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Archive for March, 2008

Fifteen Notes on the Credit Markets (and other markets)

Friday, March 21st, 2008

1)  A number of blogs pointed to this piece by Howard Marks of Oaktree, and I thought it was very well-thought out for the most part.  There are few people who think about history in the markets; they just follow present trends.  Learning how to see unsustainable trends and avoiding them not only reduces risk, but enhances long-term return.

2) Crisis!  Choose how you want to view it:

3) Tony Crescenzi sounds an optimistic note on the short-term lending markets.  His opinion should be taken seriously.  The money markets are a specialty of his.

4) To err is human, but to really mess things up, you need derivatives.  With Bear Stearns, different parties have different incentives regarding the firmSenior bondholders and derivative counterparties owed money by Bear are much, much larger than the teensy equity base of the small-cap firm.  It is my guess that they are protecting their interests by buying stock at prices over the terms of the deal.  They want the deal to go through.

5) How are the European investment banks?  My guess is that they have greater accounting flexibility, and things are better than US investment banks, but worse than currently illustrated.

6) Save our markets by risking our national credit?  I’m skeptical of many government solutions that bail out the markets, including those the Fed is pursuing.  Same for the GSEs… it seems like a free lunch to allow the GSEs to lever up further, but the losses are growing at Fannie and Freddie from all of the guarantees that they have written.  The US government backstops the whole thing implicitly, but even the capacity of the US government to fund these bailout schemes is limited.  Calling Fitch! — you often have more guts (or less to lose) than S&P and Moody’s.  Let’s have a shot across the bow, and downgrade the US to AA+.

7) Are mortgage rates finally falling?  I guess if the expectations of Fed policy get low enough, it will overcome the increase in swaption volatility.  Then again, PIMCO, Fannie, Freddie, and many others are buying prime mortgage paper again.

8 ) Thornburg, alasDilution and more dilution, in order to survive.  (That could be the fate of many financial and mortgage insurers.)  Misfinancing in the midst of a crisis gives way to a need for equity that kills existing shareholders.

9) In terms of actual losses, Commercial Real Estate lending is not in as bad of a shape as residential lending.  That said, it’s not in great shape and the market is slowing dramatically.  What lending market is in good shape today? :( We overlevered every debt market that we could…

10) When actual stock price volatility gets high, that is typically a sign of a bear market.  When it actual volatility peaks, that is often a sign of an intermediate term bottom.

11) Finally, an article on ETNs that mentions credit risk, if briefly.  Be wary of ETNs, they are obligations of investment banks, most of which have high credit spreads that you are not being compensated for in the ETNs.

12) Give the guys at Dexia some credit for being opportunistic during the crisis of financial guarantors… they had the balance sheet, conservative posture, and the team ready to take advantage of the dislocation in their subsidiary FSA.

13) Someone tell me otherwise if I am wrong, but I am not worried about the assets in my brokerage account.  In a crisis, there is SIPC and excess insurance.  Brokerages are prohibited from commingling client assets, and even if their are delivery failures from securities lending, those issues are solvable, given time and the insurance.

14) I worry about inflation in the US, because it is a global problem.  As the dollar declines, it slows foreign economies because they can’t export as much, and it raises prices here because imports cost more.

15)  This is an article that is just too early.  So the markets have rallied, and commodities have fallen?  It’s only one week, and that is no horizon over which to make the judgment that Fed policy is succeeding.  Look at it in 9-12 months, and then maybe we can hazard a good guess.

Fourteen Pounds, and What Do You Get?

Thursday, March 20th, 2008

(with apologies to Tennessee Ernie Ford on the title… my Grandpa met him when “Eighteen Wheels” was hot.)

One thing I never thought I’d have to do in life is become a broker. (My mom, my first teacher in investments, always gave me negative impressions of brokers, calling them “order-takers.”) Yes, I am studying for the Series 7 exam. Today a 14-pound box showed up at my door, with six books inside it — study materials for the series 7 exam. Four inches thick in all. Ouch.

