Bonds – Page 117 – The Aleph Blog

The Collapse of Fixed Commitments

Posted on 16 August 2007 by David Merkel

I’ve begun portfolio triage here, and am debating what to sell, and buy, if anything.? More in my next post, if I have the strength tonight.? I’m feeling a little better, though the market is not helping.

Why the collapse of fixed commitments?? Consider what I wrote In RealMoney’s columnist conversation today:

		David Merkel
		Yielding Illiquidity
		8/15/2007 4:02 PM EDT

Liquidity is the willingness of two parties to enter into fixed commitments, which can be measured by yield spreads, option prices, and bid-ask spreads. At present, the willingness to be on the giving liquidity side of the trade is declining. Even the willingness to do repos, which is pretty vanilla, has dried up. Roughly double the margin needs to be put up now to hold the same position. That dents the total buying power for what are arguably high quality assets — agency RMBS and the AAA portions of prime whole loans. This means that prices fall until balance sheet players with unencumbered cash find it sufficiently attractive to take on the mortgage assets.

I thought this era of unwinding leverage would arrive, and arrive it has. (That said, I did not expect that mortgage repo funding would be affected. That was a surprise.) I could never predict the time of the unwind, though, and though I have a decent amount of cash on hand, it can never be enough at the time.

One of the few bright sides here is that most of the real risk is concentrated in hedge funds, and hedge fund-of-funds. (Some pension plans are going to miss their actuarial funding targets dramatically.) Hopefully the investment banks with their swap books have done their counterparty analyses correctly, and didn’t cross hedge too much.

I’m still up for this year, but not by much. Perhaps I liked being intellectually wrong better while I made money on the broad market portfolio. Sigh.

Position: none

Could Countrywide fail?? It’s not impossible.? I had an excellent banking/financials analyst when I was a corporate bond manager, and she taught me that if you are a finance company, your ratings must allow you to issue commercial paper on an advantageous basis in order to be properly profitable.? If not, the optimistic outcome is a sale of the company to a stronger party.? The pessimistic outcome is failure.? We last tested this late in 2002 when we accumulated a boatload of Household International debt on weakness after they lost access to the CP markets, but had announced the merger with HSBC.? If you can make 12% in two months on bonds, you are doing well.? Paid for a lot of other errors that year.

But if Countrywide fails, the mortgage market is dead temporarily.? It would be a help after a year because of reduction in new mortgages, but in the short run, the rest of the market would have to digest the remains of Countrywide’s balance sheet.

Shall we briefly consult with the optimists?? Exhibit A is William Poole, who is more willing to speak his mind than most Fed Governors, for good and for ill.? He doesn’t see any effect on the “real economy” from the difficulties in the lending markets.? At the beginning of any lending crisis, that is true.? Difficulties happen in the “real economy” when current assets have a difficult time getting financed, and consumer durable purchases and capital investments get delayed because financing is not available at reasonable prices.? By year end, Poole will change his tune.

Now, I half agree with the Lex column in the Financial Times.? The level of screaming is far too loud for a decline of this magnitude. ? But that’s just looking at the stock price action.? The action in the debt markets in relative terms is more severe, and bodes ill for the equity markets eventually.? Remember, the debt markets are bigger than the equity markets.? Problems in the debt markets show up in the equity markets with a lag, as companies need financing.

One more optimist: private equity funds buying back LBO debt.? The steps of the dance have changed, gentlemen.? It is time to conserve liquidity, not deploy it.? The time to deploy is near the end of a credit bust, not near its beginning.

How about the pessimists?? Start with Veryan Allen at Hedge Fund.? He tells us that volatility is normal, and that it often drags the good down with the bad.? The difference is risk control, and the good don’t die, and bounce back after the bad die.? Now let’s look at the rogues’ gallery du jour. Who is getting killed?? Pirate Capital, Basic Capital, and let’s mention the Goldman Sachs funds again because the leverage was higher than expected.? Toss in an Austrialian mortgage lender for fun, not.? Consider those that are trying to remove money from hedge funds.? It may not be as severe as possible, but it could really be severe.? Investors, even most institutional investors, are trend followers.

Five unrelated notes to end this post:

Could this be the end of the credit ratings agencies?? I don’t think so.? It might broaden the oligopoly, and weaken it, but ratings are an inescapable facet of finance.? Ratings go through cycles of being good and bad, but people need opinions that are standardized about the riskiness of securities.? Go ahead, ban all of the existing ratings agencies now.? Within five years, debt buyers and regulators will have recreated them.
What is funny about this article from the Wall Street Journal is that they mix some residential mortgage REITs into an article on commercial mortgage REITs.? DFR and FBR both are residential mortgage REITs.? There may be more there too, but I haven’t checked.
If you can’t trust your money market funds, what can you trust?? I was always a little skeptical about asset backed commercial paper [ABCP] when it first arrived, but it survived 2000-2003, and I forgot about it.? Now it comes back to bite.? Some programs will extend maturities.? Some backup payers will pay, and some won’t.? Fortunately, it is not ubiquitous in money market funds, but it is worth looking for, if you have a lot in money market funds.
How rapid has this 1,000 point decline in the Dow been?? Pretty fast, though 1,000 points is smaller in percentage terms than it used to be.
Sorry to end on a sour note, but the Asian markets are having a rough go of it, and will make tomorrow tough in the US as well.

