Cramer again.? This time I disagree more, because he is talking about the Fed.? He has five views of the Fed that he hates.? Let me take them in order:
1) The Fed doesn’t matter — It depends.? In the short run, when the Fed loosens, healthy assets get stimulated, but damaged assets don’t.? In the intermediate run, companies get financing from healthy financials to reconcile dud assets that were misfinanced, but the process takes time, maybe a year or two.
2) The Fed is pushing on a string — Initially, it will look like that is true.? It almost always does. Things that are viewed as problems now will not be helped by the initial effects of Fed policy.
3) The economy won’t react to the Fed, no matter what — Cramer is right to dis this one.? The Fed will revive nominal growth after a year or two.? The hard question is how much comes from inflation, and how much comes from real growth.
4) The dollar collapses because of cuts — Here I disagree with Cramer.? The dollar will decline.? Interest rates are a more powerful factor than GDP growth in exchange rates, because financial transactions are larger than trade in goods by an order of magnitude.
5) The Fed doesn’t want to do anything and doesn’t have to do anything — Well, true on its face, but the Fed is a political creature.? It responds to market signals, and it has signaled that it wants to “solve this problem.”? Cramer is correct here.? The Fed will act; the only question is how much.
But ask yourself a different question. How could the Fed break the logjam in the commercial paper market, particularly ABCP?? I clipped a lot of articles on this.? There is a lot of CP maturing (maybe $140 billion) in the next week or so.? It is not the banks that are so much at risk, though some will have to collapse conduits and bring asset back onto their balance sheets, lowering capital ratios. ? The non-banks are the ones getting smashed, and the banks may have modest exposure to their woes.? Information Arbitrage has it right when he says that this is a case of misfinancing assets.? (Hey, maybe the Fed could directly monetize ABCP by buying it instead of Treasury notes.? No, no, please don’t… 🙁 )
Now, how much will the FOMC cut rates?? Unusually modest for PIMCO, they call for 1% by 2008.? (They never met a rate cut that they didn’t like.)? Fed Governor Plosser suggests that they have other tools they can use, without cutting the Fed funds rate. The ever-smart Jim Griffin concludes that the main risk to the Fed at present is inaction, and I agree.? At a time like this, the FOMC must do something notable, or the political heat cranks up.? Then again, we can look at the Treasury bond market as a whole, and easily conclude that at least 1% of loosening is in the foreseeable future.? As Caroline Baum puts it, “The fact that the funds rate is hovering so far above the rest of the yield curve is the most obvious sign that policy is tight. Yet Fed officials seem determined to see evidence of it in the real economy before they relent.”
Four quick notes before I end:
Remember that Fed funds futures are typically only good for predicting the next meeting, and nothing beyond that.
An excellent summary article on all of this from the Bank of International Settlements, the central bankers’ central bank.
My summary: the FOMC will cut in September, and because monetary policy works slowly, they will be politically forced into more cuts than they would like, until signs of rising inflation cuts off the cuts sometime in 2008-9.? The yield curve will be much wider then, and then the hard choices faced in the 1970s will reappear, along with the s-word: stagflation.? I hesitate to use the word, because it is so sensationalistic, but I feel that we are headed there, slowly but surely.
For the last six years, I’ve had a reasonably good call on Federal Reserve policy.? That partly stems from having been an institutional fixed income investor in one way shape or form for fifteen years.? This dates back to my days at Provident Mutual where the company at that point in time left hedging decisions in the hands of the line of business actuaries.? In 1994, I sold GICs (Guaranteed Investment Contracts) like mad after the first Fed tightening, and ran unhedged.? Smooth move at the time, but that was too much power to grant me.? In hindsight, I was a novice then, and it could have gone badly wrong.
But at the present time, my view on the FOMC is cloudy.? It’s cloudy for a few reasons:
Bernanke is new, and we really don’t know his reaction function.
He has granted more autonomy to the Board of Governors to speak their minds, unlike Greenspan.
There are more inflation hawks with voting rights at present than over the past two years.
Using the discount window adds another dimension to the puzzle.? Unless the gap between the discount window and Fed funds is narrowed further, I don’t see it becoming a major factor, unless they further liberalize collateral requirements, and who may use the window.
