March 2009 – Page 3 – The Aleph Blog

Unstable Value Funds? (IV)

Posted on 7 March 20098 March 2009 by David Merkel

This should be my last post on this topic for a while.? I thank those that sent me additional data that agreed with my theses in the piece Unstable Value Funds? (III).? I would like to start by quoting from my piece at RealMoney The Biggest Asset Class You Never Heard Of.

The bonds held in stable value funds can’t be valued at book value, because accounting rules require that they be held at market. The stable value pool goes out and purchases derivatives known as wrap agreements in order to allow the bonds to be held at book value. The wrap agreements agree to pay or receive money if any of the bonds have to be liquidated at a loss or gain respectively, thus making the fund whole for any book-value loss.

Typically, wrap agreements are only done on the highest-rated bonds, AAA, so credit risk is not covered by most wrap agreements. With most wrap agreements, once a payment is received or made by the wrapper, the wrapper enters into a countervailing transaction with the pool to pay or receive, respectively, a stream of payments over the life of the bond that was wrapped equal to the present value of the initial payment when the bond was tapped. The wrapper bears almost no risk in the arrangement; the risks are rated back to the stable value pool, and the stable value pool pays for the gains and losses through an adjustment to the pool’s credited rate. Because wrappers bear almost no risk, wrap pricing in 401(k)-type plans is typically 0.05%-0.10% per year of assets wrapped. The only risk a wrapper faces is that the interest-rate-related losses on a bond in a rising interest rate scenario are so severe that the losses can’t be repaid out of the yield of the wrapped bond. In this case, the wrapper would have to pay without reimbursement.

Interest Rate Risks

Stable value funds attempt to maintain a stable share price, but the assets underlying the fund vary as interest rates, prepayment behavior and credit spreads change. There is almost always a difference between the book value of the assets, expressed by the NAV, and the market value. When the stable value fund has a higher market value than book value, typically it pays an above-market yield. There is a risk that in an environment where interest rates have risen sharply, a stable value fund would have a lower market value than book value, with a below-market yield. In a situation like this, particularly when the yield curve inverts, there is a risk that shareholders in the stable value fund will leave in search of higher yields. If that happens to a high degree, it will worsen the gap between the market value and book value of assets. That gap will be covered by the wrappers in the short run but will reduce the fund’s yield as it pays the wrappers back. It is unlikely but possible to get a death spiral here if more and more shareholders leave the pool and the yield sags to zero. It hasn’t happened yet, so this is theoretical for now. In theory, the wrappers would keep paying once the fund’s credited rate dropped to zero, so no one would lose money unless a wrapper defaulted on his obligation. There probably would be some legal wrangling in such an event; the wrappers might try to get the fund manager to take on some of the liability, or negotiate down the amount owed, leaving policyholders with a loss. In 401(k) plans, there are limitations on transferring funds out of a stable value fund to funds that would offer an easy arbitrage, so the risk of a death spiral is further reduced but not eliminated.

Asset Default Risks

For the most part, stable value funds take little credit risk, but it’s little known that this is not universally true. Some of these funds buy corporate bonds or other, more riskily structured product bonds. Some of them take credit risk in hidden ways. For example, there are some exotic, asset- or commercial-mortgage-backed interest-only bonds that are rated AAA by the rating agencies. The agencies rate them AAA because they can’t lose principal; they have no principal to lose. But if the loans underlying the interest-only bonds default or prepay, the interest stream gets shortened. The sensitivity on these securities to default risk is more akin to BB or BBB bonds, but a manager using them can count them as AAA. If an asset in a stable value fund defaults, the fund probably will temporarily suspend withdrawals while the managers pursue one or two courses of action. If the loss is small, its managers might buy a wrap contract for the loss, which will give a haircut to the yield on the stable value fund for the life of the wrap contract. If the loss is big, they will reduce the NAV and attempt to keep the NAV stable from there. Given the history of money market funds breaking the buck, it is possible that the fund manager might pony up the funds to make the stable value fund whole, but I wouldn’t rely on that.

I want to publicly thank Chris Tobe for writing to me.? He brought me back up to speed on some aspects of stable value that I was not in touch with.? (Any errors here are mine, not his.)? After reading what he sent me, there are two major risks.? One I have described in-depth: credit risk.? The other I described in my RealMoney piece: wrapper risk.

