Call Their Bluff

Twice in 2002, and once in 2001, I engaged in a risky form of financial behavior.  I was an investment grade corporate bond manager, and I was focused on financial names.  In 2001, post 9/11, we bought all of the out-of-favor sectors from September to November.  (I remember being at a conference for insurance CIOs in October, and seeing the horrified looks on the face of the other CIOs in a closed door session, when I said we were expanding our exposure to BBBs and junk, and hotels, Airplane EETCs, etc.  What topped it all was the representative from Conseco telling me how irresponsible I was.  Coming from Conseco, that made me blink.)

But we sold them all in the second quarter of 2002, when the hunger for yield was growing.  We happily sold our bonds that were now in favor for higher prices.  Then, with the accounting disasters at mid-year, on July 27th, two of my best brokers called me and said, “The market is offered without bid.  We’ve never seen it this bad.  What do you want to do?”  I kept a supply of liquidity on hand for situations like this, so with the S&P falling, and the VIX over 50, I put out a series of lowball bids for BBB assets that our analysts liked.  By noon, I had used up all of my liquidity, but the market was turning.  On October 9th, the same thing happened, but this time I had a larger war chest, and made more bids, with largely the same result.

At that point, I noted that the market was behaving differently.  Most of the troubled names were either dead or cleaned up, so I continued to buy yieldy long-duration financial bonds as the rally continued.  Aside from a hiccup as the Iraq war started, the rally that started October 9th persisted for a long while in equities and corporates.

Why am I telling this story?  Partly because the case for panic conditions in the fixed income markets, and with the banks is thin.  By the time we were in mid-2002, the equity markets were down far more from the peak, and implied volatilities were a lot higher.

Now, what is different at present is that the losses in this market are being led by financials, because in 2002 housing was not overvalued like it is today, and in 2002, the commercial and investment banks were not so highly levered.

So, looking at the two periods, I would rate the economic stress as pretty even across the worst of 2001-2002 and now.  We bounced back from 2002 without any bailouts.  Could it get worse from here in this present era of stress?  Yes, it could.  But at some level, enterprising investors come in without the aid of the government and begin buying assets where the downside is adequately discounted, and the upside ignored.  We are close to that now, with mortgage opportunity funds starting up.  Those won’t see the light of day if there is a bailout.

So, I’m not sure we need any bailout.  As Yves Smith at Naked Capitalism notes, the calls from average people to Capitol Hill are having an impact.  Keep making them.  Call the Treasury’s bluff.  If we prove wrong, well, the next administration will craft its own measures, rather than a bunch of unaccountable lame ducks who are unaccountable even when not lame ducks.  (Did I say that?  Sigh.  Repeat after me: This is not a political blog, this is not a political blog… and I voted for Bush twice, not that it matters much in Maryland.)  I agree with Naked Capitalism again — there may not be a true crisis.

But, I can look at it from another angle.  If I had $700 billion to spend as a clever investor (versus $30 billion for Buffett, earning 17% lending to Goldman Sachs), what would I do?  I would adopt the same approach that I did in 2002 (where my war chests were hundreds of millions), and get my analysts to percolate up their best ideas, and do rough estimates of what fair value is at a number of different discount rates.  I would start small, and offer lowball bids for hundreds of millions of seemingly mispriced securities.  I would adjust my bids as I found no takers or many takers.  Price discovery in illiquid bond markets is tough, but it is something I was good at in 2001-2003.  I would also leave markets where there is no rationality… I can invest anywhere, why should I limit my reach?  If Buffett can earn 16-17% off of Goldman Sachs, why should I look for much less?

Today, Bernanke suggested the use of reverse auctions to deploy bailout money at hold-to-maturity pricing levels.  My dear naive professor, markets avoid equilibrium, they do not seek equilibrium.  When the markets are in trouble, most players are in trouble, and there is not enough liquidity to bring the markets to long-run equilibrium levels in the short run.  The fundamental value of an asset is a relative concept, and depends on factors like the yield curve, implied volatility/credit spreads, etc.

The danger with the Treasury bailout proposals is that they will waste money by buying assets at levels above what the market will bear.  The danger with Dodd’s proposal is that they will drive companies into the ground through dilution from hasty asset sales.

Looking at it from a static standpoint, perhaps $5 Trillion would solve the crisis.  I think that would fill every hole, definitely.  But on a dynamic basis, you don’t need as much to move markets.  Once a buyer of size comes in, other players adjust their bids and asks.  So, if I had $700 billion of cash, I would have a hard time disguising my moves.  I would expect to send unused cash back to my funders.

Also, the difficulty of reverse auctions when you have so many disparate securities with small sizes is tough.  So, I look at this crisis, and think that if we wait for four months, the situation might be better, and no bailout will be needed.  If not, the next administration, not lame duck, would face the consequences.


  • Fintas_1981 says:

    The problem with this suggestion is that it is rear view thinking.

    Last week after seeing LEH go and Mer submit to a shot gun wedding, the reality was MS/GS/WM/WB were on the fringe and action had to be done. The Ban on Short Selling as well as the Treasuries actions are ex.

    And because of them we now have the moment to take a breath. But make no mistake, never confuse a temporay splice that is intended to buy time with a permanent splice. Meaning, those who get to cute at this time risk the failure of that splice and the system shutting down but NOT in a sequential order.

