It’s early morning now, after two days on the road.  It is good to be home, and it will be good to get back to “regular work” once the workday begins.  A few thoughts:

1) Here are two Fortune articles where Colin Barr quotes me regarding Buffett’s offer to reinsure the muni liabilities of the financial guarantors.  He correctly quotes my ambivalent view.  I am not willing to take Ackman’s side here, nor that of the guarantors and rating agencies.  This is one of those situations where I don’t think anyone truly knows the whole picture.  My thoughts are limited to Buffett’s offer.  He’ a bright guy, and he is hoping that one of the guarantors is desperate enough to take him up on his offer.

2) Personally, I found this note from the WSJ economics blog worrisome.  Ben Bernanke is probably a lot smarter than me, but I can’t see amelioration in the residential real estate markets in 2008.  We still have increases in delinquency and defaults at present.  Vacancy is increasing. Inventory is increasing.  The market is not close to clearing yet.

3) I like the “quants.”  Are they a big force in the stock market?  Yes.  But they are an aspect of Ben Graham’s dictum that in the short run the stock market is a voting machine, but in the long run it is a weighing machine.  “Dark pools” sound worrisome, but to long-term investors they are a modest worry at best.  Traders should be concerned, but that is part of the perpetual war between traders and market makers/specialists.

4) There are two aspects to the concept of the rise in housing prices.  One is the scarcity of desirable land near where people want to live.  The second is that financing terms got too loose.  Marginal Revolution says there is/was no housing bubble.  They are focusing on the first issue, and downplaying the second issue.  My view is that there are legitimate reasons for housing prices to rise, but we built more homes than were needed, and offered financing terms to buyers that were way too generous.  To me, that is a bubble, and we are still working through it.

5) Auction-rate securities have always seemed to me to be micro-stable, but subject to macro-instability.  What do I mean?  Small fluctuations get absorbed by the investment banks, but large ones don’t.  As an old boss of mine used to say, “liquidity is a ‘fraidy cat.”  It’s around for minor jolts, but disappears in a crisis.

6) Muni bond insurance is thought insurance.  Most municipal bonds are small.  What credit analyst wants waste time analyzing a small municipality?  With a AAA guaranty, the bonds get bought in a flash, and they are liquid (so long as the guarantor continues to be viewed positively).  So, I still view municipal guarantees as having value.  Not everyone else does.

7)  Intuitively, I can feel the dispute regarding the recycling of the current account deficit.  The two sides boil down to:

• When are they going to stop buying depreciating assets?
• What choice do they have?  They have to do something with all the dollars that they hold.

It’s a struggle.  In the short run, supporting the US Dollar makes a lot of sense, but the build-up of continual imbalances is tough.  Why should we buy into a depreciating currency in order to support our exporters?

8 ) Privatize your gains, socialize your losses.  It’s a dishonest way to live, but many press their advantage in such an area. Personally, I think that losses need to be realized by aggressive institutions.  They took the risk, let them realize the (negative) reward.

That’s all for the morning.  Trade well, and be wary of things that work in the short run, but are long run unstable.

I’ve wanted to post on a bunch of little things for a while, and while it won’t make for organized reading, maybe we can have some fun with it?  Here goes.

1) If Prudential drops much further, I am buying some.  With an estimated 2009 PE below 8, it would be hard to go wrong on such a high quality company.  I am also hoping that Assurant drops below $53, where I will buy more.   The industry fundamentals are generally favorable.  Honestly, I could get juiced about Stancorp below $50, Principal, Protective, Lincoln National, Delphi Financial, Metlife…  There are quality companies going on sale, and my only limit is how much I am willing to overweight the industry.  Going into the energy wave in 2002, I was quadruple-weight energy.  Insurance stocks are 16% of my portfolio now, which is quadruple-weight or so.  This is a defensive group, with reasonable upside.  I’ll keep you apprised as I make moves here.

2) Reader Steve brought this to my attention: Mark Gilbert at Bloomberg brought attention to a monetary policy game at the San Francisco Fed’s website.  So did the estimable Marketbeat blog at the WSJ.  The game used to be found at this link.  Alas, no more.  Maybe all of the attention crashed the site, after all, the SF Fed can’t afford a heavy-duty website like mine.  Okay, sorry, they get 10x the traffic that I do, more like The Kirk Report.

