Day: October 24, 2008

NOT Born and Bred in the Briar Patch

NOT Born and Bred in the Briar Patch

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

When What Cannot Happen Happens, More Surprises Likely Await

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

The Collapse of Carry Trades

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.

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