Then again, I have passed the actuarial (in 5 years) and CFA exams (in 3 years). Funny story: when I was taking the first CFA exam, for some reason, I was 10 years older than everyone else in the room. During a break, one of the young guys with an attitude said to me, “Hey old-timer, what are you doing here?”

I blinked and said that as an actuary, I was trying to round out my skills. He said, “But what advantage does that give you in taking these exams; you’re out of your field.”

I was a little annoyed, so I said, “I guess you’re right. I am relatively old here. But I have passed a battery of exams far tougher than these, and have expertise in test-taking, compound interest math, statistics, economics, investments, accounting, and we have our own ethics code. If you think you can run rings around me because of your youth, go ahead and try.” Now he blinked, and turned away.

As I look at the pile of books, there is a summary book and a book of practice tests, in addition to more comprehensive volumes. I’m 10% through the summary book, and once I am done there, I will take a practice test. If I score better than 85% (pass rate is 70%), I will just go and take the exam. On practice tests on the web, without study, I am at the 70% level now. But if I can’t do the 85%, I will sit down and study, learning obscure bits of the securities markets. Being the nerd that I am, that could be fun, but it wouldn’t be the best use of my time if I can avoid it.

I’ll keep you posted on how I do. :)

T2 Minus A2/P2, or, Monetary Policy is Still too Tight, Maybe

Thursday, March 20th, 2008

My preferred monetary policy in normal times is for the yield curve to have about 50 basis of positive slope from twos to tens. That’s enough slope for the economy to grow, and the banks to make a little money, but not lend aggressively. It’s flat enough to restrain inflation as well. Sounds good, but it would require discipline on the part of the central bankers to stick to it, because of political pressures to goose growth, or banks complaining that they can’t earn enough.

These aren’t normal times, though. Let me explain two ways that it is abnormal. First, the Two-year Treasury, which is a good measure of what the market expects Fed funds to be in 6-12 months, is about 1% lower than the current Fed funds rate. Second, the short-term private lending markets have not followed the 3-month T-bill yield lower. The one that I have looked at most closely recently is the Treasury-Eurodollar Spread [TED Spread], which is the difference between the 3-month LIBOR yield, and the yield on a 3-month T-bill. It closed out yesterday at a spread of 2.04%. Anything over 0.60% indicates stress in the short-term lending markets.

TED spread

Not so good, huh? Will the Fed try to boost the size of the TAF again to fight this? (Hey, is that a head-and-shoulders pattern? ;) ) Now we can look at the Treasury yield curve:

Treasury Yield Curve

Well, at least the curve is positively sloped over all of its major segments now. That is a positive, right? ;) Well, in a situation where the economy is growing, it would be normal, and good for lenders. When it is because of a money market flight to safety, that’s another matter, and not a positive, at least not yet.

That brings me to my second point. The lowest prime grade of Commercial Paper, A2/P2 CP, has an inordinately high yield compared to safer short term loans when the financial system is under stress. My thought was to create a combination measure that took into account both measures of short term financial stress. Both series come from the Fed’s H.15 report. My measure is subtracting the yield on nonfinancial A2/P2 CP from the two-year Treasury yield.

T2-A2P2
A2/P2 financial paper outyields the Two-year Treasury by 1.60% at present. That’s not as bad as things were in August or December of 2007, but that level eclipses levels reached in the LTCM crisis, but not the monetary tightness overshoot back in December of 2000.

Note that the average level over the eleven-plus years that I was able to get data is very close to zero. The positive periods tend to be long and shallow, like most bull markets. Seemingly also, the measure seem slightly correlated with stock market returns, but I could be wrong there. The negative periods tend to be short and sharp, like most crises. This present period is an exception — we’ve been in the negative zone for two years.

Am I saying the FOMC should loosen aggressively from here? Not necessarily, but I am saying that the financial system is still under significant financial stress, and existing measures like the TAF have not cleared that yet.

