When I wrote for RealMoney, one of my continuing themes was that the Federal Reserve was less relevant because neomercantilistic nations like China (and perhaps OPEC nations) had reasons for promoting exports to the US that were less than economic.  As such they would buy US fixed income in order to facilitate their exports.  What could be sweeter?  You send goods; we send promises, denominated in our own currency.

With that, I want to point to a short post from Marginal Revolution.  Like me, he takes the “modified Austrian” view that the bubble was caused not only by the Fed, but also by the neomercantilists, both of which I fingered in my “Blame Game” series.  Buying longer dollar-denominated debt stimulated mortgage rates more than the Fed could, because under normal conditions the Fed can only affect the short end of the yield curve.

PS — What a long day, to NYC and back.  I appeared on Fox Business News show “Happy Hour.”  They said I did very well.  If I get video I will post it here.  As I have said before, time on live television goes fast.  The four minutes seemed like the blink of an eye.  At the end, Liz asked me for a third stock, and I blanked out, so I said Assurant, a company that I love, but don’t currently own.  I will own it in the future.  I meant to say Pepsico, but it just didn’t come to mind.

I also had dinner with my friend Cody Willard after the show.  Though our rhetoric is different, we basically agree that the actions of the government in the bailout offer much possibility/potential for favoritism.  Also, that it is easy to start a bailout, and hard to end one.

Let the government chew on this: Pepsico issued $3.3 billion of corporate debt yesterday.  For a company with recession-proof products and a Aa2/A+/AA- balance sheet, for them to pay 4%+ over Treasuries is astounding.  Liquidity?  What liquidity?  If financing needs are outside the A-1/P-1/F1 CP box, there is no help.  Not that there should be help, but the corporate bond market is a truer indicator of our stress than the money markets, which still aren’t in great shape.

Full disclosure: long NUE PRE PEP

I’m traveling, so no significant post this evening.  I would merely point you to the interview with Anna Schwartz suggesting that the Fed is fighting the last war, and is not fighting the solvency crisis, as they consider it a liquidity crisis.

As for me, with the total level of debt in the economy relative to GDP being so high, bear markets in credit should persist until that ratio is significantly reduced.  I am not a bull here on credit.  Focus on companies that can survive without external financing for three years.

I have made changes to my portfolio that reflect this.  More on that in the next few days.

I have not done well in the markets for the last six weeks.  Here is why:

  • Overweight in Life Insurers.  Yes, they are in better shape than the banks, but that only means they got hit later, not that they would not get hit.
  • Too much economic sensitivity.  I felt that global demand would hold up better than US demand, but that only means they got hit later, not that they would not get hit.
  • I suspect that hedge funds have been blowing out my positions.

I’ve ben talking about stock survivability lately.  What does that mean?

  • Low levels of short-term debt.  Few major debt maturities coming in the next three years.
  • Low levels of total debt relative to tangible capital.
  • Still earning money and producing free cash flow, even in a tough environment.
  • If a company is cyclical, it has slack assets, particularly cash equivalents.  High current and quick ratios.
  • If not a financial, trading at a historically low price to sales ratio.  If a financial, trading at a historically low price to book ratio.
  • Good accounting quality and corporate governance.
  • A leader in their industry.  It would be difficult to lose them.

With a little work on my side, I came up with 80+ names to consider, that I think fit the above criteria, mainly:


This is a portfolio that I think will do well even in tough environments.  I will be buying some of them on Monday, and let you know what I did.

I went on a shopping trip today to buy a desk for my two youngest children (10, 6), both girls.  As I drove, I listened to radio C-Span, because it is “guilt week” for the NPR stations in the area.  In hindsight, I would have rather listened to the begging from the NPR affiliates than what I heard on C-Span.

The program that I heard was hearings on the financial crisis.  All of the testimony fell into the bucket of “not me, there are evil people who tricked us.”  My daughters must have found my negative commentary to be funny.