Perhaps the game was removed over the embarrassment from Gilbert playing the game and applying the current Fed strategy to the game, and finding inflation going through the roof.  Now, for those that want to play a monetary policy game, my current favorite is this one from the Bank of Finland.  In a true American version of the game, we would replace the manic announcer with clips of who else, Jim Cramer.  Nobody does it better.  Oh and for true junkies looking for monetary policy games, here is a list of some of them.

3) Dig the falling long bond.  Worst day since 2004.  Echoing what I said yesterday, there’s a lot of fear in that part of the market, and a lot of foreign interest.  Well, at the 30-year auction, foreign interest was light at the lowest yield since regular auctions began in 1977.  A few strong economic numbers can make fear temporarily dissipate.

4) Here’s what I posted at RealMoney today:

		David Merkel
		Moody’s Downgrades XL Capital Assurance
		2/7/2008 3:34 PM EST

When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade). Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)

Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.

Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: none

Now after the close, MBIA offered stock at a 14% haircut to the closing price.   Let’s see where the price closes tomorrow… it almost boils down to the number of buyers saying, “At a 14% haircut, there’s no way that it will close below that level.  We can buy and flip for an easy profit.”  In this case, though, there are 60%+ more shares after this issuance.  That’s some level of dilution.  MBIA may keep its AAA, but that says little for the value of holding company common stock.

5) One reader wrote me, “mr. merkel — would you care at all to expound on point 2? it’s been the assertion of some that what makes the monoline threat a non-issue is specifically that there IS a harmony of interests in seeing ambac, mbia et al at least get to a point where they can run off their obligations. however, i must admit, i’ve not seen the case made with specificity — that is, what are the interests of the interested parties, and how do they conflict or coincide?”

Point 2 was the idea that a bailout would be tough to achieve, because of differing interests on the part of those being sought to bail out the guarantors.   Here’s my rationale: different investment banks have differing levels and types of exposure to the credit risks covered by the guarantors.  Coming up with an equitable allocation of concessions would be tough, but not impossible.  Beyond that, you have all of the ways that the guarantors reinsured each other, which further tangles the web of promises.  A bailout could be done, given enough time, and enough angelic third-party experts to divide the pie perfectly.  Time is short here, and I suspect the rating agencies will lose patience, given their need to protect their franchises.

6) At present, the yield curve indicates a 2% Fed funds rate by mid-to-late 2008.  Uh, that’s not what I would do, but it seems pretty likely for now.  What kind of price inflation would get the attention of the Fed here?  Beats me; the slope of the yield curve today is adequate to allow banks to make money; if the Fed waits at these levels, the economy should recover over the next two years.

7) I liked the idea of this post at the American Prospect, but for a different reason.  Since I called the housing bubble very clearly over at RealMoney, and even subprime too, does that mean that I can criticize the Fed with impunity?  Constructively, of course.

From another reader, Bamboo: I have not seen much discussion of the statutory capital requirements of the financial guaranty insurers.  It seems that Article 69 of the New York Insurance Law is the critical statute.

Is there a possibility that the financial guarantors will have to take a premium deficiency reserve for their structured finance business?

I would like to get a copy of article 69, but I can’t find one.  In general statutory regulations are less market-oriented than rating agencies and GAAP.  The problems usually show up faster on GAAP than Stat, leaving aside high growth situations.

9) Another reader, Bill Luby of VIX and More, writes: Hi David,

-Bill

Yes, AGO, Dexia (FSA), and Berky all do well from the turmoil.  Strong balance sheets benefit from increased volatility, even as weak balance sheets are harmed.

10) Finally, from Reader Scott, regarding Medicare and entitlements, “David, wondering your thoughts on how the situation gets addressed.  There is no question at all that the equation doesn’t solve, presently.  My current thoughts are that (1) taxes go higher - not even up for serious discussion; and (2) so do trade barriers.  we trade some protectionism, a la Europe, and reduced overall welfare, for a feel-good “leveling” of some of society’s current inequties.  our nation’s most influential demographic, old folks, who vote, are appeased. add to that, perhaps, some guest worker immigration policies.  second class citizens earning second-tier wages.  on balance, we begin looking a lot more like Europe, reversing the cherished myth of American exceptionalism, and staving off acceptance of the twenty-first being the China Century.  Care to comment?”

