Month: September 2008

Call Their Bluff

Call Their Bluff

Posted on by David Merkel

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.

Our Manic Markets

Our Manic Markets

Posted on by David Merkel

The markets are manic.? It is rare that we have so many large moves in a short time.? Consider these graphs:

Gold

Gold is rising since the bailout announcement.

So are crude oil prices.

And the US Dollar falls.

Swap spreads rise.

And mortgage rates rise also.

Forces larger than the US government are acting on the world economy, leading to a partial repudiation of the US Dollar by some foreign entities.? This leads to higher implied volatility in the equity markets, and higher credit and swap spreads.? Commodity prices rise also. Would you want to own the securities of a country that overpromised what it would deliver in terms of debt repayment?

I think not, and the present economic environment is decidedly hostile to fixed US Dollar denominated assets.? Play in the US dollar with care… the short trade has much to commend it in the intermediate term, though the short term is cloudy.? Also, be careful on the long end of the US fixed income market… it could deliver some significant negative surprises.

We Need Oversight, and Compensation to the Taxpayers

We Need Oversight, and Compensation to the Taxpayers

Posted on by David Merkel

Here are the issues as I see them in the bailout:

  • The Treasury can’t do it as if they are autocrats.? The powers of the other branches of our government should not be curtailed here.? The Treasury should submit to oversight from Congress and be subject to the Judiciary.? Fortunately, it seems like that is happening.
  • Second, if you are going to bail out firms that are still alive, you must ask them for equity stakes that are somewhat punitive.? The Dodd bill does that, and though there are areas where I might disagree, it is a lot fairer to the American taxpayer than the original Treasury proposal.? Bailouts should always be painful, making the rescue a last resort.? (Note, in the Dodd plan, the key weakness is that the finances of the firm selling distressed assets to the government might will likely see its stock price weaken after the purchase, leaving not enough protection by the time of sale.? But it is better than the Treasury proposal.)
  • Third, the bailout still needs a way to deal with insolvent institutions.? The Resolution Trust Corporation was a way to deal with those problems.? It’s possible that a new entity could absorb the assets of failed financial institutions, but given the nature of regulated companies, deciding on the proper transfer price is difficult.

We are on slippery ground here, and I’m not sure that the market would react badly if no plan were put in place.? A bad plan is worse than no plan, and I believe the market fell on Monday because the original Treasury plan was horrid.? If something like Dodd’s plan were enacted, I think the market would rally, even with its deficiencies.? We need oversight, and compensation to the taxpayers.

To all my readers, I still say, contact your Congressmen and Senators, and tell them to stand up to the Treasury, and demand compensation for any bailout, and if no compensation, we only bail out insolvent firms.? Bailouts must hurt.

PS — For an entertaining view of one possible future as we socialize the financial system, read this piece from the ever-wise Caroline Baum.

Two Updates

Two Updates

Posted on by David Merkel

I want to update my two Thursday evening pieces.? First with respect to Liquidity for the Government and no Liquidity for Anyone Else, the degree of financial stress in the short-term part of the market is worse.? Here’s the graph:

Much as the government wants to eliminate stress in the lending markets, I don’t think they are succeeding.? The little bounce still leaves the indicator below Thursday’s close.

One reader brought up the timing mismatch in this indicator, because I have a 2-year Treasury versus a 90-day commercial paper series.? I use the 2-year Treasury, because it is very sensitive to changes in expectations for short-term interest rates.? I suppose I could use 3-month T-bills to match, but this indicator arose out of comparing two different series that change in opposite directions when the economy strengthens or weakens.

Part 2

Now for my article Now We?re Talking Volatility.? Okay, so we had three 4% moves in a five business day period, well, now you have four of them.? Now how do the statistics look?

Oddly, after four 4% events in five days the average return is lower than that for three 4% days.? Most of the history here comes from the Great Depression, and we are dealing with the “Law of Small Numbers” here, so I am not inclined to offer definitive analysis here.? I will give you my guess, though.? Extreme volatility often begets an opportunity for profit, but also sometimes begets significant future losses.? I lean toward the profit side here in the short run, but I also realize that the actions of the US Government might not be the best for the markets, even if the markets have interpreted it positively in the short run.

I would be neutral-to-positive on the US equity market here.? The presidential cycle is a positive, as is the current market volatility.? Given the difficulties with financials, I can’t get very positive, though.? Play defense, wherever you are.

Oppose The Treasury’s Bailout Plan

Oppose The Treasury’s Bailout Plan

Posted on by David Merkel

This is not a political blog.? I have political views, but I try to keep them out of my writing here, because they aren’t relevant to my readers.? This is a rare point where the two worlds collide, and I have to take a political stand.