It’s late, so I’m going to post on my portfolio tomorrow.? I’ll give you the skinny now.? I’m evaluating the balance sheets and cash flow statements of stocks in my portfolio, and I am starting with those I have lost the most on, and evaluating their survivability under rough conditions.? I have some good ideas already, but I fear that I am too late; some names are so cheap, though leveraged (DFR is a good example), that it is hard to tell what the right decision is.? I will be making some trades, though, no doubt.

Full Disclosure: long DFR

The Value of Having a Deposit Franchise (or a Printing Press)

Posted on 14 August 2007 by David Merkel

I’m worried.? That doesn’t happen often.? Over the years, I have trained myself to avoid both worry and euphoria.? That has been tested on a number of occasions, most recently 2002, when I ran a lot of corporate bonds.? Ordinary risk control disciplines will solve most problems eventually, absent war on your home soil, rampant socialism, and depression.? I like my methods, and so I like my stocks that come from my methods, even when the short term performance is bad.? Could this be the first year in seven that I don’t beat the S&P 500?? Sure could, though I am still ahead by a few percentage points.

Let’s start with the central banks.? I don’t shift my views often, so my change on the Fed is meaningful.? But how much impact have the temporary injections of liquidity had?? Precious little so far.? Yes, last I looked, Fed funds were trading below 5%; banks can get liquidity if they need it, but credit conditions are deteriorating outside of that.? (more to come.)? I don’t believe in the all-encompassing view of central banking espoused by this paper (I’d rather have a gold standard, at least it is neutral), but how much will full employment suffer if most non-bank lenders go away?

Why am I concerned? Short-term lending on relatively high quality collateral is getting gummed up.? You can start with the summary from Liz Rappaport at RealMoney, and this summary at the Wall Street Journal’s blog.? The problems are threefold.? You have Sentinel Management Group, a company that manages short term cash for entities that trade futures saying their assets are illiquid enough that they can’t meet client demands for liquidity.? Why?? The repurchase (repo) market has dried up.? The repurchase market is a part of the financial plumbing that you don’t typically think about, because it always operates, silently and quietly.? Well, from what I have heard, the amount of capital to participate in the repo market for agency securities, and prime AAA whole loan MBS has doubled.? 1.5% -> 3%, and 5% -> 10%, respectively.? Half of the levered buying power goes away.? No surprise that the market has been whacked.

Second, away from A1/P1 non-asset-backed commercial paper, conditions on the short end have deteriorated.? As? I have said before, complexity is being punished and simplicity rewarded.? High-quality companies borrowing to meet short-term needs are fine, for now.? But not lower-rated borrowers, and asset-backed borrowers.? Third, our friends in Canada have their own problems with asset-backed CP.? Interesting how Deutsche Bank did not comply with the demand for backup funding.? Could that be a harbinger of things to come in the US?

On to Mortgage REITs.? Thornburg gets whacked.? Analyst downgrades.? Ratings agency downgrades.? Book value declines.? Dividends postponed.? It all boils down to the increase in margin and decrease in demand for mortgage securities (forced asset sales?).

It’s a mess.? I’ve done the math for my holdings of Deerfield Capital, and they seem to have enough capital to meet the increased margin requirements.? But who can tell?? Truth is, a mortgage REIT is a lot less stable than a depositary institution.? Repo funding is not as stable as depositary funding.? There will come a point in the market where it will rationalize when companies with balance sheets find the mortgage securities so compelling, that the market clears. After that, the total mortgage market will rationalize, in order of increasing risk.? Fannie and Freddie will help here.? They support the agency repo market, but the AAA whole loan stuff is another matter.? Everyone in the mortgage business except the agencies is cutting back their risk here.

By now, you’ve probably heard of mark-to-model, versus mark-to market.? The problem is that mark-to-model is inescapable for illiquid securities.? They trade by appointment at best, and so someone has to estimate value via a model of some sort.? The alternative is that since there are no bids, you mark them at zero, but that will cause equity problems for those buying and selling hedge fund shares.? This is a problem with no solution, unless you want to ban illiquid securities from hedge funds.? (Then where do they go?)

There’s always a bull market somewhere, a friend of mine would say (perhaps it is in cash? that is, vanilla cash), but parties dealing with volatility are doing increasing volumes of business, which is straining the poor underpaid folks in the back office.

Why am I underperforming now?? Value temporarily is doing badly because stocks with low price-to-cash-flow are getting whacked, because the private equity bid has dried up.? That’s the stuff I traffic in, so, yeah, I’m guilty.? That doesn’t dissuade me from the value of my methods in the long run.

Might there be further liquidity troubles in asset classes favored by hedge funds?? Investors tend to be trend followers, so? yes, as redemptions pile up at hedge funds, risky assets will get liquidated.? Equilibrium will return when investors with balance sheets tuck the depreciated assets away.

Finally, to end on a positive note.? Someone has to be doing well here, right?? Yes, the Chinese.? Given the inflation happening there, and the general boom that they are experiencing, perhaps it is not so much of a surprise.

