Over at RealMoney, toward the end of the day, I commented:

		David Merkel
		Many Hedge Funds are Systematically Short Liquidity
		8/9/2007 5:43 PM EDT

You can look at Cramer’s two pieces here and here that deal with the logjam in the bond markets. Now, there are problems that are severe, as in the exotic portions of the market. There are problems in investment grade corporate bonds in the cash market, but spreads haven’t moved anywhere nearly as much as they did in 2002. The synthetic (default swap) portion of the market is having greater problems. Oddly, though high yield cash spreads have moved out, they still aren’t that wide yet either compared to 2002. The problems there are in the CDS, and hung bridge loans.

Most hedge funds that try to generate smooth returns are systemically short liquidity and volatility. If these funds are blowing up, like LTCM in 1998, then liquidity will be tight in the derivative markets, but the regular cash bond markets won’t be hurt so bad.

I agree with Michael Comeau with a twist… this may end up being good for the equity markets eventually, but in the short run, it is a negative.

Let me try to expand a little more here. A good place to start is Cramer’s last piece of the day. Part of what he said was:

But first you have to recognize that I am not talking about opportunity. We need the Fed simply to issue a statement like it did in 1987, that it would provide all of the liquidity necessary to get things moving in the credit markets.

All of those who think the Fed is helpless are as clueless as the Fed. A statement like that would eliminate the fear all over town that committing capital is going to wipe your firm out.

The European action seemed desperate today, but it’s a bit of a desperate time, and they did what is right.

If we had made the right call on Tuesday at the Fed, we would have maneuverability over the next month to help.

Now we can’t. Not for another couple of months, [sic]

Unfortunately, Cramer is wrong here. The ECB only did a temporary injection of funds, which will disappear. The Fed also did a similar temporary injection of funds today, which brought down where Fed funds were trading. It will disappear as well, but both the ECB and Fed can make adjustments as they see fit. There isn’t any significant difference between the actions.
There have been notable failures and impairments, for sure. Let’s run through the list: the funds at BNP Paribas, funds at AXA, Oddo, Sowood and IKB, Goldman Sachs, Tykhe Capital, and Highbridge (and more). With this help from DealBreaker (most of the comments are worth reading also), I would repeat that most hedge funds that try to generate smooth returns are systemically short liquidity and volatility. Another way of saying it is that they have a hidden short in credit quality, and this short is biting bigtime.

Okay, I’ve listed a lot of the practical failures, but what classes of hedge fund investments are getting hurt? Primarily statistical arbitrage and event-driven. (Oh, and credit-based as well, but I don’t have any articles there.) The computer programs at many stat arb shops have not done well amid the volatility, and there have have been significant M&A deals that have come into question, like MGIC-Radian. Merger arbitrage had a bad July, and looking at the Merger Fund, August looks to be as bad. (Worrisome, because merger arb correlates highly with total market confidence.) As for statistical arb, I know a few people at Campbell & Company. They’re bright people. Unfortunately, when regimes shift, often statistical models are bad at turning points. Higher volatility, bad credit, and the illiquidity that they engender doom many statistical models of the market.
So, how bad is credit now? If you are talking about securitized products and derivatives, the answer is extremely bad. If you are talking about high yield loans to fund LBOs, very bad, and my won’t some the investment banks take some losses there (but they won’t get killed). High yield bonds, merely bad — spreads have widened, but not nearly as much as in 2002. Same for investment grade corporates, except less so. Now the future, like say out to 2010, may prove to be even worse in terms of aggregate default rates of corporates, because more of the total issuance is high yield. This is just something to watch, because it may imply a stretched-out scenario for corporate credit losses.

The Dreaded Subprime

Subprime mortgage lending has had poor results. I would even argue that early 2007 originations could be worse than the 2006 vintage. This has spilled over into many places, but who would have expected money market funds? The asset-backed commercial paper [ABCP] market is a small slice of the total commercial paper market, and those financing subprime mortgage receivables are smaller still. The conduits that do this financing have a number of structural protections, so it should not be a big issue. The only thing that might emerge is if some money market fund overdosed on subprime ABCP. I’m not expecting any fund to “break the buck,” but it’s not impossible.

I generally like the writings of Dan Gross. He is partially right when he says that the effects of subprime lending are not contained. Many different institutions are getting nipped by the problem. But I think what government officials mean by contained is different. They are saying that they see no systemic risk from the problem, which may be correct, so long as the aggregate reduction in housing prices does not cause a cascade of failure in the mortgage market, which I view as unlikely.

Perhaps we should look at a bull on subprime lending? Not a big bull, though. Wilbur Ross has lent $50 million to American Home Mortgage on the most senior level possible. That’s not a very big risk, but he does see a future for subprime lending, if one is patient, and can survive the present slump.