Now, Bernanke has committed to act to avoid damage to the economy from conditions in the credit markets.? To me, this is important, not because I think the Fed can help the dead and dying — they can’t.? They can help the walking wounded, and overstimulate the healthy.? In the former cases, credit spreads dominate, in the latter credit spreads are still low.? From my angle, the Fed will slowly be forced to recognize that problems developed from speculation in residential real estate, CDOs, overdone arbitrage strategies and private equity are either a) too big to solve through monetary policy, without causing a lot of inflation, or b) they will try to “solve” the problem anyway, and hope that inflation doesn’t rise too much.
There’s no panacea here, and personally, I am not expecting anything too great out of the US equity markets if the Fed starts loosening.? After all, during the tightening cycle, the market rallied, including financials.? That was weird.? Weird things come in bunches; “Don’t fight the Fed” didn’t work last time.? Will it work this time?? Many are assuming that Fed policy will make the markets go because it has done so in the past.? When too many think so, it may not work.
Treasury and Swap rates have fallen enough that we are finally getting mortgage refinancing/hedging activity. 10-year swap spreads are 12 basis points below where they peaked a month ago, and 10-year swap rates, which serve as a proxy for prime 30-year mortgage rates, are 35 basis points below their 18-month moving average. The 10-year swap rate has come down 90 bps since the peak three months ago. Remember the panic then over higher rates? I wish I had put on more then, but I didn’t panic, and my bond positions did well.At present the discount window action is doing little; I struggled to find any mention of it last night. But M2 is showing some life, and my M3 proxy as well… quietly, banks in the Federal Reserve System are expanding their balance sheets, making up for the loss of commercial paper (and mebbe absorbing some collapsing conduits…). But the monetary base is stuck in the mud, and Fed funds averages 5% since the crisis began. Lotsa talk, but not much action.
I would let the long bonds ride here, because mortgage hedging sometimes takes on a life of its own. That doesn’t mean that systemic risk has gone away, but some of it is being hidden by mortgage hedging; interest rate swaps have many uses. You can still see the systemic risk in the TED spread (over 160 bp), and other option implied volatility measures.
For more fun, look at the TIPS market, where inflation protected bonds are outrunning nominal bonds. The longest TIPS is up more than 2% today. Wow. Also, the carry trade currencies (yen/swiss franc) have been running as well.
So, fear is alive and well, and so are prime mortgage bonds. What a fascinating day to watch the bond market in action.
Position: none, my prior bond positions are with the firm that I no longer work for…
Not that I am calling for a recession in 2007, but when a hawk like William Poole says that the odds of a recession are rising, it tells me that the Fed is looking for a reason to cut rates.? With the jobs report on Friday (which I think is over-analyzed relative to its true value), the FOMC may have more reason to cut.? If nothing else, it gives them political cover to cut.
Now, there are bigger issues here, and it is possible to be too shortsighted about current policy.? Efforts to solve the immediate problem can complicate future problems.? Even the actions of the ECB, in doing nothing at their recent meeting, sends a signal that the credit markets are more important than inflation.
Financial crises will always happen, and if we use monetary policy and bank regulation to try to avoid them in entire, we only set ourselves up for larger crises in the future.? (Ask Japan how much it likes low interest rates — they are really stimulative.)? Financial crises eventually end when bad debts are liquidated, or when financing is adequate to make it through.? In this case, the Fed will have a hard time fighting the large increase in debt to GDP.? (Also here.)? Bad loans have been made.? Regulation can deal with future loans to some limited degree, but monetary policy is at best a crude tool to deal with past mistakes.
It is outside the Fed’s mandate from Congress to deal with asset bubbles unless they affect inflation or full employment of labor.? Yet the Fed gets criticism for that.? Maybe Congress should get the criticism.? As it is, most of the current problems are manifesting on the short end of the yield curve, and among non-regulated lenders.? There are some assets that Asset backed commercial paper conduits should never have financed, as the SEC is now probing.? No surprise, though; the BIS saw this coming, after a fashion, and much more clearly than US regulators.? In any case, the problems in short-term lending are difficult to deal with.? Clearly, credit losses need to be taken by lenders who made bad loans; I don’t think that Fed policy can do much about that.
The deeper problem is that financial systems that rely on short-term lending are inherently unstable.? From the end of Alan Abelson’s column this week:
But, Stephanie [Pomboy] sighs, the current credit bust is not confined to real-estate lending. In truth, there are interest rate “resets” galore across the entire economy. Borrowing short has become a raging epidemic. Floating-rate paper now accounts for 54% of total debt issuance, up from 26% as recently as 2002. That means a startling $540 billion in corporate bonds will need to be rolled over next year.
