SET GameAn off-topic post for the weekend.  My children have benefited from a card-matching game called “SET.”  The main SET website is here, and the rules are here.


What I find interesting about the game is that the optimal strategy forces you to look for linear patterns early and then shift to nonlinear patterns later in each round.  It’s a very mathematical game, and the cards are functionally equivalent to unique 4-digit base three numbers.  (Don’t tell the kids that, or it won’t be fun any more.)


Full disclosure: I just like the game, and so do my kids.  I have received nothing for mentioning here, but it could be of value to parents and grandparents.

At RealMoney today, After Dr. Jeff Miller of A Dash of Insight commented, I felt I had to add my own two cents:

David Merkel
Watch What They Do, and Less on What They Say
8/30/2007 1:57 PM EDT

Listen to Dr. Jeff on the Fed. Here are a few factoids to reinforce what the Fed is actually doing at present:

  • Fed funds have averaged 5.25% over the past five days, and 5.00% over the past fifteen, since the crisis began.
  • The Fed’s last permanent injection of liquidity was May 3rd. That’s a pretty long time for no injection, even in a tightening cycle.
  • The monetary base is flat, growing little over the last year. If policy changed recently, I can’t see it.
  • Policy change doesn’t show up in the monetary aggregates either, but lag effects dominate here.
  • We won’t know about discount window borrowings until this evening, but I don’t expect much
  • 3 month LIBOR is back around 5.60%, and the 3-month T-bill around 4% (rallying today). A TED spread at 1.6% indicates a lot of fear. Kinda surprised that swap spreads have not budged much.
  • In summary, the Fed hasn’t done much yet, aside from loosening up leverage requirements for some of the big banks, and allowing low quality collateral to come to the discount window. Though I don’t want the Fed to loosen, I don’t think they have much choice here. I expect an ordinary announcement by the end of the year cutting the Fed funds target.

    Position: none

    After that, I was pleasantly surprised to find that Calculated Risk and Econbrowser agreed with me.  Good company to be in.  After the close today, I wasn’t surprised to find that the discount window moves still haven’t done much.  Everyone will be listening to Bernanke tomorrow, but he won’t give any policy cues, most likely.  He has charted out a different course than the one Greenspan took; the hard question is whether he can maintain a policy of limited liquidity in the face of deteriorating conditions, and avoid the charge of favoritism, or, sloppy bank solvency management.  After all, credit is offered to few parties, and solvency rules are getting bent for the biggest banks.  That said, his tactics are more in line with the pre-Greenspan era.  But as this goes on, the commercial paper world shrinks for the third straight week, mainly due to the collapse of ABCP.

    Looking around the world, there are a variety of news bits:

    1. The Bank of England lends 1.6 billion pounds at the penalty rate of 6.75%Barclays plc was the borrower, again, supposedly over a clearing mess-up.  I am feeling more edgy about my Barclays stock.  Repeated problems in clearing should not happen, particularly during a period of market stress.
    2. Cheyne Finance begins a partial wind-up of its operations.  Amazing what what happens when liquidity is no longer cheaply available to finance assets.  This also points up the difference between ABCP sponsored by a bank, where they might bail it out to preserve relationships (as with the Development Bank of Singapore), and sponsorship from a hedge fund, where the balance sheet can’t fix the problems, even if they wanted to.
    3. With all of the fixed-income assets that Chinese banks have taken out of the US, is it any surprise that they took down a significant slug of subprime ABS?  I know from experience; new fixed-income investors tend to be more trusting of complexity than more experienced investors.  Failure brings maturity, and risk-based pricing.
    4. See Yen run.  Run Yen, run.  Amid all of this stress, we may have the slow unwind of the carry trade.  It has not become a rout yet, but who can tell.  I am still a bull on the yen, but I have no positions there.
    5. Amid the lack of liquidity in the US markets, foreign firms seeking debt capital go elsewhere.  Gerdau, the Brazilian steelmaker, seeks a international syndicated loan deal, rather than a deal in the US bond markets.  Just another sign of the times.  If you want to have a strong capital market for foreign entities, you must keep your domestic markets functioning, and that the US has not done.

    Closer to home, State Street has certainly had its difficulties with an underperforming short-term bond fund, and their own relatively large exposure to ABCP conduits.  Aside from the reputational hit, it’s possible that State Street won’t suffer too much damage from the conduits, they may be financing assets of good quality.