With that, that’s all for the evening.? I have more to say, but I am still not feeling well, and am a little depressed over the performance of my portfolio, and a few other things.? I hope that things are going better for you; may God bless you.

Full disclosure: long DB DFR

Why I Worry About Inflation Globally

Posted on 13 August 2007 by David Merkel

Money supply growth is high and inflation rising in much of the developing world. This is leading to inflation in China, Australia, and many other places, as the deflationary effects of adding new labor to the global capitalist labor pool gets outweighed by the hyperactive printing press.

Central banks are still adding to liquidity, perhaps to bail out banks who have made bad loans to parties on the wrong side of securities trades.? I like CLSA’s Greed and Fear, but don’t argue with what the central banks are doing, instead, try to analyze what they will do from here.

Two more notes: I don’t see China selling US Dollar assets.? It isn’t in their interest.? What they would more likely do is begin purchasing US corporations, and/or merely slowing/eliminating debt purchases — those would be more than uncomfortable enough.? Second, as I mentioned in my prior post, the risk is not US assets fleeing Asia, but Asian assets fleeing the US.

With that, have a good night.? I’ll try to get to my two other posts tomorrow.

Limits to the Power of Monetary Policy, Part 2

Posted on 11 August 2007 by David Merkel

Not many of my posts generate a large number of quality responses.? Rather than respond in the comments area, I thought I would make this a separate post.? My views on the Fed are eclectic, and a little quirky, because I am a skeptic about the power of central banking generally, on both the upside and the downside.? I’ve done fairly well as a bond manager using my views of the Fed to add some value.? (I’m not a bond manager now, though I would like to run a bond fund again at some point.)

First let’s clear the decks.? I am not short.? I am not underinvested in stocks, or private equity.? I am also a “lone wolf.”? I don’t work for anyone.? When I worked for my prior employer, what I posted here and at RealMoney often disagreed with the view of the owner/founder (a genuinely good fellow, and a bright guy).? What I said, I said on two levels.? First, what should be: maintain a tight-ish monetary? policy, because the crisis is nothing the the Fed should be concerned about.? I care about public policy.? I don’t like inflation, which is very understated by the PCE, and understated by the CPI, for reasons that I have stated previously.? I also don’t agree with the concept of core inflation.? If you want to remove volatility, trim the mean, or use a median.? But excluding whole classes of goods is bogus, particularly when their removal lowers the CPI by a lot.

My view is that the temporary injections of liquidity will fail.? There will be enough demand for additional short term liquidity that the Fed will have to begin making permanent injections of liquidity into the system, and eventually cut the Fed funds rate.? Once you cross the intellectual barrier of providing enough incremental liquidity to keep the system afloat, you have committed to an uncertain course of action that will likely lead to rate cuts eventually.? If the goal of monetary policy shifts, so will the direction of policy, usually.

Has the Fed lost control of monetary policy?? Yes and no.? Yes, if they continue to do business the way they do now.? No, if they want to get ugly, and restrict the ways the banks do business, either through regulation or through a modification of the risk-based capital rules.? Even so, what can they do about stimulus via foreign purchases of US debts?? Not much, and even the US Treasury would have a hard time there.

Why have the markets been so good for 25 years? I have five reasons:

Demographics — the Baby Boomers entered their most productive years.
Easy Federal Reserve — after the overshoot of policy in the early 80s, the Fed was far more activist and willing (particularly under Greenspan) to throw liquidity at problems that should be liquidated by the free markets.
Capitalism — Almost every nation is Capitalist now, even if it is crony Capitalism.
Deregulation — business benefited from deregulation under Reagan (and no one else).
Free-ish Trade — Trade isn’t really free, but many nations are more willing to compete globally, and the deflationary effects of that competition have been a real benefit.

Finally, I am still thinking about what will benefit from a shift in Fed policy.? I mentioned high quality financials.? To me, that means companies like Hartford (or maybe PRU), which I don’t own at present.? Maybe Wells Fargo?? I’m not sure, but it would have to be institutions that have suffered a real price setback, where a permanent impairment of capital is unlikely.? But what other industries will benefit from lower financing rates?? That is the $64 billion question, and with that, I bid you good night.

The State of the Markets

Posted on 11 August 2007 by David Merkel

I’m going to try to put in two posts this evening — this one on recent activity, and one on the Fed, to try to address the commentary that my last post generated.

Central Banking in the Forefront?

Let’s start with the state of monetary policy.? Is it easy or tight?? It’s in-between.? The monetary base is growing at maybe a 3% rate yoy.? The Fed has not done a permanent injection of liquidity in over 3 months.? MZM and M2 are around 5%, and my M3 proxy is around 8%.? But FOMC policy is compromised by the willingness of foreigners to finance the US Current account deficit, and cheaply too.? The increase in foreign holdings of US debt is roughly equal to the increase in M2.? That provides a lot of additional stimulus that the Fed can’t undo.

