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.

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:

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.

Time for another break from “All crisis, all of the time.”  I have long been fascinated by momentum anomalies, and this is an initial attempt to under stand them better.  My contentions have been that:

  • Sharp moves mean-revert, gradual moves persist.
  • In the short-run momentum persists, in the intermediate-term, it mean-reverts, and in the long-run, oddly, it persists.

Let’s see how well my default views stack up against the evidence.  I used Professor Shiller’s augmented S&P 500 data from 1871 to mid-2008 to ask the following question: given the performance of the last year and the last month, what can that tell us about the likely returns for the next year and next month?

I divided performance into ten deciles for the past year and the past month.  Here are the monthly and annual returns by decile:

For purposes of completeness, I also calculated the number of observations by decile:

Note the correlation.  The main diagonal elements support the idea that monthly and yearly returns are correlated.  Not too surprising.

Returns Over the Next Year

So, how do returns over the next year relate to returns over the last month and year?

Okay, the R-squared is low on this calculation, but the drift from the regression is that there is mean reversion from the past year’s return, and momentum from the monthly returns.  Oddly, some of the worst return occurred when yearly returns were pretty average.

Returns Over the Next Month

So, how do returns over the next month relate to returns over the last month and year?

The R-squared is a little better here, and the main result is that the past year’s returns do not impact the next month’s returns much, but the past month’s returns do.  There may be some evidence for when monthly momentum is strong, if annual momentum is strongly positive or negative, there will be outperformance.

So, what do I conclude here?

  • Monthly momentum persists over the next month and year.
  • Annual momentum might persist over the next month, and with a lesser tendency might revert over the next year.

One constant I have observed in financial economics: mean-reversion exists, but the tendency is weak.

PS — where are we now?  Lowest deciles for both monthly and annual returns, which indicates bad performance for the next month , but good performance for the next year.  Buckle in, it will be volatile.

Yesterday, I was contacted by UrbanDigs, one of my regular readers, and he asked:

UrbanDigs Says:

December 3rd, 20087:10 pm at Edit

David, Can you please email me, its provided on this comment.

I would like your opinion on an alternative to stimulate housing instead of the govt meddling with rates to 4.5% and buying up loans from GSE’s..

Its such a bad idea and they are digging this country into a debt ridden hole.

Why not tweak the tax code for investors from a 1031 deferrement to a 5 YR qualification primary residence like exemption?

http://www.urbandigs.com/2008/12/instead_of_meddline_w_rates_wh.html

GRANT THE PRIMARY TAX CAPITAL GAINS EXEMPTION BENEFIT TO INVESTORS AND CHANGE THE QUALIFICATION TERMS SO THAT THE PROPERTY PURCHASED BY THE INVESTOR MUST BE HELD FOR A MINIMUM PERIOD OF 5 YEARS

Thoughts? As an alternative to help the hoousing supply problem without the unintended consequences of govt meddling, moral hazard, taking on more risky assets, and trying to convince people to buy for the wrong reasons, like 4.5% rates.

Okay, here are my thoughts:

1) Regarding taxation, my view is that all income should be taxed equally and regularly.  I’m not generally in favor of deferring or exempting taxes on asset classes of any sort.

2) The Federal Reserve is buying up mortgage assets.  Now the Treasury is thinking of subsidizing mortgage rates.  Don’t we do enough in the US to overinvest in housing?

Call me a skeptic here.  In credit crunches, the value of the collateral is far more important than the rate charged.  I care more as a lender about the return of my money, than the return on my money.  Lending to entities where the loan-to-value is high is fraught with peril.  Losses occur with little regard for the interest rates charged.  Life events matter more: death, disaster, disability, divorce, and dismissal from employment.  Negative life events cause borrowers to choke on interest payments when refinancing is impossible.

Lowering the mortgage rate to 4.5% will subsidize borrowers who can refinance through conventional mortgages, but will do little good elsewhere.  The subsidy will also add to the financing needs of the US Treasury, which is getting stretched.

The efforts of the Fed and Treasury may lower mortgage rates for a time, but as the government borrows more, there will be pressure for rates to rise.  For now, it may seemingly work, but it will eventually fail, and the outcome will be worse than if they hadn’t acted.