    So why conduits?  It allowed banks to do more business, while keeping it off of their balance sheets, thus maximizing their returns on assets and equity.  The banks may offer liquidity to the conduits during hard times, which brings some of the problems back during a crisis.

    As a final note, all of the credit stress has led banks to tighten credit standards, and has limited the ability to finance first mortgage and home equity loans.  So where do strapped consumers go?  Credit cards.  This can last for three to six months, but eventually the credit gambit will end in a trail of losses for all lenders involved, particularly those who have low or questionable security.

    Tickers mentioned: BCS STT DBS GGB

    Full disclosure: long BCS

    Quants have it tough.  Few in the investment world really understand what you do, and even fewer outside that world.  To many investment managers, quants are the guys nipping at their heels, clipping their returns, and questioning the need for fundamental analysis.  There comes a kind of schadenfreude when their models blow up, where qualitative mangers get to say, “See, I knew it was too good to be true,” and in the newspapers, a kind of bewilderment at eggheads whose models failed them.

    I write this as a hybrid.  I am a qualitative investor that uses quantitative models to aid my processes.  As such, I was hurt, but not badly, but recent market troubles.  Any class of models can be overused, and the factors common to most quant models indeed became overused recently.  Truth is, the models don’t vary that much from quant shop to quant shop, because the market anomalies are well known.  Many of these funds held the same stocks, as seen in hindsight.  Should it surprise us that their results were correlated?

    In a situation like this, success tends to breed more success, for a time, as more money gets applied to these strategies.  The statisticians should noticed the positive autocorrelation in excess returns, rather than randomness, which should have tipped them off to to much money entering the trade.  But no.  There was another calculation that could have been done as well, estimating the prospective return from new trades, which was declining as the trades got more popular.  My view is that a quant should estimate the riskiness of his strategy, and compare the returns to those available on junk bonds.  When the return is less than that available from a single-B bond, it’s time to start collapsing the trade.  (What, they won’t pay you to hold cash?  No wonder….)

    On a different topic, consider mark-to-model.  I’ve said it before, but Accrued Interest said it better when it said that mark-to-model is unavoidable.  Most bonds in the market do not have a bid at any given time.  Most bonds are bought and held; beyond that, there are multiple bonds for a given company, versus one class of common stock.  The common stock will be liquid, and the bonds merely fungible.  It is even more true for structured securities, where the classes under AAA are very thin.  The AAAs may trade, classes with lower credit ratings rarely do.

    Now the same argument is true when looking at a whole investment bank.  How do you mark positions that never trade, and here there is no readily indentifiable bid or ask?  You use a model that is built from things that do trade.  Sad thing is, there isn’t just one model, and there isn’t just one set of assumptions.  It is likely that the investment banks of our world, together with those they deal with, have marked illiquid securities to their own advantage.  Assets marked high, liabilities low.  Aggregate it across all parties, and the whole is worth more than the parts, due to mismarking.

    Now for a tour of unrelated items:

    1. There is something about a spike in volume that reveals weaknesses in back offices.  For derivative trading, where there is still a lot of paper changing hands, that is no surprise.
    2. Prime brokerage is an interesting concept.  They bring a wide variety of services to hedge funds, but also compete in a number of ways.  At my last firm, I never felt that we got much out of our prime brokerage relationships for what we paid.  They provided liquidity at times, but not often enough.  Executions were poor as well.
    3. The market sneezes, and we worry about jobs on Wall Street.  Par for the course.  What is unusual here is that few bodies were cut 2001-2003, so pruning may be overdue.  It may be worse because the structured product markets are under stress.
    4. Catastrophe bonds are opaque to most, and Michael Lewis did us a favor by writing this.  That said, though this article begins by suggesting that 2007 will be an above average hurricane season, I ask, “What if it is not?”  It is rare for the hurricane season to shift halfway through the season.  It may be time to buy RNR, FSR, MRH and IPCR.  But regarding cat bonds, they are issued by knowledgeable insurers.  After issue, there are dedicated hedge funds that trade them, taking advantage of less knowledgeable holder, who only originally showed up for the extra yield.
    5. A break in the market affects obscure asset classes as well.  If wealthy hedge fund managers are the marginal buyers of art, and they are getting pinched now, the art market should follow.
    6. Message to Mish: If Bill Gross is shilling for a PIMCO bailout, we are all in trouble.  If the prime mortgage market and the agencies are in trouble, then I can’t think of anyone in the US that will not feel the pain.  I think Bill Gross is speaking his mind here, much as I think that Fed funds rate cuts are not needed, though I also think that they will happen, and soon.
    7. Many emerging debt markets are in better shape than the US, because their current accounts are in better order.  Now, as for this article, Brazil might be okay, but Turkey is not in a stable place here because of their current account deficits, and I would be careful.
    8. Finally we are getting real volatility.  I like that.  It helps keep us honest, and shakes out weak holders and shorts.

