The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently,activity expanded in the second quarter, partly reflecting a softening of householdgrowth in consumer spending. and exports. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and some slowing in export growthelevated energy prices are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities.commodities, and some indicators of inflation expectations have been elevated. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

TheAlthough downside risks to growth andremain, the upside risks to inflation are bothalso of significant concern to the Committee. The Committee will continue to monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming;Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser,Plosser; Gary H. Stern; and Kevin M. Warsh. Ms. Cumming voted asVoting against was Richard W. Fisher, who preferred an increase in the alternatetarget for Timothy F. Geithner.the federal funds rate at this meeting.

=-=-=–==–==-=-=–=-=-=-=-=-==-=-=-=–=

Of Note:

• No move, they are happy with the current policy.
• Even Richard Fisher is happy with the current policy.
• They will monitor economic and financial developments “carefully” now.
• They see greater weakness in economic growth, labor markets, export growth, and the financial markets.
• They are puzzled about inflation; they think/hope it will decrease soon.  (Watch for a surprise in the third quarter GDP deflator that undoes the surprise in the second quarter.)

The markets seem to be taking it in stride.  I’m glad they didn’t cut; perhaps they’ve learned something from the emergency cuts that they sterilized by not letting the monetary base grow much.  Sterilized interventions don’t do much.

The Governor of New York, possibly thinking about his tax base, and perhaps 30,000 jobs, has allowed AIG to borrow $20 billion from its subsidiaries.  Details are scant, but this can be one of three things:

• AIG has surplus assets in its NY-domiciled subsidiaries in excess of their risk-based capital requirements.  If true, borrowing against these would be a no-brainer that should have been pursued long ago.  Favoring this view is the NY Governor, who says AIG is “extraordinarily solvent.”
• AIG has surplus assets in its NY-domiciled subsidiaries, but not in excess of their risk-based capital requirements.  Borrowing against these would be a risky gamble, because it lowers the amount of risk margin available to absorb adverse deviations.
• Some combination of both — say that AIG has only $15 billion in surplus assets in its NY-domiciled subsidiaries… $5 billion would reduce risk margins.

The risk here is that you end up with insolvencies of some of AIG’s subsidiaries.  Though poential losses to policyholders would be unlikely to be large, assessments would be made to other insurer though the state guaranty funds in order to keep policyholders whole, but potentially at a cost to the other insurers.

This has the potential to look really bright or really stupid, and in a short amount of time, too.  Final note: It’s not impossible, but I would be surprised if the Federal Government or the Federal Reserve intervenes on AIG when it would not with Lehman.

From an old CC post:

		David Merkel
		Why I Don’t Like Preferred Stock
		6/9/2006 9:19 AM EDT

If I take risk, I want a decent probability of getting paid for taking the risk, and paid well. If I don’t want to take risk, I want a high degree of certainty that I’m not going to lose money, and if I do lose money, it won’t be much.

Having been a corporate bond manager in my last job (2001-03), I learned that I had all of the downside of stocks, with little of the upside of stocks. (One exception: buying MBNA floating-rate trust preferreds in late 2002 for $68 — they were at par ($100) in less than a year, matching the performance of MBNA stock, but that is rare, outside of distress situations. Another exception: fixed-income risk arbitrage was, in many cases, wider than that of equity arbitrage … examples from that era: Golden State, Household International and Allfirst, but I digress…

The situation is worse with preferred stocks. At least with corporate bonds you have a priority call on the assets of the firm in insolvency. Preferred stock typically gets 10 cents on the dollar in insolvency vs. 40 cents or so on senior unsecured corporates and 80 cents on bank debt.

Preferred stocks are called preferred because the dividend on the preferred must be paid for the common stock to receive a dividend. But with speculative ventures where the common doesn’t pay a dividend anyway, that is a small safeguard. Another small safeguard is the ability of the preferred holders to elect a few directors if the dividend is not paid. Nice, but it usually doesn’t tip the balance of corporate governance.

