Bonds – Page 112 – The Aleph Blog

Personal Finance, Part 5 ? Inflation and Deflation

Posted on 6 December 2007 by David Merkel

This is another in the irregular series on personal finance.? This article though, has implications beyond individuals.? I’m going to describe this in US-centric terms for simplicity sake.? For the 20-25% of my readers that are not US-based, these same principles will apply to your own country and currency as well.

Let’s start with inflation.? Inflation is predominantly a monetary phenomenon.? Whenever the Fed puts more currency into circulation on net, there is monetary inflation.? Some of the value of existing dollars gets eroded, even if the prices of assets or goods don’t change.? In a growing economy with a stable money supply, there would be no monetary inflation, but there would likely be goods price deflation.? Same number of dollars chasing more goods.

Let’s move on to price inflation.? There are two types of price inflation, one for assets, and the other for goods (and services, but both are current consumption, so I lump them together).? When monetary inflation takes place, each dollar can buy less goods or assets than in the absence of the inflation.? Prices would not rise, if productivity has risen as much or more than the amount of monetary inflation.

Now, the incremental dollars from monetary inflation can go to one of two places: goods or assets.? Assets can be thought of? as something that produces a bundle of goods in the future.? Asset inflation is an increase in the prices of assets (or a subgroup of assets) without equivalent improvement in the ability to create more goods in the future.? How newly printed incremental dollars get directed can make a huge difference in where inflation shows up. Let me run through a few examples:

?In the 1970s in the US, the rate of household formation was relatively rapid, and there was a lot of demand for consumer products, but not savings.? Money supply growth was rapid.? The stock and bond markets languished, and goods prices roared ahead.? Commodities and housing also rose rapidly.
In? the mid-1980s the G7 induced Japan to inflate its money supply.? With an older demographic, most of the excess money went into savings that were invested in stocks that roared higher, creating a bubble, but not creating any great amount of incremental new goods (productivity) for the future.
In 1998-1999, the Fed goosed the money supply to compensate for LTCM and the related crises, and Y2K.? The excess money made its way to tech and internet stocks, creating a bubble.? On net, more money was invested than was created in terms of future goods and services.? Thus, after the inflation, there came a deflation, as the assets could not produce anything near what the speculators bid them up to.
In 2001-2003 the Fed cut rates aggressively in a weakening economy.? The incremental dollars predominantly went to housing, producing a bubble.? More houses were built than were needed in an attempt to respond to the demand from speculators.? Now we are on the deflation side of the cycle, where prices adjust down, until enough people can afford the homes using normal financing.

I can give you more examples.? The main point is that inflation does not have to occur in goods in order to be damaging to the economy.? It can occur in assets when people and institutions become maniacal, and push the price of an asset class well beyond where its future stream of cash flow would warrant.

Now, it’s possible to have goods deflation and asset inflation at the same time; it is possible to save too much as a culture.? The boom/bust cycles in the late 1800s had some instances of that.? It’s also possible to have goods inflation and asset deflation at the same time; its definitely possible to not save enough as a culture, or to have resources diverted by the government to fight a war.

The problem is this, then.? It’s difficult to make hard-and-fast statements about the effect of an increasing money supply.? It will likely create inflation, but the question is where?? Many emerging economies have rapidly growing money supplies, and they are building up their productive capacity.? The question is, will there be a market for that capacity?? At what price level?? Many of them have booming stockmarkets.? Do the prices fairly reflect the future flow of goods and services?? Emerging markets presently trade at a P/E premium to the developed markets.? If capitalism sticks, the premium deriving from faster growth may be warranted.? But maybe not everywhere, China for example.

The challenge for the individual investor, and any institutional asset allocator is to look at the world and estimate where the assets generating future inflation-adjusted cash flows (or goods and services) are trading relatively cheaply.? That’s a tall order.? Jeremy Grantham of GMO has done well with that analysis in the past, and I’m not aware that he finds anything that cheap today.

We live in a world of relatively low interest rates; part of that comes from the Baby Boomers aging and pension plans investing for their retirement.? P/E multiples aren’t that high, but profit margins are also quite high.? We also face central banks that are loosening monetary policy to reduce bad debt problems.? That incremental money will aid institutions not badly impaired, and might eventually inflate the value of houses, if they get aggressive enough.? (Haven’t seen that yet.)? In any case, the question is how will the incremental dollars (and other currencies) get spent?? In the US, we have another demographic wave of household formations coming, so maybe goods inflation will tick up.

