19 September 2008 – The Aleph Blog

Government Policy Created Too Hastily

Posted on 19 September 2008 by David Merkel

I have been no fan of naked short selling; I have long argued that the brokers must locate shares before a short sale can be done.? Anything less than that is fraud.? But I do not support eliminating shorting, even though I almost never do it.? What would be the effects of eliminating shorting?

No more merger arbitrage funds.
No more statistical arbitrage funds.
Wait, no more arbitrage?
130/30 funds go away.
Other quant funds go away.
Barbarian hedge funds that do real research go away.
Put option implied volatility goes way up.? (A lot depends on whether specialists/market-makers can still short…)
Because of put-call parity, call implied volatility goes up as well.
Players move to credit default swaps, oh wait, might those get banned as well?
Those relying on securities lending income lose out.

Eliminating shorting is stupid.? Enforcing getting a locate is smart.

Now for something that could be smart or dumb, depending on how it is done.? The possibility of a new RTC could be a good or a bad idea.? The main criterion is whether it is proactive or reactive.? My answer my surprise many: reactive is good, proactive is bad.

What we don’t want to do is provide a place for companies to dump lousy assets at inflated prices.? Instead, a new RTC should be a last resort place that the assets of failed companies go to until they are disposed of.? Common and preferred equity should be wiped out, and bondholders should take haircuts.? New loans should be senior to all old loans, similar to the situation with AIG.

Anyone going to the new RTC should feel pain, and a lot of it.? It should be the last resort for companies that are failing.? It should not try to keep companies alive, but merely conserve the value of assets, and prevent contagion.? Remember, if the risk is not systemic, the government should not try to bail it out.

Liquidity for the Government and no Liquidity for Anyone Else

Posted on 19 September 2008 by David Merkel

I have a quirky indicator called A2P2T2. It?s the yield on the Two-year Treasury minus the yield on A2/P2 commercial paper. Both are sensitive to credit confidence issues in the economy. When times are bad, the two-year yield falls, anticipating looser Fed policy. A2/P2 commercial paper is short-term unsecured promises to pay issued by corporations rated between A3/A- and Baa2/BBB. These are investment grade firms that are large or medium-sized, tending to the lower end of investment grade. When times are bad, the yields for A2/P2 commercial paper rise, because we are less willing to lend on an unsecured basis to borderline investment grade companies.

So, the difference between the two measures can indicate real stress.? Take a look at this graph over the last twelve years:

You can see the panics around LTCM (1998), the end of the tightening cycle in 2000, and the money market troubles in 2007.? On average, though, the two-year Treasury and A2/P2 commercial paper yield about the same.? That helps to define what a normal environment looks like, but we are nowhere near normal now.

This is the daily graph as of yesterday, hitting an all-time low for this series.? The series closed above the low levels, but is still below -300 basis points, and considerably worse than the panic in late 2007.

Conclusion

With all of the hoopla this morning about central banks acting to stem the current crisis, I don’t see how their policies are effective at all.? Yes, the government and high quality borrowers can get funds, but middling borrowers are squeezed, and bad borrowers are shut out.

The short term lending markets are in a panic, and most of the programs that the Fed put into place have failed, as of now.? Al McGuire, past coach of Marquette Basketball was once asked (something like), “Would you rather have an “A” student or a “C” student at the free throw line in a tense situation?”? His answer was the “C” student, because he wouldn’t think about the situation, he would just act, and sink the free throws.

The current Fed is clever.? Too clever by half.? Their policies have not added to the problems in the short-term lending markets, but neither have they helped, and they leave the Fed with a messier balance sheet than they have had for most of its history.

Does this make me worry?? Yes, somewhat.? We are facing the distinct possibility that the Fed will lose what little control they have over the short-term lending markets, and we haven’t even factored in the possibility of OPEC and China breaking their dollar pegs.? My advice: keep your duration short, and guard against inflation risk.? If you want a hedge against deflation, buy some long zeroes or long TIPS.? I prefer the latter.

Now We’re Talking Volatility

Posted on 19 September 2008 by David Merkel

If the gyrations of the equity market today were not enough, we are in a historically unusual situation where 3 of the last five business days have had moves on the S&P 500 of over 4% in absolute terms.? Since 1928, how many times has that happened?? 69 times.? Dig this:

So, on average, you make money investing during volatile times, but the possibility of moderate-to-severe loss is significant.? Those losses came in the Great Depression era (as did the huge gains), but for those that have read me a long time, you know that I believe that a second Great Depression is not impossible.? I don’t care how much policymakers say that they have learned, the system has an odd way of mutating to create the same result through a new process.? The market always has a new way to make a fool out of you.

Aside from the crash in 1987, only the depression era has had similar volatility, and they had it for a long time.? Even 1973-74 did not rate under that measure (though it resembled the Chinese water torture).

Take this with a grain of salt.? A salt shaker even.? Eddy Elfenbein and Bespoke often do analyses like these, and they have a certain wisdom most of the time.? But data-mining is always dangerous.? The question that must be asked is whether there is a mechanism to explain the results.? In this case, there is.? Volatile markets scare investors away, and drive prices down, in general.? This causes stock to move from weaker to stronger hands, i.e., from the weakly capitalized to the strongly capitalized (now I get to send my electricity check to Mr. Buffett).

So, ask yourself this: are we heading into a depression?? If not, buy some stock.? Personally, I’m not certain about whether we aren’t heading into a depression.? I view it as a 25% chance now.? Perhaps my next article will help explain.? As for me, I am continuing my normal policy of having 70% of my net worth in risk assets.