The recent troubles with Fannie and Freddie preferreds, where they lost 80%+ of their value, has hurt the preferred stock market.  Well, good.  Preferred stock is a vehicle that hates volatility.  The preferred holder just wants to clip his dividend payments and receive his principal back eventually.  He doesn’t benefit if the common rises (I leave aside convertible preferreds), and he is not protected during times of default.

This applies to all hybrid debt, trust preferreds, etc.  They may act like fixed income securities in good times, but in situations of economic stress, they behave more like equity than debt.

Be wary of those that promise high income relative to safer strategies.  It is rare that they succeed.

There are irregular miracles from God, the Creator of all, but there is no magic.  The US government can step forward and say, “We guarantee the liabilities of Fannie and Freddie, and take control of the companies.”  But who guarantees the US government?  In the economic world, there is always a cost for every action.

Yes, the US government will continue to borrow from the Saudis and their allies, who appreciate our military actions constraining their Shi’ite adversaries, and supporting their own regimes.  China wants to continue to “grow,” and they don’t care if they are paid back in “funny money” for now, buying Treasury securities with excess dollars.

The US Dollar rallied today, even as the government absorbed liabilities that are uncertain as to size, even though I think the eventual cost will be less than $200 billion.

Who doesn’t want to be guaranteed by the government?  The auto companies are in line, can I get in line too?  I could do amazing things with a $50 billion credit line from the government.  I would assemble a small empire of undervalued companies with earnings yields higher than what I would have to pay Uncle Sam in interest.

My point is this: when you take into account the structural deficit, funding for the wars, social security currently on the balance sheet (but not its increase in liabilities), Fannie and Freddie, and future demands for bailouts of homeowners and auto companies, where does the bailout stop?  Where does the willingness of foreigners to buy Treasury debt end?

I don’t know, and this is the biggest question facing the global debt markets now.  A century from now, a fellow resembling James Grant will write several popular books explaining the decadence of the era, and how the US squandered its leading position in the world by borrowing too much.

So, call me skeptical of the US Dollar and Treasury rallies today.  Those should reverse soon.

I’ve always been a little reluctant when people argue that cash is building up on the sidelines, so it is time to buy.  First, this is an ill-defined concept.  What cash are we measuring?  For every seller, there is a buyer.  Thus, I am reluctant to be bullish after articles like this, or like this.

There is enough derivative activity going on that the cash level may not represent buying power, because they represent cash that must be held to control derivative positions.  As for individuals, they are moving from individual stocks to mutual funds.

Cash levels are hard to interpret, and have not correlated well with market movements.

With that, I warn you to be careful.  With the GSEs in flux, there are many things, good and bad that can take place.  Until the plan is announced we won’t know how it is proceeding.  What will be guaranteed and what will be wiped out?  Who will bring lawsuits against the government for damages?

There is a mantra at present: if the government takes over Fannie and Freddie, mortgages will get cheaper, and the housing market will revive.  Well, that is true until foreign governments adjust their lending practices.  Will Treasury rates remain the same when Fannie and Freddie fund off the Treasury?  I would expect that Treasury rates will rise, but agency spreads would fall more.

Be careful in this environment.  Many are being dogmatic about what will happen with stocks, given the bailout of Fannie and Freddie.  I would be a seller on strength, on most lending financials.

Just a short post, but there are two reasons why Connie Lee should not get a AAA from the rating agencies (Aaa if you speak Moody’s):

1) It violates their notching standards.  A parent company with a senior unsecured debt rating of A/A3 should only get ratings of AA/Aa3 maximum.  This is because a holding company can only provide so much incremental support to a subsidiary, so the degree of enhancement to a well-capitalized subsidary should only be three notches, particular given that there may come a time when the parent company is incapable of adequate support, and the subsidiary is in need as well.

Connie Lee is a small insurance company with a weak parent company.  Small insurers always get weaker ratings than large insurers, unless they have a deep-pocketed parent.

Now, maybe the rating agencies will say that because Ambac can now write new municipal guarantee business, the holding company itself deserves a higher rating, like AA-/Aa3, and thus Connie Lee can get a AAA/Aaa.