We have the government that we deserve.  Congress listens to self-interested loonies, rather than seek out those with intelligence that don’t have an axe to grind.  When I wrote the pieces, Blame Game, and Blame Game, Redux, what I tried to express is that there are a lot of parties to blame in our current crisis, and that everyone should ‘fess up their culpability.

With that, I want to add on a few more responsible parties:

29) FICO srcoring enabled loan underwriting to decouple from the local bank investigating the character of the borrower.  There is something lost when the underwriter does not explore the qualitative aspects of the borrower.

30) The fools who wrote that said that it is easy to make money in stocks or real estate.  They always show up near the end of the cycle.

31) Dojo suggests the Prime Brokers — How about the Prime Brokerage business model followed by most banks and investment banks which allowed their speculative clients to go “nuclear” in any marketplace as long as they had a credit facility and a cell phone. A $10 million hedge fund run out of a basement in Westchester County NY or Orange County CA could control $1 Billion worth of goodies in many cases. Yikes!! A bit severe, but there is some validity there.

32) dlr suggests the FDIC — The bank regulators at the FDIC. It was their JOB to maintain oversight of the banking industry. Every regulator who allowed the banks they were monitoring to giving liar loans, or pick a rate loans, or zero down payment loans, and didn’t call a halt, should be fired for malfeasance. The regulators who had oversight of Washington Mutual and Indy Mac should be fired. And their BOSSES should be fired. Right up to Shiela [sic] Blair. I think that all of the banking regulators deserve blame here, plus the Bush administration, who encouraged malign neglect.

My main point is this: if you are defending your core constituency in this crisis, you are at least partially wrong.  There are so many culpable parties, that few are blameless.

Final note: in many ways, this is a proper comeuppance to US policy that encourages home ownership.  Policy was trying to push home ownership to 70%+, when reality should have said “be happy with a stable 60%.”  Home ownership is not an unmitigated good.  Many cannot truly afford it, and the government tricks them into buying what they cannot afford with reasonable probability.

There was a great hoo-hah made in the ’90s and early 2000s over the grand importance of having an independent central bank, one that the politicians could not mold to their own ends.  This was largely during the Greenspan era, where the party line was independence, but Greenspan did what the administration wanted, no matter who was president.  Volcker was a better example of what an independent central banker was like, and as such, he was shown the door by Reagan.  Much as I liked Reagan, we would have been better off with Volcker, and better off with someone other than Greenspan.  (Ron Paul for Fed Chairman, baby. 😉 )

I could talk about the social or political aspects of the Fed that makes it less independent of the Government:

  • They have worked together in other roles.
  • They are grateful for their cushy sinecures.
  • The Fed has a too-large employment base that they don’t want to draw attention to.
  • There is an aspect of mutual back-scratching.
  • No one wants to take abuse from Congress or the Treasury.  Best to go with the flow.
  • News coverage always favors loose monetary/credit policy in the short run.

But I’m going to take another approach tonight, one that is more data-driven.  Here’s chart number one of the asset side of the Fed’s balance sheet:

My, but look at how Treasuries owned by the Fed and not sold to them by the Treasury have disappeared.  The most common asset (maroon) has disappeared, and has actually gone negative.  Here’s a simpler version of the graph:

Without the Treasury selling the Fed Treasury securities, the Fed would have run out of Treasuries with which to support its market intervention programs.  They are economically dependent on the Treasury.  That may have impact on their future decisions, not that the Treasury would want to ruin the Central Bank, after all they take care of the extra-constitutional stuff that the Treasury can’t.  Besides, it allows the Treasury to finance the government cheaply by issuing the Treasuries to the Fed.  The relationship is symbiotic.  What could be happier?

I’ve made the comment before that we are heading down the path of Japan with a few differences.  The differences are summarized in my pieces Liquidity for the Government and no Liquidity for Anyone Else, and Inflation for Goods Prices, Attempted Inflation for Housing-Related Assets, but Sorry, No Inflation for Wages.