When the market value of assets is lower than the book value of assets, the wrapper covers the difference when withdrawals are made.? But the difference typically gets amortized into the credited rate of the stable value fund, lowering the interest rate credited to pay back the wrapper.

But what if the interest rate were forced to zero?? Then the wrapper would take losses.? Investors take losses is if the wrapper is insolvent when book value is more than market value.? The stable value fund could try to replace the wrapper, but it will come out of the hides of investors, unless the management company bears it.

There aren’t many wrappers today.? Here’s a list:

JP Morgan
State Street
RBC
CDC
AEGON
ING
Pacific Life
AIG (few buying from them)
Rabobank (not accepting new business)

As such, with the current financial stress, wrap fees have doubled.? There is more need for wrap capacity than is currently available.? There is the potential for losses as wrappers could go into insolvency.

But how big is this problem for investors?? The stable value marketplace is very big, though the severity of any loss should be small — under 10% of capital on average (some could be worse than 10%).

There are two troubles here.? First, because the stable value industry does not reveal the market value of their assets under management.? The opaqueness adds to the mystery.? Second, because the stable value funds have more accounting flexibility than most investment options, they can wait much longer than a money maket fund, which must declare a credit event if the NAV of the MMF is under 99.5%.? There is not such a threshold for a stable value fund.? The risk is that a stable value fund engages in wishful thinking, assuming that the value of their bonds will rebound, and the rebound does not happen.

Is a loss of 5% horrible, in an investment that is supposed to be safe?? How about 10%?? 20%?? I can’t go over 20%, the fund managers must act by then.

It is likely that losses will be small in the stable value option, but losses are a real possiblity.? Transferring assets to other fixed income options or other stable options could be smart.

Opportunities in Bank Bonds, Part 1

Posted on 7 March 20098 March 2009 by David Merkel

The following piece was written about two weeks ago for Finacorp clients.? If you are an institutional investor, and would like to be a Finacorp client, please e-mail me.

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Before I get to my main topic, bank bonds, I need to explain my overall theory for this economic crisis. We are presently in a period of debt deflation. This follows a long period where government policy encouraged the buildup of private debt as a ratio of GDP to levels not seen since the Great Depression. Since 1984, the Federal Reserve ran a predominantly easy monetary policy that was quick to bring back the punchbowl the moment the economy showed modest strains.

Under such ?favorable? management of monetary policy, businessmen and consumers bid up the prices of assets, and borrowed money to do it. The additional buying power from leverage set in motion a self-reinforcing cycle that raised asset values, and raised the willingness of lenders to lend progressively more on those assets on favorable terms.

In addition to easy monetary policy, there were other factors that contributed to the increase in leverage. Securitization gave new classes of loans liquidity during the bull phase of the cycle, as leverage built up. Also, bank examiners were increasingly ?hands off? in reviewing the solvency of banks. Derivatives also made the balance sheets of financial institutions more opaque, making regulation more difficult.

Equilibrium is a weak concept in economics. Weak, because most of neoclassical economics relies on the concept that markets tend toward equilibrium. If there is a tendency toward equilibrium, in all my years as a practical economist, that tendency is weak at best. Capitalist economies are dynamic, and equilibria are fleeting. Also, when the government intervenes, it changes the terms of what an equilibrium would be.

But eventually, the unsustainability of the increase in debt would eventually be revealed, and the inability of the assets to service the debt would appear. The value of the assets had been inflated far above equilibrium levels, and a self-reinforcing cycle in falling asset prices began, with a collapse in leverage as defaults grew.

I call this a depression, and it is little different than what happened prior to and during the Great Depression. Monetary policy is tight. Ben Bernanke may not think of it as tight, but his actions are not inflating the nominal value of collateral in order to lessen the debt load. We are facing nationalistic sentiment across the globe, and the international division of labor is breaking down. The only thing different at present is that fiscal policy is as loose as loose can be. Average Americans are blinking at what the government is doing with a sense of moral horror, because those who were imprudent are rewarded by those who were prudent.

How this Affects the Banks

In this environment, bank balance sheets get compromised. The value of loans decline as creditworthiness falls and defaults rise. Also, there are unique securities that were previously thought ?money good.? They trade at low prices because there is a scarcity of buyers who can genuinely buy and hold for the duration of the security. Balance sheets are never big enough or long enough during the bust phase of a cycle, and few risk managers run stress tests severe enough for a bust phase like we are in now.

