‘economic growth was moderating.’ We have a motion before us to replace ‘moderating’ with ‘slowing.’ The motion has been seconded. The floor is open for discussion.”

1st Board Member: “Why ‘slowing'? Why not ‘moderating.’? I liked ‘moderating.’”

2nd Board Member: “I prefer‘slowing.’ We haven’t used it in a while.”

1st Board Member: “Well I don’t care for it. How about ‘restrained’?”

3rd Board Member: “Why ‘restrained’?”

1st Board Member: “Because we’ve never used ‘restrained’ and I’ve always wanted to use ‘restrained.’ (He lapses into a reverie, as if quoting from a book.) ‘She restrained herself as his strong hands grasped her heaving shoulders—’”

Chairman, interrupting: “Er, that’s fine, thank you. But I don’t care for ‘restrained.’ The markets might worry. They might think that we think that something is restraining growth that needs to be un-restrained.”

3rd Board Member: “Mr. Chairman, forgive my impertinance, but, is ‘un-restrained’ a proper word?”

Chairman, a bit testily: "Well I believe so. I'm almost certain... I recall we used it during the Barings crisis of '94..."

2nd Board Member: “I’ll look it up.”

4th Board Member, quite grumpy: “Jesus God, what are we doing here? Can’t we just say ‘The economy is okay and if things change we’ll let you know’?”

Chairman, calmly patronizing: “Please settle down. The discussion will continue while the word ‘un-restrained’ is being looked up.”

3rd Board Member: “Is ‘being looked up’ proper English?”

1st Board Member: “I think that depends on whether ‘up’ is being used as an adverb or preposition.”

4th Board Member: “This is absurd.” (He rises from the table, refills his coffee cup from a pot on the credenza, and stares out the window at the traffic on Pennsylvania Avenue.)

3rd Board Member: "Shouldn’t we really say, ‘being up-looked’?”

5th Board Member: “Frankly, I thought the proper usage was ‘Up which it is being looked’.”

4th Board Member, turning sharply away from the window: “How about ‘up yours’?”

Chairman, banging his gavel: “Please! We will have none of that. Now, where were we?”

5th Board Member: “Phil was looking up ‘un-restrained.’”

3rd Board Member: “I’d prefer ‘Phil was up-looking ‘un-restrained.’”

4th Board Member: “How about ‘Phil was up-looking your big hairy nose’?”

Chairman, sharply: “Ladies and Gentlemen, I will not have this type of disrespectful behavior. The secretary will strike the previous remarks from the record.”

Secretary, reading from note-pad: “Starting where? Starting with ‘How about Phil was up-looking’? Or starting with ‘big hairy nose’?”

Chairman, stroking his beard: “Hmmm...where to begin the striking of the records. That is a conundrum. I recall a similar situation during the Asian crisis of '98. Do I have a motion?”

3rd Board Member: “Mr. Chairman, I move that we start with ‘How about Phil was up-looking.’”

Chairman: “Excellent! Is there a second?”

4th Board Member: “I move we all stick needles in our eyes, because that would be more fun than I’m having right now.”

5th Board Member, looking harshly at the 4th Board Member: “I second the previous motion, that we start with 'How about Phil was up-looking.'”

Chairman: “Moved and seconded.” He puts down his glasses and looks around the table. "Is there discussion?”

2nd Board Member: “Mr. Chairman, before we discuss that motion, I’d like to report that the term ‘un-restrained’ is not proper English.”

Chairman, startled: “Is that right? Are you sure?”

2nd Board Member: "Quite sure."

4th Board Member: “Oh puh-leeze. I've had enough of this...” He is getting something out of his briefcase. It is a small, metallic object. The security guard at the door eyes him nervously.

Chairman, somewhat preoccupied: “Well then, all those in favor of starting the striking of the records at ‘How about Phil was up-looking,’ say ‘aye.’

(A chorus of ‘ayes’ is heard.)

Chairman: “All opposed?”

(A gunshot rings out. The 4th Board Member slumps across the table. The security guard rushes over and checks for a pulse, then somberly shakes his head.)