    See you tomorrow, DV.

    Tickers mentioned: IPCR, MRH, FSR, RNR

    Earlier today I wrote at Realmoney:

    Good Things Come in Small Packages

    8/29/2007 11:49 AM EDT

    Every now and then, the market serves up a bargain that is hard to realize, because trading liquidity is poor. I was acquiring this stock for just me, and it took ten days for me to do it. (If at the end of this, you want to buy some, use limit orders. Do not use a market order, and do your own due diligence, please.) National Atlantic Holdings is a small (primarily) personal lines insurer selling almost entirely in New Jersey. No debt. 6.9x 2007 and 2008 earnings, 69% of tangible book. It has relatively defensible boundaries in its lines of business, though no one is totally immune from the dangers of over-competition in the personal lines marketplace. I have met management, and I think that they are competent.


  • Up against larger companies that may be more aggressive in pricing.
  • Though NJ is good at present for insurance, the legal system has delivered some nasty surprises in the past.
  • Small insurers are subject to the “Law of Small Numbers,” which means that a small number of untoward events can knock the earnings for a loop.
  • They have missed earnings more frequently than many investors would like. There are a lot of burned value investors here.
  • There’s more, but these are the basic points that you can begin with as you do your own due diligence.

    Please note that due to factors including low market capitalization and/or insufficient public float, we consider National Atlantic Holdings to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

    Position: long NAHC

    Now for the rest of the story: my average cost is $9.60, and I would not recommend buying above $9.75. There has been some big player liquidating his stake at prices under $10, and I am not sure that he is done. There are significant buyers underneath $9.60, but as with many traders they don’t automatically buy when the sellers arrive there. They let the market sag, and then slowly suck in shares at the bid, while letting the bid back up.

    I mentioned the law of small numbers above. Well, that can work two ways. When the small numbers result in few claims in a quarter, the stock can pop, and it gets even better if it happens a few times in a row — then a pattern gets inferred by investors, and often wrongly so, but the price runs then.

    There is another risk I did not mention above. They are entering a new state, Texas, and new lines (though not in a big way) in New Jersey. I always worry when insurers do that, because they tend to underestimate the risks involved. That said, NAHC tends to be conservative here, and that ameliorates the risk. That, and the CEO own 13% of the company; he has grown it himself, and doesn’t want to spoil what he has built.

    Beyond that, their asset portfolio is clean, in my opinion. Their business in NJ depends on partner agents who primarily market to the wealthy of NJ, and try to cover their full insurance needs through package policies that cover their personal insurance needs, and sometimes their business insurance needs. This allows NAHC to compete away from Progressive and GEICO.

    Again, there is more to this story, but please do your own due diligence, and if you do buy, be price-sensitive, and don’t use a market order.

    Full disclosure: long NAHC

    Tickers mentioned: NAHC, PGR

    A personal note before I begin: My oldest daughter left for college today.  A bright girl who plays the harp beautifully, she is studying harp at the University of Maryland.  She is a true “people person” and an artist, and her good character is known by all of her friends.  She’ll be commuting, so I won’t lose her entirely yet, but we will miss her way with the other children.  She will be a natural mother, unlike her mother and I, who just try hard.

    Well, two off to college in a single year.  Good thing I’ve got six left, or I’d be lonely. 😀

    It takes two to make a market.  During the panic, some bond managers increased their risk postures as the market sold off.  Here is another example.  I agree with this in principle, but I at this point, I would only have moved my risk posture from “most conservative” to 20% of the way to “most aggressive,” which I actually did get to in November 2001, and October 2002.  There is a lot of leverage to unwind, and so there is a lot of room for further widening.  Take for example, these graphs of lower investment grade, and junk spreads.  We are nowhere near the 2002 wide spreads, though for investment grade, I don’t see how we get there.  Credit metrics are pretty good, though banks are more opaque and questionable.