We’ll see.? More on this tomorrow; I’ll get more practical and less theoretical.

Ten Notes on Our Crazy Credit Markets

Posted on 5 December 2007 by David Merkel

This post may be a little more disjointed than some of my posts.? Recently I have been working on calculating the fair value for mezzanine tranches of a series of real estate oriented CDOs.? Not pretty.? Anyway, here are few articles that got me thinking yesterday:

Let’s? start with CD rates.? Bloomberg had a nifty table on its system which I can’t reproduce here, except to point you to the data source at the Fed.? Note how one-, three-, and six-month CD rates have been rising, somewhat in sync with LIBOR, but widening the gap with Treasury yields. (Hit your “end” button to see the most recent rates…)
As a result, I have been debating whether the FOMC might not do a 50 basis point loosen next Tuesday.? CDs aren’t the bulk of how most banks fund themselves, but they can be a way to get a lot of cash fast.? Remember that after labor unemployment and inflation, the Fed’s hidden third mandate is protecting the depositary financial system, particularly the portion that belongs to the Federal Reserve System.
Now, I’m not the only one wondering about what the FOMC will do.? There’s Greg Ip at The WSJ, who speculates on the size of the cut, and whether the discount rate might not be cut even more, with a loosening of terms and conditions as well.? Bloomberg echoes the same themes.? Even the normally placid Tony Crescenzi sounds worried if the FOMC doesn’t act aggressively here.
The US isn’t the only place where this is a worry.? The Bank of Canada cut rates yesterday, as noted by Trader’s Narrative, partly because of credit pressures in Canada and the US.? The Financial Times notes that Euro-LIBOR [Euribor] is also rising vs. Government short-term yields, which may prompt the ECB to cut as well.? Or, they also could cut their version of the discount rate, or liberalize terms.
It doesn’t make sense to me, but the Yen is weakening at present.? With forward interest rate differentials narrowing as more central banks tip toward easing, I would expect the carry trade to weaken; instead, it is growing.? For now.
As noted by Marc Chandler, the Gulf States have largely decided to keep their US Dollar peg.? I found the article to be interesting and somewhat counterintuitive at points, but hey, I learned something.? Inflation is rising in Kuwait after they switched from the US Dollar to a basket of currencies, because residential real estate prices are rising.
Credit problems continue to emerge on the short end of the yield curve.? Accrued Interest has a good summary of the problems in money market funds.? It almost seems like Florida is a “trouble magnet.”? If it’s not hurricanes, it’s bad money management.? Then there’s Orange County, which has a 20% slug of SIV-debt in its Extended Fund.? It’s all highly rated, so they say, but ratings don’t always equate to credit quality, particularly in unseasoned investment classes.? Then there’s the credit stress from borrowers drawing down on standby lines of credit, which further taxes the capital of the banks.
As a final note, both here (point 6) and at RealMoney, I was very critical of S&P and Moody’s when they decided to rate CPDO [Constant Proportion Debt Obligation] paper AAA.? I’ll let the excellent blog Alea take the victory lap though.? We finally have CPDOs that are taking on serious losses (and here).
In summary, we are increasingly in a situation where the major central banks of our world are reflating their currencies as a group in an effort to inflate away embedded credit problems.? Most of the credit problems are too deep for a lowering of the financing rate to solve, though it will help financial institutions with modest-to-moderate-sized credit problems (say, less than 25% of tangible net worth — does the rule of thumb for P&C reinsurers apply to banks?).? This can continue for some time, and credit spreads and yield curves should continue to widen, and inflation (when fairly measured) should increase.? Some of the inflation will move to assets that aren’t presently troubled, perhaps commodities, and higher quality equities, which are doing relatively well of late.
Quite an environment.? The big question is when the “free lunch” period for the rate cuts end, and the hard policy choices need to be made.? My guess is that would be in mid-to-late 2008, just in time for the elections.? Now, wouldn’t that spice things up? 🙂

In Defense of the Ratings Agencies

Posted on 4 December 2007 by David Merkel

The ratings agencies have come under a lot of flak recently for rating instruments that are new, where their models might not be do good, and for the conflicts of interest that they face.? Both criticisms sound good initially, and I have written about the second of them at RealMoney, but in truth both don’t hold much water, because there is no other way to do it.? Let those who criticize put forth real alternatives that show systematic thinking.? So far, I haven’t seen one.