The serial abusers in this realm are — who else? — financial enterprises, who need to replace a tidy $428 billion in debt next year, a third more than this year. In 2008, too, some $160 billion worth of leverage loans mature.
To top off this orgy of borrowing short, there’s the $87 trillion interest-rate swaps market. Essentially, she explains, here’s where long-term fixed-rate obligations are converted into floating-rate short-term notes. Swaps, Stephanie reports, accounted for more than half the growth in the $145 trillion derivatives market in the past two years.
What she foresees is a kind of financial Armageddon as the credit crunch deepens and widens. “Scarcely will they finish putting the subprime situation under house arrest” before policymakers will be forced to address similar problems in “credit-card debt, commercial-real-estate loans, CLOs…and beyond.”
As the credit engine sputters, the repair crew will be forced to “print and spend.” That, she says, is what gold has figured out. And what equities, we might add, are only beginning to learn.
Now, ignore the derivatives to a degree, because for every long there is a short.? So long as the counterparty risk management of the investment banks works, there should be no reason to worry.? (I wonder about this, but know that the investment banks are trying to manage this.)? The increasing prevalence of floating rate finance should make the system more sensitive to Fed policy, but even more to LIBOR in the Eurodollar-markets, which the Fed can’t directly affect.? That doesn’t mean that they won’t try, though, and to me, it indicates that he Fed will cut rates significantly through 2008, assuming that inflation or a rapidly falling dollar doesn’t intervene.
We live in interesting times.? I think that there is an inflation bias here, and that investors should prepare for it.
How bad will the credit crunch be?? Will it last into 2008?? Will it be worse than LTCM?? Is this the end of structured finance as we know it?? My quick answers: Yes, maybe, and no.? Structured finance is too useful of a concept to regulate too heavily.? Ratings are also difficult to do without from a regulatory standpoint.? The concept of “buyer beware” must apply to fixed income managers inside regulated financial institutions.? Ratings are ratings and not guarantees; they supply useful summary data, but are no substitute for due diligence.
Finally, I should have included this in my last post, but the short term debt markets are rough in the UK as well.? UK LIBOR hit a 10-year high recently.? When many of the various LIBORs of the world are showing signs of fear, it is possible that a larger trouble is at hand.? Until recently, all of the major central banks of the world were tightening, all at once.? With the exception of Japan, I expect them all to begin loosening soon, and begin accepting higher rates of inflation.? Perhaps I have my next investing theme?
Banks lend to each other short-term in several ways.? For banks in the Federal Reserve System, they lend through Fed Funds, of which the Federal reserve provides more or less liquidity as it sees fit.? Bigger banks can lend/borrow in the overseas euro-markets at LIBOR [the London Interbank Offered Rate].? This market is unregulated — outside the direct control of the Federal Reserve.? It is an independent source of US Dollar liquidity limited only by the willingness of banks to grow/shrink their balance sheets.
The willingness of major banks to grow their balance sheets is in short supply today, so LIBOR is rising.? Commercial banks like Barclays have a greater need for short term liquidity at present because they have to bring some short-term financing back onto their balance sheets because of failed conduits.? In the bank of England’s case, it was enough to force them to inject some temporary liquidity.? There is a secondary relationship between a central bank’s policy rate (like Fed funds) and LIBOR: as a central bank injects more liquidity, the less excess demand there is to borrow at LIBOR by banks.? So, as the Fed stays tight, and the need for short term finance grows, LIBOR rises.? And as I have mentioned before, the gap between LIBOR and T-bills [the TED spread] is very wide at over 1.5%.? Anytime the TED spread exceeds 1%, there is significant worry in the euro-markets over credit concerns.? Spreads of around 0.2-0.3% are more normal.
With this much pressure on the short-term debt markets, it is my belief that the Fed will do more than they have.? Maybe they will cut the discount rate again, or allow even more marginal collateral to be used.? On the other hand, since such subtleties are wasted on the public, they will likely have to grab the blunderbuss of lowering the Fed funds target, and fire a few times. It won’t solve the problems of those who are under heavy credit stress, but it will eliminate problems for those with light to moderate credit stress, and begin the overstimulation of a new part of the US economy.
August wasn’t all that bad of a month… so why were investors squealing? The volatility, I guess… since people hurt three times as much from losses as they feel good from gains, I suppose market-neutral high volatility will always leave people with perceived pain.