So, the Government Intervenes

The US Government acts in a wide number of ways in order to fight the crisis. The FDIC takes over failed institutions and sells them off with some degree of subsidy in those banks in deeper trouble. In some situations, where there is a large derivatives counterparty, like AIG, the government acts to protect the stability of the financial system as a whole. Granted, the government should ignore holding companies, and focus on the regulated subsidiaries that are a legitimate interest of the government, but at least in the initial phases of this crisis, the government has allocated funds to holding companies. This is a boon to those that hold holding company unsecured bonds, but expensive to the taxpayers. How long will the largesse continue?

Away from that, we have the distraction of Congress as they try to:

Make the banks lend more
Control remuneration to employees
And control spending on conferences and other normal aspects of business where rewarding talented employees and loyal customers is the norm.

Away from all of this, the Fed tries to heal lending markets at the risk of replacing them. So it goes.

Government Action is not Big Enough, or Effective Enough

The government is a big player in the economy, but not so big that it can dictate terms independently. The economy is larger than the resources of the government; if the government tries to keep the price of a large asset class like residential housing above its equilibrium level, it will fail as borrowers line up for a lot of loans.

But there are other factors that make the response of the government weaker:

They don?t really understand the crisis that they are in. They will try any Keynesian remedy, even though it won?t work.
There is enough disagreement in Congress over what to do, that any approved project is a hash, and not capable of fixing the problems.
The Fed will create a bunch of obscure lending programs, but won?t let inflation take hold which might help those with assets that are underwater.
There is a limit on what the government can borrow, ill-defined as that is. International lenders will balk, and domestic lenders will look for higher rates.

Taxation capacity of the government is limited as well. Who wants to raise taxes during a severe recession?

So what can we expect today?

Let?s start with the recent past. What have the Federal Government?s actions been with respect to the financial sector so far, and how have bondholders been affected? Here is a non-comprehensive list:

Company	Government Action	Effect on Bonds
Bear Stearns	Forced sale to JP Morgan, with some government asset purchases. Equity gets a seemingly low price.	Bonds are still money good.
Fannie Mae, Freddie Mac	Pseudo-nationalization. Equity gets diluted down to near zero, preferred also. Government backstopping the large losses for now, leaving debt capitalization unaffected.	Senior bonds are money good, and may become pari passu with Treasuries eventually.
AIG	Pseudo-nationalization. Equity gets diluted down to near zero, preferred also. Government backstopping the large losses for now, leaving debt capitalization unaffected.	Senior bonds seem to be money good for now, but increasing losses make that less than certain.
Lehman Brothers	No action. Lehman goes into Chapter 11. Common and preferred are wipeouts.	Senior bonds not money good. Recovery values very low and speculative.
Countrywide	Encouraged a merger with Bank of America	As good as Bank of America, with some small amount of extra legal risk
Merrill Lynch	Encouraged a merger with Bank of America	As good as Bank of America, with some small amount of extra legal risk
Washington Mutual	Encouraged a merger with JP Morgan	JPM did not take on all of the bonds. The bonds taken on is JPM quality, and that not taken on is risky.
IndyMac	FDIC took it into conservation, and is selling off the pieces	No bonds
Citigroup	Large investment from the TARP. Guarantee of a large amount of assets. May need even more?	Government actions have helped the position of the bondholders so far. The question is how much more is the government willing to do?
Bank of America	Large investment from the TARP. Guarantee of a large amount of assets. May need even more?	Government actions have helped the position of the bondholders so far. The question is how much more is the government willing to do?
Downey Federal	Filed for liquidation; US Bancorp buys the operating companies.	Bonds trade near zero
Group of large banks receiving unasked-for aid	TARP money was offered to, even forced on some banks. Since the TARP investment is senior preferred. Warrants go along with the TARP money for shares equal to 15% of the preferred investment. Slight chance of dilution.	Government actions have helped the position of the bondholders so far. The question is how much more is the government willing to do?

There are a few common threads here. In general, where the government intervenes, they do so through preferred and common stock investments, and occasionally buying liabilities in situations of severe stress. Also, aside from the takeovers that went through the FDIC, in general, the government has been bailing out holding companies directly, rather than regulated operating entities, which is an odd way of assuring solvency of the financial sector.

So far, all of these actions support the position of bondholders. When the bailouts began to happen, there was some talk of protecting senior unsecured bonds among policymakers, but nothing formal was set as a policy.

