It has been one year since I started The Aleph Blog. During that time, we have seen a lot of changes:
The panic in China in late February 2007.
The troubles in subprime, home equity, and residential real estate generally. (Commercial real estate is a work in progress.)
Increased realized volatility in the markets.
Increased price inflation.
The accelerated decline in the US Dollar.
Blowout of private equity lending.
Trouble as the rating agencies and the financial guarantors.
Trouble in the money markets from SIVs and ABCP.
Troubles in the municipal bond markets, mainly from overspeculation, but also from troubles at the guarantors.
The FOMC shifts from being an inflation fighter to a weak economy and lending fighter.
I left my previous employer (good guys generally), and have become employed elsewhere (a much better match for my abilities and desires).
My broad market portfolio has adjusted to changing market conditions, and continues to outperform the S&P 500, as it has for the last 7.5 years.
Pretty amazing, I think. My blog is an expression of my character in the economics/finance/investment world. I have a lot of interests, so my blog is diversified in what I write about. There is almost always someone more experienced than me writing about a given issue. I think of myself as a good number 2 (3? 5? 10?) on many issues. Because of that, my job is to look for the interactions — the second-order effects in other markets that may give us a clue as to future happenings.
If you want to see a sampling of what I felt my best articles have been, you can look here. If you have other nominations for this category, I am all ears.
Why did I start the blog? Rejection from those that I wrote for and worked with. I was frustrated, and needed an outlet for self-expression. Learning from what I wrote at RealMoney, from the first day, I followed the same ethics code, to protect those that I worked for.
What of the future? I plan on some meaty articles on inflation, the PEG ratio, some book reviews, and perhaps a series on long-term investing for children. (In addition to what I mentioned in Post 500.)
Now, I did not expect the level of acceptance that I received in my first year, and so I thank my readers. I have been quoted in a wide number of places that I would not have expected when I started this. I only ask that if you like what I write, please refer my blog to your friends, as it seems best to you.
To all of my readers, here’s to a profitable year number two. Thanks for being with me over the past year. For those that have commented here, a special thank you. To my family and church, thank you. Finally, thanks be to Jesus Christ. Woo-hoo! What a great year! 😀
Perhaps I should start with a small apology because my post yesterday did not even consider the forthcoming release of the FOMC minutes.? Not that I would have had anything great to say, but being asleep is being asleep. 😉
1) I’ve been banging the increasing inflation drum for a few years, and now I think inflation is getting some traction.? There was the CPI report today, of course, but I don’t put too much stock in monthly numbers — there is too much noise.? (I don’t think anyone wonders why I don’t spend a lot of time on quarterly, monthly or weekly data releases, but if anyone does wonder, it is because the signal to noise ratio is low.? The shorter the period, the lower it gets.)? I follow a melange of public and private bits of data, but try to look at it over longer periods of time — at least a year if possible.? A rise in inflation will make the FOMC’s life difficult.? I have been arguing for asset deflation and price inflation for some time now, and that is not a mix that I would enjoy trying to manage, if I were on the FOMC.
2) But there’s another reason why I have been arguing for price inflation.? It was about four years ago that I suggested on RealMoney that the cycle would end when China begins to experience a bout of price inflation.? Well, we are there now.? It was simple for China (and other nations) to ship us goods or provide services when the US Dollar was stronger, and inflation was low.? It is much harder with a weaker dollar, and rising price inflation.? The people of China need American goods, not more paper promises stuffed inside their central bank.
3) A few central banks aside from the Fed have loosened recently, but not many, and not much.? The US is walking alone here, and other nations are trying to cope.? Many other countries are willing to let their economies slow a bit, and perhaps let their currencies rise versus the US dollar in order to reduce inflation.? A few are still tightening.? The inflationary impacts of our monetary policy continue to radiate out, and will continue to, until the Fed starts its next tightening cycle.