    Bond management is a game where you are paid not to lose, because people are relying on you for safety, and then a modestly good return on their money.  Now, though the last article doesn’t treat Bill Gross well, in this article, he praises simplicity in investing, which I would heartily agree with.  The only thing that gives me a bit of pause there is that PIMCO is a quantitative bond management shop that has historically derived most of its excess returns from quantitative strategies that rely on the equivalent of selling deep out of the money options against their positions, and mean-reversion, and variety of other things.  When the ordinary relationships don’t work, PIMCO could be disproportionately hurt.

    Though investment grade looks fine, junk is another thing; it could reach the 2002 wides.  As an example, aside from all of the high yield deals that would like to get done, and all of the LBO debt standing in line waiting to be funded, there are still entities like Calpine that want to emerge from bankruptcy.  Willingness to take risk is not what it was when the banks made their commitments, so they’ll have to take losses to move the loans off of their books.  That will help to back up spreads, as buyers will toss out other paper to buy the Calpine debt, if it comes at an attractive enough concession.

    In situation like this, one would expect municipal [muni] bonds to be a haven, and largely, they are, partly because they are one of the few areas not touched by foreign capital.  But I was genuinely surprised when I read this article.  Muni arbitrage?  Okay, it comes from one simple insight muni investors want low volatility, which means short duration bonds, while most municipalities want to lock in long term funding.  After all, most of their projects are long term in nature.  Muni hedge funds (sigh) step in to fill the gap, buying long dated bonds, and selling short bonds against them to muni investors, clipping a yield spread in the process.  Worked fine for a while, but the hedge funds warped the market by their own participation, and played for yield spreads that were too low for the risks involved.  As the market normalized, they got hurt, and some aggressive selling of the long end happened.  Now, long munis are probably a good deal.  For taxable accounts, they make sense, if your time horizon is long enough.

    During financial stress, financial journalists may get a little over the top.  Comparing Ken Lewis to JP Morgan is an example.  First, the rescue is not that big, relative to Countrywide’s total liquidity needs.  Second, Countrywide, even if it failed, would not have that big of an impact on the total US financial system; it’s just not that big.  Would it be inconvenient?  Yes.  A bother for the regulators?  Sure.  But it would not appreciably affect the average financial institution, and it would inject some needed caution into those that lend to less secure entities.  Third, in a real rescue, far more capital is hazarded; honestly, the Fed did more by opening the discount window, pitiful as that was… it offered unlimited liquidity to (ahem) “quality” assets at a price.  (Quality has been redefined for now.)

    At a time like this, a bevy of survey articles come out to describe what has gone wrong.  Some tell of how aggressive players overplayed their hands as the willingness to take risk dried up.  In this case, they boil it down to bad lending models, whether subprime mortgages, bank debt for LBOs, or internal leverage inside hedge funds.  Other articles point at historical analogies, looking for something that might tell when the crisis will end.  The two years compared, 1987 (dynamic portfolio hedging) and 1998 (LTCM), do offer some help, but are not adequate to deal with an overall mortgage lending problem, and a large external debt, getting larger through the current account deficit.

    Is information failure the best way to describe it?  I don’t know; there were a lot of savvy people (myself included) who could see this coming, but could not put a date on it.  Toward the end of almost any bull market, underwriting gets sloppy, and the mess that it leaves usually persists until early in the next bull phase.  That’s the nature of human beings, and the markets they create.

    As I have stated before, central bank policy can help marginal entities refinance, but is no good at aiding balance sheets that are truly broken.  As you analyze your own assets, be sure to ask which entities need financing over the next two to three years, and how badly they need the help.  Don’t play with companies that are at the mercy of the capital markets.  Even if in the short run, after a volatility event, stocks tend to do well, there may be more volatility events than just one.  This first one is over financing; there will be defaults later.  Be ready for the volatility that will come from them.

