6 December 2008 – The Aleph Blog

A Bold Move from Mr. Heebner

Posted on 6 December 20087 December 2008 by David Merkel

Just a quick note because I am tired, but Ken Heebner has turned bullish on financials.? I’m not there yet, because I think there is more pain to come in losses from benk lending in HELOCs, Credit Cards, Commericial Mortgages, etc.? I am slightly underweight at present with exposure to insurance only.

I admire Ken Heebner a great deal… I think he is early here, unless collateral prices stop declining.? Unlike Ken, I think the actions of our government will prove ineffectual.? Perhaps it would be better to buy the bank loans or senior debt of these firms.? Less downside, and reasonable upside.

Protectionism Pressures

Posted on 6 December 20087 December 2008 by David Merkel

Sometimes I wonder whether there are elements of the economic system that are hard to discern, that lead economic players down a path they want to go on in the short-run, but don’t want to go on in the long-run, but that short-run choices inevitably lead to a bad long-run result.? Another way to say it is that past mistakes were the result of logic that linear thinkers would consider rational even now.

This post derives from MIchael Pettis’ post regarding a post of Dani Rodrik.? Beijing wants to employ many people who are migrating from the farms to the cities, and so it wants to produce more goods that they can export.? To make those goods competitive, they don’t want the Yuan to appreciate.? And over the past week, it has depreciated.

If you want a Keynesian stimulus to work more powerfully, you don’t want its effect to leak out to other nations, and thus, a tendency toward protectionism.? Interventionism begets more interventionism.? Everyone protecting their own interests leads to a collapse of the division of labor, and greater poverty.

No fun, I say, and it will be interesting if the US and China can strike a better deal than protectionism.

We’re All Hedge Funds Now

Posted on 6 December 2008 by David Merkel

With apologies to the recently departed Tanta of Calculated Risk, who said, “We’re all subprime now,” I add that “We’re all hedge funds now.”? After reading this article in the Wall Street Journal, I said, “That logic can justify any action.”? Here’s the critical quotation:

The plan the Treasury is considering would encourage banks to issue new mortgages at lower rates by offering to purchase securities underpinning the loans at a price equivalent to the 4.5% rate.

The Treasury would fund the purchases by issuing Treasury debt at 3%, suggesting the government could make a profit on the difference.

One of the major ways that we got into this crisis is that we had? a large number of parties willing to buy lower quality assets that they levered up their (then) higher quality balance sheets to buy.? Clip a spread and make free money.? The US government may repeat this error.? To make it absurd, why doesn’t the US Government buy every dodgy asset?? It could make money on them, and save money for taxpayers.? Well, the money has to come from somewhere, whether from citizens in the US, or foreigners.? At some level, those lenders revolt, particularly as they realize the the risks being taken by the US government are increasing, and may compromise their credit interests.

The US government is becoming a hedge fund, and we as taxpayers are becoming mutual owners of the beast.? We are all hedge funds now.

The Liquidity Monopoly

Posted on 6 December 2008 by David Merkel

I’ve been racking my brain to think about the bond market, and all that it implies.? I think Treasury securities are a bubble, but that’s a very different sort of bubble than we are accustomed to.? Most bubbles involve risky assets, and are driven by greed.? This bubble involves “safe” assets, and is driven by fear.

During fear, market players seek liquidity.? Liquidity means many things, but in this case it means the ability to reverse direction at low cost, and fast.? Nothing feels truly safe, aside from the most trusted entities in the market, maybe.? Governments, with their taxation authority, assume leading roles, and low funding costs.? Those allied with the governments get low funding costs as well, and everyone else has to suffer.

This is particularly evident now, because of the wide spreads between Treasuries, Investment Grade Corporates, and High Yield Corporates.? Trading volumes are tilted to higher quality securities — Treasuries, Agencies, and those that they guarantee.? Even the Fed expressing willingness to buy Agencies or long Treasuries can produce a real rally in the short run.

Whether well-intentioned or ill-intentioned, the government’s efforts to support areas of the market draw liquidity away from unsupported areas of the market, helping lead to wide credit spreads in the unsupported areas.? Personally, I don’t think it is a help overall; by making a sharp distinction between areas that the government will protect, and those it won’t, it increases the total panic level — better they should not guarantee anything.? Their own life is at enough risk already.

What we are seeing is a liquidity monopoly.? The government, by misguidedly trying to assure liquidity in markets that are under stress, end up replacing the markets as they intervene, and hoard liquidity to themselves.? The result is a lack of liquidity outside of their favored areas.

You’ve heard me say before: bubbles are financing phenomena.? They end when cash flows to finance the bubble are inadequate to carry the assets in the bubble.? But wait — we’re talking about Treasury securities here.? How does this work, because it’s not as if there are a ton of leveraged players here, right?

Well, no.? We do have the T-bill market, and the short stuff is close to zero, or negative.? The repo market implies negative rates on Treasury collateral, though not always.

What is more clear is that an increase in price inflation, or greater currency depreciation would leave a sour taste in the mouths of buyers of Treasury securities.? Real returns would go negative.? It hasn’t happened yet, but the great temptation will eventually be to monetize the new debts that our government cannot afford to pay back.

In closing, some articles:

Start with the eminent James Grant, who no one is laughing at any more.? With Treasuries, we no longer have risk-free return, we have return-free risk.? (Also, Henry Blodget at Clusterstock.)
This is not just a US phenomenon — it is happening to long government rates in many developed nations.
We have the Fed buying short Agency notes.? (And Bloomberg.)

The government may think that it is aiding market liquidity, but by providing guarantees, it is absorbing liquidity, and starving the markets that it does not guarantee.? Thanks for nothing, you are doing more harm than good.