4) The way I understand the FOMC’s behavior at present, is that they will drop rates hard for a time, and then remove policy accommodation dramatically once normal economic activity resumes.? My concern is that it may be more difficult removing policy accommodation than many suppose.? The TAF is holding down the TED spread at present, though the TED spread is still high.? What happens when it goes away?? Extending liquidity is always easier than removing it.? And, as it said in the 1/21/2008 portion of the FOMC minutes:
Some members also noted that were policy to become very stimulative it would be important for the Committee to be decisive in reversing the course of interest rates once the economy had strengthened and downside risks had abated.
The FOMC is not intending on letting low short rates remain for a long time.? That would make me queasy if I had a lot of money riding in the belly of the yield curve, say 4-7 years out.
5)? How would I characterize the FOMC minutes, then?? Weak economy, but not a shrinking economy.? Difficulties in the lending markets; credit spreads are high.? Inflation higher than we would like, but economic weakness, especially that affecting the financial system comes first.
6) From yesterday, my friend Dr. Jeff asked:
What was the Fed reply about M3?? I have continuing curiosity about this topic, as you know.? My economist friends tell me that it is not a useful measure.? It includes elements that are exchanges not increasing monetary supply and is also not subject to policy action.? MZM is interesting, but distorted by investors selling stocks and going to cash.? The latest macro textbooks stick to M2.
Meanwhile, many wingnuts (not you of course) see the dropping of the M3 reporting as some conspiratorial move.? They credit large government bureaucracies with much more conspiratorial power than could possibly be mustered!
By reading actual transcripts, you have vaulted into the top 1% of Fed analysts – if you were not there already 🙂
The nice fellow at the Fed who e-mailed me back confirmed that I should be looking at the H.8 report for an M3 proxy.
If you’re not into monetary policy, you can skip this. Within the month, the Federal Reserve will stop publishing M3. Now, I think M3 is quite useful as a gauge of how much banks are levering themselves up in terms of credit creation, versus the Fed expanding its monetary base. I have good news for those anticipating withdrawal symptoms when M3 goes away: The Federal Reserve’s H.8 report contains a series (line 16 on page 2 – NSA) for total assets of all of the banks in the US. The correlation between that and M3 is higher than 95%, and the relative percentage moves are very similar. And, from a theoretical standpoint, it measures the same thing, except that it is an asset measure, and that M3 incorporated repos and eurodollars, which I think are off the balance sheet for accounting purposes, but should be considered for economic purposes.
But it’s a good substitute… unless Rep. Ron Paul’s bill to require the calculation of M3 passes, this series will do.
Position: noneI since modified that to be total liabilities, and not total assets.? My use of M3 is a little different than most economists.? There is a continuum between money and credit, and M3 is more credit-like, while measures that don’t count in time deposits are money-like.? My view of M3 was versus other monetary measures, helping me to see how much the banking system was willing to borrow from depositors in order to extend credit.? As an aside, non-M2 M3 growth is highly correlated with stock price movement (according to ISI Group).
7) I give credit to the members of the FOMC who said (regarding the intermeeting 75 bp rate cut):
However, some concern was expressed that an immediate policy action could be misinterpreted as directed at recent declines in stock prices, rather than the broader economic outlook, and one member believed it preferable to delay policy action until the scheduled FOMC meeting on January 29-30.
This is just an opinion, but on policy grounds, I would have found it preferable for the FOMC to have cut 125 basis points on the 30th, rather than the two moves.? I don’t believe that the FOMC should react to short-term market conditions, and in general, they should avoid the appearance of it.? Monetary policy works with a long and variable lag.? One week would not have mattered; the FOMC needs to consider the way their actions appear, as well as what those actions are.
I like variety at my blog.? I like to think about a lot of issues, and the interconnections within the markets.? Sometimes that makes me feel like a lightweight compared to others on critical issues.? But what I am is a stock and bond investor who analyzes the economy to make better investment decisions, primarily at the sector level, and secondarily at the asset class level.
At present, analyzing the FOMC is a little confusing.? Why?
We have Fed Governors speaking their minds, because Bernanke doesn’t maintain the control that Greenspan did.? Thus we hear a variety of views.
The economy is neither strong nor weak, but is muddling along.
The Dollar is weak, but doesn’t seem to be getting weaker; it seems that a pretty accommodative forecast of FOMC policy has been baked in.