2) Connie Lee has no track record of its own, and many on the management team that made the faulty decisions at Ambac, Inc. are still in place.  Yes, they managed their muni business well, but what if they go down the same diversification path again?  Regulators have short memories, and they do move on to other pursuits after some time.

It seems that Connie Lee will be a subsidiary of Ambac Assurance, so fraudulent conveyance issues are probably dead.  If Ambac Assurance were unable to pay all claims, Connie Lee could be sold, and the proceeds used to help pay claims.

It will be interesting to see what the rating agencies do with this.  It would be in their short-term profit interest to make Connie Lee AAA/Aaa, but they’ve been burned by Ambac before.  If they make Connie Lee AAA/Aaa, they should get complaints from others alleging unfair notching.  Also, to give them a AAA/Aaa would be to put the rating agencies own business models at risk if something more goes wrong at Ambac, and their new notching means they have to downgrade Connie Lee.

If I were in the shoes of the rating agencies, I would wait to see how the non-municipal guarantee business matures over the next two years, particularly given softness in the residential real estate markets.  Then, if Ambac Assurance began to look healthier, I would consider upgrading it and Connie Lee, one notch at a time.

PS — maybe larger municipalities will finally be weaned from needing insurance, and this market will amount to still less in the future…

I can’t comment on everything, at least above the degree of quality that I try to impose on myself.  (I know, the standards could be raised. )  But I did want to comment on a paper on banking capital regulations that came out of the Jackson Hole conference.  Odd Numbers and Naked Capitalism commented on it, and I thought both had good things to say.  I have my own twist to share, having been a risk manager inside two insurance companies.

The basic idea of the paper is that risk levels have to be reduced at banks, but banks want to stay highly levered so that they can earn high returns on equity, so asking them to reduce debt levels or internal leverage is not feasible.  Instead, why not have them buy insurance policies that pay out during banking crises?  Then they will have the capital when it is needed, and they can continue to lend in all environments.

(SIgh.)  I have oversimplified their arguments, but I have done it to help make some points, which are:

1) The cost of the insurance policy will get factored into the equity calculation for return on equity, at least at far as a prudent bank manager would view it.  The insurance policy is illiquid, and its cost should be reckoned as a part of the surplus it replaces, which may allow for a reduction in overall surplus levels carrying the business.  (Note to regulators: anytime you allow a financial entity a reduction in required surplus from a risk transfer agreement, you should analyze the alternative of using the premium(s) paid to add to surplus, and ask, which looks better.  Also, these are collateralized agreements, but in uncollateralized agreements, analyze the counterparties, and deny surplus credit frequently.)

2) Do the authors realize how expensive these agreements should be?  Consider:

• The insurer is asked to post the collateral, which takes money out of its surplus.
• The insurer is asked to be ready to lose an asset at a very bad point in the credit cycle.
• The monies are invested in Treasury securities, so there is no possiblity for the insurer to make money from investing the premium more aggressively, but still safely.
• Large banking crises happen about once every 20 years or so, with smaller ones more frequent.  With a long enough agreement, the loss of the Treasury collateral is almost certain, making the cost high.
• If these were common, a sort of moral hazard would develop, similar to what has happened with the financial guarantors.  Banks would conduct business aggressively, realizing that they have the capital backstop.  Initial results would look good, until the crisis. Then, double surprise! The insurers figure out that they didn’t charge enough for the insurance, and the banks find out that their losses were larger, because of their aggressive behavior.  Wound banks be willing to pay premiums around 5-15% of the face amount insured, depending upon where the risk trigger kicks in?

3) Beyond that, there would probably be a scarcity of providers.  Few want to dedicate a large portion of their capital bases to the events that are entirely a process of human action.

Take a lesson from the reinsurance industry.  Ideally, you would want an agreement that took the risks directly off of your books, such that the capital would come when you specifically had losses above a threshold.  That’s been done in the insurance industry for reinsuring companies as a whole, and the reinsurers have usually come off the worse for it.  The insurers almost always know their risks better than the outsiders.  Reinsurers prefer to reinsure specific risks that they can underwrite, not companies as a whole.

But, lest I merely seem to be a critic, let me offer three suggestions for how to try to make this work.

