Liquidity Crunch or Credit Crises?

This question has rattled in my mind over and over the last couple of days. The ramifications are huge. If this is a liquidity crunch, then you should seriously be looking at various investments using this as a buying opportunity as hedge funds are being forced to liquidate when they do not want to. If this is a credit crises then you should probably be hoarding cash and wait on the sidelines. Another way to look at it is using Mohnish Pabrai framework that he talking about in The Dhandho Investor. Is this a low risk, high uncertainty period of time (Wall Street hates uncertainty and these situations are the best investment opportunities) or is this a high risk, high uncertainty time? Over the last few days (really when the market started going up Tuesday and Wednesday) I started leaning heavily toward the first one, high risk combined with high uncertainty. This was a result of reading a few things that made me think that it is even worse than I thought it was. I recently just left one of the largest CLO shops in the world. I know some of the bank deals that were getting done without covenants at incredibly tight yields. It was insane!! And yet if everything in the letter I posted yesterday is true it is even worse that I thought.


Anyway as a result of all these thoughts, I further raised cash cutting down some of my bigger winners that I have had for awhile. In some ways this is killing me. I am always a huge contrarian and I see all this selling and I want to buy. When I have these urges I repeat to myself over and over that this was a bubble. It's to early. This was a bubble. If this is a true credit crises than we are in for a long term correction where intrinsic value changes. (Of course it does not because intrinsic values assumes you know everything and it never changes but forces you to discover it but what I meant was the inputs we assume need to change). Margins will change and we must consider new normalized earnings. Cost of capital changes as a true credit crunch will raise it over a much longer term than a short term liquidity crunch.

Really the question becomes what will the new normal look like? I really think the big issue not really being talked about is the willingness of foreign borrows to lend to U.S. CLO's and buy mortgage back securities. I have read bits and pieces here and there discussing this but overall not much and it is here where I think the real story lies and why I lean toward credit crises. The aftershocks of a bubble can linger a long, long time. It is why large cap U.S. stocks have lagged (until recently) mid and small cap stocks since really 2001ish. Once an asset class implodes the money goes many different places and will not return for a long, long time. As I have said in previous postings and as the crises in the European banking system displayed today, it is the foreigners who are taking the disproportionate brunt of all of this. Good for us now bad for us later. The debt ratings system has to be severely discredited in international eyes. The appetite for U.S. denominated non government backed debt is currently zero and I really think will stay this way for a long time. Alot of people are comparing this to 1997/1998 or the Mexico peso crises but the difference is that we aren't being affected by the problem, we are the problem. We are not coming to the aide of people with problems we are spreading our problems. I have to think this plays into the equation somehow someway when comparing it to history. But let's just look at 1998. Financials across the board lost 50% in 3 months. We are around 20% currently maybe getting close to starting month 2. I am not talking risky financial firms in 1998, I am talking about the big boys. Citigroup, JP Morgan, Morgan Stanley. See below (click on it to blow it up)

This was really more of just a liquidity crunch for the United States but it decimated the Asian countries for years to come. Valuations were some of the cheapest in the world for years. It is thought Korean stocks still receive a discount to proper valuation for what happened 10 years ago. Carry this over to U.S. debt. How long will it be before we see what we would consider "normal" credit spreads return? It could be years. As Buffett has described in his letters and talked about numerous times we are selling off little pieces of our farm to finance our consumption desires. Well now my guess would be that to fill our consumption desires we are going to have to be paying much more for quite a long time.

I do not know, maybe I am being to bearish but as Buffett has said "It is not how much money you make in the good times but how much money you lose in the bad times" If I miss the bottom so be it.

As a side note I do believe their are all kinds of opportunities for those with the proper balance sheet. (i.e. Buffett) This is one of those times being big helps you. There are pieces of debt that have overreacted and even actual subprime debt. However, unless you have many millions of dollars, as an individual, they are essentially untouchable.