So what have the Central Banks done lately? Barry does a good job of summarizing the actions, all of which are temporary injections of liquidity, together with statements of support for the markets.? So why did short-term lending rates to banks spike?? My guess is that there were a few institutions that felt the need to shore up their balance sheets by getting some short-term liquidity.? I’m a little skeptical of the breadth of this crisis, but if anything begins to make me more concerned, it is that some banks in the Federal Reserve System needed liquidity fast.? Also, some banks needed quick liquidity from the unregulated eurodollar markets.? But who?? Inquiring minds want to know… 😉

So, over at FT Alphaville they wonder, but in a different way.? What do central bankers know that we don’t?? My usual answer is not much, but I am wondering too.? Panicked calls from investment bank CEOs?? Timothy Geithner worrying about systemic risk?? Maybe, but not showing up in swap spreads, yet.? Calls from commercial bankers asking for a little help?? Maybe.? I don’t know.? I wonder whether we’ve really felt enough pain in order to deserve a FOMC cut.? We haven’t even had a 10% correction in the market yet.? Obviously, But some think we’ve had enough pain.? But inflation is higher than the statistics would indicate, and is slowly getting driven higher by higher inflation abroad, some of which is getting transmitted here.? Not a fun time to be a central banker, but hey, that’s why they pay them the big money, right? 🙂

Speculation Gone Awry, Models Gone Awry

We can start with a related topic: money market funds. Some hold paper backed by subprime mortgages.? With asset backed commercial paper, some conduits are extending the dates that they will repay their obligations.? Not good, though ABCP is only a small part of the money markets.? Ordinary CP should be okay, even with the current market upset, though I wonder about the hedge funds that were doing leveraged non-prime CP.

In an environment like this, there will be rumors.? And more rumors.? But many admit to losing a lot of money.? Tykhe. Renaissance Technologies. The DWS ABS fund.? There are some common threads here.? I believe that most hedged strategies (market-neutral) embed both a short volatility bet, and a short liquidity bet, which? add up to a short credit spreads bet.? In a situation like this, deal arbitrage underperforms.? The Merger Fund has lost most of its gains for the year.? Part of the reason for losses is deals blowing up, and the rest is a loss of confidence.? Could other deals blow up, like ABN Amro?? If you want to step up now, spreads are wider than at any point in the last four years, and you can put money to work in size.

More notable, perhaps, are the extreme swings in stock prices. Many market-neutral strategies are underperforming here.? (Stock market-neutral does not mean credit market-neutral.)? Statistical arbitrage strategies were crowded trades.? Truth is, to a first approximation, even though almost all of the quant models were proprietary, they were all pretty similar.? Academic research on anomalies is almost freely available to all.? Two good quants can bioth start fresh, but they will end up in about the same place.

Last week, I commented how my own stocks were bouncing all over the place.? Some up a lot, and some down a lot on no news.? Many blame an unwind in statistical arbitrage.? Was this a once in every 10,000 years event?? I think not.? The tails in investing are fat, and when a trade gets crowded, weird things happen.? It is possible to over-arbitrage, even as it is possible to overpay for risky debt.? As the trade depopulates, prices tend to over-adjust.? Are we near the end of the adjustment?? I don’t think so, but I can’t prove it.? There is too much implicit leverage, and it can’t be unwound in two weeks.

Odds and Ends

Two banking notes: S&P has some concerns about risk in the banking sector, despite risk transfer methods.? A problem yes, but limited in size.? Second, ARM resets are going to peak over the next year.? The pain will get worse in the real estate markets, regardless of what the Fed does.

Insider buying is growing in financial stocks, after the market declines.? I like it.? My next major investment direction is likely overweighting high quality financials, but the timing and direction are uncertain.

Finally, from the Epicurean Dealmaker (neat blog. cool name too.), how do catastrophic changes occur?? I love nonlinear dynamics, i.e., “chaos theory.”? I predicted much of what has been happening two years ago at RealMoney, but I stated the the timing was uncertain.? It could be next month, it could be a decade at most.? The thing is, you can’t tell which straw will break the camel’s back.? I like being sharp rather than fuzzy, but I hate making sharp predictions if I know that the probability of my being wrong is high.? In those cases, I would rather give a weak signal, than one that could likely be wrong.

Limits to the Power of Monetary Policy

Posted on 11 August 2007 by David Merkel

I posted this on RealMoney on 5/6/2005, when everyone was screaming for the FOMC to stop raising rates because the “auto companies were?dying.”

/*-/*-/*-/*-/*-/*-/*-/*-/*-/*-/*-/*-

On Oct. 2, 2002, one week before the market was going to turn, the gloom was so thick you could cut it with a knife. What would blow up next?

A lot of heavily indebted companies are feeling weak, and the prices for their debt reflected it. I thought we were getting near a turning point; at least, I hoped so. But I knew what I was doing for lunch; I was going to the Baltimore Security Analysts’ Society meeting to listen to the head of the Richmond Fed, Al Broaddus, speak.

It was a very optimistic presentation, one that gave the picture that the Fed was in control, and don’t worry, we’ll pull the economy out of the ditch. When the Q&A time came up, I got to ask the second-to-last question. (For those with a Bloomberg terminal, you can hear Broaddus’s full response, but not my question, because I was in the back of the room.) My question (going from memory) went something like this:

I recognize that current Fed policy is stimulating the economy, but it seems to have impact in only the healthy areas of the economy, where credit spreads are tight, and stimulus really isn’t needed. It seems the Fed policy has almost no impact in areas where credit spreads are wide, and these are the places that need the stimulus. Is it possible for the Fed to provide stimulus to the areas of the economy that need it, and not to those that don’t?