Need a reason for optimism? Look at the insiders. They see more value at current levels.
Need another good investor to follow? Consider Jean-Marie Eveillard. I’ve only met him once, and I can tell you that if you get the chance to hear him speak, jump at it. He is practically wise at a high level. It is a pity that Bill Miller wasn’t there that day; he could have learned a few things. Value investing involves a margin of safety; ignoring that is a recipe for underperformance.
Call me a skeptic on 10-year P/E ratios. I think it’s more effective to look at a weighted average of past earnings, giving more weight to current earnings, and declining weights as one goes further into the past. It only makes sense; older data deserves lower weights, because business is constantly changing, and older data is less informative about future profitability, usually.
I found these two posts on the VIX uncompelling. Simple comparisons of the VIX versus the market often lead to cloudy conclusions. I prefer what I wrote on the topic last month. When the S&P 500 is below the trendline, and the VIX is relatively high, it is usually a good time to buy stocks.
What does a pension manager want? He wwants returns that allow him to beat the actuarial funding target over the lifetime of the pension liabilities. If long-term high quality bonds allowed him to do that, then he would buy them. Unfortunately, the yield is too low, so the concept of absolute return strategies becomes attractive. Well, after the upset of the past six weeks, that ardor is diminished. As I have said before, to the extent that hedge funds seek stable, above average returns, they engage in yield-seeking behavior which prospers as credit spreads and implied volatilities fall, and fail when they rise. Eventually pension managers will realize that hedge fund returns cannot provide returns over the full length of the pension liability, in the same way that you can’t invest more than a certain amount of the pension assets in junk bonds.
Is productivity growth slowing? Probably. What may deserve more notice, is that we have larger cohorts entering the workforce for maybe the next ten years, and larger cohorts exiting as well, which will decrease overall productivity. Younger workers are less productive, middle-aged most productive, and older-aged in-between. With the Baby Boomers graying, productivity should fall in aggregate.
This is just a good post on sector data from VIX and More. It’s worth looking at the websites listed.
Economic weakness in the US doesn’t make oil prices fall? Perhaps it is because the US is important to the global economy, but not as important as it used to be. It’s not hard to see why: China and India are growing. Trade is growing outside of the US at a rapid pace. The US consumer is no longer the global consumer of last resort. Now we get to find out where the real resource shortages are, if the whole world is capitalist in one form or another.
Calendar anomalies might be due to greater macroeconomic news flow? Neat idea, and it seems to fit with when we get the most negative data.
Is investing a form of gambling? I get asked that question a lot, and my answer is in aggregate no, because the economy is a positive-sum game, but some investors do gamble as they invest, while others treat it like a business. Much depends on the attitude of the investor in question, including the time horizon and return goals that they have.
Massachusetts vs. the laws of economics. Beyond the difficulty of what to do with expensive cohorts in a public insurance system, I’ve heard that they are having difficulties that will make the system untenable in the long run… most of which boil down to antiselection, and inability to fight the force of aging Baby Boomers.
Rationality is one of those shibboleths that economists can’t abandon, or their mathematical models can’t be calculated. Bubbles are irrational, therefore they can’t happen. Welcome to the real world, gentlemen. People are limitedly rational, and often base their view of what is a good idea, off of what their neighbor thinks is a good idea, because it is a lot of work to think independently. Because it is a lot of work, people conserve on hard thinking, since it is a negative good. They maximize utility where utility includes not thinking too hard. Any surprise why we end up with bubbles? Groupthink is a lot easier than thinking for yourself, particularly when the crowd seems to be right.
Is China like the US with 120 years of delay? No, China has access to better technology. No, China does not have the same sense of liberty and degree of tolerance of difference. Its culture is far more uniform from an ethnic point of view. It also does not have the same degree of unused resources as the US did in the 1880s. Their government is in principle totalitarian, and allows little true freedom of religious expression, which is critical to a healthy economy, because people work for more than money/goods, but to express themselves and their ideals.
As I have stated before, prices are rising in China, and that is a big threat to global stability. China can’t continue to keep selling goods without receive goods back that their workers can buy.
The US needs more skilled immigrants. Firms will keep looking for clever ways to get them into the US, if the functions can’t be outsourced abroad.
It’s my view that dictators like Chavez possess less power than commonly imagined. They spend excess resources on their pet projects, while denying aid to the people whom they claim to rule for their benefit. With inflation running hard, hard currencies like the dollar in high demand, and the corruption of his cronies, I can’t imagine that Chavez will be around ten years from now.