Where we vary from Japan’s path of quantitative easing is that the money created from government credit in Japan was pumped into the banking system as a whole. In the US, it is pumped into the Fed’s plans to fix various lending markets. This article from The Economist has a good discussion of the similarities and differences.  Whether that will result in fixing those markets, or result in the Government/Fed becoming the one sole counterparty for those “markets” (with a difficult disentanglement) remains to be seen.

In a financial crisis, there are no good solutions.  The good solutions existed 7-20 years ago when orthodox central banking was replaced with tinkering, through oversupply of liquidity in minor problems that should not be called crises, which allowed investors to build up the level of leverage, because the Fed always came to the rescue.  Also, many Fed Chairmen of the past (in the 50s, 60s, and Volcker) stood up to the Adminstration and Congress, and did not enable their policies.  The economy was healthier as a result in the intermediate-term.

I’ve also said that Fed policy works through stimulating healthy parts of the economy, and that pulls the sick parts of the economy out eventually.  Well, because of the overleverage of the past, there are no healthy parts of the economy to work with.  I wish I could be more optimistic here, but given the path that the government is taking, I see the explicit debt of the US Government going to 100%+ of GDP before the system stabilizes, just in time to leave us overleveraged for our entitlements crisis.  At least the debt is denominated in US dollars. 🙁  How long will our lenders continue to honor that?

We face painful choices over the next 20 years partly as a result of the policies of the last 20 years.  20 years of pain… hmm… that sounds like Japan as well.  Let’s pray for a better outcome.

It is an interesting academic question for Dr. Bernanke.  “Perhaps we should consider asset prices in our monetary policy after all?”  Nice to be considering that idea now, when it is too late.  The Fed has toyed with the idea in the past, often obliquely through the wealth effect, and how asset price inflation affects the creation of credit in banks.  Consider this post from RealMoney:

David Merkel
The Media Overstated Greenspan’s Point
8/26/2005 1:36 PM EDT

Tony, you probably have more experience than me in this, so if you disagree after I write this, I defer to you.

I’m not sure the media didn’t get Greenspan’s point, but merely cast it in the most sensationalistic way. That the FOMC uses asset prices in making decisions is nothing new; the 1999 transcripts indicated how they used them with respect to the wealth effect.

Secondarily, though they haven’t stated it as plainly, when asset markets have an effect on depositary institutions, the Fed has a responsibility to protect the depositary institutions; the only real debate is whether it should be done through regulatory or monetary policy means. Cramer prefers regulatory means (boost regulatory capital held against risky loans), and I would agree, except that the Fed for political reasons doesn’t like to hold a smoking gun. That’s why they didn’t raise margin rates during the Nasdaq bubble, and why they are conducting a very quiet campaign through the bank examination process to put the fear of God into bank CEOs.

Where the media errs is that the FOMC would focus on assets solely. It’s just one criterion among many for a FOMC that has been notably elastic in their decision-making process (and monetary policy) during Greenspan’s tenure.

Partly, I see Greenspan’s comments as partly about the past to the present, but also pointing the way he would go in the future, if he had the opportunity. That said, barring unusual circumstances (i.e. a dilatory President Bush) he only has three FOMC meetings remaining … what Greenspan thinks about the future conduct of monetary policy is irrelevant, if the new Fed chairman thinks differently.

Position: None, but all of the likely successors to Greenspan worry me, and that is saying a lot…

I’ve argued in the past that both asset and goods/services price inflation should influence monetary policy.  I’m no great fan of fiat money, but if you are going to have fiat money, you must regulate the growth and nature of credit in order to make the system work in the longer-run.  Better we should move to a gold standard (after the crisis) or something like it.

Get the government out of the money and credit business.  They have not done well at it.  We would have more recessions/panics, but they would be shorter and sharper, but much easier for the system as a whole to recover from.  Under a gold standard, we could not build up the kind of leverage that we have done now, or at the Great Depression.

