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Archive for October, 2008

A Puzzle

Friday, October 31st, 2008

Okay, here’s a question that I don’t know the answer to.  Why are current coupon Ginnie Mae MBS yielding roughly the same as Fannie Mae MBS?  THe Ginnie Maes are government guaranteed, so they should have a lower cost of funds.  Why isn’t the spread bigger?

I write this because there are many who think that folding Fannie and Freddie into the US Government could lower their funding costs, and lower mortgage rates. Well, Ginnie Mae is already there, and it does not seem to be making much difference. The Feds could have put the pedal to the metal with Ginnie Mae, but there does not seem to be much advantage, and I don’t know why.

What is the Value of Market Dividend Yields?

Thursday, October 30th, 2008

Blogging is often a cooperative venture, so this piece begins with thanks to three people:

When I read the piece at The Capital Spectator, my response was “Huh, neat article, wonder how it would look with a larger data set?”  Given Eddy’s help, I had that data set, and so I got to work.  Here is the main result:

The results at The Capital Spectator went from 1995 to 2003. My results go from 1871 to 2003. His results give a tight relationship, while mine indicate a loose relationship.  His R-squared was far  higher than my 7%.  Why?

In aggregate, many relationships in finance are tenuous.  Do interest rates mean-revert?  Yes, but the tendency is weak.  In this case, high dividend yields foreshadow high five-year total returns, but that tendency is weak.

In the graph above I tried to highlight the eras for different alignments of dividend yields and future five-year returns.  Depending on the era, the relationship of dividend yield to future returns differed.  In the long run, there is a weak positive relationship between dividend yields and total returns, but in the short run, many other factors predominate.

So what does this tell us?

  • Use larger data sets when possible.
  • Realize that many relationships in finance are not stable.  Indeed, that is a strength of Capitalism.  It adjusts to changing conditions, and is not stable.
  • When dividend yields are high the market is attractive.  Of course, factor in how high bond and cash yields are at the time.
  • Beware relying on intermediate-term relationships in quantitative finance.  They last for less than a decade.
  • Beware trusting correlation coefficients calculated over short intervals.
  • In finance, we know less than we think, so we should be cautious in our conclusions.
  • The best forecasts come when we are at extreme values of the system.  In the middle, everything is a muddle.

I am a firm believer in dividends. My portfolio has an above average dividend yield.  In general, high dividend yields pay off in investing, subject to credit quality.  But, the payoff varies over time; a heavy reliance on the dividend yield of the market as a sole indicator is not advised.

Redacted Version of the FOMC Statement

Wednesday, October 29th, 2008

The Federal Open Market Committee decided today to lowerkeep its target for the federal funds rate 50 basis points to 1at 2 percent.

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

In light of Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the declinesearlier increases in the prices of energy and some other commodities and the weaker prospects for economic activity, the. The Committee expects inflation to moderate in coming quarters to levels consistent with price stability.later this year and next year, but the inflation outlook remains highly uncertain.

Recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain.The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman;Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Ms. Cumming voted as the alternate for Timothy F. Geithner.

The Upshot:

  • They have finally concluded that the real economy is in trouble, and not just the financial economy.
  • They think inflation will move to stable levels (and perhaps they fear deflation — they have moved from a position of rhetorical uncertainty to certainty).  They no longer fear inflation.
  • They hope that all they have done so far will work.

My interpretations all, but this statement changed a lot from the last one.

The Fed Funds Target Rate is an Exercise in Futility

Wednesday, October 29th, 2008

I spend time watching the Fed.  Much of that time is wasted, but they are an important cog in the machine that is our economy.  Today, around 2:15 when the Fed’s policy statement is released, and the guy on CNBC at the Fed talks into the mike that sounds like it is a coffee can, many will focus on the change in the Fed funds target rate.  I am here to say that given the changes that have happened in our economy, and the new ways that the Fed conducts its policies, the Fed funds target rate is not all that relevant.  Why?