The Fed is facing some very hard choices here. I wouldn’t want to pursue a zero interest rate policy here in the US like they have in Japan, with not that much success. But maybe that’s because the Fed is behaving like the Bank of Japan. The Fed has been sterilizing its rate cuts and its unorthodox measures, and not allowing the monetary base to grow, which makes no sense to me in a loosening cycle. (Well, I take that back, it makes perverse sense. They are trying to draw to an inside straight — they are trying to restrain price inflation at the same time they solve problems in the financial system by downgrading their own balance sheet by lending and selling Treasuries. I don’t think it will work.)

Maybe the Fed should buy A2/P2 CP (please no :( )? My view is that they should let the monetary base grow, and do some permanent injections of liquidity. We haven’t had one in 10.5 months, which is really unusual, particularly for a loosening cycle.

Will they do that? My guess is no, not until they have run out of Treasuries to sell or lend.

Update

Go to Alea and look at the repo fails on Treasuries.  Just another sign of system stress.

Predictably Irrational

Wednesday, March 19th, 2008

Zubin Jelveh has a good post over at Portfolio.com on rationality and markets. Here’s my take:

Behavioral economics is very useful to practitioners, and we are grateful to those who say it is not, because it makes it more useful to the rest of us.

Think of the Adaptive Markets Hypothesis as a tree, and every anomaly/strategy as a bird. As a strategy works, the bird gets fed more, reinforcing the return pattern. When a bird gets too fat, the branch breaks, and the strategy can have a colossal failure. The bird hits the ground, walks away, and the branch re-grows. Eventually, after the bird slims down, he flies back to the branch.

Anomalies/strategies come and go. Too much money can pursue any strategy, even indexing. Wise investors try to ask the question “Where is there too much investor interest?” and then they avoid those strategies until they blow up.

To give an example, it is a great time now to manage unlevered structured product, agency or non-agency, MBS or ABS. Too many levered players have blown up, and there is a lot of good paper that needs a home.

I have talked about this a numberf of  times before, but one of the more fun times was this article:)  Here’s another one.

The concept of rationality is a fuzzy one.  I’m not sure that all rational people could agree on a definition. :)

My view is that people are not uniformly rational, but that they are in aggregate predictable.

Dissent at the FOMC

Wednesday, March 19th, 2008

There were a number of commentators who noted the double dissent today of Fisher and Plosser. I looked at that and wondered how common dissents were on the FOMC.

One of the things that Fed-watchers have to realize is that vote disclosure is a relatively new thing at the FOMC. It started in 1982, and became regular in 1984. In the earlier days, the internals of the FOMC were even more of a “black box” than they are today. In order to gauge any policy change, one would have to look at the effect of open market actions on Fed funds; there was no announcement.

Late in the Volcker Era, the FOMC began announcing the votes on policy. Early in the Greenspan era, the FOMC would publish a statement, and indicate who dissented. Finally, they began recording the reasons for the dissent in the middle of Greenspan’s tenure.

Over the past 25+ years, how common has dissent been?

FOMC 1

Single dissents happen about 27% of the time, and double dissents 10% of the time. Dissents of three and four occur 5% and 1% of the time.

The two quadruple dissents occurred during the 1989-1992 easing cycle, when commercial real estate was in the tank. Both occurred at meetings where no action happened, and the alternative was loosening.

In general, high levels of dissent occur near cycle turning points. That said, in the latter part of the Greenspan era, discipline was tight enough that dissent was rare. Wait, how does dissent vary among Fed Chairmen?