So, Professor Bernanke, that’s a really interesting academic point about asset prices and monetary policy, but there are no bubbles to avoid now, and it is not possible to reflate a bubble, short of massive monetary inflation, leading to price inflation of real assets.  Monetary policy works through stimulating healthy sectors of the economy; unhealthy sectors face credit spreads so large that moves by the Fed are useless, unless they themselves lend to or buy bad debt from the damaged sectors, with losses getting washed to taxpayers through reduced/negative seniorage.

And, if I may say it plainly… I think the governments and central banks of the developed world are going to find out that they are smaller than the size of the credit problems, which will lead to:

  • A severe credit-driven recession, and/or,
  • Significant socialization of the financial system (much more than what has been done so far), and/or
  • Insolvency of several major developed country governments.

The problems of excess leverage can be shifted, but they can’t be eliminated by government action.  I am repositioning my portfolio into companies that can survive the worst (hopefully), largely because I don’t think the present government policies will work in the intermediate-term.

Just a brief note on corporate bonds.  When I was a corporate bond manager 2001-2003, I learned a lot about inverted curves.  It was a tough time.  But what kind of inversion am I talking about?

Ordinarily, when there is little doubt over the creditworthiness of a company, the amount of incremental yield over Treasuries (spread) rises with the length of the security.  This is normal, leaving aside times when the yield curve is flat or inverted, because usually, the risk of default rises with time with even the best securities, because the future is less certain than the present.

The second stage is an inverted spread curve for a given company, which given a positively sloped Treasury yield curve, might leave the corporate yield curve positively sloped, but less so than Treasuries.  This indicates moderate worry over the credit risk of the company in question.  (Note: during a time of credit stress, the Treasury curve is almost always positively sloped, as the Fed tends to loosen during times of credit stress.)

Next is an inverted yield curve, where short term yields are moderately higher than long term yields.  This indicates significant worry over the credit risk of the company.

Finally, there is an inverted dollar (price) curve for the company.  This is where default is viewed as a likelihood.  The prices of the longest-dated bonds reflect current estimated recovery levels after default.  Short-dated bonds may trade near par. (Par: usually $100, also usually the amount of principal remaining to be received.)

This is a qualitative/quantitative way of thinking about the corporate bond market during a time of credit stress.  What percentage of the market falls into each bucket?

  • Not inverted
  • Inverted spread curve
  • Inverted yield curve
  • Inverted dollar price curve
  • In default

The more names in lower categories, the greater the degree of credit stress.  For companies with multiple issues of bonds, it is a simple way of characterizing the market, even in the absence of rating agencies.  (As a closing aside, equity implied volatility tends to rise as a company goes down the list.)

Wait, that’s not quite a close, and not an aside.  That is another way to lookat corporate bonds.  As the implied volatility of the equity gets higher, the more they migrate down the list.  Remember, leaving aside bank loans, usually only stable companies issue corporate debt.  As their prospects get less certain, implied volatility of the equity rises, and their debt moves down the list.

After reading jck’s piece Securitization: Not Guilty, I said to myself, “well said.” He cited a study that showed that misaligned incentives were more to blame than secutritization itself.  (Academic paper here.)  And he cited this clever piece from the seemingly erstwhile blog Going Private.

Here’s my view.  I have lived through the first era of securitization, and I always thought that the equity/originator got off too easily.  They got their money out of the transaction too quickly, allowing themselves to profit if the deal survived for a while, and then died.  The equity of the deal should take the largest risks, rather than the subordinate certificates (most junior aside from equity).

Here’s my solution.  Require that the deal sponsor and originators retain the full equity piece, and that the size be regulated to make it significant.  Further require that the equity is a zero interest tranche, where the excess interest builds up to protect the subordinate securities.  They get paid last out of any residual cash flows of the deal.  The size of the equity piece might vary from 1% of principal on credit card, auto and stranded cost ABS, to 10% on CDOs.  Note that the equity pieces cannot be traded here, they must be owned by the sponsors or originators.

Now, if the equity only gets paid at the end, several things occur:

  • Sponsors/Originators have to be well capitalized.
  • They will be a lot more careful about credit selection, and not accept high-interest risky borrowers.
  • The subordinate certificates will get paid less interest, but with more certainty.