Increasingly, there is talk in the media of why bondholders get off the hook so easily, so this operational hypothesis may come under political pressure, particularly since many bonds are issued at the holding company. The holding company can go under with a low level of impact on the regulated operating entities, which if the regulators have been doing their jobs (cough, cough) they should be able to stand on their own, or sold off to better management teams.

Also, this does not apply to smaller institutions. There is some size level where the regulators say, ?Liquidate and sell off the pieces.? Even for the small banks that got small amounts of TARP money, the regulators will let them go under. TARP 1 was a unique exercise where the money flowed freely with very little in the way of restrictions. That won?t happen again.

If this crisis gets larger, and I think it will, with many entities asking for money, and many coming for second, third, fourth, fifth, etc. allotments of aid, the political will to protect the banks and other financials will erode. Along with that will erode support for holding company bondholders.

Opinion:

In bonds, better safe than sorry. So far government actions have supported bondholders, but that may not persist for a number of reasons:

As the crisis gets larger, the resources of the government will get stretched. Already, the government is feeling pinched.
Political pressure is building to make the bondholders of bailed out institutions feel some pain.
The rationale behind bailing out holding companies is dubious. Eventually policymakers will not bailout holding companies because it does not protect the financial system.
So far returns on government actions have been poor, to say the least. The concept that the government would make money on this was laughable at the time, but now it is proven ridiculous.
Eventually the government will take larger insolvencies through the FDIC, and bondholders will accept some amount of equity and warrants for their bonds.

Buying financial holding company bonds is a bet on stability of policy, and that the crisis does not grow. There may be some opportunities in buying unsecured bonds of financial companies here, but institutions relying on government support may prove to be poor investments, because the odds of policy shifting against bondholders is moderate. Don?t assume that ?too big to fail? means that holding company bondholders get a free pass.

The Bane of Broken Balance Sheets

Posted on 6 March 2009 by David Merkel

I?ve talked about the troubles in our economy stemming from asset-liability mismatch.? Too many people/institutions financed risk assets:

With inadequate equity (provision for adverse deviation)
With lending terms that were much shorter than that of the assets financed
Where the borrowing terms can shift against the borrower in an adverse economic environment.? Think of borrowing in a harder currency, or loans that can reset of recast with payments going higher.
Where lending terms could be modified by third parties.? Think of the rating agencies downgrading a company and it has to put up more assets as collateral.

Another way to say it is too many relied on the ability to refinance on favorable terms.? But now that favorable terms are no longer there, we live in a time of broken balance sheets.? What were some of the classic examples of this phenomenon?

Buying houses with little money down.
Buying houses where the terms can reset against you.? Houses are long term assets, and must be funded with a generous amount of equity, and long term financing as far as the debt is concerned.
Hedge funds bought long duration assets, stocks and longer bonds, when their capital bases could be withdrawn at much shorter intervals.
Many mergers were done for cash near the peak of the product pricing cycle for their particular industry.? The debts incurred hang around, but funny, the pricing power doesn?t when demand collapses.
Many companies invested in new productive capacity ? energy, agriculture, mining, just as the global economic cycle was peaking.? Others in developing markets had ramped up industrial capacity beyond the world?s capability to absorb it.
Defined benefit pension liabilities were increased by states and municipalities which relied on the idea that tax revenues would grow indefinitely at a rate of 4-5% or more.? The same for corporations that assumed 7-10% asset returns for the next 50 or so years.
Even 10-year commercial mortgages with 30-year amortization presumed on the ability to refinance 10 years out.? Was there the possibility that ten years out, refinancing terms would be worse than at origination?? Yes, and we are there now.

In any case, there was often a mismatch as the global economy grew during the boom phase.? New long term assets were created, and financed with not enough equity, and debt terms that were shorter than the life of the assets.

Much of this can be laid at the doors of the Central banks of our world, because they pulled out all of the stops in the early 2000s to help establish an unending prosperity.? News flash: the boom/bust cycle is endemic to mankind; efforts to eliminate it merely create a version with long shallow booms and big busts.? Eventually the piper must be paid; there are no free lunches.? The easing of monetary policy 2001-2003 led to one final big bout of risk taking 2003-2007.? We are living with the aftermath now, as the central banks do everything to try to reflate with no success.? When consumers have little capacity to increase indebtedness, monetary policy is useless, leaving aside helicopter tactics.