MZM and my M3 proxy are running ahead at double-digit rates, while M2 trots at around 6%, and the monetary base lags at a 2% rate.? We are now more than nine months since our last permanent injection of liquidity.? I asked the Federal Reserve in an e-mail to tell me what the longest time was previously between permanent open market operations one month ago, but they did not respond to me.? (They did respond to me when I suggested my M3 proxy, total bank liabilities.)
The Treasury yield curve still has a 2% Fed funds rate in 2008, but the recent curve widening should begin to inject some doubt into the degree of easing that the Fed can do.? Once yield curves get near maximum steep levels, something bad happens, and the loosening stops.? At a 2% Fed funds rate, we will be near maximum steep.
The TAF auctions have reduced the TED spread to almost reasonable levels, but it almost seems that the Fed can’t discontinue the auctions, because the banks have found a cheap source of financing for collateral that can’t be accepted under Fed funds.
At present, I see a 50 basis point cut coming at the 3/18 meeting.? That’s what fits the yield curve, Fed funds futures, and the total chatter.? For the loosening trend to change, we will need something severe to happen, such as a inflation scare or a dollar panic.
Now the equity markets are not near their peak, but the debt markets are showing more fear, and that is what is motivating the Fed.? Capital levels at banks?? Credit spreads on bonds?? Ability to get financing?? The Fed cares about these things.
In some ways, Bernanke cares the most.? Of all the people to have in the Fed Chairman seat at this time, we get a man who is a scholar on the Great Depression, and determined to not let it happen again, supposing that it was insufficient liquidity from the Federal Reserve that led to the Depression.? That might not have been the true cause, but it does indicate a Fed biased toward easing, until price inflation smacks them hard.
One last note.? Though I haven’t read through the 2001 transcripts of the FOMC, I have scanned the 1999 and 2000 transcripts.? The FOMC is flexible in the way that they view policy, and willing to consider things that aren’t perfectly orthodox, such as the stock market, even if it is hidden in the rubric of the wealth effect.
There are a variety of interested parties with an interest in keeping the guarantors in one piece, as is pointed out in this article from Bloomberg. Downgrading half a trillion of asset-backed bonds if a split happens? Yes, that is the price, and that is why there will be many lawsuits to contest any split, as pointed out by naked capitalism. The discussion of that post is worth reading, because it got me thinking about the differences between swaps and insurance. There are two ways to go here:
A swap that mimics the nature of an insurance contract is an insurance contract. After all, that is the way their regulators have been behaving, at least up until now.
A swap is a side agreement between the operating company (the actual insurer, not the parent holding company MBIA or Ambac), and the counterparty. In liquidation, they would be treated at general creditors, behind the policyholders in liquidation preference.
I looked at a few of the relevant state legal codes yesterday, and if the state regulators want to play hardball, they would go with the second interpretation, and pull the rug out from under the feet of those who were relying on the first interpretation. They could argue that swaps are a different class of business than insurance, and try to make the case that if an insolvency occured, those with with swap contracts would face a much lower recovery than those with insurance contracts, so let’s make it formal and do a split.
Now, most of the business done was by insurance contracts, and the laws on rehabilitation, conservation and liquidation indicate that similar parties are to be treated equitably within each class of claimants. Policyholders are all in the same class. Splitting the companies into municipal insurance and everything else would not treat all policyholders equally. Thus the lawsuits.
As I’ve said before, I would not be bullish on the equities of the compromised financial guarantors. They may survive, but only after much dilution. Now we have Ambac trying to raise $2 billion. What will they use? A rights offering? A PIPE? Mandatorily convertible debt? Surplus notes at their operating insurance companies? In order to get cash today, they have to give up a lot of the potential profits of the business. And what, will they take the $2 billion to try to buy off the structured securities claimants? Not enough, I think, if that half-trillion figure is correct, with $35 billion of mark-to-market losses for the market as a whole (Ambac’s portion would be big).