Americans are exceptional, and that is not always a good thing.  We have fewer presuppositions than most of the world, and that leads to innovative solutions, a certain amount of unnecessary chaos, and occasional hubris.  We are probably heading for an era of leveling, but that is not certain.  Historically, it is likely.  Trade may be another matter; we may be getting close to a point where the rest of the world sees the value of freer trade, even if the US goes the other way.  Organized efforts against free trade are weak compared to protectionist eras.

As for old folks that vote, yes, that’s what makes this problem tough.  I’m not into doom and gloom, but I can see a negative self-reinforcing cycle coming.  If Bush, Jr., got smacked over his all-too-cautious attempt at Social Security reform (it would have done almost nothing, but listen to the squeals), can you imagine what true reform of a much bigger problem might entail?  We would need a full blown panic in the debt markets to get focus there, and as for now, foreigners are still very willing to roll over US debt denominated in US dollars.

Full disclosure: long AIZ, LNC

Every now and then, valuation metrics in a market will get changed by the entrance of an aggressive new buyer or seller with a different agenda than existing buyers or sellers in the marketplace.  Or conversely, the exit of an aggressive buyer or seller.

Think of the residential mortgage marketplace over the last several years.  With an “originate and securitize” model where no one enforced credit standards at all, credit spreads got really aggressive, and volumes ballooned. Many marginal mortgage lenders entered the market, because it was strictly a volume business.  Now with falling housing prices, there are high levels of delinquency and default, and mortgage volumes have shrunk, leading to the failures/closures of many of those marginal lenders.  Underwriting standards rise, as capacity drops out.  Even prime borrowers face tougher standards.  In two short years, fire has given way to ice.

If you’ll indulge another story of mine, I worked for an insurer who had a well-run commercial mortgage arm.  Very conservative.  They did small-ish loans on what I would call “economically necessary real estate.”  See that ugly strip mall with the grocery anchor?  Everyone in the area shops there; that’s a good property.

Well, in 1992, the head of the Commercial Mortgage area had a problem.  The company had only three lines of business, and two lines representing 60% and 20% of the assets of the firm were full up on mortgages.  What was worse, was they didn’t want to even replace maturing loans, because the ratings agencies had told the company that commercial mortgage loans were a negative rating factor.  Never mind the fact that the default loss rate was 40% of the industry average.

He stared down the possibility that he would have to close down his division.  He had one last chance.  He called the actuary that ran the division that I was in (my boss), and pitched him on doing some commercial mortgages.  The conversation went something like this:

Mortgage Guy: I know you haven’t liked commercial mortgages in the past, but my back is against the wall, and if you don’t take my originations, I’ll have to shut down.  You’ve heard that the other two divisions won’t take any more mortgages at all. 

Boss: Yeah, I heard.  But the reason we never took commercial mortgages was that we didn’t like the credit spread compared to the risks involved.  150 basis points over Treasuries just doesn’t make it for us.

M: Well, because many companies have reduced originations, the spreads are 300 basis points now.

B: 300?! But what about the quality of the loans?

M: Only the best quality loans are getting done now.  I can insist on additional equity, in some cases recourse, and faster amortization.  My loan-to-values are the lowest I’ve seen in years.  Coverage ratios are similarly good.

B: Well, well.  Perhaps I’ve been right in the past, but I’m not pigheaded.  Look, we could take our percentage of assets in mortgages from 0% to 20%, but no more.  At your current origination rate, that would allow you to survive for two years.  We will take them all, subject to you keeping high credit quality standards.  Okay?

M: Thank you.  We’ll do our best for you.

And they did.  For the next two years, our line of business and the mortgage division had a symbiotic relationship, after which, spreads tightened significantly as confidence came back to the market.  We had 20% of our assets in mortgages, and the other two lines of business now felt comfortable enough with commercial mortgages to begin taking them again — at much lower spreads (and quality) than we received.

It’s important to try to look through the windshield, and not the rear-view mirror in investing.  Analyze the motives of current participants, new entrants, and their likely staying power to understand the competitive dynamics.  I’ll give one more example: the life insurance industry was a lousy place to invest for years.  Why?  A bunch of fat, dumb, and happy mutual companies were willing to write life insurance business earning a minimal return on capital.  As another boss of mine once said, “It doesn’t take mere incompetence to kill a mutual life insurer; it takes malice.”  Well, malice, or at least its cousin, killed a number of insurers, and crippled others in the late 80s to mid 90s.  Investment policies that relied on a rising commercial real estate market failed.