  • The Fed does most of its direction of incremental liquidity through special programs like the TAF, TSLF, PDCF, ABCPMM, rescues, etc.  It doesn’t send most of the liquidity out through the banks, and perhaps into the economy more generally (if the banks would lend).
  • The Fed is having a hard time targeting Fed funds in an era where they can pay interest on excess reserves.  Effective fed funds has been averaging 0.75% over the past 10 days.
  • The closer we get to the zero bound, the less punch the Fed has through ordinary monetary policy.  Expectations of policy failure swamp the cash flows involved, at least for a while.
  • Real short-term lending rates are at present not connected to Fed funds.  That includes semi-real rates like LIBOR, and somewhat more real rates like A1/P1 commercial paper, and real short term rates like A2/P2 CP, where only the free market is lending, and the Fed is not.

If the Fed funds target falls to 1%, and commentators trot out Greenspan’s name, remember this: the two situations are not the same.  In 2003, the banks were healthy, and there were still areas of the economy that could benefit from lower rates and lever up, thus boosting GDP and markets.  We got a housing bubble amid other consumer finance bubbles, and probably a bubble in commercial real estate as well.  All of that added up to a bubble in companies that did lending.

A 1% Fed funds target will not have any punch this time around.  Even 0% with “quantitative easing” a la Japan will lead to Japanese-style results, though again, only favored markets get the liquidity.

So, don’t expect much out of the rate.  Read the announcement for what little qualitative information it might yield.  I’ll be back with a compared version of the last and current statements later today.

Fifteen More Notes and Comments on the Current Crisis

Wednesday, October 29th, 2008

1) Do Fannie and Freddie deserve some blame for the crisis that we now face? Yes, but not without blaming Congress and the Executive Branch for pushing homeownership far beyond the natural rate of ownership, which I wager is around 60% rather than the 72% that it touched for a brief time.

But here are some ways that F&F went out of their way to help create the current crisis:

  • F&F did push loan growth and growth of their retained portfolios in order to benefit their shareholders.
  • They bought significant amounts of Alt-A and other lower quality loans for their retained portfolio.
  • They aggressively lobbied to protect their position.
  • They argued for capital standards that were lower than would be needed in a crisis (so did many financial institutions)
  • They lowered underwriting standards in order to meet competition from private lenders. They could have given up business, delevered, and been stronger companies for when the crisis would hit.
  • They managed to their GAAP financials. A prudent financial institution manages to a stressed version of their most stringent capital constraint.

Finally, I would add that this was an area where Greenspan was right on policy, along with a few of the more conservative members of Congress. If you are going to have F&F at all, then use them contra-cyclically. When the mortgage markets are lending, F&F should sit on their hands, and let the market do its work. If F&F’s balance sheets weren’t impaired now, they could be doing some real good here, but because their credit quality is suspect, as well as the commitment to their solvency from the Federal Government, their cost of fresh capital is high, making mortgages more expensive than they otherwise would be.

Note the current rise in Fannie 30-year mortgage rates.  This series tends to peak out at 6.20% but I am expecting rates to exceed that and soon.

Personally, I don’t think the government should be in financial businesses. Government agencies tend to overlend, and lend to bad risks with insufficient compensation. Then again, I don’t think governments should be in the money business either; they abuse the privilege, stealing from us in the process.

2) Will contractual terms be honored by the courts? Some hedge funds will press for their rights. My guess is that they won’t win in this environment. The system has a tendency to fight individual rights in a crisis. But, there is no free lunch. To the extent that contractual rights are infringed, rates will rise when lending resumes to compensate for expropriation risk.

3) Get financing when you can, not when you have to. Others have pointed to this post, but it bears repeating. The banks ran for too long on capital bases that were too slender. Now they are paying the price. The only pseudo-equity capital available is that from government sources.

Now, there may be a competition for that capital from the government, and perversely, it might lead to banks using the capital to buy other institutions (PNC has already done it to Nat City), rather than make loans, and on net, I would expect that to result in still fewer loans being made than in the absence of a merger. So let the competition begin for who can gobble their cheap competitors with cheap government capital.

4) Away from that, the Fed is having a hard time controlling Fed funds since they started paying interest on reserves deposited at the Fed.

Though I have written on the changing balance sheet of the Fed [link] and its implications, Jim Hamilton of Econbrowser has a very good post on it as well. The only place where I think we differ is that I think this will eventually be inflationary to goods prices when the Fed is forced to stop sterilizing.