    Tickers mentioned: CPNLQ BAC CFC

    I like writing about the Federal Reserve because I understand it well, but this is beginning to make me tired. Here goes:

    1. There are some who believe that the Fed will not cut rates soon. I half agree with them, because the Fed should not cut rates here. Let bad loans get their due punishment. That said, that ‘s not the way the Fed has acted for almost 80 years. Given that the Fed has to interact with politicians and businessmen, they are going to get a lot of negative feedback if they don’t loosen the fed funds rate. I general, the Fed caves to political pressure. This Fed is doing it now, but just in small steps, while they console themselves that they haven’t moved yet.
    2. On the surface, not much happened with the reduction in the discount rate. But the real story boils down to a willingness of the Fed to accept classes of securities that previously they would not. This includes ABCP. Beyond that, the Fed is allowing several large banks to lend beyond prior limits to their securities affiliates. This allows the banks to lever up more, and in relatively risky business. I am waiting to hear of charges of favoritism; failing that, of irresponsibility of the Fed in overseeing bank solvency of some of the largest banks.
    3. The actions that the Fed takes now will shape the next financial crisis. Where it loosens, leverage will flow to healthy areas that can absorb it until they become glutted as well.
    4. US T-bills have righted themselves, but i was surprised to see that Canadian T-bills went through a similar mishap. Oh well, they had ABCP also.
    5. SIVs are one issuer of ABCP, and many of them are doing badly now. I would not be too quick to rescue them, or be too optimistic about their ability to make good a maturity. The assets in the SIVs that have gone bad are not likely to turn around quickly. Next cycle, we will be more careful about what we lend against, until we commit the same error in a new way.

    I hope the Fed’s actions so far will be enough, but I believe that they will have to do more.

    1. In commercial real estate, operators that are willing to “feed their properties” during bad times get respect, and sometimes even lower financing costs from those who lend to them.  In a similar vein, and perhaps it is making a virtue out of necessity, it was interesting to see KKR offer to pump money into their specialty finance affiliate.  Don’t get me wrong, they haven’t become altruists, but a longer-term orientation is refreshing, perhaps.
    2. Arb spreads remain wide on deals though they have come back significantly recently.  For a gauge of that, simply look at a graph of the Merger Fund.
    3. Who can get out of what?  Well, private equity [PE] got the Home Depot board to cave in to a lower offer.  Guess they needed the money.  But what of other private equity deals?  I suspect more will lower prices as well, but not all of them; some deals will break up.  But what of the banks committed to lending money on deals?  Many of them are doing all they can to get off the hook, but so many banks surrendered their flexibility to exit deals in order to get the business during the boom phase.  Now they are paying for it, or, at least, considering paying for it, since losses look like they will be 10-12% of the amount loaned, as they sell the loans to institutional investors.
    4. “There is pressure to deploy,” said Ilan Nissan of law firm O’Melveny & Myers. “This business is about using resources to buy and sell companies. No one is making money by holding.”  To me, that what’s wrong with private equity.  If PE is just a larger version of condo-flippers, it has little reason to exist.  Improving operations and marketing would be far better things to do.
    5. Somewhat off-topic, back to the Fed Model, since that deals with the tradeoff of debt for equity, much like PE firms do.  I felt that Dr. Hussman’s methods were mistaken, and so I commented over at A Dash of Insight:Even though his regression fit well, there were two things amiss. One, how many models did he try before he published his model? Did he do a specification search? When I did my model, I did only two passes over the data, and the first was accidental because I didn’t have a lengthy corporate yield series. The Moody’s series is one of the few that goes back a long way, and Bloomberg did not carry it. I wanted to use BBB corporates from the start, but could not find a series, so I did one pass with Treasuries.

      Second, after doing the analysis, the rest of his results rely on an extrapolation from the recent past to the further past. Dr. Hussman is the one who argues that the 80s are unique, but that is a large part of the data that he uses to estimate his backcast. No matter how good the fit, it is not safe to do extrapolations. Too many structural things change over time in capitalist economies.

    That’s all for now.  I might have the strength for one more post tonight.

    Tickers mentioned: KFN HD

    Before I begin this evening, let me just mention that I have expanded my blogroll. These are the blogs that are on my RSS reader at present. As I add more, I will add them to my blogroll. One more thing before I start: the comeback on Friday was nice, but I don’t think this is the end of the troubles; the leverage issues still aren’t dealt with, though the money markets (CP, ABCP) may be getting reconciled in the short term. Tonight’s topic is the mortgage market:

