Month: March 2008

The Value of a Balance Sheet

The Value of a Balance Sheet

Monday, at about 10AM, I sold my holdings in Deerfield, Deutsche Bank, and Royal Bank of Scotland.? I did it bloodlessly, realizing that Deerfield is the largest loss I have ever taken.? With the proceeds, I bought two placeholder assets that I will hold until the next reshaping (coming in a month), the Industrial (XLI) and Technology (XLK) Spiders.? By doing that, I cut the majority of the links that I had to the leveraged lending economy, which is collapsing at present.? When I saw that haircuts on repo for prime agency collateral had been raised for the second time, I threw in the towel, because too many things have broken that even I did not expect would break. (Even the haircuts on Treasuries have risen.)

With Deerfield, I made the error that if the collateral was very high quality, it could survive, even at high levels of leverage.? In a true panic, that does not matter.? All that matters is whether your leverage is low enough to allow you to survive the credit bust, and that you can do that over your financing horizon.

Financing horizon?? By that I mean how often your solvency gets measured.? For many mortgage REITs, that is a daily, weekly, or monthly phenomenon.? The longer the period, the better the odds of survival.? Short repo financing is by its nature is a weak financing method in a crisis.? The day you cross the line (margin inadequate) the brokers move to liquidate.? Given that some other managers may have been more aggressive, your excess capital can disappear, as more aggressive mangers miss margin calls, and the pressure of their liquidations, forces your more conservative positions down, and you have to liquidate also.

Now, think of a life insurance company, a long-tailed casualty insurer or a defined benefit pension plan.? If they buy AAA whole loans, or prime mortgage collateral, they can hold that position for 3+ years without worry.? Their liabilities aren’t going anywhere.? They know what they will be able to hold the investment through the panic period.? There are still questions over what the best time to buy is, but with many large companies or plans, the optimal thing to do is to suck in a little bit each day, quietly, when the bonds are cheap.? You won’t get the exact bottom; no one does, but you will do well.? My own example is buying floating rate trust preferreds back in late 2002.? Bought a 2% position over two months for my life insurance client without disturbing the markets.? My client cleared a minimum of 10% on those investment grade bonds within a year as the panic lifted.

Accounting vs. Financing

Now, there’s a lot of talk about fair value accounting standards, and how they are adding to the volatility at present.? They are adding to the volatility, but they have less effect than the way things get financed.? Unless the fair value accounting leads a company to violate a debt covenant, typically it does not have that much effect, because it does not change the pattern of cash flows that the company will generate.? Short term financing, where the portfolio’s “market value” gets measured on a daily basis has a much bigger impact, because as prices fall, liquidation of assets can feed a collapse of prices.? Or consider this article from Going Private, which cites an article from Financial Crookery, which highlights an attempt by Merrill Lynch to avoid having to pay out cash on a putable bond.? In order to do that, they make the bond more valuable, so that it won’t be put.? But this isn’t an accounting issue.? It is a financing issue.? Merrill doesn’t want to part with cash now, so it makes its future financing schedule more difficult.? It is a complex way of selling off a bit of the future in order to bail out the present.

Now, I disagree with The Economist article that spawned those posts as well.? There is a better way.? In place of the four common financial statements (Income Statement, Balance Sheet, Cash Flow Statement, and Shareholders Equity), have six.? The two additional statements would come from having a amortized cost income statement, and a fair value statement, and then, the same for the balance sheet.? It would not be a lot of extra work, because all of that data has to be gathered now already.? It would just create two different ways of looking at a financial entity.? One views it as a buy-and-hold investor (amortized cost), and the other as a trader (fair value).? The interpreter of those statements could decide which is more relevant.

I proposed this to an IASB commissioner 2-3 years ago, and she was horrified at the idea.? Two income statements?? Two balance sheets?? What confusion.? I pointed out to her that every financial statement is designed to answer one question.? Bond investors have to rearrange the data to do their analyses; we could create an EBITDA statement to make life easier for them, but we don’t.? The two statements types define two different ways of looking at a firm.? Each is more valid in different situations.

Now, for utility and industrial firms, these distinctions usually don’t matter much, but they do matter for financial firms.? There could be a seventh statement added there, which life insurance companies calculate for their regulators.? All financial companies should have cash flow testing done over the greater of the life of their assets and liabilities, over a wide number of interest rate and credit scenarios, calculating the present value of distributable earnings, to show where they are vulnerable.? They should publish the assumptions and results, and then let the market stew over them.

Now, for my actuarial friends, this would be the “Actuarial Full Employment Act.” Life Insurers control risk not by looking at short term movements in market prices, but through long-term stress testing.? It is no surprise that the insurers are doing much better than the banks in this environment.

Negative Real Interest Rates and Asset Deflation

Negative Real Interest Rates and Asset Deflation

I always try to separate my views of what I think the FOMC will do, versus what the FOMC should do. It’s hard for me now, because I think the FOMC is pursuing the wrong strategies. The yield curve is steep enough now, that further easing will not yield much incremental benefit. Further, a loose monetary policy only stimulates healthy areas of the economy that can absorb more borrowing, not areas with impaired balance sheets.