5) Now the Fed is in the business of short-term unsecured lending to corporations via buying CP. (I think this will help lead to the first real CP default since Penn Central.) Early indications are that CP funding costs are higher than before the crisis if CP is funded by the Fed.

6) Never buy something you don’t understand, unless you have a friend who is smart and trustworthy by your side to advise you. Many municipalities got bamboozled by investment banks in much the same way that homebuyers got swindled by those offering subprime loans. Through derivatives, they offered a way to lower the current costs of debt by having the municipality sell options against their position that would force costs higher under certain circumstances which seemed unlikely, but were more likely than not.

The same is true of many investment products created by Wall Street for retail investors.  Sell them something that offers a high yield with safety, subject to some options sold short that are unlikely to come into the money.  I see it often.  Don’t but complex structured products from your broker.  Odds are they are taking you for a ride.

7) Those who have read me for a long time know that I think GM and Ford are eventual zeroes for the equity, and the subordinated debt.  Even the senior debt will get whacked severely.  There is no value in corporations that have huge promises to their employees way out into the future, when competing against better capitalized and better run foreign competitors like Toyota and BMW.

So, don’t bother trying to rescue them.  Rather, let foreign competitors buy them out, if they want them.  That will be a good test as to whether there is value there or not.  Possible foreign buyers have worked under the assumption that the Big 3 cannot be bought.  If the US sends a message that they can be bought, would any of them be bought?  My answer is no, unless the US Government or the PBGC sweetens the pot.  Other notes:

  • Daimler thinks Chrysler is a zero. (no surprise here)
  • The Treasury should give up on lending to the automakers. (Much as other think they are critical.  If the plants are valuable, foreign capitalists will maintain them.)
  • The TARP may lend to auto financing arms, but that is probably a mistake as well.
  • We should not bail out the auto makers, regardless of how politically expedient is is.  Because of the employee benefit promises made, there is no way any US automaker can beat foreign competition.  It is time to let them fail, and let the unions take the rebuke that they royally deserve.
  • GM is not too big to fail.  Let them fail, and then expedite the bankruptcy process, so that senior debt becomes equity, the firm goes non-union, and the firm can compete globally for the first time in 40 years.

8 ) Greg Mankiw asks if we have learned enough.  My view is no, we have learned little, and what Bernanke thinks he learned regarding the Great Depression is wrong.  This is not a crisis of confidence and liquidity, it is primarily a crisis of solvency, which drains liquidity.  High levels of total leverage make a financial system inherently unstable, and the only way to cure it is through expedited bankruptcy procedures.  As it is now, Bernanke and Paulson are trying to save the financial system by wagering the credit of the USA.  (My opinion is that our nation is great enough that we whould risk another Great Depression rather than give up our liberties to the Government.)

9) A young friend e-mailed me from LIthuania (where she has a semester abroad), and asked me how serious the current economic situation is.  My response:

To give you the quick summary, we may be headed into Great Depression 2.  Or, as I sometimes call it, the Not-so-great Depression.

A Depression is a severe recession where the solvency of the banks is compromised.  Debt levels of financial companies, consumers and our Government have gotten to levels where repayment of debts in full is difficult if not impossible.  The system is overleveraged, and funded by leveraged institutions that could fail if they aren’t paid back.  There is kind of a “domino effect” here, where failures can cascade.

That’s why the Government has stepped in, encouraging financial institutions to shift their debts over to the Government.  That will work for a while, but eventually parties will become reluctant to lend to our Government as it becomes a bottomless pit of promises.  Then inflation of the currency will begin.

This is an ugly situation, one that is the product of sloppy monetary policy, poor regulation of financial companies (for two decades), poor risk controls, overlending by government institutions, and a cultural failure where we borrowed too much and saved too little.

I wish I could be more chipper here, but this is ugly, and what the government is doing is not likely to solve the problems at hand.

10) Slow moves tend to persist, sharp moves tend to mean-revert.  Don’t put much confidence in today’s sharp move up.  Strong one-day upside moves are characteristic of bear markets.