Let me state this plainly at the beginning of my piece, so that you know where I am going: I am asking all of my readers, and all of the financial bloggers that read me (whether here or at Seeking Alpha) to call their Congressmen, and ask them to oppose the Bailout Plan as currently structured.? I am also asking the financial bloggers to ask their readers to do the same thing. I don’t do things like this often, so understand that I think that this bailout plan is very ill-conceived.? I also think that opposing the bailout should appeal to all, regardless of party affiliation.

Okay, now let me explain why, and propose an alternative.? Some links to begin:

As I stated in my last blog post:“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.”

The current proposal is proactive.? Proactive solutions are expensive, and do not fairly distribute the losses to those who caused them through their shoddy lending practices.? The owners of bad assets should risk their equity before taxpayers put up one red cent.? The government should not try to prevent financial failure, but prevent financial failure from spreading as a contagion.? Common and preferred stockholders of failed institutions should be wiped out.? Subordinated debtholders should take a haircut.? But depositors and senior debtholders should be guaranteed, in order to protect other financial institutions that invest in those instruments, thus avoiding contagion effects.

Second, the proposed bill is vague, and offers the Treasury a “blank check” to do pretty much what it wants.? Section 8 states: “Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.” Who are we kidding here?? I don’t care how great the emergency may be, the other branches of government should be able to act as needed.

Third, there is nothing to assure that fair market value will be paid for assets.? If an investment manager is hired, who could tell if he plays favorites or not?? Clever investment firms will take advantage of the government and its agents, and only sell overpriced assets to the government.

Fourth, there is no easily identifiable upside for taxpayers here.? If we bail out a firm, it should be painful, as it was for the GSEs and AIG, where most of the equity gets handed over to the government in exchange for a senior loan guarantee.

Fifth, though the name of the Resolution Trust Corporation has been invoked here, this is nothing like the RTC.? The RTC only dealt with insolvent S&Ls.? It did not try to keep existing S&Ls afloat.

This proposal is an expensive boondoggle and should be opposed by all.? As one bit of evidence here, how many noticed that mortgage rates went up on the day the deal was announced?? Here is a graph for Fannie 30-year fixed-rate mortgages:

x

The announcement of a bailout may have caused mortgage credit spreads to shrink, but it caused Treasury yields to rise even more. The announcement was not a positive for the mortgage market, and my guess is that it will get worse from here.

My Solution

Bring back the Resolution Trust Corporation, for real.? Don’t do deals with solvent institutions.? Let them figure out how to best maximize their financial positions on their own; after all, it was their great decisionmaking skills that got them into this.

But do do deals with insolvent companies.? Take in their illiquid assets, reposition them, and auction them off once they are more saleable.? To the extent that we bail out whole firms, make it so costly to the firms that it is clearly a last resort, as with Fannie, Freddie, and AIG.

I am willing to testify before Congress on this issue, not that I think that will happen.? If anyone from Congress happens to read this and wants me to testify, please contact me here.

Finally, to any readers or financial bloggers that take me up on my request, I offer you a hearty thanks. 🙂

Government Policy Created Too Hastily

Government Policy Created Too Hastily

Posted on 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

Liquidity for the Government and no Liquidity for Anyone Else

Posted on 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

Now We’re Talking Volatility

Posted on 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.

Hodgepodge, Seven Notes

Hodgepodge, Seven Notes

Posted on by David Merkel

When I wrote for RealMoney, I would do a number of “Miscellaneous Notes” posts, because I had something to say on a lot of topics.? In the blogosphere, that doesn’t play so well, so I try to avoid it.? This post is an exception to that rule.

1)? Let’s start with my knockoff of the S&P oscillator that Cramer likes to cite.? It is in buying territory now, and I have been adding to positions on net.? This level of selling pressure is tough to maintain in the short run.

2) Bill Rempel said that he likes high yield here.? I agree.? I was talking to a high yield manager friend of mine today, and asked him what they were doing. He said, not much, his main client was scared. (I know this client, you can time the market by doing the opposite of what they do.) So I asked him what he would do if he got a fresh allocation, and he said “leg in over the next ten months.” I think that is a reasonable strategy, because we haven’t really seen defaults yet. Defaults may come later this cycle, because covenant protection was lousy, but that will likely mean that severity will be higher when defaults come. He and his assistant suggested focusing on the higher quality “BB” bonds for now.? Maybe leg in over 18 months… or 24.

I learned a lot from this guy, especially trading tactics. It might surprise you, but as a bond manager, I was an aggressive trader. There are many micro-level opportunities to add value.

3) Look at the TED spread.? It was over 3% today, indicating a lack of confidence in the banking system.? We have not seen levels like ever, including 1987.

4) The Fed announced another new program today.? This is the first Fed where their creativity exceeds their balance sheet, and there’s the rub.? Here’s an FT Alphaville summary of the program.? But the best summary comes from Alea’s jck:

the fed is running of t-bills therefore they cannot sell t-bills in order to drain excess reserves resulting from their liquidity operations, enter treasury selling t-bills to the people and depositing the cash at a fed account, the net result being drain of excess reserves resulting from ?etc?