But that was the point to begin investing in life insurers.  They began pricing capital economically, and the industry began insisting on higher returns as a group.  Many mutuals demutualized, and the remaining large mutuals behaved indistinguishably from their stock company cousins.  The default cycle of 2001-2003 reinforced that; it is one of the reasons that the life insurance industry has had only modest exposure to the current difficulties afflicting most financials.  After years of being outperformed by the banks, the life insurers look pretty good in comparison today.

I could go on, and talk about the CDO and CLO markets, and how they changed the high yield bond and loan markets, or how credit default swaps have changed fixed income.  Instead, I want to close with an observation about a very different market.  Who likes Treasury bonds at these low yields?

Well, I don’t.  At these yield levels the odds are pretty good that you will lose purchasing power over a 2-3 year period.  Then again, I’m a bit of a fuddy-duddy.  So who does like Treasury yields at these levels?

• Players who are scared.
• Players who have no choice.

There is a “fear factor” in Treasury yields now.  Beyond that, there is the recycling of the current account deficit, which is still large relative to the issuance of Treasuries.  The current account deficit is large, but shrinking, since the US dollar at these low levels is boosting net exports.  As the current account deficit shrinks, Treasury yields should rise, because foreign demand has been a large part of the buyers of Treasuries.  The Fed can hold the short end of the curve where it wants to, but the long end will rise as the current account deficit shrinks.

I think the current account deficit does shrink from here, because the cost of buying US debts, and not buying US goods is getting prohibitive.  Also, fewer retail buyers will take negative real yields.

That’s my thought for the evening.  Analyze the motives of other players in your markets, and don’t assume that the current state of the market is an equilibrium.  Equilibria in economics are phantoms.  They exist in theory, but not reality.  Better to ask where new entrants or exits will come from.

I had some “down time” today (taking my third child to junior college), when I could sit and think about some of the issues in the markets, when all of a sudden, a weird correlation hit me.  Similarities between:

• The near bankruptcy of the Equitable back in the early 90s.
• Neomercantilism
• The relationship of Moody’s and S&P to MBIA and Ambac.

Now, I write as I think, so at the end of this, I hope to have a theory that links all of these.  For now, let me tell a story.

When I was younger, I worked for AIG in their domestic life companies.  While I was there 1989-92, the life insurance industry was undergoing a lot of troubles from overinvestment in mortgages and real estate.  Many companies were under stress.  A few went bankrupt.  One big one was probably insolvent, and teetered in the balance — the Equitable.  I was the juniormost member of AIG’s team.  I have a lot of stories about what happened, and why AIG lost and AXA won.  If readers want to read about that, I’ll write about it.  For now though let me mention what I did:

• Produced an estimate of value of the annuity lines in four days.
• Estimated the “hole” in reserving for the Guaranteed Investment Contract line of business (accurate within 10%, according to the writedown they took later)
• Wrote an analysis of AXA that indicated that we should take them seriously (probably ignored).
• Analyzed the Statutory statement, the Cash Flow testing, and Guaranteed Separate Account filing (Reg 128), and came to the conclusion that the latter two were in error.  (Those filings, I later learned, forced the NY department to
  tell Equitable that it had to find a buyer, because they could not believe the rosy scenarios.)
• Analyzed the investment strategies that the Equitable employed in the late 80s.  (They doubled down.)

Two years after that, I was at the Society of Actuaries annual meeting, where I met a well-known actuary who had worked inside the corporate actuarial area of the Equitable during the critical years.  I.e., he watched and analyzed the assets and the liabilities as they arose.  The conversation went something like this:

David: What was it like working inside the Equitable during that period of fast growth?

Corporate Actuary: It was amazing.  It took everything we could do to stay on top of it, and still we fell behind.

D: Didn’t you think that perhaps you were offering guaranteed rates that were too attractive?

C: We wondered about it, but with money coming in, everyone felt great about the growth.  We simply had to find ways to productively deploy all of the cash flow.

D: But wait.  Didn’t the investment department have a difficult time investing all of the proceeds?  With that much money coming in, the likelihood of making severe errors would be high.