3rd Board Member: “Mr. Chairman, I note the presence of a dead body on the table. Would you like a motion to remove the body?”

Chairman, somberly: “First let me express my shock and surprise—(He pauses and clears his throat, amid solemn murmurs and nods around the table)—that the term ‘un-restrained’ is not proper English.”

Other Board Members: “Hear, hear.”

Chairman, more brightly: “As for starting the striking of the records at ‘How about Phil was up-looking,’ the secretary will note five in favor, none opposed, and a dead guy on the table.”


Jeff Matthews
I Am Not Up-Making This

© 2007 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.


fivetonsflax said...

It's "hear, hear," not "here, here."

buckeye1 said...

It seems to me like if the Fed is responsible, they will allow the junk bond market implode or at least become more rational. As you have commented on several times previously, the debt market is currently in a bubble that is now showing signs of deflating. In my opinion, that is a good thing, although it also could be a sign of bad things to come for asset prices. It is time for Ben to shake off the legacy of Greenspan and allow the liquidity filled euphoria to end.

David said...

>>The derivatives market is imploding. There is no overstating the issue: it’s imploding as you read this.<<

Too simplistic. I've been writing about this over at my blog, and while the subprime ABS derivatives market very well may be imploding, the derivatives market as a whole is not imploding, at least not yet.

That said, spreads in the cash and synthetic corporate and CDO markets (sorry, all debt markets) got way too tight, and eventually that mispricing of risk will get its due reward when the credit cycle turns. Aside from lower junk rated credits, most investment grade corporate balance sheets are in pretty good shape, so I'm concerned, but not deeply worried yet.

wsf said...

That was hilarious, and reminiscent of a Churchill story. After an editor had rearranged a sentence to avoid ending it with a preposition, Churchill fired this note back at him: "This is the sort of bloody nonsense up with which I will not put!"

Johnny said...

This post neglects, well most everything. And some pretty ample cherry picking of companies. US Foodservice makes the headlines but their financing fell apart for structural reasons, not price reasons.

Magnum coal is a middle market single commodity producer. Those deals fall apart frequently. See James River Coal

And Catalyst paper is ridiculously tiny. Sub $18mm EBITDA? You can draw something about debt markets from that deal struggling?

There is something going on in the debt markets, but it's nowhere near an implosion, it's barely a correction -- slight pushback from a buyside which has been letting weaker and weaker structures shoved down their throats, like PIK toggle on the HY side or covenant lite on the bank side.

Anonymous said...

Jeff: I'm not sure I understand how you make the causal link between what's happening with derivatives of sub-prime mortgages (i.e., CDO's) and the "push-back" by investors in corporate debt offerings.

I would think the markets for derivatives in sub-prime mortgages and corporate bond offerings are quite dis-similar in terms of risk and how that risk is priced.

The only thing I can think of is that participants in the derivatives market are finding it diffiult to value their investments in light of the ongoing "melt-down" in subprime mortgages. Since derivatives are, as a general rule, illiquid investments, when the risk with illiquid investments is "mispriced", that, I think, is leading up to the "implosion" which you mention via a sell-off of assets (hello, Bear Stearns).

As for the debt offerings like U.S. Foodservice that investors are turning away from, I think investors feel they are not being "paid" an adequate premium for the risk they bear when buying more liquid investments such as "covenant-lite" loans or PIK-toggle bonds (yuk!).

I agree with Johnny's post above that these events seem more like a pushback by investors and less like an implosion among market participants in derviatives.

I could be wrong, though.

jmf said...

:-) from Germany


John M said...

JMF dropped by this morning to recommend this post, and he also contributed a link to the following article that speaks to some of the same issues.

"LBO Debt Alarms Fidelity, Lehman, TIAA-CREF Managers", by Cecile Gutscher and Caroline Salas, Bloomberg, July 5, 2007.

GuruFocus said...


I am the editor of I am wondering whether we can republish your blogs on They are excellent!


Charlie Tian

Philip said...

awesome post jeff

Jennifer said...

@ GuruFocus:

Get in line.

Jeff, you will get more requests like this. You might want to give some thought to your best-case scenario.