Two last notes: legally, I don’t see how splitting the guarantors gets done. It flies in the face of decades of contract law regarding insurers. Second, wouldn’t it be a troubling unintended consequence if the regulators managed to protect the municipalities, and in the process, ended up destroying the investment banks, leading to a bigger catastrophe? 🙁
With apologies to Mr. Krugman, I must correct some of what I wrote in my piece, “Pushing on a String? Credit Marches to its Own Drummer.“? When one does statistical analyses, one needs to understand the limitations/features of the tools that one uses.? Bloomberg’s regression function had a funny default that led me to make an error.? Had I done it right, the R-squared over the full sample period would have been 64.8% (correlation 80.5%), with a beta of 0.614.? Lagging the Fed funds target by one year, roughly the time it takes Fed policy to work boosted the R-squared to 77.2% (correlation 87.9%), with a beta of 67.1%.
But, here ‘s what is unusual.? If one is looking at the last five years, the relationship has broken down.? During that period, with no lag, the R-squared was 11.2% (correlation 33.5%), with a beta of negative 13.0%.? Even with the lag, the R-squared was 3.8% (correlation 19.4%), with a beta of negative 3.7%.
My conclusion: given the unusual credit conditions in the 2000s, where we have had extremes of default and monetary policy, I would not rush to say that the Fed is pushing on a string, yet.? That said, the debts of financial companies are a larger part of the index than they were five of ten years ago, and they are the ones in trouble at present, unlike the prior difficulties in industrials and utilities in 2001-2003.? Because of that, the Baa index of Moody’s may lag longer than ordinary versus Fed funds… but Fed policy has been called impotent before, and usually just before it shows its bite, as in the tech bubble of 2000, or the liquidity rally of spring 2003.
To my readers: if you see something that might be amiss in my writings, post a comment.? I owe it to all of you that I post corrections when I make mistakes.? Thanks for bearing with me on this one.? In the original piece, I sounded more certain than I should have, to my detriment…
What do municipalities want from their bond market? Low long-term financing rates. In and of itself, that’s not a bad goal to pursue. The question is how you do it.
What prompted this post was an article from The Bond Buyer (via Google cache). The need for short-dated tax-free muni bonds drives hedge funds (typically) to buy long munis and sell short term debt to finance the bonds, which tax-free money market funds buy. For more on Variable Rate Demand Structures, look here. (Thanks, Accrued Interest. The article was prescient to the current troubles.) The Wall Street Journal also anticipated the current troubles in this article. The hedge funds could only take the pain for so long. As perceived risks rose with the sagging prospects of the financial guarantors, fewer market players wanted to buy the short term debt, because the collateral underlying the short term debt no long had high enough ratings. That led to the hedge funds having to collapse their balance sheets, selling the long munis, and repaying the short term debts, taking losses in the process.
Part of the difficulty here is that auction rate structures are unstable. They can handle 30 mph winds, but not 60 mph winds. Auction rate structures deliver low rates when things are calm, but can be toxic when short term liquidity dries up. A sophisticated borrower like the NY Port Authority should have known that going in. Small borrowers are another matter, their investment banks should have explained the risks.
Yes, the explanations are all there in the documents, but a good advisor explains things in layman?s terms. That said, it is usually the shortsightedness of local governments wanting low rates and long term funding at the same time that really causes this. You can have one or the other, but not both with certainty.
Most of the municipalities with the failed auctions are creditworthy entities that don’t need bond insurance. Bond insurance is “thought insurance.” The bond manager doesn’t have to think about the credit if he knows the guarantor is good. If the guarantor is not good, then the bond manager has to get an analyst to look at the underlying creditor. That takes work and thought, and both of those hurt. Daniel Dicker is on the right track when he says the municipalities are racing refinance. Well, good. Auction rate structures are stable under most conditions, but under moderate stress, like the lack of confidence in the guarantor, they break. I would like to add, though that auction rate structures are kind of a cheat. Why?
1) The municipality gets to finance short, which usually reduces interest costs, but loses the guarantee of fixed-rate finance. 2) This is driven by investors who want tax-free money market funds. Most municipalities don’t want to issue the equivalent of commercial paper. They want long term financing. 3) The auction rate structure seems to give the best of both worlds: long term financing at short rates, without having to formally issue a floater. 4) For minor hiccups, an interested investment bank might take down bonds, but in a crisis, they run faster than the other parties from a failed auction.