11) My post last night neglected one item.  Stable value funds have more flexibility than many other financial entities.  Be wary if the credited rate drops a lot.  Better to withdraw funds in that scenario, because it implies that the market value of assets is significantly less than the book value.

12) Be ready for a surprise in the GDP data, as I highlighted last quarter.  The implicit deflator for Gross Domestic Product will be extra high in the third quarter because of the fall in energy prices.  Just as it pushed “real” GDP higher in the second quarter, it will exact its pound of flesh in the third quarter.

13) My pal Cody is red hot, and though he is less measured than I am, I agree with much of what he says.  We need to vote out Republicans and Democrats.  We need new options.  Personally, I think we need to radically change the Constitution, and move to have a parliment, where the head of state is the head of the majority party.  That will create government that is closer to the consensus.  Eliminate the Presidency — it is too dangerous of an institution.

As Cody put it today: 2. Real headline today: “White House Encourages Money-Hoarding Banks to Start Lending” – I thought profit-motive was what was supposed to encourage banks to lend. And only profits make stocks go up, so why would shareholders want the banks to start lending if the bankers don’t think it’ll be profitable?

I can’t agree more, and the Treasury is pushing on a string if they are trying to force the banks that they have financed to lend.

14) Commercial Real Estate is the shoe yet to fall, yet the CMBS market has anticipated much of the decline.  Are the Fed and Treasury ready for this?  They weren’t ready for residential housing declines.

15) The foolishness that exists today regarding the government buying stakes in financial companies has now transferred itself to policymakers who think the equity market is now cheap, so invest the Social Security surplus in the equity market.  Problems:

  • We have always avoided Socialism like this in the past.
  • How can a bureaucrat with no profit motive figure out whether out whether this is a good decision or not?  Or, how will the bureaucracy extract maximum value for the taxpayers?
  • Is the market really cheap now, or, only seemingly so.  The time to invest is during a baby bust, not a baby boom as it is now.

As with so many of these decisions, the answer will only be clear in hindsight.

A Maximum of One Year of Interest Lost

Tuesday, October 28th, 2008

A reader asked if I had an update to my piece Unstable Value Funds? Yes, I do.

Have we survived the demise of Fannie and Freddie, Ambac and MBIA? It seems that way, but I would not be certain. These credits were crammed into stable value funds. How do you feel about life insurers? The stock prices of those that issue GICs have fallen significantly. Credit spreads have widened significantly.

Should you worry here?  My view is yes.  Any significant negative impact on the GSEs, Financial Guarantors or Life Insurers could affect the solvency of stable value funds to the tune of one year’s worth of interest.

This is similar to the way that I view money market funds.  It is possible that they could lose a year’s worth of interest.  Beyond that, I don’t see likely losses, unless the stable value fund had an unusual investment policy.

Eight Notes and Comments on the Current Crisis

Monday, October 27th, 2008

1) Greenspan — what a waste.  A bright, engaging man becomes a slave to the Washington political establishment.  Now he gives us a lame apology, when he should be apologizing for his conduct of monetary policy, which encouraged parties to take on debt because of the Greenspan Put.  Now the debts are too big to be rescued by the Bernanke/Paulson Put, where the Government finances dodgy debts.

On a related note, Gretchen Morgenstern is right when she calls the apologies hypocritical.  I would only add that Congress also needs to apologize; they did not do oversight of the Administration properly.  Many members of the oversight committees are not economically literate enough to do their jobs; they can only score political points.

2) I found this post highly gratifying, because it points out the disconnect between macroeconomics and finance, which I have been writing about for years.  When I was an economics grad student, I felt economics had gone astray by trying to apply statistics/mathematics to areas that could not be precisely measured.  In this case, if your models of macroeconomics can’t accommodate the boom/bust cycle, you don’t deserve to be an economist.

3) You want accounting reform?  Start with accounting that disallows gains-on-sale in a financial context.  WIth modern life insurance products, gain from sale is not allowed under SFAS 97, and I would modify SFAS 60 to be the same way.  No profits at sale.  Profits are earned in a level way over the life of the business as risk decreases.  Let other financial firms use something akin to SFAS 97, and many business problems would be solved.