Here are the realities:

There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves.? The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.? The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
Somewhere in the financial system there has to be room for parties that offer opinions who don’t have to worry about being sued if their opinions are wrong.
Ratings can be short-term, or long-term, but not both.? The worst of all worlds is when the ratings agencies shift time horizons.

For my first point, the fixed-income community has learned that the ratings agencies offer an opinion, and they might pay for some additional analysis through subscriptions, but if they were forced to pay the fees that issuers pay, they would balk; they have in-house analysts already.? The ratings agencies aren’t perfect, and good buy-side shops use them, but don’t rely on them.

Second, the regulators need simple ways in a complex environment to account for credit risk, so that capital positions can be properly sized.? They either need rating agencies, or have to be one.? No way around it.

Third, financial institutions will buy new securities, and someone has to rate them so that proper capital levels can be held (hopefully).

Fourth, financial institutions and regulators have to be “big boys.” If you were stupid enough to rely on the rating without further analysis, well, that was your fault.? If the ratings agencies can be sued for their opinions (out of a misguided notion of fiduciary interest), then they need to be paid a lot more so that they can fund the jury awards.? Their opinions are just that, opinions.? Smart institutional investors often ignore the rating, and read the commentary.? The nuances of opinion come out there, and often tell smart investors to stay away, in spite of the rating.

Last, ratings agency opinions are long-term by nature, rating over a full credit cycle.? During panics people complain that they should be more short-term.?? Hindsight is 20/20.? Given the multiple uses of credit ratings, having one time horizon is best, whether short- or long-term.? Given the whipsaw that I experienced in 2002 when the ratings agencies went from long- to short-term, I can tell you it did not add value, and that most bond manager that I knew wanted stability.

Now there are alternatives.? The regulators can ban asset classes until they are seasoned.? Could be smart, but there will be complaints.? I experienced in one state the unwillingness of the regulators to update their permitted asset list, which had not been touched since 1955.? In 2000, I wrote the bill that modernized the investment code for life companies; perhaps my grandson (not born yet), will write the next one.? Regulators are slow, and they genuinely don’t understand investments.

Another alternative would be to allow for more rating agencies.? I’m in favor of a free-ish market here, allowing the regulators to choose those raters that are adequate for setting capital levels, and those that are not.? For other purposes, though, the more raters, the better.

Let those who criticize the ratings agencies bring forth a new paradigm that the market can embrace, and live with in the long term.? Until then, the current system will persist, because there is no other realistic way to get business done.? There are conflicts of interest, but those are unavoidable in multiparty arrangements.? The intelligent investor has to be aware of them, and compensate for the inherent bias.

On the Value of Secondary and Primary Markets

Posted on 3 December 20074 December 2007 by David Merkel

My main thesis here is that secondary and primary markets benefit investors in different ways, but that they are equally valuable to investors, and the public at large. Government policy should not discriminate in favor of one or the other.

I come at this topic from the point of view of someone who has been both a bond and stock investor professionally. When managing bonds, one boss of mine would say, “Primary market levels validate trading levels in the secondary market.” His point was that in the bond market, since a large proportion of the dollar value of transactions came from new issues, those deals in the primary markets were a good indication of where trades should go on in the secondary market for similar pieces of paper. He had a point; bigger markets should dominate smaller similar markets in discerning overall price/yield movements.

In the primary markets, deals have to come a little cheap on average in order to get deals done. That cheapness is necessary in order to get a lot of liquidity from investors at once. But that level of cheapness attracts flippers, i.e., people who buy the cheap new issue, and sell it away for a quick profit in the secondary markets. Bond underwriter syndicates do what they can to detect flippers, but some almost always get in. Even so, the flippers have some value. They reveal the level of discounting inherent in the offering process; when the discounting is high, there’s a lot of fear in the marketplace, and new deals stand a decent chance of performing well. Vice-versa when discounting is low, or even worse, when a new deal “backs up” and closes below the IPO price.