The municipalities could have issued fixed or floating-rate debt over the same term, but they didn’t because it was more expensive. Well, now they will have to bear that expense, and yes, as Daniel points out, that will make the muni yield curve steepen.
Pain to municipalities, which will mean higher taxes for debt service. Fewer auction rate securities to tax free money market funds. It’s a crisis, but not a big crisis.
Position: none
Let me put it another way. No one complained when hedge funds levered up the long end of the muni market, allowing municipalities to finance more cheaply than they should have been able to. But now that the leverage is collapsing, and municipalities that did not prudently lock in their rates, but speculated on short rates are getting hurt, should it be a major crisis? I think not. Personally, I think the wave of auction failures will give way to refinancing long, and a new group of speculators buying auction rate securities at higher yields than the prior short-term equilibrium yield.
Thanks to Naked Capitalism for pointing out this post by Paul Krugman. Here was my response:
Mr. Krugman, do your homework.Extend the graph out to five years, and you will see that yields on Baa bonds fluctuated between 7.1% and 5.7% over that time period.The correlation between Fed funds and Moody’s Baa series was pretty small during that time period, whether the fed funds rate was rising or falling.I just calculated the R-squared on the regression — 0.1%, for a 3.2% correlation.
Maybe it’s just a bad time period, so I ran it back to 1971, which was as far as my Bloomberg terminal would let me go.(Maybe I’ll go to FRED and download longer series, and use Excel, but I don’t think the result will be much different — the R-squared was 6.5%, for a correlation coefficient of 25.5%.Not a close relationship in my book for two time series relationships that are both interest rates.
Practical economists like me are aware that credit-sensitive investments often have little practical relationship to Fed funds.We work in the trenches of the bond market, not the isolation of academic economics, where you don’t contaminate your theories with data.
The Fed may or may not be pushing on a string, but you have certainly not proven your case.
-=-=-=-=-
Here’s the graph for the Fed funds rate and Moody’s Baa yield series since 1971. (When I ran my calculations, I used monthly, but could only get the graph back to 1971 if I went to quarterly.
(graph: Bloomberg)
As I said, not much of a correlation, but why so low?? This is related to a topic on which Bill Rempel has asked me for an article.? (To do that article, I have to drag a lot of yield data off of Bloomberg for analysis; I will be getting my full subscription soon, and once that happens, I can start.)
As an investment actuary, I’ve had to develop models of the full? maturity/credit yield curve — maturities from 3 months to 30 years (usually about 10 points) and credit from Treasuries, Agencies and Swaps to Corporates, AAA to Single-B.? A Treasury yield curve at any point in time can be fairly expressed by a four factor model, and the R-squared is usually around 99%.? (I learned this in 1991, and there is a funny story around how I learned this, involving a younger David and a Bear Stearns managing director.)
The short end of the Treasury yield curve is usually far more volatile than the long end in yield terms (but not in price terms!).? All short high-quality rates are tightly correlated, and that includes Fed funds, Agency discount notes, T-bills, LIBOR (well, usually), A-1/P-1 commercial paper, etc.? As one goes further down the yield curve in maturity, the correlations weaken, but still remain pretty tight among bonds rated single-A or better.? (As a further note, Fed funds and 30-year Treasury yields also don’t correlate well.)
Credit is its own factor, which varies with expectations of the economy’s future prospects.? A single-B, or CCC borrower can only repay with ease if the economy does well.? If prospects are looking worse, no matter what the Fed does to short high-quality rates, junk grade securities will tend to rise in yield.? Marginal investment grade securities (BBB/Baa) will tread water, and short high-quality bond yields will correlate well with Fed funds.
When I say “credit is its own factor,” what I am saying is that outside of Treasury securities, every credit instrument participates to varying degrees in exposure to the future prospects of the economy.? (Credit in its purest form behaves like equity returns.)? For conservatively capitalized enterprises with high quality balance sheets, their credit spreads don’t change much as prospects change for the economy.? For entities with low quality balance sheets, their spreads change a lot as prospects change for the economy.