It was a dumb question, one that I knew the answer to, but I was trying to make a point. All the liquidity in the world doesn’t matter if the areas that you want to stimulate have impaired balance sheets. He gave a good response, the only surviving portion of it I pulled off of Bloomberg: “There are very definite limits to what the Federal Reserve can do to affect the detailed spectrum of interest rates,” Broaddus said. People shouldn’t “expect too much from monetary policy” to steer the economy, he said.

When I got back to the office, I had a surprise. Treasury bonds had rallied fairly strongly, though corporates were weak as ever and stocks had fallen further. Then I checked the bond news to see what was up. Bloomberg had flashed a one-line alert that read something like, “Broaddus says don’t expect too much from monetary policy.” Taken out of context, Broaddus’s answer to my question had led to a small flight-to-safety move. Wonderful, not. Around the office, the team joked, “Next time you talk to a Fed Governor, let us know, so we can make some money off it?”

PS — ?Before Broaddus answered, he said something to the effect of: “I’m glad the media is not here, because they always misunderstand the ability of the Fed to change things.” ?A surprise to the Bloomberg, Baltimore Sun, and at least one other journalist who were there.
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And now to the present application:

My main point in posting this story is to point out the impotence of Fed policy in helping areas of the economy with compromised balance sheets. ?When credit spreads are wide, cuts in the fed funds rate do not appreciably affect the funding costs of firms deep in junk grade.

Beyond that, temporary injections of liquidity are meaningless, and that is all the major central banks of the world have done, together with words saying they will support the markets. ?Well, what happens after the market digests that, and the temporary injections of liquidity are gone. ?They will expect the Fed to stand and deliver something more permanent. ?Much as I have resisted this thought, and hate it in terms of public policy, the FOMC will cut rates at that point in time, and begin a loosening cycle. ?It’s the wrong thing to do, and won’t achieve the goals intended, but my view of Fed policy is that I must focus on will they will do, not what they should do.

So you have my change of view here and now. ?The central banks of our world have caved in to an unrealistic fear of what is going on in the fixed income markets. ?The next move of the Fed is to loosen. ?It will happen in 2007. ?Look for the areas of the economy that are healthy, and will benefit from cheap financing, because they will get it. ?The trade: buy high quality financial stocks. ?Time to overweight.

The Current Market Morass

Posted on 9 August 200710 August 2007 by David Merkel

Over at RealMoney, toward the end of the day, I commented:

		David Merkel
		Many Hedge Funds are Systematically Short Liquidity
		8/9/2007 5:43 PM EDT

You can look at Cramer’s two pieces here and here that deal with the logjam in the bond markets. Now, there are problems that are severe, as in the exotic portions of the market. There are problems in investment grade corporate bonds in the cash market, but spreads haven’t moved anywhere nearly as much as they did in 2002. The synthetic (default swap) portion of the market is having greater problems. Oddly, though high yield cash spreads have moved out, they still aren’t that wide yet either compared to 2002. The problems there are in the CDS, and hung bridge loans.

Most hedge funds that try to generate smooth returns are systemically short liquidity and volatility. If these funds are blowing up, like LTCM in 1998, then liquidity will be tight in the derivative markets, but the regular cash bond markets won’t be hurt so bad.

I agree with Michael Comeau with a twist… this may end up being good for the equity markets eventually, but in the short run, it is a negative.

Let me try to expand a little more here. A good place to start is Cramer’s last piece of the day. Part of what he said was:

But first you have to recognize that I am not talking about opportunity. We need the Fed simply to issue a statement like it did in 1987, that it would provide all of the liquidity necessary to get things moving in the credit markets.

All of those who think the Fed is helpless are as clueless as the Fed. A statement like that would eliminate the fear all over town that committing capital is going to wipe your firm out.

The European action seemed desperate today, but it’s a bit of a desperate time, and they did what is right.

If we had made the right call on Tuesday at the Fed, we would have maneuverability over the next month to help.

Now we can’t. Not for another couple of months, [sic]

Unfortunately, Cramer is wrong here. The ECB only did a temporary injection of funds, which will disappear. The Fed also did a similar temporary injection of funds today, which brought down where Fed funds were trading. It will disappear as well, but both the ECB and Fed can make adjustments as they see fit. There isn’t any significant difference between the actions.
There have been notable failures and impairments, for sure. Let’s run through the list: the funds at BNP Paribas, funds at AXA, Oddo, Sowood and IKB, Goldman Sachs, Tykhe Capital, and Highbridge (and more). With this help from DealBreaker (most of the comments are worth reading also), I would repeat that most hedge funds that try to generate smooth returns are systemically short liquidity and volatility. Another way of saying it is that they have a hidden short in credit quality, and this short is biting bigtime.

