The Value of Having a Deposit Franchise (or a Printing Press)
I’m worried. That doesn’t happen often. Over the years, I have trained myself to avoid both worry and euphoria. That has been tested on a number of occasions, most recently 2002, when I ran a lot of corporate bonds. Ordinary risk control disciplines will solve most problems eventually, absent war on your home soil, rampant socialism, and depression. I like my methods, and so I like my stocks that come from my methods, even when the short term performance is bad. Could this be the first year in seven that I don’t beat the S&P 500? Sure could, though I am still ahead by a few percentage points.
Let’s start with the central banks. I don’t shift my views often, so my change on the Fed is meaningful. But how much impact have the temporary injections of liquidity had? Precious little so far. Yes, last I looked, Fed funds were trading below 5%; banks can get liquidity if they need it, but credit conditions are deteriorating outside of that. (more to come.) I don’t believe in the all-encompassing view of central banking espoused by this paper (I’d rather have a gold standard, at least it is neutral), but how much will full employment suffer if most non-bank lenders go away?
Why am I concerned? Short-term lending on relatively high quality collateral is getting gummed up. You can start with the summary from Liz Rappaport at RealMoney, and this summary at the Wall Street Journal’s blog. The problems are threefold. You have Sentinel Management Group, a company that manages short term cash for entities that trade futures saying their assets are illiquid enough that they can’t meet client demands for liquidity. Why? The repurchase (repo) market has dried up. The repurchase market is a part of the financial plumbing that you don’t typically think about, because it always operates, silently and quietly. Well, from what I have heard, the amount of capital to participate in the repo market for agency securities, and prime AAA whole loan MBS has doubled. 1.5% -> 3%, and 5% -> 10%, respectively. Half of the levered buying power goes away. No surprise that the market has been whacked.
Second, away from A1/P1 non-asset-backed commercial paper, conditions on the short end have deteriorated. As I have said before, complexity is being punished and simplicity rewarded. High-quality companies borrowing to meet short-term needs are fine, for now. But not lower-rated borrowers, and asset-backed borrowers. Third, our friends in Canada have their own problems with asset-backed CP. Interesting how Deutsche Bank did not comply with the demand for backup funding. Could that be a harbinger of things to come in the US?
On to Mortgage REITs. Thornburg gets whacked. Analyst downgrades. Ratings agency downgrades. Book value declines. Dividends postponed. It all boils down to the increase in margin and decrease in demand for mortgage securities (forced asset sales?).
It’s a mess. I’ve done the math for my holdings of Deerfield Capital, and they seem to have enough capital to meet the increased margin requirements. But who can tell? Truth is, a mortgage REIT is a lot less stable than a depositary institution. Repo funding is not as stable as depositary funding. There will come a point in the market where it will rationalize when companies with balance sheets find the mortgage securities so compelling, that the market clears. After that, the total mortgage market will rationalize, in order of increasing risk. Fannie and Freddie will help here. They support the agency repo market, but the AAA whole loan stuff is another matter. Everyone in the mortgage business except the agencies is cutting back their risk here.
By now, you’ve probably heard of mark-to-model, versus mark-to market. The problem is that mark-to-model is inescapable for illiquid securities. They trade by appointment at best, and so someone has to estimate value via a model of some sort. The alternative is that since there are no bids, you mark them at zero, but that will cause equity problems for those buying and selling hedge fund shares. This is a problem with no solution, unless you want to ban illiquid securities from hedge funds. (Then where do they go?)
There’s always a bull market somewhere, a friend of mine would say (perhaps it is in cash? that is, vanilla cash), but parties dealing with volatility are doing increasing volumes of business, which is straining the poor underpaid folks in the back office.
Why am I underperforming now? Value temporarily is doing badly because stocks with low price-to-cash-flow are getting whacked, because the private equity bid has dried up. That’s the stuff I traffic in, so, yeah, I’m guilty. That doesn’t dissuade me from the value of my methods in the long run.
Might there be further liquidity troubles in asset classes favored by hedge funds? Investors tend to be trend followers, so yes, as redemptions pile up at hedge funds, risky assets will get liquidated. Equilibrium will return when investors with balance sheets tuck the depreciated assets away.
Finally, to end on a positive note. Someone has to be doing well here, right? Yes, the Chinese. Given the inflation happening there, and the general boom that they are experiencing, perhaps it is not so much of a surprise.
With that, that’s all for the evening. I have more to say, but I am still not feeling well, and am a little depressed over the performance of my portfolio, and a few other things. I hope that things are going better for you; may God bless you.
Full disclosure: long DB DFR
August 15th, 20072:30 am at
Hope you feel better soon David… I find your insights very enlightening and I thank you (again) for sharing them.