C: Were you a bug on the wall at our meetings?  Yes, that is exactly what happened.  The money came in faster than we could invest it prudently.

D: Wow.  I thought that was what happened, but it amazes me to hear it confirmed.

They offered free options, and surprise, investors took them up on them.  They couldn’t make enough to fund the promises, and undertook a risky strategy in the late 80s that I called “double or nothing.”  The strategy failed, and they almost went broke, except that AXA bought them, pumped in a little capital, and then the real estate market turned.

What’s my point here?  Twofold: one, rapid growth in financial institutions is rarely a good thing; it usually means that an error has been made.  Two, there is a barrier in many financial decisions, where responsible parties are loath to cry foul until it is way past obvious, because the cost of being wrong is high.

So what of my other two cases?  With the neomercantilists, which I have written about more at RealMoney, they entered into the following trade: sell goods to the US and primarily take back bonds.  This suppressed inflation in the US, and lowered interest rates, because their bond buying reduced the excess supply of bonds.  In one sense, through export promotion, the neomercantilistic countries sold their goods too cheaply, and then had little current use for the US Dollars, since they did not want their people buying US goods.  So, they took the money and bought US bonds, probably too dearly.  Certainly so, after taking the falling US Dollar into account.

With the major rating agencies and the major financial guarantors, they are locked in a co-dependent relationship, one that I highlighted in a RealMoney article three years ago.  The financial guarantors are next to a cliff, and the rating agencies have a choice:

• The guarantors are clearly in trouble, but how bad is it?  Do we push them over the edge to save our franchise, at a cost of a lot of forgone revenue in the short run?
• Or do we sit, wait, and hope that things are not as bad as the equity markets are telling us?  This could preserve our ability to make money, and the government is giving us pressure to go this way, for systemic risk reasons.  Besides, someone could bail them out, right?

Ugh, I went through this back in 2001-2002, when the rating agencies changed their methodology to become more short-term in nature.  Funny how they always do that in bear markets for credit.

So, what’s the common element here?  Each situation has a major financial entity at the core.  Underpriced goods or promises were made in an effort to attract revenue.  When the revenues came too quickly, errors were made in deploying the revenues, whether into goods or bonds.  The faster and the larger the acquisition of the revenues, the larger the problem in deployment.

In each of these situations, then, there is a cliff:

• Do the rating agencies push the guarantors over?
• Does the NY department of insurance force Equitable to find a buyer?
• Do neomercantilistic nations keep sucking down dollar claims in exchange for goods, importing inflation, or do they finally give up, and purchase US goods, and slow down their own economies, and the inflation thereof?

This is what makes practical economics tough.  Cycles that are self-reinforcing eventually break, and when they break the results can be ugly.  Why else are credit cycles long and benign in the bull phase, and short and sharp in the bear phase?

There are some books that were important to forming the way I think about economic problems, but if I write about it, I feel that I can’t do justice to the quality of the book. The Volatility Machine, by Michael Pettis, is one of those books. Michael Pettis was a managing director at Bear Stearns, and an adjunct professor at Columbia University when he wrote it.

The book was written in 1999-2000, and published in 2001. It explains how economic activity in the developed world travels into the smaller markets of the developing world, amplifying booms and busts. Coming off the Asian/Russian crises of 1997-1998, it was a timely book. During boom periods, capital flows from the developed countries to the developing countries; during bust periods, capital gets withdrawn. There is a kind of “crack the whip” effect, where the tail feels the change in direction the most.

Borrowing short is a weak position to be in, as the Mexican crisis in 1994 showed us, as the Fed raised rates and the tightening spilled into Mexico, which was financing with short-term debt, cetes. The same is true of corporations that finance with short debt; they are ordinarily less stable than firms that finance long. The Volatility Machine explains why the same forces apply to both situations.

Buffett has said, “It’s only when the tide goes out that you learn who’s been swimming naked.” Rising volatility is that tide going out, and it reveals weak funding structures and bad business/government plans. Booms set up the overconfidence that leads some economic parties to presume on future prosperity, and choose financing terms that are less than secure if the market turns.

Countries that are small and reliant on continued capital inflows are vulnerable to volatility. In the 1970s-1990s, that was the developing countries. Today, the developing countries vary considerably. Some have funded themselves conservatively, some have not, and a number are net capital providers. The US is the one reliant on capital inflows. So what would Michael Pettis have to say in this situation?