4) What freaks me out about this article is that Taiwan is refusing the full faith and credit of the US Government, which stands behind GNMA securities.  Don’t bite the hand that feeds you; who knows but that you might be traded for the elimination of Kim Jong Il.

5) It figures that the moment the PBGC buys the specious arguments of a pension consultant that the equity markets crash.  Whaat makes it worse is that the PBGC tended to buy long Treasury debt which has been one of the few securities rallying  recently.

Given all the furor over investing in long duration bonds for pensions versus equities, it is funny that the PBGC rejected the growing conventional wisdom that DB plans should invest in safe long bonds.  Once they reject their current pose, the equity market could rally.

6) Is the economy weak?  Well, look at the states.  If their tax receipts are going down, so is the economy.  We are in a recession, and maybe a depression, given the lack of strength in the banks.

7) Do we need a new system for managing the global economy?  The Chinese certainly think so.  They finance the US and don’t get much in return.  Perhaps China could host the new global reserve currency?  I don’t think so.  Their banking system isn’t real yet, and they still want to subsidize their exports.  The global reserve currency role will flow to the largest economy allowing free flow of capital.  Now, who is that?  Japan?  Too small, but the world now recognizes that their banks may be in better shape than many other countries.  Plus, they have been through this sort of crisis for a while, and may be closer to the end of it than the rest of us.  The alternative is that Japanese policymakers still don’t have the vaguest idea of what to do, much like the rest of the world now.

Thing is, we don’t have a logical alternative to the US Dollar as the global reserve currency.  The Euro is a creation of an alliance of nations untested by economic crisis.  Perhaps the rest of the world should consider the possibility of no global reserve currency, or keep the US Dollar, or, move to a commodity standard like gold or oil.

For now, though currencies will follow the path of panic, as carry trades unwind, as countries that had too much borrowing see loans repaid (Japan, Switzerland), and countries with high interest rates see a demand for liquidity, which perversely will push rates higher.  (Isn’t everything perverse in the bust phase, just as everything is virtuous in the boom phase?)

8 ) On the bright side, some boats are rising.  After seeming irrelevant, the IMF has found a reason to exist again with loans to Iceland, Hungary, and Ukraine, with more to come.  The small/emerging markets once again learn that they were at the end of the line in this economic game of “crack the whip.”  That said, the developed market banks financing them will get whipped too.  This is truly a global crisis.

And given that it is a global crisis, I wonder how willing the developed nations will be to add more funds into the IMF when they have crises at home to deal with?  I’m skeptical, as usual.  Perhaps the Treasury can send them a raft of T-bills.  The IMF can ask the Fed for contact info.

(more to come)

NOT Born and Bred in the Briar Patch

Friday, October 24th, 2008

Originally, I was not a fan of Bernanke, but the more I read about him, the more I liked him.  Still, my main fear that I wrote about at RealMoney at the time of his nomination has largely been realized in my mind.


David Merkel
Why I Don’t Like Bernanke as Fed Chairman
10/24/2005 12:09 PM EDT

From my post on April 4th:

“I’m not crazy about Ben Bernanke being selected chairman of the Bush administration’s Council of Economic Advisers. This is not because I think he’ll do a bad job there; odds are, he’ll do fine. It’s kind of a nothing job, anyway. I just suspect that this is a stepping stone to becoming the next Fed chairman. Bernanke is too much of a dove on inflation for me, and too seemingly certain of his own opinions. If we have very placid economic conditions, he could do fine as Fed chairman. If we have crisis conditions, the last thing I want is a dovish idealist as Fed chairman.”

Greenspan was more of a political operative than an academic, and as such, fairly pragmatic as he threw liquidity at every crisis, creating a climate of moral hazard. Investors lose fear of loss, because monetary policy will bail them out in a crisis.

Academics think they understand how monetary policy affects the economy, and in my opinion, have a higher degree of confidence in their views than say, a banker in a similar position would. When models of the world are imperfect, a false certainty can do a lot of damage. Bernanke is a bright guy, but bright doesn’t mean right.