So I’m not crazy about government action here.  Why should we risk the credit of the Republic over homeowners?  Let real estate prices find their levels where ordinary people con afford ordinary homes without incurring a boatload of debt.

I will admit to being unimpressed when the NBER came out and declared that we have been in a recession since last December.  There are two reasons for that:

  • I don’t think the question of being in a recession or not is important.  I would rather spend time analyzing industry prospects, because often the effects differ across sectors and industries.
  • I would rather see them give us a quicker result, and then adjust it if they prove wrong.  Personally, I don’t buy the idea that if they declare a recession, that it will push us into a recession.  The average person doesn’t care all that much about what economists say — they look at their own prospects.

So, while I was driving on Tuesday, I happened to hear this piece from Dave Ross of CBS Radio twice.  The local affiliate, WTOP, usually only plays it once, but they liked this one so much that they played it a couple of times.  I don’t normally do multimedia — I prefer reading, because you can get information faster than through audio or video, so this is a rare case where I link to an audio file.

DAVE ROSS: Flash — it’s a recession!

Maybe the government should outsource the whole thing to ECRI, which has an admirable record in predicting the business cycle, and with better timing.  As it is, they are projecting a deep recession, and we should listen.  They are rarely wrong.

I listen to ECRI.  I don’t listen to the NBER.  Dave Ross, he’s a funny guy.

I voted for a third-party candidate for President this year.  Aside from voting for Bob Casey, Sr. for governor back when I lived in Pennsylvania, that is unusual for someone who has generally voted Republican.  Though I am generally a libertarian on economics and a conservative on social issues, I try to stay flexible enough that I can appreciate where each side of the political spectrum is coming from.  Even as I write about economic policy, I write on two levels:

  • Optimal policy (usually non-interventionist, or correcting mistaken prior interventions)
  • Okay, since optimal isn’t on the table, what’s the best you can do if you are going to meddle?

So, I heard our president-elect on the radio today, and my friends that I met with mentioned what they heard as well.  When he spoke to the Conference of Governors, he said in closing:

Now, let me just wrap up by saying this. I know these are difficult times. I don’t think anybody here is viewing the situation through rose-colored glasses. We’re going to have to make some hard choices in the months ahead about how to invest these tax dollars. We’re going to have to make hard choices like the ones that you’re making right now in your state capitols, we’re going to have to make in Washington.

And we are not, as a nation, going to be able to just keep on printing money. So at some point, we’re also going to have to make some long-term decisions in terms of fiscal responsibility. And not all of those choices are going to be popular.

But what I can promise you is this. That I’m going listen to you. I’m going to seek your counsel. And, by the way, I’m going listen to you especially when we disagree because one of the things that has served me well at least in my career is discovering that I don’t know everything. And all of you, I think, are going to be extraordinarily important in keeping us on track, not allowing Joe and myself to get infected with Washingtonitis, and to constantly be reminded of the realities that are happening to folks back home.


If he wants me to think that he has a head on his shoulders (not required in politics), he has made a good start.  Yes, we can’t make our way out this situation by printing money, or borrowing money.  My view is that we will only get out of this mess as overall debt levels are reduced to around 1.5x GDP, and ordinary lending to high quality borrowers begins again.  It will be a smaller financial sector, but a more stable one.

Two asides:

1) I suggested that the US Government lock in long term yields with a century bond.  Now the head of BlackRock, formerly the guy who formerly eliminated the 30-year, agrees.  Hey, I admire intellectual flexibility.  That takes humility.

2) Yes, others have noticed the move in the Yuan.  This is a worry.  If China wants to compound their own adjustment problems, and finance the US Treasury at the same time, that is a way to do it.

1) What a mess.  I had been lightening up on equity exposure over the last week, but seemingly not enough.  The last three months have been hard for me, with my performance trailing the S&P 500 in each of the last three months.  Well, at least I admit it when I lose; let’s see if I can’t do better in the future.

2) The rally in long Treasuries is the cousin to the fall in equities.

