Ten Aspects of Our Current Market Troubles

1) One of the unwritten rules of the corporate bond market is avoid the sector that has been the biggest issuer lately.  Underwriting and credit quality get sloppy in any sector that issues a lot of debt.  It would be a salutary warning for telecom bonds in 2000 and financials in the mid-2000s.  Even though they are not  corporates, the same would apply to mortgage bonds near the end of the real estate boom.  The little bit of extra spread would not be worth it.

Well, what if a sector is expanding rapidly, and there is no incremental spread?  Again, not a corporate sector, but that describes our dear Government today.  We talked about “crowding out” in early 80s, but it never truly materialized.  It is probably not happening now either.  Most corporations that want to borrow can’t, and those that can don’t want to.

All the same, outside of TIPS, I don’t see a lot of value in Treasuries at present.

2) Note to the Fed: if you want to keep mortgage rates low, buy mortgage bonds, not Treasuries.  The cost of that is that the Fed would bear some risk if Fannie of Freddie went down.  But Fannie, Freddie, and the Fed have one unified balance sheet given that the Federal Government is behind all of them.

3) But, is it desirable that banks lend at this point?  It might be better for them to restore their balance sheets, battered from the sloppy underwriting of the boom years.  Then they could once again lend soundly.

It makes little sense to try to force debt onto the US consumer who is largely overleveraged.  So why try to prompt banks to lend?  This applies to my mutual bank idea as well.  Do we really need more aggregate lending when the economy as a whole remains overlevered?

4) We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.”

So said Mr. Luo, a director-general at the China Banking Regulatory Commission.  I’ve been saying for a long time that China is stuck, and that we are their problem, and not vice-versa.  There may come a point where they stop buying US Dollar-denominated debt, and let existing debt mature, but that will come after a shift in their own economy where they are no longer driven bythe promotion of their exports.  There aren’t many large good alternatives to US debt for parking the proceeds from exporting aggressively.

5) In a downdraft, pockets of hidden leverage get revealed.  Consider the states of the US.  With the declining economy, revenues from real estate taxes decline, as do capital gains and wage taxes.  Budgets of 46 of the states are facing significant deficits.  Governments got to used to capital gains taxes, rising wages, rising property assessments, and high turnover of property.  Now those are gone.   Rainy day funds were not established at necessary levels and were drained too early.

6) In a downdraft, pockets of hidden leverage get revealed.  Consider the Ponzi schemes that have come to light: Madoff, Stanford (it seems), and a small number of smaller Ponzis.  Why revealed now?  During a boom period liquidity is superadequate; most investors don’t face a need to call for cash.  Investors are happy to receive highish stable rates of return that come with seeming safety.  During the bust period many need cash, and the frauds are revealed for what they are.  Ponzi schemes are mini-bubbles; they pop when the call on cash is too great, if aren’t discovered as frauds during their growth phase.

7) In a downdraft, pockets of hidden leverage get revealed. Prime brokerage is very profitable to investment banks, but even they have to do risk control in a tough environment.  Hedge funds with better risk control get more leverage, those with worse risk control get less.  As I have said before, hedge funds aren’t the most stable vehicles in a downdraft.  They are reliant on the good graces of their prime brokers and the patience of their limited partners.

8 ) In a downdraft, pockets of hidden leverage get revealed. While housing prices kept rising, aided by increasing buying power facilitated by poorly underwritten loans, the mortgage insurers happily clipped profits; their greatest worry was the banks eating their business through second lien loans.  Most of the banks that did a lot of that financing have gotten whacked.  The mortagage insurers had somewhat more flexibility in their balance sheets, but if present loss rates continue for the next two years, many of their operating insurance subsidiaries will need to file a plan to remedy their impaired balance sheets.

9) In a downdraft, pockets of hidden leverage get revealed. (Sorry, last one.)  Just as Iceland was a harbinger of global weakness, and especially to the UK, might Eastern Europe prove to be that for Western Europe, and particularly Austria?  (Also here and here.)  Many Western European banks are exposed to Eastern European creditworthiness.  Some individual borrowers in Eastern Europe have mortgages denominated in Swiss Francs or Euros.

I’ve seen situations like that before, and sometimes I call it a currency vise.  It works well for a time during the boom phase, but then weaker currencies get trashed during the bust phase.  It simultaneously makes it more difficult to service the debt in the newly expensive hard currency, and the lender isn’t better off either — he now faces credit problems.

10) I’ve done many pieces on hidden credit problems inside ETFs and ETNs.  After my last piece, a reader asked if I would do a survey article on the problems.  Sorry, no survey article, but I can summarize them all for you here.

  • Exchange Traded Notes [ETNs] carry the risk that their sponsor will default.  They are unsecured obligations of a bank, but they have done some sort of hedge to provide the ETN buyer with a certain return so long as their bank is solvent.  For the bank, it is a sweet deal, because to them it is cheap funding.
  • Leveraged funds carry two risks.  The first is that any swap counterparties that the fund deals with goes bust.  The second is the money market instruments / cash equivalents behind the derivatives in these funds don’t prove good.  Granted, it is hard to lose in the money markets, but choose your credits with care.  Lehman went down pretty quickly.
  • Then there is the risk that a counterparty could go bust in a currency fund, as in the last article that I wrote.

ETFs and ETNs are great new  products that increase the scope that an investor can pursue.  Just be aware that in some funds there can be credit risk — with currencies, commodities, leveraged funds, and ETNs.