1) Call Ajit Jain at Berkshire Hathaway.  They have the capital.  Give him a detailed proposal of what you want, and let him give you the quote that makes your jaw drop, or, watch him decline the business, unless you put your bank into a straitjacket of terms and limitations of coverage.

2) Try setting this up through an Industry Loss Warranty.  You would get paid capital during bad times if the industry has suffered losses past a threshold, and you have suffered losses in excess of a threshold as well.

3) Or, try setting this up as a catastrophe bond.  Borrow money through the bond at a high rate of interest.  Junk bond buyers will fund you.  During a crisis, if the banking industry losses exceed a threshold, the principal of the notes gets written down, and voila!  You have capital when you need it.  Note that the junk bond buyers should require more of a premium here, because bank losses tend to be correlated with other junk bond losses — no big benefit from diversification here.

I will leave aside the idea of setting up captive reinsurance sidecars, because those are just regulatory arbitrage.

My main point here is that I don’t think that this type of insurance will work.  Even for those willing to contemplate the structure, the true price will be too high for the banks to gain any benefit.  Perhaps this could be done on a limited basis for one more turn of the credit cycle, but I think for those that offer the insurance, the banks that buy it, and the regulators, they will be less than happy with the results.

In my opinion, we need to bring down leverage ratios for the banks, slowly but inexorably.  If that hurts their ROEs, well, I’m sorry.  If we are going to do a leveraged fiat money system, the leverage must be considerably lower than where we are now, and all synthetic exposures (derivatives) must be brought on balance sheet as if they were cash transactions.  It is that lack of transparency and increase in leverage that has made our financial system so much more risky, as this other paper from the Jackson Hole conference states.  I did not feel that the discussants really understood what they were talking about, because they could see the micro level risk reductions from derivatives, but miss the added leverage, lack of transparency, and concentration of risk in the hands of parties that were greedy for yield, and may not be able to make good on all agreements in a crisis.

Much complexity and leverage will need to be unwound before this credit crisis is over.  The era of high ROEs for banks should be over for some time, that is, until the regulators fall asleep again during the next boom phase.  Some things rarely change.

After writing parts one and two of what I thought would not be a series, I have another part to write.  It started with this piece from FT Alphaville, which made the point that I have made, markets may not need the ratings, but regulators do.  (That said, small investors are often, but not always, better of with the summary advice that bond rates give.  Institutional investors do more complete due diligence.)  The piece suggests that CDS spreads are better and more rapid indicators of change in credit quality than bond ratings.  Another opinion piece at the FT suggests that regulators should not use ratings from rating agencies, but does not suggest a replacement idea, aside from some weak market-based concepts.

Market based measures of creditworthiness are more rapid, no doubt.  Markets are faster than any qualitative analysis process.  But regulators need methods to control the amount of risk that regulated financial entities take.  They can do it in three ways:

1. Let the companies tell you how much risk they think they are taking.
2. Let market movements tell you how much risk they are taking.
3. Let the rating agencies tell you how much risk they are taking.
4. Create your own internal rating agency to determine how much risk they are taking.

The first option is ridiculous.  There is too much self-interest on the part of financial companies to under-report the amount of risk they are taking.  The fourth option underestimates what it costs to rate credit risk.  The NAIC SVO tried to be a rating agency, and failed because the job was too big for how it was funded.

Option two sounds plausible, but it is unstable, and subject to gaming.  Any risk-based capital system that uses short-term price, yield, or yield spread movements, will make the management of portfolios less stable.  As prices rise, capital requirements will fall, and perhaps companies will then buy more, exacerbating the rise.  As prices fall, capital requirements will rise, and perhaps companies will then sell more, exacerbating the fall.

Market-based systems are not fit for use by regulators, because ratings are supposed to be like fundamental investors, and think through the intermediate-term.  Ratings should not be like stock prices — up-down-down-up.  A market based approach to ratings is akin to having momentum investors dictating regulatory policy.

Have the rating agencies made mistakes?  Yes. Big ones.  But ratings are opinions, and smart investors regard them as such.  Regulators should be more careful, and not allow investment in new asset classes, until the asset class has matured, and its prospects are more clearly known.