For Volcker we only get the latter part of his tenure, but dissent was relatively common. For Greenspan, you can divide his tenure into two parts. Prior to 1993, dissent was common, but after that, he effectively brought the remainder of the FOMC into lockstep. He was very effective at controlling meetings, as was noted by Laurence Meyers.

http://www.federalreserve.gov/boarddocs/speeches/1998/199804022.htm

Look at this graph for an example of how Greenspan got stronger over the years:

Bernanke is still in his break-in phase, and he is faced with the difficulties of an easing cycle. Dissent is more common easing cycles:

Personally, I would not make that much out of a double dissent at this phase in the FOMC cycle. This is the time that we should be seeing dissent – early in Bernanke’s tenure, and loosening. Also, Bernanke is taking a looser hand to the remaining Governors – he wants them to speak their minds. It is much the same way it was when he was an economics department chairman, except now the stakes are higher. Much higher, Ben, if you are reading this. (I harbor no illusions here, I know a few people read me inside the Fed, but my thoughts aren’t worthy of the attention of any of the Fed Governors. They are busy people.)

Now, that said I would like to point to some comments on the current FOMC actions by Paul Volcker. I’m glad he is still around. He is one of the few people who have instant credibility when talking about the current Fed actions.

http://blogs.wsj.com/economics/2008/03/18/volcker-feds-extreme-intervention-raises-some-real-questions/

In one sense his main point is that the Fed is charged with protecting banks that they regulate. They are supposed to act in the interest of all Americans, and when it intervenes on behalf of investment banks that they don’t regulate, or one in particular, Bear Stearns, there is a question as to whether it is right for them to do so.

When Volcker was Fed Chairman, derivatives were not an issue. They are now, and the interlinkages almost require a rescue. Now, better that the Fed should regulate investment bank leverage, particularly if they are lending to investment banks now. I am not a fan of regulation or central banks, but if we are going to have a complex financial system with derivatives and central banks, they need to be regulated by the central bank. (Let’s just go back to a gold standard, okay? :( Yeah, I didn’t think so.)

There are real problems with what the current FOMC is doing, but to me it seems the best solution at present. Greenspan should not have lowered rates so much in 2001-2002, nor should he have raised them so much in 2004-2006. There were ways to avoid this crisis in the past, at a cost of some minor short term pain, but we weren’t willing to do that in the latter era of Greenspan.

Now Bernanke is stuck with a badly-dealt hand. He’s coping as best he can. In general, I don’t like the way monetary policy is going, but I will say that we are taking a policy path that is close to optimal in the short run (though I would be expanding the monetary more aggressively). The real question is whether we will have any additional blowups that the Fed’s balance sheet is too small to handle.

FOMC: Fanning Our Monetary Conflagration

Tuesday, March 18th, 2008

From RealMoney:


David Merkel
FOMC: Fanning Our Monetary Conflagration
3/18/2008 2:16 PM EDT

The Federal Reserve Open Market Committee lowered the Fed funds target and discount rate by 75 basis points. The vote was 8-2, with Fisher and Plosser dissenting. The growth risk assessment is weakness.

The prices risk assessment is balanced.

Overall, FOMC makes noises about some inflation, lending markets, and economic weakness.

The 10-year Treasury yield was down 2 basis points in yield after two minutes. The S&P 500 was down 80 basis points.

We now return you to our regularly scheduled programming. The fixation is ended! Trade!

Position: none

Okay, so 75 basis points isn’t 100. 75 is still pretty aggressive, and combined with all of the other actions that the FOMC has taken, it provides some stimulus. It would provide a lot more stimulus if they stopped immunizing all of their unorthodox policy measures, but hey, they are trying for a hat trick:

  • Solve the problems in the lending markets.
  • Don’t permanently add to the monetary base, and so restrain price inflation.
  • Stimulate a weakening economy.

Personally, I think they will eventually have to stop giving with the right hand and taking with the left, but for now, they can continue this policy. It might even work if nothing else material blows up. Credit spreads are considerably tighter today, but one day does not a recovery make.

A Social View of the FOMC

Tuesday, March 18th, 2008

I’ve put together a PDF file that summarizes the current Federal Open Market Committee.  My objective in this exercise is provide a handy way of getting data on the various Members of the Federal Open Market Committee.  It was also a way for me to better understand who is making out monetary policy, and from a social angle, try to understand their biases.