The Fed is running low on T-bills, and doesn’t want to expand the monetary base, so, they want the Treasury to do their dirty work for them.? Why not?? They are partners in crime.

I don’t see this ending well.? The Fed has applied to be able to pay interest on reserves now, as opposed to 2011, as passed by Congress.? Perhaps we need to think of the Fed as unitary with the Federal Government, and not possessing independence, except to the degree that the Federal Government itself lacks explicit authority, and so the Fed can act in ways that the Federal Government can’t, thus extending the power of the Federal Government in implicitly unconstitutional ways, though not explicitly.

5) There was some misunderstanding over my post last night over 99.5%.? What I mean is not 99.5% of days, but years.? I’m talking about protecting yourself against all but 1-in-200 year (not measured by normal distributions) threats.? We diversify against those threats, and some major threats — war, plague, famine, aggressive socialism, are not diversifiable.

6) One reader asked. “David, why do you think the AIG preferreds will have any value? Two years without a dividend, and a senior creditor who is committed to an orderly sale of all the assets, and the prospect of even worse CDS problems as they try to unwind the book… sounds like there is ample reason for the preferreds to trade to very near zero.“

That might be so.? I don’t know, and when I wrote last night I had less detail than I have now.? I don’t like preferred stock, and it is difficult to tell what any security in the middle of the capital structure is worth in a stressed situation.

7) We face the continuing laxity in bank capital requirements.? I would support laxity if I knew that in the bull phase that capital requirements would get tighter.? But that has not been the case in the US.

That’s all for now.? Be wary, and be willing to commit some, but all of your funds in the present panic.

AIG: America’s Insurance Giant

AIG: America’s Insurance Giant

Posted on by David Merkel

How Much Can the US Government Guarantee? For now, whatever they want, or so it seems.? Perhaps the new question should be what dodgy assets can the Federal Reserve cram into the monetary base?

I’m talking about AIG, and this is one place where only the Fed could have acted, aside from the State of New York (too small).? The Fed can act because in a crisis, they can lend to anyone on a collateralized basis.? Essentially, they took most of the company as collateral for the loan with 80% ownership if things go right.? If things go wrong it will only increase our monetary inflation.? (Note: regulators typically take over financial companies, and though AIG is a holding company with many insurers domiciled in NY, most of the company is not regulated by the State of New York.? The Treasury could not act, and the State of New York did its best, but it was not enough.)

Consider some of the good articles posted on the deal:

(Naked Capitalism live-blogs, almost)

(WSJ)

(Big Picture)

(NYT)

(Bloomberg)

I find it amusing that the former CEO of Allstate, Ed Liddy, is the new CEO.? Allstate, for all its complexity, is a matchbox car compared to AIG’s non-functional Maserati.? That said, I like the pick.? He will simplify, simplify, simplify.? He will also have the time to do it.? (And, if he found getting Allstate’s stock price up to be a challenge, so he said to me once, oh my, here is the challenge of a lifetime.)? I also find it amusing because AIG often did not think much of Allstate.

Now, the senior secured bank loan effectively subordinates all other holding company debt.? That said, that debt will probably rally as a result of the rescue.? I’m not so sure about the stock, though, this is a lot of dilution to swallow.? Even though the preferred may not get dividends for two years, that might rally on the rescue.

But could this have been avoided?? Yes.? It comes down to one simple concept: Risk Based Liquidity.? Never finance illiquid assets with liquid liabilities.? Doing so invites a run on the bank.? Now in the modern context, one has to consider contingent liquidity: do you have ratings triggers in your bonds, insurance agreements, or derivative agreements?? That sets up a slippery slope where a cliff used to be.? AIG got killed primarily because they allowed for short-term calls on cash as credit ratings declined.? If the troubles from Life Insurers regarding GICs is not enough, nor utilities or reinsurers with ratings downgrade clauses, certainly this should show the folly of allowing ratings triggers in insurance/financial agreements.? I’m not saying that insureds are stupid to ask for them; I am saying that they should be illegal.

AIG left itself in a position where a very bad credit environment could destroy the company.? That resulted from writing insurance on seemingly unlikely credit events that are now more likely than one could have expected.? Also, there are the years of accounting misstatements because of the culture of fear that pervaded the company.

What can I say?? The financial companies that have failed had liquid liabilities and illiquid assets.? The first job of risk control is to assure sufficient liquidity under 99.5% of all scenarios.? This was not true of Fannie, Freddie, Merrill, Bear, Lehman, AIG, Countrywide, etc.? LIquidity costs money, which is why short-sighted managements intent on current earnings scrimp on liquidity.? But liquidity is the lifeblood of business, far more so than earnings.

Remember this when you invest, and look for companies that provide for significant adverse deviation.? And, all this said, I worry for our republic.? Our liberties are slowly disappearing before us, in a haze of government rescues.

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