    1. Reduction in capacity is the rule of the day. Who is shrinking or disappearing? Lehman’s subprime unit, Thornburg (shrinking), Luminent (cash injection under distress), American Home (what were the auditors thinking?), Capital One (closing Greenpoint), Countrywide (layoffs), Accredited, HSBC’s US mortgage unit, and more.
    2. Who has lost money? Who has decided to pony up more? Carlyle ponies up, Bank of China, speculators including Annaly, and many others, including IKB, BNP Paribas, and British, Japanese and Chinese banks. The losses are mainly a US phenomenon, but not exclusively so.
    3. Thing is, in a credit crunch, before things settle down, everyone pays more. The CEO of Thornburg suggests that the mortgage markets aren’t functioning. Well, if excellent borrowers aren’t getting loans, he is correct. After risk control methods are refined, new capital finds the better underwriters, who underwrite better loans. For those with good credit, any imbalances should prove temporary.
    4. Now what do you do if you are a surviving mortgage lender, and you can’t get enough liquidity to lend? Raise savings and CD rates. (A warning to readers: no matter how tempting, do not lend to mortgage lenders above any government guaranteed threshold on your deposits.)
    5. Could the Truth in Lending Act cause loans to be rescinded? As I commented, If TILA claims are successful, there would probably be a breach of the reps & warranties made by the originator. I think there is a time limit on the reps and warranties though, and I’m not sure how long it is.
      If a securitized loan has to be taken by the originator, the AAA part of the deal will prepay by that amount. Losses will be borne first by the overcollateralization account, and then the tranches, starting with the most junior, and then moving in order of increasing seniority. If a bank goes insolvent as a result of this, any claims against the bank by the securitization trust would be general claims against the bank.

      Very interesting, Barry. Thanks for posting this. It’s just another reason why in securitization, it is better to be a AAA holder, or an equity holder. They have all of the rights — the AAAs when things are bad, and the equity when things are good to modestly bad.

    6. Or, could Countrywide, and other lenders run into difficulties because they might have to buy back loans that they modify the terms, if they are pre-emptive in doing so, rather than reactive to a threatened default? On the other hand, modifications are generally allowed for true loss mitigation, or if they are loss neutral to the senior investors. But what if the servicer offers modification to someone with a subprime loan who really doesn’t need it? Not likely in this environment. Almost everyone who took out a subprime loan expected to refinance. Modification is just another way of getting there.
    7. What could fiscal policy do to get us out of this mess? Maybe expand Fannie and Freddie, or FHA? Or have a bailout from some other entity, as Bill Gross or James Cramer might suggest? I’m a skeptic on this, as I posted at RealMoney on Thursday:

      David Merkel
      Every Little Help Creates a Great Big Hurt
      8/23/2007 5:09 PM EDT

      So there are some that want the US Government to bail out homeowners. Need I remind them that on an accrual basis, we are running near record deficits? Never mind. In another 5-10 years, it won’t matter anymore, because foreigners will no longer fund the gaping needs of the US Government as the Baby Boomers retire.But so as not to be merely a critic, let me suggest an idea to aid the situation. Income tax futures. We could speculate on the amount the US Government takes in, and the IRS could use it for hedging purposes. One thing that I am reasonably sure of: tax rates will be higher ten years from now, and I would expect the futures to reflect that.

      Position: long tax payments

    8. Beautiful San Diego, where my in-laws live. What a morass of default and foreclosure, as is much of California. Good blog, by the way.
    9. For those who have read me at RealMoney, the troubles in residential real estate came as no surprise to me, though many at Wall Street were either surprised, or feigning surprise.
    10. One other easy way that we can tell that we are in a residential real estate bear market is the incidence of fraud. Face it, in a bear market, the scams play to the fear of people, whereas in a bull market, they play to their greed.
    11. What effects will the increase in consumer debt, including mortgages, have on the economy? Well, the Fed Vice-Chairman wrote a piece on it, and the answer is most likely slower growth in consumer expenditure, and greater sensitivity of demand to interest rate movements.
    12. What happens when the equity and debt markets get shaky? Commercial landlords in New York City and London get nervous. Personally, I wouldn’t be that concerned, but perhaps some of them overlevered? (Hey, remember how MetLife sold a large chunk of their NYC properties for record valuations? Good sales.)
    13. How much value will get wiped away before the residential real estate bust is done? $200 billion to several trillion (implied as a worst case by the article)? I lean toward the several trillion figure, but not strongly.
    14. Something that trips people up about the mortgage troubles, is that little has been taken in losses so far, why is there such a panic? Markets are discounting mechanisms, and they forecast the losses, and bring the currently expected present value of losses to reflect on the value of the securities. Beyond that, weak holders of mortgage securities panic and sell, exacerbating the fundamental movements.
    15. Why are credit cards doing well when mortgages are doing badly? This is unusual. What it makes me think is that there is a class of homeowner out there thinking: “The mortgage? I’m dead, no way I can pay that. I have to look forward to renting in the future, and I don’t want to destroy access to my credit card.”
    16. Finally, ending on an optimistic note: even if housing is so bad, in a global economy, it may not mean so much to the stock market. That’s my view at present, and why I am willing to be a moderate bull, even as I continue to do triage on my portfolio. (PS — that graph entitled, “Trouble at Home,” is scary.)