Most of the data in the PDF file (Excel file available here), comes from the Fed’s own websites.  I reorganized it, and deleted some bits of data that I thought were less important.  I added links to their bio, books, speeches, academic papers, etc.  (Full disclosure: if you buy a book from Amazon using one of the links, I get a small commission.)

When I look at this data, what jumps out at me is the number of Ph. D. economists – they are 10 out of the 15 here, then three MAs in Economics and related fields, one MBA (Fisher) and one JD (Warsh).  (Personally, I would want to limit the number of Neoclassical economists on the committee to five, and put in a few Austrian School economists.  Monetary policy is too important to be left to a bunch of Neoclassical economists.)  Beyond that, among the economists, there are many of them that have done direct work on the inter-linkages between monetary policy and financial markets  (Bernanke, Kohn, Kroszner, Mishkin, Plosser, Evans, and Lacker).  A number of them have written about central banking and financial markets under conditions of stress.

Historically, it would be hard to find a group of Fed Governors more prone to using unorthodox methods to try to fight a crisis in the financial markets.  They have the training for it, and they do not want to go down as not having learned from the received wisdom on monetary policy regarding the Great Depression.  They will be fast, not slow.  Unorthodox, not orthodox, and bending/breaking the rules where possible.  They will tolerate a possibly large permanent increase in inflation, and avoid the Japanese experience 1990-Present.  They will pursue a unilateral course of action, and ignore foreign grumbling.

This is the FOMC that we have today, and the composition of the committee matters when considering how they will execute monetary policy.   Expect aggressive responses, with considerable volatility.

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

Two postscripts: To me, the Committee seems young, with an average age of 51.  Second the compostion of the committee will likely change after the elections, because Congress is holding up the nominations that President Bush has put forth.  The nominees are Fed Governor Randall Kroszner, whose term officially ended Jan. 31, Capital One Financial Corp. executive Larry Klane and Virginia community-banker Elizabeth Duke.  Kroszner can continue to serve at the Fed until a successor is appointed.   

The two businessmen would have been an interesting addition, but will not likely be approved because of the politics.  The one that wins the presidential election will have a large impact on the Fed, because he will get to appoint three board members.  The current economic volatility will have a large impact on the skill set of those that get nominated.

Post 600

Tuesday, March 18th, 2008

As WordPress counts, every 100 articles, I take a step back, and think about blogging.  I wasn’t sure what I was getting myself into when I started the blog.  I was unsatisfied with my work and my other writing outlets when I decided to start Alephblog up.  I wanted more creative control, and an ability to build a brand of my own.  That’s why I started the site.

So far, so good. The support from other blogs has been significant (in order): Abnormal Returns, Alea, The Big Picture, FT Alphaville, Seeking Alpha, the Kirk Report, and Naked Capitalism.  I also appreciate the overall blogging community on finance issues; it is fascinating to see the relatively high quality of opinions that get expressed on the web.  It is more than competitive with the print media (and we get paid peanuts, if anything…).

In the near term, I will be updating my blogroll.  I want it to reflect what is on my RSS reader.  I updated my “leftbar” recently.  I  did it because I wanted to highlight the books that I have reviewed, and I wanted to push the Google ads further down the page.  I don’t make that much from them; at some point I may discontinue them.

Along with that, I will be doing some blog maintenance to make the top of my blog clickable to return to the homepage, update a few of my old static pages, and turn off comments on posts older that a month.

It’s been interesting to meet new people through the blog.  I appreciate those that e-mail me, and those that comment here, though my time to reply is limited.

