11 September 2007 – The Aleph Blog

My 9/11 Experience

Posted on 11 September 200712 September 2007 by David Merkel

Six years ago, I was a neophyte (2 months) corporate bond manager, also doing mortgage bonds, and nominally Chief Investment Officer of a medium-sized life insurance company. I was leading our asset management team through a merger with another firm as well. On 9/11, I was going to have a meeting with my new bosses and the management of our one and only life insurance client.

I was running a little late, so I got to the office as the first tower fell. I talked with a few of my brokers, and concluded that nothing would be trading today. After the second tower fell, our offices were crowded from people in the insurance company watching the spectacle on CNBC. I told my staff to prepare a broad threat report, describing what parts of our portfolio would be harmed by the events; after that, they could go home and grieve. (Our KBW coverage died that day; he was a good fellow.) I went to the meeting, where we canceled our agenda, and I gave a brief threat report, and told them they would have full threat report every day at 4PM until the markets normalized. Aside from owning part of a mortgage on a building near the World Trade Center (One Liberty Plaza) which was rumored to be leaning (not true), the problems were pretty light; liquidity was adequate.

That evening I showed my family video clips from the Internet, and explained what had happened. We’re a pretty matter of fact bunch, so they took it in stride, and realized that the world had changed for the worse.
Because of the merger, the portfolio was relatively high quality. Good thing, too. The markets were closed for the whole week, and reopened the next week. Bond markets are networks, and so, they come back proportionally to the square of the nodes. After one week, the bond market was half functional. After two weeks, 80% functional. After three weeks, 100% functional. We started trading sooner than most, and offered liquidity in exchange for good deals. When our merger closed on 9/30, was began a massive down-in-credit trade, buying bonds in sectors most affected by the disaster. Our logic was that the terrorist event was a “one off” matter where the highjackers got really lucky, and that the odds of a second event were nil, now that the US was on alert.

When I went to a Chief investment Officer’s forum in October, there was a “closed door” meeting with “peer companies” to discuss problems and strategies. One of the early questions was how investment strategy had changed since 9/11. I was the odd man out. We were the only one in the room taking more risk. Everyone else was running up-in-credit trades, and avoiding affected sectors. Not only did I get a “you’re weird” look from the other participants, but I got the “you’re irresponsible” look as well. Not fun.

We continued the down-in-credit trade for another month until we had gone as far as we thought prudent. Then our client came to us and said that the ratings agency heard what we were doing, and told us to knock it off, or face a downgrade. We were done, so we agreed. By this time, it was mid-November. By December, a little more willingness to take risk took hold, and by the first quarter of 2002, there was a full-fledged scramble for yield. We sold into it, doing a massive up-in-credit trade that left the portfolio higher quality than it was prior to 9/11, and giving us room for the upset that would happen as Worldcom went down, and the corporate bond markets doing a double dip in late July and early October. We played the risk cycle very well.

There are four investment points here:

Don’t follow the crowds during panics.
Don’t follow the crowds during manias.
Know your limits. No matter how good an idea will work out eventually, don’t overplay it, because the market can be crazy longer than you can stay solvent.
After a panic event, analyze what has truly changed, and ask what things will be like when the next steady state comes, and how long it will likely take to get there.

It was not a consensus view at the time, but the idea that not much had changed permanently proved to be a valuable idea. Capitalist economies tend to be resilient, bending but not breaking. With that, guard your emotions, and try to be analytical toward investing, even when times are abnormal, and people think you are nuts.

The Road from Here to Stagflation

Posted on 11 September 2007 by David Merkel

Cramer again.? This time I disagree more, because he is talking about the Fed.? He has five views of the Fed that he hates.? Let me take them in order:

1) The Fed doesn’t matter — It depends.? In the short run, when the Fed loosens, healthy assets get stimulated, but damaged assets don’t.? In the intermediate run, companies get financing from healthy financials to reconcile dud assets that were misfinanced, but the process takes time, maybe a year or two.

2) The Fed is pushing on a string — Initially, it will look like that is true.? It almost always does. Things that are viewed as problems now will not be helped by the initial effects of Fed policy.

3) The economy won’t react to the Fed, no matter what — Cramer is right to dis this one.? The Fed will revive nominal growth after a year or two.? The hard question is how much comes from inflation, and how much comes from real growth.

4) The dollar collapses because of cuts — Here I disagree with Cramer.? The dollar will decline.? Interest rates are a more powerful factor than GDP growth in exchange rates, because financial transactions are larger than trade in goods by an order of magnitude.

5) The Fed doesn’t want to do anything and doesn’t have to do anything — Well, true on its face, but the Fed is a political creature.? It responds to market signals, and it has signaled that it wants to “solve this problem.”? Cramer is correct here.? The Fed will act; the only question is how much.

But ask yourself a different question. How could the Fed break the logjam in the commercial paper market, particularly ABCP?? I clipped a lot of articles on this.? There is a lot of CP maturing (maybe $140 billion) in the next week or so.? It is not the banks that are so much at risk, though some will have to collapse conduits and bring asset back onto their balance sheets, lowering capital ratios. ? The non-banks are the ones getting smashed, and the banks may have modest exposure to their woes.? Information Arbitrage has it right when he says that this is a case of misfinancing assets.? (Hey, maybe the Fed could directly monetize ABCP by buying it instead of Treasury notes.? No, no, please don’t… 🙁 )

Now, how much will the FOMC cut rates?? Unusually modest for PIMCO, they call for 1% by 2008.? (They never met a rate cut that they didn’t like.)? Fed Governor Plosser suggests that they have other tools they can use, without cutting the Fed funds rate. The ever-smart Jim Griffin concludes that the main risk to the Fed at present is inaction, and I agree.? At a time like this, the FOMC must do something notable, or the political heat cranks up.? Then again, we can look at the Treasury bond market as a whole, and easily conclude that at least 1% of loosening is in the foreseeable future.? As Caroline Baum puts it, “The fact that the funds rate is hovering so far above the rest of the yield curve is the most obvious sign that policy is tight. Yet Fed officials seem determined to see evidence of it in the real economy before they relent.”

Four quick notes before I end:

Remember that Fed funds futures are typically only good for predicting the next meeting, and nothing beyond that.
There’s still a lot of subprime debt to be reconciled in money market funds.
Central banks are supposed to help with illiquidity but not insolvency.? At the edges, this is not so clear.? Illiquidity can lead to insolvency if bank capital levels are inadequate.
An excellent summary article on all of this from the Bank of International Settlements, the central bankers’ central bank.

My summary: the FOMC will cut in September, and because monetary policy works slowly, they will be politically forced into more cuts than they would like, until signs of rising inflation cuts off the cuts sometime in 2008-9.? The yield curve will be much wider then, and then the hard choices faced in the 1970s will reappear, along with the s-word: stagflation.? I hesitate to use the word, because it is so sensationalistic, but I feel that we are headed there, slowly but surely.