Makes me want to buy Plum Creek, Potlach, or Rayonier. The pine beetle is eating its fill of Canadian pines, and then some, with difficult intermediate-term implications. More wood will come onto the market in the short run, depressing prices, but in the intermediate term, less wood will come to market. Watch the prices, and buy when the price of lumber is cheap, and prices of timber REITs depressed.
Pax Romana. Pax Americana. One went decadent and broke, the other is well on its way. I love my country, but our policies are not good for us, or the world as a whole. We intrude in areas of the world that are not our own, and neglect the proper fiscal and moral management of our own country.
Finally, it makes sense for economic commentators to make bold predictions, because there’s no such thing as bad publicity. Sad, but true, particularly when the audience has a short attention span. So where does that leave me? Puzzled, because I enjoy writing, but hate leading people the wrong way. I want to stay “low hype” even if it means fewer people read me. At least those who read me will be better informed, even if it means that the correct view of the world is ambiguous.
When the market gets wonky, I write more about current events.? I prefer to write about longer-dated topics, because the posts will have validity for a longer time, and I think there is more money to be made off of the longer trends.? Before I go there tonight, I would like to say that at present the Fed says that it is ready to act, but it hasn’t done much yet.? As for the Bush Administration, and Congress, they have done nothing so far, and the few credible promises are small in nature.? My counsel: don’t be surprised if the markets stay rough for a while.
Onto longer-dated topics:
Perhaps this should go into my “too many vultures” file, but conservative players like Annaly can take advantage of bargains produced by the crisis.? My suspicion is that they will succeed in their usual modest conservative way.
Falling rates?? Falling equity prices?? Pension funding declines.? This issue has not gone away in the UK, and here in the US, the PBGC is still struggling.? As it is, FASB is facing the issue head on (finally), and the result will likely be a diminution of shareholders’ equity for most companies with defined benefit plans.
China is a capitalist country?? Eminent domain can be quite aggressive there.? At least now they are promising compensation, but who knows whether the government really follows through.
Any strategy, like quant funds, can become overcrowded.? As a strategy goes from little known to crowded, total returns rise and then flatten.? Prospective returns only fall as more and more compete for scarce excess returns.? As the blowout occurs, total returns go negative, and more so for the most leveraged.? Prospective returns rise as capital exits the trade.? Smart quants measure prospective return, and begin liquidating as prospective returns get too low.? Not many do that for institutional imperative reasons (investor: what do you mean cash is building up?? What am I paying you for?), but it is the right strategy regardless.
This is a useful graph of sector weights in the S&P 500.? If nothing else, it is worth knowing what one is underweighting and overweighting.? I am overweight Energy, Basic Materials, Staples, Utilities, and (urk) Financials, and underweight the rest.? My portfolio, right or wrong, never looks like the market.
I’ve written about SFAS 159 before.? Well, we may have a new poster child for why I don’t like it, Wells Fargo.? Mark-to-model is impossible to escape in fixed income, but I would treat gains resulting from changes in model assumptions as very low quality.? Watch SFAS 159 disclosures closely with complex financial companies.? If we wanted to repeat the late 90s headache from gain on sale accounting, we may have created the conditions to repeat the experience in a related way.
How dishonest is the P&C insurance industry?? It varies, as in most industries.? Insurance is a bag of complex promises, which leaves it more open to abuse.? This article goes into some of that abuse, and teaches us to evaluate a company’s claims paying record.? You may have to pay more to get Chubb or Stancorp, but they almost always pay.
China’s financial system is maturing slowly; one example of that is reduced reliance on bank finance, and issuing bonds directly.
I don’t care what regulations get put into place, capitalist economies are unstable, and that’s a good thing.? There are always information asymmetries, and always crowd behavior, such that risk preferences change precipitously.? That’s the nature of the system.? The only true protection is to be aware of this reality, and adjust your behavior before things get crazy.
A firm I was with had an early opportunity to invest in LSV and we didn’t do it.? The two members of our committee that read academic research thought we ought to (I was one), but the practical men of the committee objected to investing with unproven academics.? Oh, well, win some, lose some.
Speaking of academic research, here’s a non-mathematical piece on cognitive biases.? Economists believe that man is economically rational not because of evidence, but because it simplifies the models enough to allow calculations to be made.? They would rather be precisely wrong than approximately right.