Finally, I haven’t run out of things to write about, and given what I wrote here and at RealMoney, this economic environment was made for me.  Volatility — what will break next?  Reminds me of 2002, and owning too many BBB bonds.  But future topics may include:

  •  Academic Finance Lies (okay, assumptions that aren’t true)
  • Rescuing Capitaism from Capitalists (half-written)
  • Fundamentals of Market Bottoms
  • CP-T2 as a panic gauge
  • Risk Management vs VAR vs ERM
  • Can Central Banks Lose Money?
  • The Main Ignored Problem in Taxation (by both political parties)

Finally, I thank my family, I thank God, and I thank my new employer, Finacorp Securities, for their support.  Let’s keep this up; I enjoy the writing and the feedback.

Investment Banks Are Priced Like Bermuda Reinsuers

Tuesday, March 18th, 2008

Late in the day, I looked at a table of valuations of the remaining major investment banks, and thought, “Huh, they’re priced like Bermuda Reinsurers.  Price-to-book near 1 or lower, and expected P/Es in the middle single digits.”  Well, that got me thinking… how are those two groups of companies alike?

  •  When losses come they can be severe.
  • Both have strong underwriting cycles where a lot of money is made in the boom phase, and a lot gets lost in the bear phase.
  • Earnings quality can be poor, unless management teams have a bias against meeting Street expectations, and allowing earnings to be ragged.
  • The opacity of the investment banks’ swap books is matched by that of the reinsurers’ reserving.
  • Both businesses are highly competitive, and global in scope.

Now, what’s different?

  • The reinsurers typically don’t have asset problems, only reserving problems.
  • The Bermuda reinsurers know that one day a change in their tax status may come (somehow forced to pay US tax rates — ask Bill Berkley), and that would lower earnings.
  • The financial leverage of the reinsurers is a lot lower.
  • The financing of reinsurers is a lot more secure.

The risk-reward seems balanced to me across the two groups.  The reinsurers are lower-risk/lower-reward, and the investment banks are higher on both scores.  Choose in accordance with your risk tolerance — as for me, I’ll look at the reinsurers.

Last Thoughts on the FOMC Meeting

Monday, March 17th, 2008

FOMC cycles usually have some sort of underlying consistency to them. In this cycle, the underlying consistency has been:

  • Unorthodox measures, attempting to use the asset side of the Fed’s balance sheet to solve lending problems among banks and broker-dealers.
  • They have effectively “sterilized” their unorthodox measures by withdrawing other liquidity from the system, leading to…
  • Lack of growth of the monetary base, which has only risen 2% in the last year, and the last permanent injection of liquidity was 5/7/07. (After reviewing the Annual Reports of the Open Markets desk of the NY Fed 1996-2007, I think that’s a record… it is certainly a record for a loosening cycle. How can you have a loosening cycle without growing the monetary base significantly? Unless they are planning on reversing their policy easing rapidly once the financial crisis is past.)
  • They have never cut rates less than expected.

So, that leaves me at a 1% cut in Fed funds tomorrow, with a parallel cut in the now-meaningful discount rate. Now that primary dealers can borrow there, that will be an active window. That said, the Fed will probably try to sterilize any borrowings there, withdrawing liquidity elsewhere.

Come to think of it, that was one of the problems with the Bank of Japan as they slid into their crisis in the 1990s. They always sterilized their monetary policy so that it had little effect, thus restraining inflation, but not doing much for their overleverage situation.

In this case, that’s a mistake. We can live with price inflation. Dealing with the collapse of leverage is a lot tougher. The Fed can use unorthodox measures until their supply of lendable/saleable Treasuries runs out. Then they will have no choice but to begin monetizing the debts of the US Government or its agencies, if they want to attempt further stimulus. Then we will get price inflation. As for me, I would own TIPS here. CPI inflation will likely rise if the bailouts needed exceed the size of the Fed’s balance sheet. I also like agency residential mortgage bonds here. Implied volatilities can’t get that much higher, so we should get some sort of rally.

Let see what happens tomorrow.

Update

So what happens after I hit the publish button, but I receive a great article from Calculated Risk talking about the same issues.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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