But what will the Fed do? Loosen. Aggressively. Don Quixote would be proud. They will make the TAF permanent and big, and the discount window will be a relic of a simpler age.

Let’s think of the short run versus the long run. In the short run, the FOMC wants to get the economy moving again, and is willing to tolerate negative real interest rates in order to do so. The Fed funds target is already 1%+ below the CPI, and the argument is over whether the next move will be to loosen 50 or 75 basis points. Negative real interest rates promote goods and services price inflation. (I don’t know about everyone else, but when filling up my gas tank nears $100 I begin to worry. Eight kids — 15-seat van, 10 cylinders…) In the long run, the FOMC will have to deal with price inflation. Even with the current yield curve, I can tell you that goods price inflation will worsen, leading to monetary tightening that will be painful, or no tightening, and inflation that rivals the 70s.

The Fed could target lending to the weak areas of the economy, while leaving monetary policy alone. That would invite charges of favoritism, which is why it won’t happen.

So, in my opinion, asset deflation will persist, and goods price inflation will increase. As for me, I will likely sell my positions in Deerfield Capital, Royal Bank of Scotland, and Deutsche Bank on Monday, replacing the exposure with an index for now. I have agonized over the seemingly cheap capital markets names for some time now, and I have been the loser there. I will return, but for now, it is safer to have no investment banking or mortgage exposure. The asset deflation is hitting them hard, and lending is contracting.

Full disclosure: long DB RBS DFR

One New Bit of Data on Prime Agency Collateral

One New Bit of Data on Prime Agency Collateral

Well, it looks like the collateral haircut for repo financing of agency mortgages has gone up, from 3%, to somewhere between 4 and 5%.? That may account for some of the panic, especially regarding Carlyle.? It also may mean that Deerfield Capital is kaput.? I am presently long, but I may sell next week.? This company would be my personal biggest blunder ever, and my apologies to those who were influenced by me to own the company.

full disclosure: long DFR

Bill Pass

Bill Pass

First permanent injection of funds in 10 months.? A bill pass.? Now, it qualifies as permanent, but the $10 billion injection will only last 2-3 months.? Not very permanent to me.

The Fed is doing all it can to cram liquidity into the short end of the market.? They have expanded the TAF to $100 billion, and might go beyond that.

I suspect that these measures can succeed in bring the TED spread down for now, but unless they make the TAF permanent, there will be an effect when they unwind it. ? What these measures can’t do is unjam our mortgage markets.? A coupon pass where they buy some agency debt would make a nice statement.

Buy Agency Bonds.  Buy Agency Passthroughs.

Buy Agency Bonds. Buy Agency Passthroughs.

This will not be a long post.? Ask yourself this: in this environment, would the US government step away from the mortgage agencies?? I think not.? If anything, they might invest in its subordinated debt, particularly if there were a conversion into common stock feature.

Spreads are wide, very wide, and I don’t think the government will let the GSEs fail, particularly after raising their lending limits.? The agencies will need more capital for lending , so I would expect more preferred stock issues, and perhaps an equity issuance, if to a key investor, like the US Government.

I don’t see the US Government guaranteeing all of the debt of the Agencies, but I could see it doing it for a period of years on new issues, particularly if the Government received equity warrants.

In this wide spread environment, I would be a buyer, particularly versus Treasuries.

“The Unwind”

“The Unwind”

I invest like a moderate bull and I reason like a moderate bear.? Why?? In general, in free economies, the equity markets favor the bulls over long periods of time.? So, I stay invested in equities in almost all markets, and let my other risk reduction techniques do my work, rather than making large changes in asset allocation.? That said, I appreciate the risks that the markets have been throwing off lately, and I am somewhat worried.

I have been a bear on residential housing and residential housing finance for the last four years.? I expected that those that took a lot of credit risk — subprime, Alt-A mezzanine and subordinates, would get hurt.? What has surprised me, though, is the degree to which AAA whole loan collateral and agency loan collateral has been hurt.? I failed to see the amount of leverage being employed there.? I looked at that area and said, “You can lever this stuff 10x, and you probably won’t get hurt if you are smart.”? Fine if 10x is the limit, but you had players at over 30x, and now you have that paper being tossed back into the market, depressing prices, and raising yields.? This raises the risk of a self-reinforcing move that will only end when unlevered and lightly levered buyers soak up the high yielding safe assets that couldn’t find a home elsewhere.

Any asset can be overlevered. ? A house, a home loan, a corporation… there is some level of debt that will kill the owner of a given asset.? High quality mortgage paper got overlevered, and even though current market prices are attractive to unlevered buyers, there is the short-term risk that more players will be forced to delever.? So when is the right time to buy?