So, for two reasons, Mr. Krugman should not have expected the Fed funds target rate and the Moody’s Baa yield to correlate well:
Fed funds is a short rate, and Moody’s Baa is relatively long (bonds go over the full maturity spectrum).
Fed funds correlates well with the highest quality yields, and Baa is only marginally investment grade.? Recessions should hurt Baa spreads, leaving yields relatively constant.
The move may help regulators protect investors who have municipal bonds insured by the firm. But it could also force banks who are large holders of the other securities to take significant losses. Some banks that have been talking with FGIC in recent weeks to bolster the firm were taken aback by the announcement and could yet try to block it, say Wall Street executives.
and —
The banks learned of the split-up plan Friday by seeing it reported on CNBC, this person said, calling it a “bizarre situation.”
All of the banks have hired legal counsel and are prepared to go to court. The person familiar with the situation said FGIC’s move could result in “instant litigation.” FGIC didn’t respond to queries about the banks’ reaction to Friday’s announcement.
?now, it could lead to:
One plan the parties are discussing involves commuting, or effectively tearing up, the insurance contracts the banks entered into with FGIC, according to another person familiar with the matter. In exchange, FGIC would pay the banks some amount to offset the drop in value of those securities, or give them equity stakes in the new municipal-bond insurance company.
and —
However, if a breakup is endorsed by the New York Department of insurance, that could limit the legal liability.
One other wild card: If FGIC splits into two, it could throw into turmoil potentially billions of dollars of bets that banks, hedge funds and other investors have made on whether FGIC would default on its own debt. If FGIC is split, it isn’t clear how those “credit default swaps” would be valued, since one half of the new company would have a higher risk of default than the other.
?To the extent that the NY Department of Insurance limits the legal liability of PMI, they raise their own liability.? If I were one of the banks, I would sue the State of New York, and quickly, because NY is moving more quickly than they ought to.? There is no NY crisis here, and the politicians and bureaucrats of New York should behave as gentlemen, and not thugs.
Now, one thing I would agree with the NY Department of Insurance on is this: no dividends to the holding companies.? Until things stabilize, retain assets at the operating companies in order to make sure that claims can be paid.? If MBIA and PMI go broke, that is no great loss, except to those that hold equities, or holding company debt.? But if the operating subsidiaries go broke, that is significant to those who will make claims against the companies.
So FGIC requests to be broken in two.? Personally, I expect that it stemmed from giving into strong-arming from the New York Department of Insurance and perhaps the Governor as well, but if I were FGIC, I would want to do this.? Who wouldn’t want the option of splitting his business in two during a crisis, putting the good business into subsidiary A, which will stay solvent (and protect some of your net worth) and putting the bad business into subsidiary B, which will go insolvent, and pay little to creditors?
In many other situations this would be called fraudulent conveyance, but when you have a state government behind you, I guess it gets called public policy.? The NY Insurance Department tries to sidestep a big insolvency by creating favored classes of insureds.
Those with concentrated interested in non-municipal guarantees should band together to protect their rights, and sue FGIC and NY State (seeking punitive damages) to block the breakup.? The question is, who will be willing to bear the political heat that will arise from this, and oppose an illegal “taking?”
This will be a brief note because it is late, but the state insurance commissioners lack authority to favor one class of claimants over another to the degree of setting up a “good bank/bad bank” remedy, where municipalities get preferential treatment ovr other potential claimants.? The regulators allowed the nonstandard business to be written for years, with no objection.? The insureds that would be forced into the “bad bank” would likely not have agreed to the contract had they known that the claims-paying ability of the guarantor would be impaired.
There is nothing in contract law that should favor municipalities over other claimants.? Now, if they want to modify the law prospectively, that’s another thing.? Create a separate class of muni insurers, distinct from financial guarantors that can guarantee anything for a fee.? Different reserving and capital rules for each class.
Now this doesn’t mean that New York won’t try to split the guarantors in two; I think they will lose on Ambac because it is Wisconsin-domiciled.? With MBIA, they will lose after a longer fight, because they don’t have the authority to affect the creditworthiness of contracts retroactively.