Bit by bit, the efficient markets hypothesis get chipped away.? Here we have a piece indicating persistence of excess returns of the best individual investors.? For those of us that have done well, and continue to plug away in the markets, this is an encouragement.? It’s not luck.
I have enough for two more pieces on longer dated data.? It will have to come later.
Listen to Dr. Jeff on the Fed. Here are a few factoids to reinforce what the Fed is actually doing at present:
Fed funds have averaged 5.25% over the past five days, and 5.00% over the past fifteen, since the crisis began.
The Fed’s last permanent injection of liquidity was May 3rd. That’s a pretty long time for no injection, even in a tightening cycle.
The monetary base is flat, growing little over the last year. If policy changed recently, I can’t see it.
Policy change doesn’t show up in the monetary aggregates either, but lag effects dominate here.
We won’t know about discount window borrowings until this evening, but I don’t expect much
3 month LIBOR is back around 5.60%, and the 3-month T-bill around 4% (rallying today). A TED spread at 1.6% indicates a lot of fear. Kinda surprised that swap spreads have not budged much.
In summary, the Fed hasn’t done much yet, aside from loosening up leverage requirements for some of the big banks, and allowing low quality collateral to come to the discount window. Though I don’t want the Fed to loosen, I don’t think they have much choice here. I expect an ordinary announcement by the end of the year cutting the Fed funds target.
Position: none
After that, I was pleasantly surprised to find that Calculated Risk and Econbrowser agreed with me.? Good company to be in.? After the close today, I wasn’t surprised to find that the discount window moves still haven’t done much.? Everyone will be listening to Bernanke tomorrow, but he won’t give any policy cues, most likely.? He has charted out a different course than the one Greenspan took; the hard question is whether he can maintain a policy of limited liquidity in the face of deteriorating conditions, and avoid the charge of favoritism, or, sloppy bank solvency management.? After all, credit is offered to few parties, and solvency rules are getting bent for the biggest banks.? That said, his tactics are more in line with the pre-Greenspan era.? But as this goes on, the commercial paper world shrinks for the third straight week, mainly due to the collapse of ABCP.
Looking around the world, there are a variety of news bits:
Cheyne Finance begins a partial wind-up of its operations.? Amazing what what happens when liquidity is no longer cheaply available to finance assets.? This also points up the difference between ABCP sponsored by a bank, where they might bail it out to preserve relationships (as with the Development Bank of Singapore), and sponsorship from a hedge fund, where the balance sheet can’t fix the problems, even if they wanted to.
See Yen run.? Run Yen, run.? Amid all of this stress, we may have the slow unwind of the carry trade.? It has not become a rout yet, but who can tell.? I am still a bull on the yen, but I have no positions there.
Amid the lack of liquidity in the US markets, foreign firms seeking debt capital go elsewhere.? Gerdau, the Brazilian steelmaker, seeks a international syndicated loan deal, rather than a deal in the US bond markets.? Just another sign of the times.? If you want to have a strong capital market for foreign entities, you must keep your domestic markets functioning, and that the US has not done.
So why conduits?? It allowed banks to do more business, while keeping it off of their balance sheets, thus maximizing their returns on assets and equity.? The banks may offer liquidity to the conduits during hard times, which brings some of the problems back during a crisis.
As a final note, all of the credit stress has led banks to tighten credit standards, and has limited the ability to finance first mortgage and home equity loans.? So where do strapped consumers go?? Credit cards.? This can last for three to six months, but eventually the credit gambit will end in a trail of losses for all lenders involved, particularly those who have low or questionable security.
Quants have it tough.? Few in the investment world really understand what you do, and even fewer outside that world.? To many investment managers, quants are the guys nipping at their heels, clipping their returns, and questioning the need for fundamental analysis.? There comes a kind of schadenfreude when their models blow up, where qualitative mangers get to say, “See, I knew it was too good to be true,” and in the newspapers, a kind of bewilderment at eggheads whose models failed them.
In a situation like this, success tends to breed more success, for a time, as more money gets applied to these strategies.? The statisticians should noticed the positive autocorrelation in excess returns, rather than randomness, which should have tipped them off to to much money entering the trade.? But no.? There was another calculation that could have been done as well, estimating the prospective return from new trades, which was declining as the trades got more popular.? My view is that a quant should estimate the riskiness of his strategy, and compare the returns to those available on junk bonds.? When the return is less than that available from a single-B bond, it’s time to start collapsing the trade.? (What, they won’t pay you to hold cash?? No wonder….)