So what can the government do at a point like this, since they are committed to permanent prosperity?

Inflate, raising the nominal value of collateral.? This is the simplest solution, and the Fed resists it.? It would also force the other governments of the world to go along.
Provide long-term financing to troubled corporations, whether through long debt, equity, or hybrid instruments.
Bail out states and municipalities with burdensome pension liabilities.

(NB: I am not saying the government should do any of these things.? I am simply saying that these are better than what the government is currently doing.)

Government funding is short duration by nature because of the annual appropriations process, and lack of any restraint ? little in the way of rainy day funds ? a presumption of prosperity in budgeting.? Few governmental entities in the US assume that receipts will be lower in future years.? Budgets are often made assuming that spending will increase, and that taxes will rise to fill the gap.? Well, no more of that, at least for a while.

Any scheme that relies on increasing prosperity is inherently mismatched.? No tree grows to the sky, and that includes nations and their governments.? There is a natural process where nations are born, grow, mature, decay, and die, unless some event intervenes to revivify the nation, giving it new purpose and energy.? With the US over the last 75 years, there has been slow decay amid prosperity.? Payment for obligations is pushed out into the future, because growth will solve our funding crises.? Government debt covers a multitude of sins, in the intermediate-term.

Financing the Economy at Treasury Interest Rates

When I hear talk that the government should borrow to fund mortgages, or dodgy companies, I cringe.? I hear things like: ?These assets are at depressed levels because of a lack of confidence.? The government can borrow and buy them, and make a profit on the spread, particularly after confidence resumes.?? ?Let the government absorb Fannie and Freddie and make loans at affordable rates to people.? They can provide mortgages much cheaper than the private sector.?? ?The value of the assets of AIG is artificially depressed.? The government can finance those assets and sell them for a profit when confidence reappears.?

The borrowing capacity of the US Government is limited.? I don?t know what the limit is ? which straw will finally break the back of the camel, but there is a limit.? The borrowing capacity of our government should be used to its best effect, and playing as a bank or a hedge fund is likely not the right answer.

An overage of private and public leverage pushed asset prices above their equilibrium levels.? Residential housing is a good example here.? Prices still need to come down to restore the affordability levels that existed through the second half of the 20th century.? The Fed could inflate some of the problems away, but that does not seem to be on their menu of choices at present.

I have seen private residential mortgage bonds trading at levels where I said, ?The odds of these not being money good are remote.?? Yet, the bonds trade (if they trade) below 70.? (100 is being paid in full.)

This is because there are fewer entities capable of holding the bonds to anything near maturity.? When someone complains to me about the price of a mortgage bond, after analysis, I often say to find an entity that is willing to hold the bond to maturity, or slightly less, and they can garner full value.? But anyone holding that bond that can?t hold it to maturity, or doesn?t want to, is merely a speculator.

We developed too many speculators in the 2000s, and not enough parties that would hold assets to maturity.? We now suffer for that, including our dear government.? Our dear government is like Brer Rabbit punching the Tar Baby, but without the advantage of being born and bred in the briar patch.? They don?t know what they are doing.? They have some vague idea about what Keynes said, but don?t understand the limitations of his theory.? Bernanke is the expert on the Great Depression, so whatever he suggests in this context must be right? Right?!

Sadly, no.? To the extent that private sector debts are not reduced, the crisis does not end.? Even the swapping of private for government debt is merely a ?delay of game? strategy, because there will be a greater crisis when the US Government cannot service its debts.? We live in a period of waning prosperity, with the US Government having decreasing ability to influence events.

At present, absent inflation for the Fed, the broken balance sheets of our world imply a slow recovery, where any earnings go to fill in balance sheet holes, and buy up broken competitors.? It?s not a fun environment, but it is an environment where good managements can pursue relative advantage if they are careful.? Guard your liquidity carefully, and persevere through this tough time.

Unstable Value Funds? (III)

Posted on 5 March 2009 by David Merkel

There’s a lot that I don’t know here, but what I do know concerns me.? Stable Value funds are a murky part of the market.? They are murky because they don’t report the value of the underlying assets, but only the smoothed value of assets, and the rate that they are currently crediting.? (Note: for those that want the grand tour of Stable Value Funds, I wrote this piece at RealMoney, The Biggest Asset Class You Never Heard Of.