August 15th, 20072:35 am at
BTW the more I read of your blog the more I hope that you follow through with your newsletter proposal.
August 15th, 20076:56 am at
David,
Per your Canadian ABCP comments, it’s really been a mess up here. Lots of conduits having trouble getting funding rolling over their CP. With respect to backup funding for the conduit you referred to, apparently there were 3 backstops, and along with Deutsche Bank, Barclays also pulled their funding, and only Societe Generale was willing to lend. More problematic, Canadian banks were hammered yesterday due to their large backstop commitments, and they are a large component of the TSX composite. I spent a large amount of yesterday trading the banks, trying to be nimble, but it was very ugly at one point. In the end, I would expect the Bank of Canada to backstop the banks, and this will stabilize the issue.
With respect to underperformance and depression, take heart and and solace from the Bible. “Do not worry” says Jesus, and I take him at his word.
God bless you,
Steve
long some Canadian banks
August 15th, 20077:10 am at
Dear David,
Feel better! This too shall pass.
August 15th, 20077:21 am at
One mortgage REIT that may ride out the storm is Redwood Trust (RWT). It has lots of liquidity, and its (mostly prime) portfolio is doing very well. Trading at GAAP book value and below “core” book value (i.e. ex-FAS-115 for you insurance types)
Long RWT
August 15th, 200710:53 am at
To all,
Typo in my message to David; I take Jesus at His word, not “his”, sleep deprived typo, forgive me.
And AA is right, this too shall pass.
Steve
P.S. – Bank of Canada issued statement regarding acceptable repo collateral up here, and seems to have staunched the CP worries up here, so one less thing for the global capital markets to worry about for now.
August 15th, 20074:01 pm at
I like to think of two competing views of the market; one is an analogy to a swimming pool where the flow of money/liquidity in and out moves the level up and down. The other is a meter where prices reflect opinions of the underlying equity/asset values regardless of the money flow. In the short term, imbalances in money flow dominate price movements and price movements influence people’s perception of the values. But eventually the flows change direction, and objective opinions about the underlying values act as an attractor for market prices.
In terms of portfolio positioning, I think one has to go with your strong suits. If you are good at predicting money flows, then use that edge. If you are good at judging dislocations in value (both where they are now and where they are going), then use that edge. If no edge, then use index funds. If one has a lot of risk tolerance in a portfolio, then that is an edge also, and one can use it by gradually increasing virtual leverage as prices fall down (e.g. gradually increase exposure to the most value dislocated stocks with the highest beta).
August 15th, 20074:03 pm at
I forgot to mention my question. What do you make of the fact that high yield corporate bonds sold off before the equity market and now seem to be rallying? I’m looking at HYG, for example.
August 15th, 20076:58 pm at
Following up my own question, this piece suggests part of the strength in high yield, besides piggybacking on Treasuries, could be more unwiding: http://www.cnbc.com/id/20278980
Unwinding is the best explanation for most of the stuff I see from day to day.
August 16th, 200712:44 am at
David — thanks for the heads up on my blog — very thoughtful. A few points on DFR that I thought were relevant and some questions:
1. DFR said on their call that they do not have another major repo refunding until the end of the August and that will only be a portion of their repo base. Seems like the rolling refunding will either give them time to increase the cushion or will turn this into a slow motion car crash.
2. The deal with Deerfield — IF they are able to get the cash to do the deal and it closes in the next few days as promised, how does that change their liquidity situation? Would it all be legally separate or could the additional assets and income stream help the portfolio (I recognize the size differential is huge but at this point every bit helps right?)
3. If the REIT portfolio becomes insolvent, what happens to the management company? Would there be something left over for equity holders or would any equity in the management company be used to pay off the portfolio creditors?
great analysis on the markets — thanks for writing.
Kyle
August 16th, 20071:08 am at
I hope you feel better, too. This has been a tough summer.
August 16th, 200710:11 pm at
Great commentary Gentleman! In terms of the panic I had several high maintenace individuals call and give me a hard time; and two pulled their money out of the stock market. As good a signal as any for the short term anyway. I really like HCBK in this environment with their surplus capital for bank/thrift exposure;
August 19th, 20075:36 pm at
I had the enormous good fortune to be away from constant exposure to the market this last week. No WONDER you weren’t feeling well!
I tremendously enjoy your blog and your insights. NONE of us, save the Almighty, can know everything! You’re doing a fine job and I’ve touted your blog to others of my acquaintance. Hope the Friday rally improved your mood and that your health is good. And, most importantly, remember that God’s blessing and love is more important than ALL of this other stuff!