On a different topic, consider mark-to-model.? I’ve said it before, but Accrued Interest said it better when it said that mark-to-model is unavoidable.? Most bonds in the market do not have a bid at any given time.? Most bonds are bought and held; beyond that, there are multiple bonds for a given company, versus one class of common stock.? The common stock will be liquid, and the bonds merely fungible.? It is even more true for structured securities, where the classes under AAA are very thin.? The AAAs may trade, classes with lower credit ratings rarely do.
Now the same argument is true when looking at a whole investment bank.? How do you mark positions that never trade, and here there is no readily indentifiable bid or ask?? You use a model that is built from things that do trade.? Sad thing is, there isn’t just one model, and there isn’t just one set of assumptions.? It is likely that the investment banks of our world, together with those they deal with, have marked illiquid securities to their own advantage.? Assets marked high, liabilities low.? Aggregate it across all parties, and the whole is worth more than the parts, due to mismarking.
Now for a tour of unrelated items:
There is something about a spike in volume that reveals weaknesses in back offices.? For derivative trading, where there is still a lot of paper changing hands, that is no surprise.
Prime brokerage is an interesting concept.? They bring a wide variety of services to hedge funds, but also compete in a number of ways.? At my last firm, I never felt that we got much out of our prime brokerage relationships for what we paid.? They provided liquidity at times, but not often enough.? Executions were poor as well.
The market sneezes, and we worry about jobs on Wall Street.? Par for the course.? What is unusual here is that few bodies were cut 2001-2003, so pruning may be overdue.? It may be worse because the structured product markets are under stress.
Catastrophe bonds are opaque to most, and Michael Lewis did us a favor by writing this.? That said, though this article begins by suggesting that 2007 will be an above average hurricane season, I ask, “What if it is not?”? It is rare for the hurricane season to shift halfway through the season.? It may be time to buy RNR, FSR, MRH and IPCR.? But regarding cat bonds, they are issued by knowledgeable insurers.? After issue, there are dedicated hedge funds that trade them, taking advantage of less knowledgeable holder, who only originally showed up for the extra yield.
A break in the market affects obscure asset classes as well.? If wealthy hedge fund managers are the marginal buyers of art, and they are getting pinched now, the art market should follow.
Message to Mish: If Bill Gross is shilling for a PIMCO bailout, we are all in trouble.? If the prime mortgage market and the agencies are in trouble, then I can’t think of anyone in the US that will not feel the pain.? I think Bill Gross is speaking his mind here, much as I think that Fed funds rate cuts are not needed, though I also think that they will happen, and soon.
Many emerging debt markets are in better shape than the US, because their current accounts are in better order.? Now, as for this article, Brazil might be okay, but Turkey is not in a stable place here because of their current account deficits, and I would be careful.
A personal note before I begin: My oldest daughter left for college today.? A bright girl who plays the harp beautifully, she is studying harp at the University of Maryland.? She is a true “people person” and an artist, and her good character is known by all of her friends.? She’ll be commuting, so I won’t lose her entirely yet, but we will miss her way with the other children.? She will be a natural mother, unlike her mother and I, who just try hard.
Well, two off to college in a single year.? Good thing I’ve got six left, or I’d be lonely. 😀
It takes two to make a market.? During the panic, some bond managers increased their risk postures as the market sold off.? Here is another example.? I agree with this in principle, but I at this point, I would only have moved my risk posture from “most conservative” to 20% of the way to “most aggressive,” which I actually did get to in November 2001, and October 2002.? There is a lot of leverage to unwind, and so there is a lot of room for further widening.? Take for example, these graphs of lower investment grade, and junk spreads.? We are nowhere near the 2002 wide spreads, though for investment grade, I don’t see how we get there.? Credit metrics are pretty good, though banks are more opaque and questionable.
Bond management is a game where you are paid not to lose, because people are relying on you for safety, and then a modestly good return on their money.? Now, though the last article doesn’t treat Bill Gross well, in this article, he praises simplicity in investing, which I would heartily agree with.? The only thing that gives me a bit of pause there is that PIMCO is a quantitative bond management shop that has historically derived most of its excess returns from quantitative strategies that rely on the equivalent of selling deep out of the money options against their positions, and mean-reversion, and variety of other things.? When the ordinary relationships don’t work, PIMCO could be disproportionately hurt.