Position: None

Bernanke spent a lot of time studying the Great Depression as a grad student, and I did not.  As an academic, there is the bias that says, “Yes, but we have learned from the past, and know what to do next time.  We have the game plan to fight Depression II set.”

I think the wrong lessons were learned by Dr. Bernanke, and many academic macroeconomists.  They look at the ineffective remedies at the time: negative monetary growth, Smoot-Hawley, and lack of stimulus, and they conclude that if they can stimulate a lot more, they can avoid Depression II.

Depressions occur because market actors take on too much debt, including financial institutions, and at the tipping point, cash flow proves insufficient to service the debt, starting a self-reinforcing bust cycle going the opposite direction of the prior self-reinforcing boom.  Once the self-reinforcing bust starts, I’m sorry, but there is little that can be done.  Liquidation of bad debts must happen to clear the system.  In the absence of that, we can have a Japan-style scenario where rates go to zero, and we stay in a funk, or we could inflate the mess away, harming savers and pensioners.

The boom-bust cycle is normal to Capitalism and should be enjoyed, rather than avoided by policymakers.  A lot of smaller busts are better than one big bust when national debt to GDP levels are at record levels.

At this point, stimulus merely slows down the inevitable.  We aren’t liquidating debts as much as transferring them to the government.

I am waiting for the first Treasury auction failure.  They won’t call it a failure, and they may reschedule it.  When that happens, we will have a statement that shifting private debts to the US Government is not appreciated by the creditors of the government.

We also could have semi-failures, where the market clearing rate at the auction is well above the average bid.  A few of those, and the yield curve could be at record wide levels.

I view the Federal Reserve and Treasury as being a bunch of amateurs here.  That’s not an insult.  Take me, James Grant, or any number of bright critics of the Fed and Treasury, and if they were in charge now, they would be amateurs also.  There is nothing in their training that prepares them for dealing with the credit equivalent of nuclear winter.  Nor should there be.  These abnormal periods happen every 40-80 years whether we like it or not, once we forget the lessons of building up too much leverage under a fiat money system.

Should they be blamed for not bailing out Lehman?  That was the inflection point for this crisis as it is manifesting now.  Yes and no.  Yes, since they took it upon themselves to be the guardians of the whole financial system.  Yes, since they bailed out Bear and AIG, two institutions that they had no business bailing out.  Both were bailed out for reasons relating to systemic risk, and both were politically unpopular.  But though Lehman may have posed less systemic risk than AIG, it certainly posed more risk than Bear.  Yes, because they jolted expectations.  No, because they couldn’t have known the full chain of events that allowing Lehman to fail would touch off.

A hidden cost here is that activism begets more activism, or, at least, a demand for more activism.  If the Federal Government and the Fed are now the lenders of first resort, it is no surprise that many will come-a-beggin’.  Once you are willing to lend to support one critical area of the economy, my but many areas will deem themselves critical as well.  Where does it stop?  At this point, I think it might have been better to let Bear, Fannie, Freddie, and AIG fail, but with some sort of expedited bankruptcy process that quickly disposes of equity rights, and converts all debt claims into varying degrees of new equity.  This extinguishes debt claims, and accelerates the healing of the economy.  This would be true reform.

Looking Forward

Now, suppose for a moment that the monetary and fiscal stimulus programs work in the short-run, and bring down rates.  What happens when the Fed tries to exit?  My guess is that they can’t exit.  In paying interest on reserves, the Fed is slowly replacing the Fed funds market with its own lending.  If the Fed leaves, the crisis reappears.  But even apart from that, the government ends up with more debt, and that has to be serviced in some way.

In providing guarantees to money market funds, buying top-rated CP, and helping financial firms finance paper of varying quality, the Fed replaces markets that ceased to function for a time.  The Fed sets yields and prices for credit, but with little to guide their decisionmaking.  Set the price too high, and there are few takers.  Too low, and there are many takers.  Beyond that, with so many programs, what is a bureaucrat to do to figure out which programs are offering the most relief?  I’ll tell you, it is not possible to figure that out.  The money going out is certain, but the benefits are not.