One way to tell how hot the market is, is how rapidly deals close. Seven minutes? Days?? Mania and Lethargy are common attitudes for the market.? Normal behavior is, well, abnormal.? Abnormal behavior provides clues into what is likely to happen next, even if the timing is difficult.? Hot IPO markets eventually go cold, and vice-versa.

The secondary markets provide valuable clues for the primary market as to where deals should be priced, whether equity or debt.? Even if the primary market were dominated by buy-and-hold investors (more common in bonds, less common in stocks), the speculation inherent in much secondary trading provides real value to the IPO syndicates, and longer-term investors.

Longer-term investors who buy-and-hold, or sell-and-sit-on-cash provide clues to speculators as well. The longer-term investors are the ones who create “support” and “resistance” levels.? They care about valuation.

Secondary markets need primary (IPO) markets also.? Without the possibility of a company being bought out, share prices tend to suffer.? When few new companies go public, it is often a sign that the secondary markets are cheap.

My main point here is both markets are valuable, and they need each other.? Speculation is an inescapable part of the capital markets, and it should not be legally discouraged.? (Note: I am not about to become a speculator; I am a longer-term investor, and will stay that way.)

How does the system discourage speculation?? There are differential rates of taxation based on holding period, or investment class. My view is that all income, no matter how generated, should be taxed at the same rate.? All income generation is equally valuable, whether it comes quickly or slowly.

So, when I read drivel like this fellow Lawrence Mitchell is putting out, advocating high taxes on short-term investing, I sit back and say, “You’re not thinking systematically.? You’ve only thought through the first order effects; the remaining effects have eluded you.”? Imagine a system where we are all forced to become buy-and-hold investors through tax policy.? Where would the price signals for the primary markets come from?? Where would liquidity come from?? Would activist investing shrink, with the honesty that it helps to bring?? Who would be willing to step up to an IPO if he knew that tax policy favored him holding for ten years?? What would happen to venture capital if the secondary markets dried up because of tax policy?? Where would their exit door be?

A world composed of only long-term investors would not be as rich of world as we have now.? Though many short-term investors are only “noise traders,” the ability of short-term investors to take advantage of market dislocations helps stabilize the markets.? There should be no penalty to short-term investing versus long-term investing.

Now, if that’s not controversial enough, perhaps I will write a post where I say that tax policy should not favor savings over consumption.? Let people make their own decisions on buying and selling, and let the IRS take a consistent cut, but social policy through tax preferences is for the most part not a good idea.

Notes on Fed Policy and Short-term Credit

Posted on 28 November 2007 by David Merkel

I just did my usual review of my FOMC indicators.? The FOMC should cut 25 basis points at the December 11th meeting.? Whatever the formal “bias” is, the verbiage will be a little of this and the a little of that, something like:? “Yes, we are worried about the solvency of some financial institutions.? That’s why we cut.? But this cut very likely should be enough, so don’t expect anymore.? Now leave us alone.”
So Goldman sees a 3% Fed funds rate in mid-2008?? So do I.? Small moves in FOMC policy don’t achieve the desired ends, either when policy is rising or falling.? Large cumulative moves are needed to affect the behavior of market participants.
The TED [Treasury – Eurodollar] spread is at its largest one-year moving average since 1990.? That’s significant short-term credit stress to the large banks, and it is worth watching.? It’s not just a US phenomenon either; in the UK the banks are under stress as well.
Residential housing is driving the decisions of the FOMC.? As prices fall, more houses become non-refinancable, and non-salable (except at a loss).? All it takes then is for a problem to happen… death, disability, divorce, unemployment, or casualty, and another house goes on the market because of insolvency.
So, I agree with Accrued Interest (great blog, doesn’t everyone want to read about bonds?).? Many Fed governors talk between meetings, and they trot out their baseline scenario, but often it is the worry of avoiding a somewhat likely negative scenario that can drive policy.
At some level though, if the dollar falls far enough, the FOMC will have to reverse course, as Caroline Baum has pointed out.? Remember, that’s what drove the FOMC to tighten in 1986-87.
Of course, the credit stress in the short end of the market has led some money market fund sponsors to bail out their funds (Legg Mason, Wachovia and B of A, while GE lets a pseudo-money market fund take a hit.? Remember, with money market funds, it’s not wise to stretch for yield, particularly not in bear markets for credit.
One more weak Commercial Paper [CP] funding structure: using it as part of a “super senior” tranche in CDOs.? Now in this case, the collateral is weak — subprime mortgage loans, but this could be true of any CDO where the collateral comes under stress in the future, including high yield corporate bonds.? I wrote about this three months ago, but this one is still unraveling.
I haven’t talked about it, because I wasn’t sure I had anything to add to the discussion, but the M-LEC, or super-SIV, proposed by the major banks seems like hooey to me.? After all, if this shifting of assets from one pocket to another created value, why wasn’t it done before?? It doesn’t change the underlying asset prices, and for the banks as a whole, it is just a zero sum game, unless new parties enter, at which point, they will have to offer a discount to move the paper, which eliminates one of the reasons for doing the deal.
Putting another nail in the coffin, HSBC takes their SIVs onto their own balance sheet, cleaning up their own financing, and making it more difficult for the other banks who want to do the Super-SIV.