Okay, I’ve listed a lot of the practical failures, but what classes of hedge fund investments are getting hurt? Primarily statistical arbitrage and event-driven. (Oh, and credit-based as well, but I don’t have any articles there.) The computer programs at many stat arb shops have not done well amid the volatility, and there have have been significant M&A deals that have come into question, like MGIC-Radian. Merger arbitrage had a bad July, and looking at the Merger Fund, August looks to be as bad. (Worrisome, because merger arb correlates highly with total market confidence.) As for statistical arb, I know a few people at Campbell & Company. They’re bright people. Unfortunately, when regimes shift, often statistical models are bad at turning points. Higher volatility, bad credit, and the illiquidity that they engender doom many statistical models of the market.
So, how bad is credit now? If you are talking about securitized products and derivatives, the answer is extremely bad. If you are talking about high yield loans to fund LBOs, very bad, and my won’t some the investment banks take some losses there (but they won’t get killed). High yield bonds, merely bad — spreads have widened, but not nearly as much as in 2002. Same for investment grade corporates, except less so. Now the future, like say out to 2010, may prove to be even worse in terms of aggregate default rates of corporates, because more of the total issuance is high yield. This is just something to watch, because it may imply a stretched-out scenario for corporate credit losses.

The Dreaded Subprime

Subprime mortgage lending has had poor results. I would even argue that early 2007 originations could be worse than the 2006 vintage. This has spilled over into many places, but who would have expected money market funds? The asset-backed commercial paper [ABCP] market is a small slice of the total commercial paper market, and those financing subprime mortgage receivables are smaller still. The conduits that do this financing have a number of structural protections, so it should not be a big issue. The only thing that might emerge is if some money market fund overdosed on subprime ABCP. I’m not expecting any fund to “break the buck,” but it’s not impossible.

I generally like the writings of Dan Gross. He is partially right when he says that the effects of subprime lending are not contained. Many different institutions are getting nipped by the problem. But I think what government officials mean by contained is different. They are saying that they see no systemic risk from the problem, which may be correct, so long as the aggregate reduction in housing prices does not cause a cascade of failure in the mortgage market, which I view as unlikely.

Perhaps we should look at a bull on subprime lending? Not a big bull, though. Wilbur Ross has lent $50 million to American Home Mortgage on the most senior level possible. That’s not a very big risk, but he does see a future for subprime lending, if one is patient, and can survive the present slump.

A note on Alt-A lending. There’s going to be a bifurcation here; not all Alt-A lending is the same. As S&P and the other rating agencies evaluate loan performance, they will downgrade the deals with bad performance, and leave the good ones alone. The troubles here will likely be as big as those in subprime. Perhaps the lack of information on lending is the crucial issue. Colloquially, never buy a blind pool, or a pig in a poke. Information is supremely valuable in lending, and often incremental yield can’t compensate.

Summary Thoughts

I think 1998 is the most comparable period to 2007. There are some things better and worse now, than in 1998. In aggregate it’s about the same in my opinion. Now with hedge funds, the leverage in aggregate is higher, but could that be that safer instruments are being levered up? That might be part of it, but I agree, aggregate leverage is higher.

In a situation like this, simplicity is rewarded. Complexity is always punished in a liquidity crisis. Bidders have better thing sto do in a crisis than to figure out fair value for complex instruments when simpler ones are under question.
Another aspect of liquidity is the investment banks. As prime brokers, their own risk control mechanisms cause them to liquidate marginal borrowers whose margin has gotten thin. This protects them at the risk of making the crisis worse for everyone else as the prices of risky asset declines after liquidations. Other investors might then face their own margin calls. The cycle eventually burns out, but only after many insolvencies. My guess: none of the investment banks go under.

Finally, let’s end on an optimistic note, and who to do that better than Jim Griffin? As I said before, simplicity is valued in a situation like this, and stocks in aggregate are simple. As he asks at the end of his piece, “What are you going to buy if you sell stocks?” I agree; there will be continued problems in the synthetic and securitized debt markets, but if you want to be rewarded for risk here, equities offer reasonable compensation for the risks taken. Just avoid the areas in financials and hombuilders/etc, that are being taken apart here. The world is a much larger place than the US & European synthetic and securitized debt markets, and there are places to invest today. Just insist on a strong balance sheet.

Nine Global Macroeconomic Trends: Watching the Currency Speculation, Watching the Inflation Pot Boil