You don’t have to look far. Today, Michael Pettis is a professor at Peking University’s Guanghua School of Management. He is studying China from the inside, and writes about it at his blog (I read it every day, and will add it to my blogroll the next time I update it), China financial markets. Among his most interesting recent posts:

China’s latest batch of numbers aren’t good

Chinese pro-cyclicality makes predictions so difficult

More on why high share prices don’t mean Chinese banks are in good shape

The new China-Europe-US world order

Things have gotten grimmer in China

His views are complex and nuanced, and reflect the sometimes asymmetric incentives that politicians and policymakers face.  When I read his writings on China, I am simultaneously impressed with the rapid growth, and with the potential fragility of the situation.

So, enjoy his blog if that is your cup of tea.  If you want to learn how international finance affects developing economies, buy his book.

Full disclosure: if you buy the book through the link above, I will receive a pittance.

1) From an old post at RealMoney:

		David Merkel
		Nominate Fisher for the ‘FOMC Loose Cannon’ Award
		6/1/05 4:05 PM ET

It was pretty tough to dislodge William Poole, but if anyone could win the coveted “FOMC Loose Cannon” award in a single day, it would be Richard Fisher, after suggesting that the FOMC was “clearly in the eighth inning of a tightening cycle, we’ve been doing 25 basis points per inning, it’s been very transparent, and very well projected by the Federal Open Market Committee under the leadership of Chairman Greenspan,” and, “We’re in the eighth inning. We have the ninth inning coming up at the end of June.” [quoted from the CNBC Web site] Why don’t they have media classes for rookie Fed governors and Treasury secretaries? Even if he’s got the FOMC position correct, typically the Fed governors come out with a consistent message, and then, they cloak and hedge opinions, in order not to jolt the markets.

Okay, so Fisher dissented.  So he hasn’t had a predictable tone since becoming a Fed Governor.  Big deal.  The Fed needs more disagreement, and more original thought generally, even if it is wrong original thought, just to challenge the prevailing orthodoxy, and force them to think through what are complex decisions that might have unpredictable second order effects.

2) I hate the phrase “ahead of (behind) the curve,” because there is nothing all that clear about where the curve is.

3) Watch the yield curve, and note the widening today.  That is a trend that should persist, regardless of FOMC policy.

4) Rate cutting begets more cutting, for now.  The current cuts will not solve systemic risk problems embedded in residential real estate, and CDOs, anytime soon.  They will help inflate China (via their crawling dollar peg), and healthy areas of the US economy.

5) Where is the logical bottom here?  How much below CPI inflation is the Fed willing to reduce rates before they have to stop, much less raise rates to reduce inflation?  My guess: they will err on lowering rates too far, and then will be dragged kicking and screaming to a rate rise, as inflation runs away from them.  The oversupply in residential housing will cause housing prices to lag behind the price rises in the remainder of the economy.

6) Eventually the FOMC will resist Fed funds futures, but for now, the Fed continues to obey the futures market.

7) The stock market loves FOMC cuts in the short run, but has not honored them in the intermediate-term.

Ugh, today was a busy day.  My views of the FOMC were validated as to what they would do and say, though I was wrong on the stock market direction on a 50 bp cut.  The bond market direction I got right.

Look at this post from Bespoke.  Ignore the percentage increase, and just look at the raw spread levels.  Better, add an additional 3%+ (for the average Treasury yield) to the current 685 spread, for a roughly 10% yield.  When you get to 10% yields, the odds tip in your favor on high yield.  That said, today’s crop of high yield corporate debt is lower rated than in the past.  Don’t go hog wild here, but begin to take a little more risk.  I was pretty minimal in terms of credit risk exposure for the last three years, owning only a  few bank loan funds, the last of which I traded out of in June 2007.

With fixed income investing, if I have a broad mandate, I start by asking a few simple questions:

• For which of the following risks am I being adequately rewarded?  Illiquidity, Credit/Equity, Negative Convexity (residential mortgages), Duration, Sovereign, Complexity, Taint, Foreign Exchange…
• What are my client’s tax needs?
• How much volatility is my client willing to tolerate?
• How unconventional can I be without losing him as a client?
• What optical risks does he face from regulators and rating agencies, if any?