Does this change the nature of securitization?  Yes, and in a good way.  Securitization is useful, but in its initial phases, it suffered from the equity not having enough at risk.  My proposal solves that.  Put the equity at the back of the cash flow bus, such that the originator never makes a gain on sale, and that part of the financial system will be sound once again.

Ordinarily, when I sit down top blog, I know what I want to write.  That’s not true now.  Yes, I could do a few book reviews.  I have six books read, and ready to go, but given the volatility of the markets, I feel I have to say something about the current activity.

I am a strong believer that there are few free lunches.  If there are simple policies that will easily produce prosperity, they would likely have been done by now.

As I have commented before, what we are seeing now is a shift in debt from the banks to the government.  Banks get capital, the government gets debt, and the money for the debt comes from three places: taxpayers, foreign lenders (central banks, probably) and perhaps at some point, the Federal Reserve could buy it (whether they monetize it or not is another question).  As jck noted yesterday, this has led to a selloff in Treasuries.  (Interesting that it happened on a day when the cash markets were closed, but the futures markets were open.  The reaction of cash bond market today is similar to that which the futures market exprerienced yesterday.)

Which brings me to my first point.  Today, when the rally in the fixed income markets gets reported (the markets again, were closed yesterday, you will likely hear that spreads rallied sharply.  But watch for the discussion of yields and prices (if there is any).  It’s quite possible that yields rise from Friday to the close of business today.

Second point, today $250 billion of the $700 billion got used on nine big/critical banks.  Now, this may have been somewhat coercive to some of the nine banks; as was said at Bloomberg:

None of banks getting government money was given a choice about it, said one of the people familiar with the plans. All of the banks involved will have to submit to compensation restrictions, said the person.

The government will also guarantee the banks’ newly issued senior unsecured debt, making it easier for them to refinance their liabilities, the person said.

Possibly the following message was delivered, “Be a good boy and get in line.  This is good for the nation, and we won’t be around for a decade.  You want to be a survivor, right?  You want friendly regulators when we review the levels at which you are marking your illiquid assets?  We thought so.  Sign here.”  (No surprise that Goldman then applies for a NY State, rather than Federal bank charter.  State regulation, particularly when you are a local champion, is much more flexible.  Just ask AIG. 😉 )

Though this leads to a short-term bounce in bank share prices, the long term effects are less clear, which brings me to my third point.  It’s one thing to bolster their balance sheets.  It is another to get them to lend, particularly in the bear phase of the credit cycle.  Also, as leverage comes down, and it will come down, so will profitability at the investment banks, and probably other banks as well.  Securitization will be less common, eliminating hidden leverage that allowed for less capital.

The same thing is going on in Europe, though they actually think about how they might pay for the bailouts.  In the UK, it pushes the national debt to GDP ratio to 100%.  As it gets closer to 150%, the international debt markets usually start to choke.  We have traded bank credit risk for national solvency risk at the margin.  Maybe that will be different here, if only government creditworthiness is perceived to be safe.  It is a “new era,” right? 🙁

I find it interesting that Barclays is refusing help.  Either the UK regulators aren’t so coercive as those in the US, or Barclays is not as levered as I thought.  Or, it could be hubris on the part of Barclays’ management team.

Even Japan is getting into the act, though these measures seem so weak that I wonder why they would bother.  The government and Bank of Japan stop selling bank shares, and allow companies to buy shares back more aggressively.  That may push share prices up in the short run, but it substitutes debt for equity, which shouldn’t have much of a long-term impact.

On the Central Banking Front

Now, with the seemingly limitless amount of US liquidity being to the short end of the US money markets, you would think that we would get a bigger move than we have gotten so far. This will take time, but watch the yield as well as the spread.  Also remember that LIBOR has become somewhat of a fiction at present.  There many quotes, but not so many loans to validate the quotes.

What is being done that is new?