I have agonized on this one, because the problem is short-term financing.? Repo financing from brokers that have their own balance sheet worries.? (Note: some are talking about mark-to-market accounting — yes, that has a small effect here, but not as large as the financing issue.)? Repo financing is short-term collateralized lending.? 97% of the value of the agency loan collateral gets loaned, with 100% of the agency loan collateral as security.? If collateral prices move down, more margin must be posted. This is an unforgiving situation.? If you can’t meet the margin call (demand for more funds to support a losing position), your collateral will be liquidated.? (There also issues in how one hedges, but that is for another time.)

When to buy?? Most repo funding is short — a day to a week.? Some extends over 30-90 days, and Annaly uses 1-3 year repo financing (where do you get that?).? My sense is this: wait for two weeks after you hear of any major fund liquidation, and commit half a position.? After another two weeks, commit the other half, if no further liquidations have been heard.

At my last firm, I would talk with my boss about “The Unwind.”? All of the areas of the credit market where ordinary prudence was being ignored, and in the short run, leverage was increasing, because is paid to do so in a rising market.? Eventually, asset cash flow would prove insufficient to finance the interest costs, and then “The Unwind” would happen.? Leverage would have to come out of the system, both from explicit loans and from derivative contracts.

We are in “The Unwind” now.? Leverage is coming out, even in asset classes that I did not anticipate.? “The Unwind” will end when players with strong balance sheets hold most of the previously overlevered assets.

No, You <U data-src=

No, You Should Worry About Negative Short TIPS spreads

From four years and shorter, the yields on TIPS reflect a belief that nominal inflation measured by the unadjusted CPI will exceed the yields on nominal treasury bonds. This should come as no surprise, except that it was so slow in coming. The CPI has been running at 3-4%+ annualized for some time now, and the sleepy TIPS market continues to estimate a 2-3% short-term CPI. That, in the face of a rising CPI. (Hey, a reason to buy TIPS! The actual inflation accretion is high than the implied accretion.)

Consider the following graphs:

Source: Federal Reserve, David Merkel

The first chart shows the TIPS-derived inflation breakevens taken from the smoothed series that the Federal Reserve puts out. It is interesting to note that the breakevens today are still below peak levels reached in 2005 and 2006. The second chart takes the breakeven rates to maturity, and calculates the forward breakeven inflation relationships. In this case, the forward breakeven rates have been rising, particularly between five and ten year out, though they are still not at record levels.
The third chart looks the forward inflation curves at five special points in time:

  • 8/24/04 ? Widest spread between expected five-year inflation, and ten-year inflation, ten years forward
  • 9/9/05 ? Largest inversion of the spread between expected five-year inflation, and ten-year inflation, ten years forward
  • 6/29/06 ? End of the tightening cycle, as I date it
  • 8/10/07 ? Beginning of the loosening cycle, as I date it
  • The present

The present environment is unusual because of the relatively large difference between two-year inflation five years forward, and three-year inflation seven years forward. The logical play would be to go long seven-year TIPS, and short seven-year nominal Treasuries. As views on future inflation shift higher, the low implied rate of inflation in the seven-year part of the curve should adjust to the higher inflation forthcoming.

Now, why should the negative TIPS yields on the front end be a concern?? Negative real yields, which are even more negative if trailing actual CPI figures are used, indicate even more inflation to come.? Does this mean sell equities?? No, but don’t hang out in long bonds.? Keep your bonds short, and maybe buy some TIPS, say, 15 years out.? Hedge by selling nominal Treasuries short, if you like.? Negative real yields are a sign inflation is likely to accelerate, particularly when the Fed is showing no signs of raising? rates, but has further decreases coming.

Can You Carry The Position?

Can You Carry The Position?

My post yesterday on corporate bond spreads was received well.? I want to amplify one point that I did not make strongly enough.? During market crises, asset values cheapen not only in response to likely losses over the long run, but the possibility that there might be forced sellers due to:

  • Reduction of leverage because of asset values declining
  • Reduction of leverage because of brokers lending money get skittish
  • Reduction of leverage because of rating agency downgrades
  • Reduction of leverage because of client withdrawals
  • Reduction of leverage because of an increased need for capital from the regulators
  • Arbitrage from falling prices in related markets

This can temporarily self-reinforce falling asset prices, until unlevered (or lightly levered) buyers find the returns from the assets to be compelling.? Though my piece yesterday was more fun to write, this makes the argument plain.? Can you carry the asset through hard times?? What about the rest of the asset holders?

The concept of weak hands versus strong hands is a very real issue, and for those with a subscription to RealMoney, I recommend these four classic (Labor of love) articles of mine:

Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders? Hands, Part 1
Get to Know the Holders? Hands, Part 2

These articles are core to my thinking, and I spent a lot of time on them.

Bloomberg Radio

Bloomberg Radio

Apologies.? I should have put this out earlier, but I will be on Bloomberg Radio Wednesday between 8:15AM and 8:45AM Eastern.? I will see if I can’t get a transcript or a recording.? For those that can listen live, here is the link.? One thing I enjoy about my present employer is that they like my blog, getting quoted in magazines, and being on radio and television.? It builds the business.

I’ll be talking about current economic conditions.? I hope to give a nuanced view that doesn’t jump around with every monthly data point.

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