Posted on 9 August 2007 by David Merkel

This piece is a little dated, but I’m using it to illustrate the nature of consumer surveys in the US.? If rates have been rising, those polled extrapolate the current trend.? As it was, that particular poll was close to the short-term turning point on inflation expectations.? I feel more comfortable trying to tease out inflation expectations by looking at the relative spread of TIPS to nominal bonds.? Right now, that’s not moving much.
I’m already on record that I don’t like the concept of core inflation, and that I think current methods of measuring inflation understate it, though now I would say only by 1%/year.? But regarding core inflation, there are many who say there are better ways to remove volatility from the estimation of central tendency.? Use of a median or trimmed mean are superior methods to excluding whole classes of goods, like food and energy, which conveniently have been rising faster than most other good in the CPI.
Inflation is rising in many places.? New Zealand is one example.? This is one of those temporarily self-reinforcing situations where foreign investors are willing to invest because of high nominal rates, while discounting any possibility of the currency moving against them.? In the short run, the more people who believe this, the less likely that an adjustment occurs.? But the additional liquidity stimulates the economy, raises inflation, and makes the central bank want to tighten more, leading to higher rates in which foreign investors want to invest.? It will only break when the high rates slow the NZ economy to a crawl, or, for some unexpected reason, the currency starts depreciating, and it feeds on itself.? Personally, I would not be long the Kiwi.
The Economist has noticed many of the same trends, adding in Latvia and Iceland to NZ.? In the short run, so long as foreign investors have confidence in the currencies of these three nations, their central banks are impotent.? But in some sort of crisis that would disrupt global capital flows, all of these currencies would be at risk.? No telling when that will happen, but once the adjustment happens, like those who borrowed at teaser rates, they will be sorry they invested in high interest rate currencies, and borrowed in low interest rate currencies.
China.? Easy to underestimate.? Easy to overestimate.? Hard to get a fair picture.? Their Central bank keeps tightening, but doesn’t let the currency adjust upward.? As a result, inflation keeps rising there… too much credit is chasing too few goods produced for domestic consumption. (Diseases affecting pigs, and high grain prices don’t help.? Food is a larger portion of the budget of the average person in China.)? Exports dominate Chinese economic policy, and with an dirty-floating undervalued currency, trade surpluses build up almost everywhere, except the Middle East and Japan.? The Chinese economy keeps rolling ahead, growing at near-record rates if you can believe the statistics.? (Which I largely believe, the current account surpluses don’t lie.)? That has costs, though.? There are costs to the environment, food safety, working conditions, etc.? The communist party has in some ways transformed themselves in a bunch of crony capitalists.? Those at the top get the favors, and the rest trickles down, but not as well as in the US.? In the short run, that can produce amazing economic results, but can’t produce a society that is truly creative, and self-sustainingly productive.? What will happen to China when it no longer has incremental cheap labor to deploy?? Productivity will drop?? Already I am hearing of some manufacturers decamping to Vietnam, and other cheaper places.
The reported US Government deficit is shrinking.? Good as far as that goes.? Corporate taxes are filling much of the gap.? We still have the Iraq/Afghanistan Wars off-budget, and Social Security on budget, both of which reduce the true size of the deficit.? On an accrual basis, counting everything in, we are running deficits at near record levels.? Promises are being made for the future the aren’t getting counted today.? Corporations would have to accrue them, but the government does not.
And now a word from our sponsors, the optimists.? Let’s start with the ISI Group.? They have ten reasons why we won’t have a recession soon.? I have been arguing for a recession in 2008, but as GDP growth remains positive each quarter, it gets harder to maintain that a recession is around the corner.? Though inflation is rising, credit spreads are widening, and the US Dollar is falling, the US economy has been resilient, credit spreads and implied volatilities have not been out of control.? And housing finance is not good, but most of the lending risk is concentrated in the hands of a few speculators.? The US economy is seeing export-led growth for the first time in a while.? There are reasons for optimism here; just because it is easier as a writer to be a skeptic and a pessimist, doesn’t mean you should invest that way.
Why do I like most but not all emerging markets here?? They are better managed on both fiscal and monetary bases than many developed economies, and capitalism is finally becoming a sustainable ideology.? That’s why amid the rise in credit spreads for junk grade corporations here in the US, many emerging market spreads have tightened.? Going back to points 3 and 4 above, those that don’t have strong fiscal and monetary policies, like Turkey, may very well get whacked, after a disruption in capital flows, war, or some event that changed the willingness of investors to take currency or sovereign risk.
What if we try to get away from currencies, and focus on commodities instead?? Metal scrap prices are robust.? Aluminum beer kegs are getting sold for scrap, among other things.? In another place, Historian Niall Ferguson tells us that we should not worry about running out of oil, but out of arable land for farming.? Personally, I’m not worried about either.? Rising food prices will slow the development on arable land, and in some cases, redevelop land for farming.? Further, contrary to the over-estimated Malthus (whose great contribution in life was giving inspiration to Darwin), we have been able to grow agricultural productivity considerably faster than population, in areas where capitalism is allowed to thrive.? That said, I am bullish on the prices of food products; in the short run, there will be more excess demand.