Now, as Greenspan mumbles, wondering about how this crisis could have come about, those of us that are more aware (or intellectually honest), look at the increase in total debt levels and say, “It’s pretty amazing that the system held together for so long.”  It’s an ugly situation, but it is worth asking whether the current actions of our government might harm the future well-being of our nation.

It’s almost never a good idea to sacrifice freedom for security.  But the Federal Reserve has done that.  They are now tied to the Treasury Department, and any policy independence they had is gone.  Book-smart Bernanke has been co-opted by the street-smart Paulson.  Bernanke is a bright guy, but he was not “Born and bred in the briar patch,” as was Paulson, who learned the ropes on Wall Street.  (Do I have to say that Wall Street produces harder characters than academia?  No?  Good.)

In this case though, we are beyond normal, even for seasoned veterans of Wall Street.  There are no comparables any more.  This is more severe per unit time than 1973-4 or 2000-2.  Only the Great Depression remains as a benchmark, and that era grins at us as we think we can beat the process of delevering through government action, of which they had much.

I’m not grinning here.  We are looking at tough times.  May the Lord help us.

When What Cannot Happen Happens, More Surprises Likely Await

Friday, October 24th, 2008

After not feeling well for a few days, I am back to writing.  Let me start with a blast from the past from RealMoney, during happier times:


David Merkel
Swap Curve Inverts a Teensy Bit, for a Moment
2/17/2006 12:29 PM EST

Nothing big here, but the swap curve briefly inverted twos to tens a few minutes ago. There is no reason to panic here; I’m just pointing out something that is highly unusual in the bond market. Having successfully traded bonds 2001-2003, I can say that strangeness tends to beget more strangeness. If this inversion gets larger and persists, I will have a post on the topic, but for now, this is just a curiosity.

Position: none, but the swap market affects us all in a wide number of quiet ways…



David Merkel
The Deepening Inversion
2/22/2006 11:06 AM EST

I did not expect the inversion in the Treasury curve to get so deep so quickly. At present, the Treasury curve is inverted 15 basis points from twos to tens. Does this mean the market is falling apart? No, only the economics of spread-based lenders.

Whoever taught me (way back when) that the swap curve can’t invert deserves a few whips with a wet noodle. It’s small, but swaps are inverted two basis points twos to tens. What will I see next? Inverted corporate curves for BBB bonds? I can’t imagine what that would imply for the economy. It would deepen my feeling that we are in uncharted waters in a low nominal world.

On the CPI, it is an advantage for TIPS buyers that the bond market focuses on the core CPI, when TIPS buyers get paid off of the unadjusted CPI. It allows us to get more yield off of our TIPS.

Inflation is higher than the core CPI indicates for a wide number of reasons, but the simplest one is that they exclude food and energy, whose prices have risen at faster than everything else for the past 10-20 years.

Eventually the long end of the Treasury curve will react badly when market players revise their long run inflation expectations, which in my opinion are too low. But for now, international flows dominate because US yields are higher than those in most other countries, and pension fund flows dominate because of a need to fund long liabilities. Until those factors quit, we will continue to live in a weird bond market, with uncertain implications for GDP and the equity markets as a whole.

This doesn’t make me change any of my strategies yet, but it does leave me uneasy.

Position: long long-dated TIPS, bank floating rate loan funds

Back then the yield craze was upon us, and credit risk forgotten.  The swap curve was theoretically never supposed to invert on a yield basis.  That was then, this is now.  A new yield craze is upon us, where credit risk is omnipresent, even in securities of the highest quality.  It reads, “I don’t care about the yield, just give me guarantees for a long time, and keep me safe.

That is manifesting in (at least) three ways right now:

  • Failure to deliver in repurchase markets. (Alea, Jesse’s Cafe Americain)
  • Swap spreads going negative on the long end of the curve. (Across the Curve, FT)
  • What bond deals are getting done for investment grade names are getting done at amazing spread levels.  (Baker Hughes, Pepsi — in 2002, spread levels for single-A names never got this wide, though some cyclical BBBs got that wide.)

The grab for safety is relentless, and the efforts of our Government are small relative to the size of the economy.  The yields of the investment grade bond market are a truer measure of the troubles, because no one is fiddling with it yet.  Even so, the fiddling may not turn even the manipulated markets around.