Though investment grade looks fine, junk is another thing; it could reach the 2002 wides.? As an example, aside from all of the high yield deals that would like to get done, and all of the LBO debt standing in line waiting to be funded, there are still entities like Calpine that want to emerge from bankruptcy.? Willingness to take risk is not what it was when the banks made their commitments, so they’ll have to take losses to move the loans off of their books.? That will help to back up spreads, as buyers will toss out other paper to buy the Calpine debt, if it comes at an attractive enough concession.
In situation like this, one would expect municipal [muni] bonds to be a haven, and largely, they are, partly because they are one of the few areas not touched by foreign capital.? But I was genuinely surprised when I read this article.? Muni arbitrage?? Okay, it comes from one simple insight muni investors want low volatility, which means short duration bonds, while most municipalities want to lock in long term funding.? After all, most of their projects are long term in nature.? Muni hedge funds (sigh) step in to fill the gap, buying long dated bonds, and selling short bonds against them to muni investors, clipping a yield spread in the process.? Worked fine for a while, but the hedge funds warped the market by their own participation, and played for yield spreads that were too low for the risks involved.? As the market normalized, they got hurt, and some aggressive selling of the long end happened.? Now, long munis are probably a good deal.? For taxable accounts, they make sense, if your time horizon is long enough.
During financial stress, financial journalists may get a little over the top.? Comparing Ken Lewis to JP Morgan is an example.? First, the rescue is not that big, relative to Countrywide’s total liquidity needs.? Second, Countrywide, even if it failed, would not have that big of an impact on the total US financial system; it’s just not that big.? Would it be inconvenient?? Yes.? A bother for the regulators?? Sure.? But it would not appreciably affect the average financial institution, and it would inject some needed caution into those that lend to less secure entities.? Third, in a real rescue, far more capital is hazarded; honestly, the Fed did more by opening the discount window, pitiful as that was… it offered unlimited liquidity to (ahem) “quality” assets at a price.? (Quality has been redefined for now.)
At a time like this, a bevy of survey articles come out to describe what has gone wrong.? Some tell of how aggressive players overplayed their hands as the willingness to take risk dried up.? In this case, they boil it down to bad lending models, whether subprime mortgages, bank debt for LBOs, or internal leverage inside hedge funds.? Other articles point at historical analogies, looking for something that might tell when the crisis will end.? The two years compared, 1987 (dynamic portfolio hedging) and 1998 (LTCM), do offer some help, but are not adequate to deal with an overall mortgage lending problem, and a large external debt, getting larger through the current account deficit.
Is information failure the best way to describe it?? I don’t know; there were a lot of savvy people (myself included) who could see this coming, but could not put a date on it.? Toward the end of almost any bull market, underwriting gets sloppy, and the mess that it leaves usually persists until early in the next bull phase.? That’s the nature of human beings, and the markets they create.
As I have stated before, central bank policy can help marginal entities refinance, but is no good at aiding balance sheets that are truly broken.? As you analyze your own assets, be sure to ask which entities need financing over the next two to three years, and how badly they need the help.? Don’t play with companies that are at the mercy of the capital markets.? Even if in the short run, after a volatility event, stocks tend to do well, there may be more volatility events than just one.? This first one is over financing; there will be defaults later.? Be ready for the volatility that will come from them.
I like writing about the Federal Reserve because I understand it well, but this is beginning to make me tired. Here goes:
There are some who believe that the Fed will not cut rates soon. I half agree with them, because the Fed should not cut rates here. Let bad loans get their due punishment. That said, that ‘s not the way the Fed has acted for almost 80 years. Given that the Fed has to interact with politicians and businessmen, they are going to get a lot of negative feedback if they don’t loosen the fed funds rate. I general, the Fed caves to political pressure. This Fed is doing it now, but just in small steps, while they console themselves that they haven’t moved yet.
The actions that the Fed takes now will shape the next financial crisis. Where it loosens, leverage will flow to healthy areas that can absorb it until they become glutted as well.
SIVs are one issuer of ABCP, and many of them are doing badly now. I would not be too quick to rescue them, or be too optimistic about their ability to make good a maturity. The assets in the SIVs that have gone bad are not likely to turn around quickly. Next cycle, we will be more careful about what we lend against, until we commit the same error in a new way.
I hope the Fed’s actions so far will be enough, but I believe that they will have to do more.