    So the Fed opens up the discount window, and drops the rate 0.5%, banks go gonzo, right?  Well, no, I wouldn’t call it a “brisk business.”  A lot of the “business” was in and out in short order, for average borrowings of $1.2 billion.  For the discount window of its own to make a real dent in monetary policy, we would need to see more than $10 billion of net borrowings, because the Fed is decreasing the monetary base by $10 billion through other actions.  As it is, after the discount rate was decreased, there was a flurry of action, and then nothing.  So, in order to keep the monetary base up, the Fed injects temporary liquidity of $17.25 million, the most in 2 weeks (i.e., since permanent temporary injections started).  Does this have a big impact on the Fed funds rate?  No, it closes out the day at 4.875%, which is close to the average level of 4.90% over the past two weeks.  The number looks big, but it is meaningless.  Look at the monetary base or one of the monetary aggregates; they haven’t moved much.  Should we expect a lot of incremental economic action of out of this?  I don’t think so.

    Onto the Commercial Paper Market.  CP outstanding had its biggest weekly drop since 2000. It is down almost 10% over the past two weeks.  Most of the decrease is asset-backed CP.  Bill Gross declares that the ABCP market is “history.”  He’s wrong.  Again.  ABCP will remain but with safer classes of asset-backed securities, wider spreads, and larger margins of safety, at least until the next lust for yield comes upon us. 😉  As it is, the safer parts of the ABCP market are beginning to function normally, albeit at higher spreads.

    Things can get bad in the ABCP market, particularly if you are an issuer that doesn’t have a big balance sheet.  That’s what happened to Canada’s Coventree.  For banks issuing ABCP, it should not be as big of a problem; many banks will step up and make up the loss.  If the risk is $891 billion in commercial paper, I would be surprised if the losses were more than 2% of that amount.  At $18 billion, that is no threat to the system, though some rogue money market funds might get whacked.

    Now corporate bond issuance is returning, though some of it is replacing CP.  I expect that effect to stop soon.  Things are returning to normal in corporates, though high yield will take more time.

    This article helps point out that the Fed, though still powerful, has reduced powers because less of the financial system consists of depositary institutions. ABS and mutual funds have picked up the slack.  What that implies is that ordinary bond buyers are willing to take on the risks that depositary institutions once did.  That reduces the power of the Fed.

    As for this article, I’m sure Fed Governors are thinking, “What’s next?  Are we just running from fire to fire, or is there a systemic way to restore order?”  I’m not so sure here.  I think a permanent injection of liquidity would do it, temporarily, but there are so many places where leverage got too great that are in loss positions now.  For the Fed, the only real question should be, how much did our banks lend to the overleveraged?

    From Michael Sesit at Bloomberg, there are four things for the central banks to do in order to avert the crises: The world’s major central banks face four challenges as they strive to prevent the global financial system from unraveling and growth from stagnating: Acting in a concerted manner; improving transparency; deciding who gets bailed out and who doesn’t; and making sure whatever monetary medicine is administered doesn’t come with destabilizing side effects.

    All four are not easy.  I would argue that the last two are the most important, but that it is very difficult to legally discriminate between who needs it and who doesn’t.  Destabilizing side effects are part and parcel of monetary policy.  To the degree that the Fed can discriminate, it will eventually run the risk of being view as unfairly discriminatory, and unelected as well.

    So, I don’t see much happening here from monetary policy.  It is simply a question of how the excess leverage presents itself through the financial system.  So far, it has served up some notable troubles, the question is how much more before it burns out.  With residential housing prices sagging it may persist for a long while, until the Fed debases the currency such that debtors can pay back their debts in devalued terms.  It almost reminds me of the bimetalism of the late 19th century; debasing the currency to let a wide number of debtors off the hook.  Well, if the Fed doesn’t do it, maybe Congress will.  After all, Congress can do something targeted,and live with the political heat.  The Fed risks its independence if they look like they behave on behalf of the the few, nor the many.