What an interesting time in the short-term debt markets.? For now, prudence dictates staying high quality in what financial institutions you lend to short term.

Seven Observations From Barron’s

Posted on 17 November 200718 November 2007 by David Merkel

Kinda weird, and it makes you wonder, but on the WSJ main page, I could not find a link to Barron’s. I know I’ve seen a link to Barron’s in the past there; I have used it, which is why I noticed its absence today.
I found it amusing that the mutual fund that Barron’s would mention on their Blackrock interview, underperformed the Lehman Aggregate over 1, 3 and 5 years. Don’t get me wrong, Blackrock is a great shop, and I would work there if they offered me employment that didn’t change my location. Why did Barron’s pick that fund?
I’m not worried about the effect of a financial guarantor downgrade on the creditworthiness of the muni market. Munis rarely fail. Most of those that do fail lacked a real economic purpose. What would be lost in a guarantor downgrade is liquidity. Muni bond insurance is a substitute for analysis. “AAA insured, I’ll buy that.” Truth, an index fund of uninsured munis would beat an index of insured munis, because default rates are so low. But the presence of insurance makes the bonds a lot more liquid, which makes portfolio management easier.
I’ve been a US dollar bear for the last five years, and most of the last fifteen years. Though we have had a little bounce recently, the dollar has of late been at record lows against currencies that trade freely against the dollar. I expect the current bounce to persist in the short term and fail in the intermediate term. The path of the dollar is lower, unless the Fed decides to not loosen more. Balance needs to be restored in the global economy, such that the rest of the world purchases more goods and services, and fewer assets from the US.
I don’t talk about it often, but when it comes up, I have to mention that municipal pensions in the US are generally in horrid shape. The Barron’s article focuses on teachers, but other municipal worker groups are equally bad off. The article comments on perverse incentives in teacher retirement, which leads older teachers to retire when it is feasible to do so. For older teachers, I would not begrudge them; they weren’t paid that well at the start, and the pension is their reward. Younger teachers have been paid pretty well. I would not expect them to get the same pension promises.
I like Japan. I own shares in the Japan Smaller Capitalization Fund [JOF]; it’s my second-largest position.

Japan is cheap, and small cap Japan is even cheaper. I would expect a modest bounce on Monday.
We still need a 15-20% decline in housing prices to bring the system back to normal. There might be an undershoot in price from the sales that forced sellers must do. Hopefully it doesn’t turn into a self-reinforcing decline, but who can be sure about that? At that level of housing prices, man recent conforming loans will be in trouble, much less non-conforming loans.

Full disclosure: long JOF

Book Review: The Intelligent Investor

Posted on 15 November 200715 November 2007 by David Merkel

Fifteen years ago, my mom gave me a book that would change my life: The Intelligent Investor, by Benjamin Graham. Prior to that time, I was primarily investing in mutual funds, and did not have a coherent investment philosophy. The Intelligent Investor provided me with that philosophy.

What are the main lessons of this book?