With that, I lay the blame at the door of the regulators.  You could have barred investment in novel asset classes but you didn’t.  The rating agencies did their best, and made mistakes partially driven by their need for more revenue, but you relied on them, when you could have barred investment in new areas.

In summary, I still don’t see a proposal that meets my five realities:

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

And because of that, I think that solutions to the rating agency problems will fail.

I like to think that I have a pretty strong stomach for risk.  I am used to losses.  I have my sell disciplines, and I act on them.  I also try to be forward-thinking about risk; not just reacting, but trying to anticipate what the markets are likely to deliver.  Every now and then, I get a surprise.  Here’s the surprise, which I got from The Big Picture (Barry’s blog).  Institutional Risk Analytics does some good work, and this article is representative of their work.  In it, they describe the two risks facing the large banks — risks from their assets, and risks from their derivative books.

The second link made me pause.  I know things are bad, and I can’t vouch for Institutional Risk Analytics’ risk based capital model for banks, but the level of notional derivatives exposure at many of the major banks to their tier 1 surplus made me pause.  There are two claims on surplus — losses from direct lending, and losses in the derivative books.

Those who have read me for a long while know that I think the derivative books at the investment banks are mismarked and possibly mishedged.  When accounting rules are not well-defined, and instruments are illiquid, even well-meaning managements tend to err in their favor in the short run.

This is significant in a number of ways, but the main one was pointed out in the first link, that with the continuing failure of small banks, how will the FDIC make depositors secure if a large-ish institution fails, when reserves are relatively low?  They need to raise their fees that they charge solvent banks to replenish their coffers.  They are also bringing back retirees with experience in dealing with insolvent banks.

So, are the banks in trouble?  Some of them are experiencing stress, and that is coming through higher credit spreads on their debt.  Given the higher costs entailed in funding for banks, it is all the more important in your investing to look for companies that don’t need much external finance.  After all, many banks may find it harder to lend.  Consider the difficulties in funding InBev’s purchase of Anheuser-Busch.  Large banks are straining at their limits.  They don’t have enough parties to sell loans off to, nor do they want to hold onto so much of the risk.

The bank loan and and bond markets are closely connected.  Troubles in one tend to spill over to the other.  Loans have a higher priority claim, so the yields are lower than for bonds.  As it is, investment grade corporate bonds, particularly financials, are facing higher yields.  The high yield market has slowed considerably.

So, what does this imply?  The banks are hunkering down.  They are scrutinizing all risk exposures.  They aren’t expanding lending, which is showing up in MZM, M2, and my M3 proxy.  Credit is getting tough/sluggish.

Money Supply

And the degree of leverage that banks are willing to use versus the Fed’s monetary base is dropping, and hard (the graph covers 28 years).

Bank Leverage

So, I’m not optimistic here. I believe in the value of “long only” money management as having better chances of risk control than hedged strategies, but this is making me queasy. What it makes me think, is that the FOMC’s next move is a loosen. It hurt to say that, particularly given my dislike of inflation, but the solvency of the financial system comes ahead of inflation in the Fed’s calculus, even though loosening won’t help much.

With that, I am looking to continued problems in banks, and perhaps for the economy as a whole.  Our next president will have a fun time with this…

Just a quick post to give a mid-quarter view of my main industry rotation model.  The recent moves in the market have knocked many energy sector industries out of the hot zone (red), but any bounce in financials has not knocked them out of the cold zone (green).  I’m still not ready to play in the depositary and credit sensitive financial companies, my insurance exposure is cheap, and earning money with low-ish risks.  That said, this is the type of environment that reveals which insurers have been taking on too much risk with marginal bonds.

industry-ranks-8-21-08

Remember that my industry ranks can be used in two modes: momentum mode (look at the red zone), and value mode (green zone).  I spend most of my time in the green zone, looking at industries where I think pricing power will return.  For me, the red zone is more useful for sale decisions.  When an industry is running hot, I delay selling out in entire, and content myself with trimming positions in order to limit risk when the eventual turn happens.