A $4 move in the long bond would be significant enough — that is a top 5 move, but the shocker is seeing the 30-year yield near 3.20%.  That should lead to lower mortgage yields, refinancing, and perhaps, lower rates in the short run.  The long run is another matter.

3) Part of this came from Bernanke’s comments that the Fed would buy Treasuries.  If I may, what isn’t the Fed going to buy?  Do they really want to flatten the yield curve when the long end is this low already?  Don’t they have enough to do with instruments that have credit risk?  They can flatten the Treasury curve, but the corporate yield curve is out of their reach for now.

4) One example of that is the junk bond market, where the average yield is now over 20%.  Areas where the government does not guarantee see little liquidity, because government guarantees in other areas help siphon liquidity away.

5)  So I’m not impressed with the FDIC insured bond offerings from a public policy standpoint.  They crowd out non-guaranteed bonds.  But I would be inclined to buy the bonds in place of allocations to Treasuries or Agencies.

6) TIPS, excluding the long end, are trading below par.

Also, the on-the-run securities are trading at a premium, because their inflation factors are close to 1 because they are young securities.  The inflation factors can’t go below 1, but older securities can see more past inflation erased, should we get a period of sustained deflation.  I don’t see that coming over the intermediate-term, but in the short-term we could see that.  Eventually the Fed will have to monetize many of the promises that it is making.

7) Perhaps we need another means of calculating how bad it is for non-guaranteed areas of the market, like A2/P2 CP.  That is a true horror.  I remember criticizing those investing in levered nonprime CP back when I was writing for RealMoney, but most of those investors are dead or gone now.  My measure of credit stress, the 2-year Treasury less A2/P2 yields, is at a new record.

8 ) It is no surprise here that GM is scrambling, as are the other automakers.  Let them try to get debtors to compromise.   They will try to get the PBGC to take on the pension liabilities in foreclosure, though that may not be so easy.  They have refused to accept some liabilities in the past.

9) I was an early critic of reverse auctions organized by the US Treasury, largely because of the complexity involved.  I guess it took Paulson longer to realize the immensity of setting up those auctions.  It’s not as if the problem is unsolvable, but it would take a lot of work, and the payoff at the end is uncertain.

10) Is anyone else concerned that the Yuan is falling relative to the US Dollar? This graph gives the history since they “floated” the Yuan.  (Note the dirty float free market-like movements. 😉 )

Granted, it is a large-ish 2-day blip, but for the global economy to heal, we need China to begin to use the large surpluses that they have built up, buy abroad, and build up their domestic markets.

It would be a simple matter of fairness as well.  As it is, the surpluses in the government’s hands fuel a bloated financial system and inflation, which could be partially solved by importing more goods for their citizens to buy.

11) It’s my view that the economics profession comes out of this crisis with a black eye or two.  There is a lot of room for humility here.  Neoclassical economics does a lousy job of understanding how the real economy (goods and services) interacts with the financial economy (stocks, bonds, etc.).  That is a strength of the Austrian school, though.

Even on a microeconomic basis, periods of stress like this can make one question some of the theorems of Modigliani and Miller.  The way that assets are financed does make a difference when there is financial stress, and even more in insolvency.  Also, the financing windows are not always open.  Theories that rely on markets remaining open and liquid, such as many arbitrage-type arguments are not valid except when the market has “fair weather.”

12) There is no shortage of liquidity for the US Treasury, which takes that liquidity, gives T-bills to the Fed, which uses them to replace bail out specific lending markets, and downgrade the quality of their balance sheet buy up securities where liquidity is temporarily in short supply.  Personally, I don’t think it will work.  It is much easier to get into a market than to get out, particularly if you are a large player with no profit motive.  Three last semi-related articles that I found interesting:

T-bills are in high demand, perhaps the government should take advantage of it and issue a lot of them.  There are some dangers though:

a) This could be what finally does in the dollar.
b) The US debt maturity structure has been shortening of late — I wouldn’t want it to get too short, or we could face rollover risk, as Mexico did in 1994.

It might be better for the US Government to lock in long funding rates while they are available.  Who thought the 10-year or 30-year could be so low?