Don’t overinvest in equities. Markets wash out occasionally, and it’s good to have some bonds around.
Don’t underinvest in equities. Bonds can only do so much for you, and it is good to deploy capital into equities when they are out of favor.
Stocks provide modest compensation against inflation risks.
Avoid callable bonds. Avoid preferred stocks.
Be conservative in bond investing. Read the prospectus carefully. Often a bond is less safe than one would expect, and occasionally, it offers more value than one would expect.
Purchase bargain issues on a net asset value basis when you can find them, but be careful of quality issues.
Volatility of stock prices can be your friend if you understand the underlying value of a well-financed corporation.
Having a longer-term investment horizon is valuable, because one can take advantage of short-term fluctuations in price.
Growth is worth paying up for, but be disciplined. Don’t overpay.
Be wary of mutual funds.
Be wary of experts.
Pay attention to the balance sheet; don’t invest in companies that are inadequately financed.
Review average earnings of cyclical companies.
Buy them safe and cheap. Don’t overpay for growth and trendiness.
Avoid highly acquisitive companies.
Watch cash flow, and question unusual accounting treatments.
Be careful with unseasoned (new) companies.
Strong dividend policies, in companies that can support the dividends, are an indicator of value.
Aim for a margin of safety in all investing.

That’s my quick synopsis of the book. Though I am not a strict Graham-and-Dodd investor (who is?), I apply the basic principles to most of what I do. This is still a relevant book today because the principles are timeless. If you want the updated version with writing from Jason Zweig, that’s fine. You gain in current relevance, and lose a little in nuance. Graham was a very bright guy. I give Zweig credit for trying, but aside from Buffett or Munger, who would really be adequate to revise The Intelligent Investor? I don’t think I would be adequate to the task….
Classic:

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As Revised by Jason Zweig:

Full disclosure: I get a small payment on the sale of the books, but if you are buying from Amazon anyway, it won’t increase your costs.

Contemplating Life Without the Guarantors

Posted on 8 November 2007 by David Merkel

Here’s another recent post from RealMoney:

		David Merkel
		Contemplating Life Without the Guarantors
		11/1/2007 1:30 PM EDT

Hopefully this post marks a turning point for the Mortgage Insurers and the Financial Guarantee Insurers, but when I see Ambac trading within spitting distance of 50% of book, I cringe. I’ve never been a bull on these companies, but I had heard the bear case for so long that my opinion had become, “If it hasn’t happened already, why should it happen now?” Too many lost too much waiting for the event to come, and now, perhaps it has come. But, what are all of the fallout effects if we have a failure of a mortgage insurer? Fannie, Freddie, and a number of mortgage REITs would find their credit exposure to be considerably higher. The Feds would likely stand behind the agencies, because Fannie and Freddie aren’t that highly capitalized either. That said, I would be uncomfortable owning Fannie or Freddie here; just because the government might stand behind senior obligations doesn’t mean they would take care of the common and preferred stockholders, or even the subordinated debt.

Fortunately, the mortgage insurers don’t reinsure each other; there won’t be a cascade from one failure, though the same common factor, falling housing prices will affect all of them.

Other affected parties will include the homebuilders and the mortgage lenders, because buyers without significant down payments will be shut out of the market. Piggyback loans aren’t totally dead, but pricing and higher underwriting standards restrict availability. Third-order effects move onto suppliers, investment banks and the rating agencies. More on them in a moment… this will have to be a two-parter, if not three.

Position: none

And since then, the mortgage insurers have fallen a bit further.? On to part two, the financial guarantors:

Unfortunately, the financial guarantors have had a tendency to reinsure each other.? MBIA reinsures Ambac, and vice-versa. ? RAM Holdings reinsures all of them.? The guarantors provide a type of “branding” to obscure borrowers in the bond market.? Rather than put forth a costly effort to be known, it is cheaper to get the bonds wrapped by a well-known guarantor; not only does it increase perceived creditworthiness, it increases liquidity, because portfolio managers can skip a step in thinking.

Now, in simpler times, when munis were all that they insured, the risk profiles were low for the guarantors, because munis rarely defaulted, particularly those with economic necessity behind them.? In an era where they insure the AAA portions of CDOs and other asset-backed securities, the risk is higher.

Now, guarantors only have to pay principal and interest on a timely basis.? Mark to market losses don’t affect them, they can just pay along with cash flow.? The only trouble comes if they get downgraded, and new deals become more scarce.? Remember CAPMAC?? MBIA bought them out when their AAA rating was under threat.? Who will step up to buy MBIA or Ambac?? (Mr. Buffett! Here’s your chance to be a modern J. P. Morgan.? Buy out the guarantors! — Never mind, he’s much smarter than that.)