PS — As a final note, a kind word for the CDS market — their netting procedures work admirably, as pointed out by Alea (numerous times), and Derivative Dribble (a valiant start for a new blog).  Here’s a wild thought: we need the same thing on a broader and more complex scale, allocating the embedded losses in our financial system to their rightful recipients, wiping out common, preferred equity, and subordinated debt as needed, and forcing the conversion of debt claims to equity, delevering the system in a colossal way.

CDS netting does that in a flash for synthetic debt exposures, but how do you do it for a wide number of assets at once?  I’m not sure it can be done.  My question is this: do the present actions of policymakers genuinely help, as they shift debts from private to public hands, or do they merely delay the inevitable?  I hope the former, but I think it is the latter.

Full disclosure: long PEP

The Collapse of Carry Trades

Friday, October 24th, 2008

In his usual brief style, jck at Alea displays the collapse of carry trades through the appreciation of the yen.

Put on your peril-sensitive sunglasses before viewing.  When I was at RealMoney, I wrote a lot about carry trades, and how the end would be ugly.  We are experiencing that now.


David Merkel
The Craving for Yield, Part 2
2/6/2007 2:55 PM EST

If you hang around bond investing long enough, you run into the phrase “carry trade.” It’s a simple concept where one borrows at a lower rate, and lends at a higher rate, just like any bank would do.

Free money, right? Yes and no. People make money in these trades often enough to make them popular, but there are often points where they blow up. The simplest example is when the Treasury yield curve is very steep, like it was in late 1993, or mid-2003 right after Alan Greenspan finished his last contest of “How much liquidity can I provide?” At that point, it seemingly paid to borrow short and buy longer dated Treasuries, clipping the interest spread. That works well when interest rates are falling, or when the FOMC is on hold at the bottom of the cycle, but once the hint that the first tightening might occur, it doesn’t work well until the first loosening is hinted.

Carry trades can involve other factors as well. Some creditworthy entity can borrow cheaply, and invest in less creditworthy or more illiquid paper, capturing a spread. That trade also goes in cycles; good to do it when everyone is scared to death, as in late 2002. Bad to do it in late 1999-2000, as the negative side of the credit cycle kicks in.

Carry trades can involve different currencies. Borrow in the low interest rate currency (Yen, Swiss Francs, Offshore Yuan), and invest in the high interest rate currency (US dollars, NZ dollars, Australian dollars, Korean Won, Indian Rupee, etc.) Again, it all depends where you are in the cycle, as to whether this is a good trade or not. The weak tendency will be for low interest rate currencies to appreciate versus high interest rate currencies, but in the short run, currency movements are somewhat random.

What fascinates me in the current environment is the size and variety of all the carry trades being put on at present. CDOs of all sorts. Borrowing in developed markets and investing in emerging markets currencies. Levering up nonprime commercial paper. Borrowing offshore in Yuan. Borrowing short to finance paper with short embedded call options. Corporate, RMBS, CMBS and ABS spreads are tight.

When I think of all of the different risks that can be taken in bonds (duration, convexity, credit/equity, illiquidity, currency, etc.) they are all being taken now, and at relatively high levels. There is an exception. Duration risk is not being taken because of invested yield curves. (But who is borrowing long to lend short? Not many I hope.)

The danger here is not immediate. As with most topping processes, it is just that, a process. Bubbles pop when cash flow proves insufficient to finance them. Cash flow is still sufficient now. Banks are still growing their balance sheets faster than their central banks. Petrodollars and Asian surpluses are still being recycled. Wealthy investors are still for the most part bullish. We’re not to the point of no return yet; the sun is shining amid large cumulus clouds. But as those clouds cumulate, we should prepare for rain. Okay, snow.

Position: none

Alas, but the boom has given way to a bust, andAll the king’s horses and all the king’s men, Couldn’t put Humpty together again.” Sad times these, but they had to come. There was too much leverage in the the system, and now leverage is collapsing, and the value of assets whose prices were artificially high due to the temporary additional purchasing power that leverage afforded.

Have a wonderful day amid the chaos, and be grateful if you have food, shelter, clothing, family, friends, and peace with God.

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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