A note on Alt-A lending. There’s going to be a bifurcation here; not all Alt-A lending is the same. As S&P and the other rating agencies evaluate loan performance, they will downgrade the deals with bad performance, and leave the good ones alone. The troubles here will likely be as big as those in subprime. Perhaps the lack of information on lending is the crucial issue. Colloquially, never buy a blind pool, or a pig in a poke. Information is supremely valuable in lending, and often incremental yield can’t compensate.

Summary Thoughts

I think 1998 is the most comparable period to 2007. There are some things better and worse now, than in 1998. In aggregate it’s about the same in my opinion. Now with hedge funds, the leverage in aggregate is higher, but could that be that safer instruments are being levered up? That might be part of it, but I agree, aggregate leverage is higher.

In a situation like this, simplicity is rewarded. Complexity is always punished in a liquidity crisis. Bidders have better thing sto do in a crisis than to figure out fair value for complex instruments when simpler ones are under question.
Another aspect of liquidity is the investment banks. As prime brokers, their own risk control mechanisms cause them to liquidate marginal borrowers whose margin has gotten thin. This protects them at the risk of making the crisis worse for everyone else as the prices of risky asset declines after liquidations. Other investors might then face their own margin calls. The cycle eventually burns out, but only after many insolvencies. My guess: none of the investment banks go under.

Finally, let’s end on an optimistic note, and who to do that better than Jim Griffin? As I said before, simplicity is valued in a situation like this, and stocks in aggregate are simple. As he asks at the end of his piece, “What are you going to buy if you sell stocks?” I agree; there will be continued problems in the synthetic and securitized debt markets, but if you want to be rewarded for risk here, equities offer reasonable compensation for the risks taken. Just avoid the areas in financials and hombuilders/etc, that are being taken apart here. The world is a much larger place than the US & European synthetic and securitized debt markets, and there are places to invest today. Just insist on a strong balance sheet.

There’s a lot of talk about the superiority of yield-based strategies, and that has been true in hindsight, particularly since interest rates have fallen for pretty much the last 25 years, while corporate profits and free cash flow have generally grown, allowing for greater dividend capacity.  A potent mix that has favored yield, but what if the environment changes?

I don’t go looking for yield, but stocks with some yield tend to find their way into my portfolio.  Why?  Companies with stable business models, strong balance sheets, and good earnings quality tend to produce free cash flows in excess of their reinvestment needs.  That cash can be given to shareholders as dividends, or used to buy back stock.

But there is something positive about what a dividend does to a company’s management team, which in the American context, is viewed as a pseudo-obligation.  This makes the cost of capital tangible to the management team, which will be more careful about how they use their cash.  After all, they have a dividend to maintain.

Now, yield in itself can be manipulated.  Leverage can be increased to pay dividends, and with low quality companies that often happens.  Smart investors look to see how well a company’s dividend yield is covered by the earnings.  Avoid the shares of a company that isn’t likely to earn its dividend, particularly if the have to compromise the balance sheet to do it.

A yield in itself does not make a company more safe; if the yield is high enough such that there are naive yield investors in the stock, that yield can actually make the stock more risky, if a disappointing earnings report puts the dividend in jeopardy.

Finally, as an aside, a quick note on intelligent vs. dumb buybacks.  Intelligent management teams have an estimate of what they think their firm is worth, and they don’t buy back stock, unless the stock is trading below that level.  The management team won’t tell you that level, but they might tell you if they follow such a strategy, if you ask them.

After that, you can find out where they are buying stock back.  If you look in the cash flow statement, under cash flows from financing, you can see how much they spent buying back stock, and in the statement of shareholders equity you can see how many shares they bought back.  Those two figures will enable you to calculate the average buyback price.  This figure can be important even for traders, because it can indicate a level where a management team is willing to buy buy shares when they have free cash, and as a result, can become a support level for the stock.

Good fundamental investing means looking at more than just a few summary variables, like yield.  You have to dig through the financial statements to see how the business adds value.  If that means that your stock gives you a yield, like most of my stocks do, that is icing on the cake.