Well, at present the rating agencies are re-thinking the ratings of the guarantors.? This isn’t easy for them, because they make so much money off of the guarantors, and without the AAA, business suffers.? If the guarantors get downgraded, so do the business prospects of the ratings agencies (Moody’s and S&P).

Away from that, municipalities would suffer from lesser ability to issue debt inexpensively.? Also, stable value funds are big AAA paper buyers.? They would suffer from any guarantor getting downgraded, and particularly if Fannie or Freddie were under threat as well.?? All in all, this is not a fun time for AAA bond investors.? A lot of uncertainties are surfacing in areas that were previously regarded as safe.? (I haven’t even touched AAA RMBS whole loans…)

This is a time of significant uncertainty for areas that were previously regarded as certain.? Keep your eyes open, and evaluate guaranteed investments both ways.? I.e., ABC corp guaranteed by GUAR corp, or GUAR debt secured by an interest in ABC corp. This is a situation where simplicity is rewarded.

Second Video on the Federal Reserve

Posted on 29 October 2007 by David Merkel

Here’s my second video from TheStreet.com on the Federal Reserve.? This one is on where to invest from an equity standpoint.? There are two areas to look at.? Companies that benefit from:

Lower borrowing rates
Higher inflation

In the first category are healthy financials, and companies with the flexibility to borrow short-tern and buy back stock.? I highlighted insurance companies in my video, but this could apply to other financials and yield-sensitive companies, so long as they don’t face any significant fallout from housing and housing finance.

In the second category are companies that are exporters, and companies where the global prices of their products will rise in dollar terms, while their inputs stay relatively fixed.? This would include energy and most commodities.

Bonds were not a topic of discussion, but I still favor foreign, high quality and short-to-intermediate bonds for now.

Reviewing the Fed Data

Posted on 26 October 2007 by David Merkel

Last night’s post got eaten by a loss of power. It’s time to return to “FOMC mode” in anticipation of the meeting ending on the 31st. Let’s review the data as I see it:

Even with the recent loosening in FOMC policy, the Fed still hasn’t done a permanent injection of liquidity since May 3rd.? Growth in the monetary base since then has been anemic.
The narrow monetary aggregates have not been growing rapidly, even since the FOMC began its temporary liquidity injections back in August.? Even M2 has been flat.
My M3 proxy has not been flat, though it overstates matters somewhat.? Total bank liabilities have grown 4% since mid-August, which is close to a 20% annualized rate.? This has to be taken back a bit, because with the Treasury-Eurodollar [TED] spread around 110 basis points, liquidity from the unsecured Euro-dollar markets has diminished.? How much for US banks?? I’m not sure; I can’t find a data series for that yet.
The TED spread has retreated 65 basis points since the last meeting.? Things are better, but external dollar liquidity is still tight, which in my book means a TED spread above 60 basis points.
Off of Fed funds options, the odds of no change are 10%, odds of a 25 basis point cut are 70%, and the odds of a 50 basis point cut are 20%.
Since the last meeting, fed funds have averaged 3 basis points over the target.
The discount window moves aided PR efforts, but never amounted to much.
As measured by TIPS, five year forward five year inflation has fallen since the last meeting, but has been slowly rising over the past five years.

There’s my data, now for the analysis.? Credit conditions have loosened, but monetary conditions aren’t loose.? Banks have been willing to expand their balance sheets, I believe partly due to the Fed loosening capital requirements, e.g.,? lending to securities affiliates.? Also, with the bigger banks, the Federal Reserve is talking tough, but not playing tough in bank examinations, because they can’t allow credit to contract that much, or their loosening policy will have little impact.? The smaller banks, and banks where mortgage lending could have a big impact are undergoing sharper examinations.? Part of that looseness is canceled out by the tightness in the Euro-dollar markets; the big banks are less than fully willing to trust each other’s balance sheets.

My opinion: The FOMC will loosen 25 basis points on 10/31, and will continue to express worries over economic growth.? Though inflation is a growing threat, the FOMC will downplay that.? There will be a lot of trading noise around the news, but after the dust clears, stocks and bonds won’t have done much, and the yield curve will be a little wider.? TIPS should outperform inflation un-protected bonds.? The dollar will weaken to the degree that the FOMC hints that they aren’t done.