    The Buffet move comes as a RESULT of last weeks moves.

    So I’d sumbit to move forward and as it is done, implement forced buy ins, increase margins for short selling, FIX the DTCC or replace it. A inventory list is worthless if the starting counts are false.

    Put the liars/cheats and thieves and those who are complict and front running in jail and as all this is occuring yes consider other ways to fix things AFTER the system is up and running. IF NOT, and this comes from one who has been involved in some of the most sophisticated startups in the world. FAILURE WILL OCCUR. NOT IF!
    There’s a time to talk and a time to ACT. We should have been ACTING YEARS ago re NAKED SHORT SELLING when the real patriots were out there imploring ENFORCE THE LAW and DELIVER THE SHARES. Patrick Byrne/Budd Burrel/Mark Faulk/Gary Aguirre are but a few who were warning us as many ridiculed and mocked them. And NOW we listen to those who ask HOW could this happen? I’d ask, NO why didn’t many in position DO THEIR JOBS? And why are we still listening and hearing from the same gang that didn’t ACT?

  • The question is do we go with Adam Smith and wait for the “invisible hand” or do we bring a sledgehammer down on this entire mess of a market? I think its great to see investors like Buffett coming out of their shells to take advantage of a depressed market. Investors are not acting rational and are basing their “fundamentals” on their gut instinct equip with heavy emotions. The Fed’s are trying to bail out companies when they are in themselves digging themselves a deeper hole. War in Iraq +Mortgage Crisis is the root of all of our current implications. I think this is Bush’s last effort to better the blunder’s he’s made and caused our country. On they said “To be of any consequence in the context of the root issues of excessive… U.S. Government and U.S. Consumer Debt, it seems to me any Congressional Bill currently under consideration to shore up the U.S. Financial System will have to go some distance to altering the fundamental U.S. ‘free capitalist structure’ to a revised system with clear socialistic overtones.” If we alter our free structure.. is it still really free anymore?

  • Jack Reacher says:

    Call their bluff?

    Right. When money markets start failing, it’s time to poke your head up and see whats what.

    Surprised Merkel is this niave.

  • I’ve written about the troubles in the short term debt markets and the failures of some money market funds. The troubles there are significant, but the bailout will do little to help that situation. It won’t make the banks more willing to lend to each other.

    The government has already acted on the money market funds. The problem is outside that, unless they doubt the government’s ability/willingness to act.

    My main point is that we do not have to be rushed into a deal; let the next administration deal with it. If we have to do “one off” deals between then and now, fine. Set up RTC 2 — but don’t do a proactive bailout, unless it costs the companies dearly to avoid bankruptcy.

  • Estragon says:

    Jack Reacher – “Merkel is this niave”

    It seems to me Merkel raises a very good point. We’ve seen this sort of thing before. This too shall pass. There are lots of very bright people with lots of money to throw at this if assets get cheap.

    No doubt markets are becoming disfunctional, but that’s not surprising given that the rules of the game are being changed on an almost daily basis. One financial lives and another dies on a whim? Government officials quite obviously and deliberately juice markets?

    Just a few months ago we were told the economy was strong and the mortgage problems contained, and now the secretary of the treasury needs to spend 3/4 of a trillion by Tuesday or surely the apocalypse shall follow?

    Who’s being naive here?

  • Walt French says:

    Give ‘em credit for one thing: Paulson & Bernanke only have one hand between ‘em, remarkable for anybody with economics training.

    But that’s as far as I’ll go — just yet, anyhow. I haven’t been able to glue to the toob all week, but I don’t get that anybody’s asked my $64Trillion question: how can mortgage derivatives stabilize when the mortgage instruments themselves look like they’re covered with maggots?

    You can soak up all the outstanding bad MBSs, but look at the components of a mortgage valuation model: defaults get driven by real income and loan-to-current-value; not a pretty sight as one is sliding and the other is in free-fall. Next, interest rates that might tease the new buyer; anybody want to guess what sort of mortgage rates we’ll see when Uncle Sam is trying to float another oh, trillion dollars of agencies?

    At least we can discount accelerated pre-pays.

    Oh, the equation above doesn’t allow for abnormal risk appetite? You mean no matter how much Mr. Bernanke’s flashlight goes in search of a good price, it won’t help the underlying mortgages, or those sitting unsecuritized on small banks’ books?

    Oh, too bad. Well, Mr. Paulson’s successor can always come back for more.

  • Strasser says:

    David, have followed your writing for years. Simply thanks for your level-headedness

  • Andrew says:


    I don’t trade for a living, as you do (and neither, I might add, does Mr Bernanke).

    One observation though – from all that I’ve read, “The danger with the Treasury bailout proposals is that they will waste money by buying assets at levels above what the market will bear” is a feature, not a bug, as far as B/P are concerned.

    This is an attempt to do a stealth recapitalization of the financial sector, nominally via the US taxpayer. What’s really odd is that the Treasury was recently writing stimulus checks to said taxpayer, courtesy of the kindness of foreigners. The taxpayer can’t afford the recapitalization from his own pocket, and once bitten, twice shy by foreign equity investors.

    So the plan, such as it is, is a replacement for SWF investments, albeit at a cost of increased external debt rather than equity (which they won’t give us now).

    So in a sense, I guess it’s an attempt to keep Bretton Woods II going, at least until the election gets here. What happens afterwards, of course, is someone else’s problem.