1. This piece is a little dated, but I’m using it to illustrate the nature of consumer surveys in the US.  If rates have been rising, those polled extrapolate the current trend.  As it was, that particular poll was close to the short-term turning point on inflation expectations.  I feel more comfortable trying to tease out inflation expectations by looking at the relative spread of TIPS to nominal bonds.  Right now, that’s not moving much.
2. I’m already on record that I don’t like the concept of core inflation, and that I think current methods of measuring inflation understate it, though now I would say only by 1%/year.  But regarding core inflation, there are many who say there are better ways to remove volatility from the estimation of central tendency.  Use of a median or trimmed mean are superior methods to excluding whole classes of goods, like food and energy, which conveniently have been rising faster than most other good in the CPI.
3. Inflation is rising in many places.  New Zealand is one example.  This is one of those temporarily self-reinforcing situations where foreign investors are willing to invest because of high nominal rates, while discounting any possibility of the currency moving against them.  In the short run, the more people who believe this, the less likely that an adjustment occurs.  But the additional liquidity stimulates the economy, raises inflation, and makes the central bank want to tighten more, leading to higher rates in which foreign investors want to invest.  It will only break when the high rates slow the NZ economy to a crawl, or, for some unexpected reason, the currency starts depreciating, and it feeds on itself.  Personally, I would not be long the Kiwi.
4. The Economist has noticed many of the same trends, adding in Latvia and Iceland to NZ.  In the short run, so long as foreign investors have confidence in the currencies of these three nations, their central banks are impotent.  But in some sort of crisis that would disrupt global capital flows, all of these currencies would be at risk.  No telling when that will happen, but once the adjustment happens, like those who borrowed at teaser rates, they will be sorry they invested in high interest rate currencies, and borrowed in low interest rate currencies.
5. China.  Easy to underestimate.  Easy to overestimate.  Hard to get a fair picture.  Their Central bank keeps tightening, but doesn’t let the currency adjust upward.  As a result, inflation keeps rising there… too much credit is chasing too few goods produced for domestic consumption. (Diseases affecting pigs, and high grain prices don’t help.  Food is a larger portion of the budget of the average person in China.)  Exports dominate Chinese economic policy, and with an dirty-floating undervalued currency, trade surpluses build up almost everywhere, except the Middle East and Japan.  The Chinese economy keeps rolling ahead, growing at near-record rates if you can believe the statistics.  (Which I largely believe, the current account surpluses don’t lie.)  That has costs, though.  There are costs to the environment, food safety, working conditions, etc.  The communist party has in some ways transformed themselves in a bunch of crony capitalists.  Those at the top get the favors, and the rest trickles down, but not as well as in the US.  In the short run, that can produce amazing economic results, but can’t produce a society that is truly creative, and self-sustainingly productive.  What will happen to China when it no longer has incremental cheap labor to deploy?  Productivity will drop?  Already I am hearing of some manufacturers decamping to Vietnam, and other cheaper places.
6. The reported US Government deficit is shrinking.  Good as far as that goes.  Corporate taxes are filling much of the gap.  We still have the Iraq/Afghanistan Wars off-budget, and Social Security on budget, both of which reduce the true size of the deficit.  On an accrual basis, counting everything in, we are running deficits at near record levels.  Promises are being made for the future the aren’t getting counted today.  Corporations would have to accrue them, but the government does not.
7. And now a word from our sponsors, the optimists.  Let’s start with the ISI Group.  They have ten reasons why we won’t have a recession soon.  I have been arguing for a recession in 2008, but as GDP growth remains positive each quarter, it gets harder to maintain that a recession is around the corner.  Though inflation is rising, credit spreads are widening, and the US Dollar is falling, the US economy has been resilient, credit spreads and implied volatilities have not been out of control.  And housing finance is not good, but most of the lending risk is concentrated in the hands of a few speculators.  The US economy is seeing export-led growth for the first time in a while.  There are reasons for optimism here; just because it is easier as a writer to be a skeptic and a pessimist, doesn’t mean you should invest that way.
8. Why do I like most but not all emerging markets here?  They are better managed on both fiscal and monetary bases than many developed economies, and capitalism is finally becoming a sustainable ideology.  That’s why amid the rise in credit spreads for junk grade corporations here in the US, many emerging market spreads have tightened.  Going back to points 3 and 4 above, those that don’t have strong fiscal and monetary policies, like Turkey, may very well get whacked, after a disruption in capital flows, war, or some event that changed the willingness of investors to take currency or sovereign risk.
9. What if we try to get away from currencies, and focus on commodities instead?  Metal scrap prices are robust.  Aluminum beer kegs are getting sold for scrap, among other things.  In another place, Historian Niall Ferguson tells us that we should not worry about running out of oil, but out of arable land for farming.  Personally, I’m not worried about either.  Rising food prices will slow the development on arable land, and in some cases, redevelop land for farming.  Further, contrary to the over-estimated Malthus (whose great contribution in life was giving inspiration to Darwin), we have been able to grow agricultural productivity considerably faster than population, in areas where capitalism is allowed to thrive.  That said, I am bullish on the prices of food products; in the short run, there will be more excess demand.