  • TAF expanded to $900 billion.
  • New commerical paper program where the Fed backstops the A-1/P-1/F1 CP market, including ABCP.  Terms hereFAQ here.  This is big, and it is much easier to start such a program than to end it.  It is difficult to end any program where credit is granted on less than commercial terms.  My guess is that it will be extended past its April 30th, 2009 planned expiry date.
  • Swap agreements allowing unlimited dollar liquidity to foreign entities through agreements with their central banks.
  • The Fed can now pay interest on reserve balances held at the Fed, which allows them to increase their balance sheet significantly.  In one sense, they become the Fed funds market.

What is not new is the idea that all we have to do is restore confidence, and everything will be fine.  No, we have to delever, and the US Gowernment is included in the list of those that need to delever.  There is no national reform going on here, but merely a shifting of obligations from private to public hands.

For investors:

For those that are investors, the biggest bounces tend to occur during depressionary conditions.  I would not get overly excited about the rally yesterday.  As John Authers at the FT points out, given the extreme changes being made, there should have been a bounce.  The question is whether it will persist.  I was a net seller into the rally toward the end of the day.  I think we have more troubles ahead.  Two things to watch:

  • LIBOR, CP yields and the TED spread. (The short end)
  • Overall yields of medium-to-long Treasuries and other long-dated debt.  (The long end.)

I expect yields to rise, even if some spread relationships fall.  The added financing needed by the US government is large.  Let us see where Treasury buyers have interest.

There are elements of this that remind me of my The US Dollar and the Five Stages of Grieving piece. This is for two reasons: first, we are asking foreign entities to hold more dollar claims at a time when they are stuffed full of them.  Second, this phase of the credit crisis reminds me of the “bargaining” phase of the five stages of grieving.  We are past a long denial phase, and the anger continues, but now we bargain that these proposals will allow us to escape the pain that comes from delevering.

I’m skeptical, but I hope that I am wrong, lest we get to the fourth stage “depression,” before we finally reach “acceptance.”  As it is, I am looking for companies with blaance sheets strong enough to survive the worst.  That is my task for the next few days.

Back to the crisis.  I want to be a bull, really.  I read what Barry wrote on 10 bullish signals, and I think, yes that’s what history teaches us.  I have used that for profit in the past.  I even have a few more.

Here’s my knockoff of S&P’s proprietary oscillator:

That’s the lowest reading ever, with statistics going back to 1990.  For more, consider the discounts on closed-end funds — they are lower than ever.  Or, consider that the IPO market is closed.  Or consider that every implied volatility measure under the sun is through the roof in ways that we haven’t seen since 1987.  The yield curve of the US is wide.  Fed policy is accommodative; don’t fight the Fed.  Consider that well-respected value investors like Marty Whitman are finally excited about the market.  Credit spreads are at record highs in the money markets and in the corporate bond markets.  Finally, consider that the lack of insider transactions indicates a potentially bullish situation:

I have a hard time accepting the bullish thesis at this point because of troubles in most of the major banks, and the disappearance of all of the major investment banks.  I have a saying that when you have a major market malfunction, there tend to be many things going screwy at the same time.  I don’t like to say that it is different this time, but rather, we have to be careful whenever there is a significant hint of depressionary conditions.  If that is the case, we should see many abnormalities:

This is a global crisis, affecting most governments and firms.   Our most severe crises, aside from the Great Depression, tended to be local, or limited to just a segment of the world.

Final notes: I warned about this disaster in advance, though I am not as prominent as a George Soros or Jeremy Grantham.   I can dig up the references at RealMoney if necessary.  Last, as in the Great Depression, some moves by the government exacerbated the crisis, that may be true here as well.

With that, I conclude that we are back to the one key question: are we facing a recession or a depression?  If a recession, we should be buying with both hands, but if a depression, there will be better bargains later. At present, given the condition of the banks and the global scope of the problem, I lean toward the depression side of the argument, but I am not totally sold on the idea. There are bright people on both sides of the question. That said, I am not jumping to buy at present, even with many indicators that are favorable. The state of the financial system matters more.