Eight Great Straight Points on Real Estate

Posted on 7 August 20078 August 2007 by David Merkel

So Moody’s tries to clean up its act, and finds itself shut out of rating most Commercial Mortgage-backed Securities [CMBS] deals? That’s not too surprising, and sheds light on the value of ratings to issuers and buyers. With issuers, it’s easy: Give me good ratings so that I can sell my bonds at low yields. With buyers, it is more complex: We do our own due diligence — we don’t fully trust the ratings, but they play into the risk management and capital frameworks that we use. We like the bonds to be highly rated, and misrated high even better, because we get to hold less capital against the bonds than if they were correctly rated, which raises our return on capital. Moody’s was always in third place behind S&P and Fitch in this market, so it’s not that big of a deal, but I bet Moody’s quietly drops the change.
The yields on loans are not only going up for LBOs like Archstone, leading to further deal delays, but yields are also rising on commercial real estate loans generally. Here is an example from one of the big deals. The risk appetite has shifted. Is it any surprise that equity REITs are off so much since early March? The deals just can’t get done at those high cap rates anymore.
An old boss of mine used to say, “Liquidity is a ‘fraidy cat.” It’s never there when you really need it, and with residential mortgage finance now, the ability to refinance is being withdrawn at the very time it is needed most. What types of mortgages are now harder to get? No money down, Jumbo loans, Alt-A, more Alt-A, and you don’t have to mention subprime here, the pullback is pretty general, with the exception of conforming loans that are bought by Fannie and Freddie. For (perverse) fun, you can see how detailed the guidance to lenders can become.
Should it then surprise us if some buyers of mortgage loans have gotten skittish? No, they forced the change on the originators. A buyers strike. But maybe that’s not the right move now. Let me tell you a story. When I came to Provident Mutual in 1992, the commercial mortgage market was in a panic. The main lines of business of Provident Mutual, hungry for yield, had accepted low-ish spreads from commercial mortgages from 1989-1991, because it improved their yield incrementally. The Pension Division avoided commercial mortgages then, because they felt the risks were not being fairly compensated. In 1992, the head of the commercial mortgage area came to the chief actuary of the pension division, and told him that unless the Pension Division bought their mortgage flow, they would have to shut down, because the main lines couldn’t take any. The chief actuary asked what spreads he would get, and the spreads were high — 3% over Treasuries, much better than before. He asked about loan quality, and was told that they had never had such high quality loans; only the best deals were getting done because of the panic in the market. The chief actuary, the best actuarial businessman I have ever known grabbed the opportunity, and took the entire mortgage flow for the next two years, then stopped. (Saving the Mortgage Division was icing on the cake.) Spreads normalized; credit quality was only average, and the main lines of the company now wanted mortgages. The point of the story is this: the firms that will do best now are not the ones that refuse to lend, but the ones who lend to high quality borrowers at appropriate rates. It’s good to lend selectively in a panic.
Eventually the ARM mortgage reset surge will be gone. Really. We just have to slog through the next two years or so. This will lead to additional mortgage delinquencies and defaults. We’re not done yet. There is a lot of mis-financed housing out there, and unless the borrowers can refinance before the fixed rate period ends to a cheap-ish conventional loan, I don’t see how the defaults will be avoided. Remember houses are long-term assets. Long term assets require long-term financing. Floating rates don’t make it. Non-amortizing loans don’t make it.
Should it then surprise us that the downturn in housing prices is large? No. With all of the excess supply, from home sellers and homebuilders, current prices are not clearing most of the local real estate markets, and prices need to fall further. (Maybe we should offer citizenship to foreigners who buy US residential real estate worth more than $500,000. A win-win-win. Excess supply goes away. Current account deficit reduced. Wealthy foreigners get a safe place to flee, should they need it. 😉 )
As a result, the homebuilders are doing badly. They aren’t making money on the hgomes they build and the value of the land (and land options, JVs, etc.) that they bought during the frenzy is worth a lot less. Sunk costs are sunk, and though you lose money on an accounting basis, in the short run, it is optimal to builders to finish developments that they started.
Could I get John Hussman to like this Fed Model? It’s from the eminent Paul Kasriel, and it compares the earnings yield of residential real estate and Treasury yields, and he suggested in early June that residential real estate was overvalued. There are limitations here; no consideration of inflation and capital gains, no consideration of the spread of mortgage yields over Treasuries. The result is clear enough, though. Don’t own residential real estate when you can earn more in Treasuries than you can in rents. (I know real estate is local, frictional costs, etc., but it does give guidance at the margins.)

Does Greg Ip Still Have an Inside Line on the FOMC?

Posted on 7 August 20077 August 2007 by David Merkel

During the tightening era, a number said that the Federal Reserve Open Market Committee [FOMC] would telegraph their views through Greg Ip of the Wall Street Journal. If so, today’s article should be a concern to those favoring the view that the FOMC must loosen in order to ~~keep the speculative frenzy going~~ preserve the integrity of the markets. Leaving aside the issue of whether it is even desirable to have any intervention in the market, such as Fannie and Freddie buying more mortgage loans, it seems like the debate has shifted to the question of encouraging moral hazard, something foreign to Alan Greenspan, who thought he could micromanage monetary policy.

The consistent throwing of liquidity at crises lulled investors into complacency over financial risk. Economies work best in the long run when risk-taking is moderate, not absent or crazed. It is good to have a bear market every now end then; it keeps investors honest. It is even good to allow failures of financial institutions, particularly risky ones at the fringe of the financial system for the same reason. Financial firms are opaque by nature, and investors should be skeptical of those furthest out on the risk spectrum, particularly when credit spreads are tight.

To those who favor using monetary policy to bail out dud (primarily) non-banks, I say two things: first, are we capitalists only for our profits and not for our losses? Are we the hypocrites who privatize our gains and socialize our losses? Second, it’s not in the FOMC’s charter. Alan Greenspan violated the purposes of the FOMC when he used it for any thing other than low inflation, low unemployment, and preservation of the portion of depositary financial system overseen by the Federal reserve.

Score me in the camp that sees no substantive change in the FOMC’s direction, but sees a nod in the statement toward the current troubles, and a little more in the minutes, but keeps the focus on inflation. I still don’t think the FOMC is moving in 2007.