One of my rules of thumb is that if none of the other risks are offering adequate reward, then it is time to increase foreign bond positions.  That is where I have been for the past three years, and now it is time to adjust that position.  With respect to the list of risks:

• Illiquidity: indeterminate, depends on the situation
• Credit/Equity: begin adding, but keep some powder dry
• Negative Convexity: attractive to add to prime RMBS positions at present.
• Duration: Avoid.  Yield curve will widen, and absent another Great Depression, long yields will not fall much from here.
• Sovereign Risks: Avoid.  You’re not getting paid for it here.
• Complexity/Taint:  Selectively add to bonds that you have done due diligence on, that others don’t understand well, even if mark-to-market may go against you in the short run.
• FX: Neutral.  Maintain core positions in the Swiss Franc and the Yen for now.  Be prepared to switch to high-yield currencies when conditions favor risk-taking.

That’s where I stand now.  The biggest changes are on credit risk and FX.  That’s a big shift for me.  If you remember an early post of mine, Yield = Poison, you will know that I am willing to have controversial views.  Also, for those that have read me here and at RealMoney.com, you will know that I don’t change my views often.  I’m not trying to catch small moves.  Instead, I want to average into troughs before they hit bottom.  If you wait for the bottom, there will not be enough liquidity to implement the change in view.

Some of the commentary regarding inflation and deflation misses the point.  We are presently faced with both rising consumer price inflation and asset deflation.  Not a fun combination, to say the least.  It puts the FOMC into a real box.  To borrow an analogy from the Bible, Greenspan ate sour grapes, and Bernanke’s teeth are set on edge.

So what does the FOMC do in such a situation?  We don’t have that much history to work with, but during the ’70s, the FOMC generally loosened.  Fixed income portfolios should tilt toward shorter duration, even though you are losing income, and away from the dollar.  It is probably still too early to begin taking a lot of additional credit risk, but the bet is getting more attractive by the day.

Now, there are a number of commentators that can’t wait one week, and say the FOMC should act now.  The economy is not like someone that you have to take to the emergency ward; one week makes little difference, and the FOMC will do better work if they are meeting each other face-to-face under normal meeting conditions, than over a conference call.

Given the present equity market distress, should we assume that the FOMC will do more than 50 basis points in January? Had you asked me last week, I would have said “no.”  The political pressure is a lot higher now, so I would say yes, they will do more.  It won’t help the areas under credit stress, but it will make it look like they are serious about “fixing the economy.”

We could see a move of either 75 or 100 basis points.  I debate internally how good Fed funds futures are in abnormal environments like this.  Under Greenspan, I sometimes felt that monetary policy had been privatized, and whatever the futures market said, the FOMC would do that.  I don’t know if Bernanke has the same faith that futures traders know what the right monetary policy is.  If I were a Fed Governor, I certainly would not have that confidence.  Once the yield curve gets to a certain slope, the recovery will come in time.  Making the curve steeper won’t make it any faster.

People are impatient, and their complaining causes the FOMC to overshoot on policy decisions.  The lag that monetary policy has is significant, and the FOMC in recent years has made it even slower through their policies of incrementalism.

There are several possibilities here for the FOMC action:

1. They hold firm, and don’t lower much (50 bp), because price inflation is a concern.
2. They take the judgment of the futures traders, and move a full 100 bp.  Or, they conclude that asset deflation is a bigger risk, and decide to make a bold statement.  After all, isn’t Bernanke the guy who never wants to see the Great Depression recur, and loose monetary policy can prevent that?  (I don’t think that’s right, but…)
3. They split the difference, make bows to both camps in their language, and do a 75 bp cut.

The last of those seems most likely to me.  I have said in the past that the FOMC is:

• Being politically forced to loosen more than they would like, and
• Dragging their heels in the process.

That’s why I think we end up on the low end of where Fed funds futures will likely point tomorrow.  75 basis points does not trip off the tongue, but will be a compromise position in the minds of Federal Reserve Governors who are puzzled at the present situation.  Because of political pressure, they know that they have to move big, but consumer price inflation will make them less aggressive.

Give the Fed some credit. Not literally, of course. Isn’t it their job to give us credit?

I haven’t talked a lot about Fed policy in a while, so I thought it was time to do an update. Five months have passed since my 3% sometime in 2008 call was made, and now it is becoming the received orthodoxy. That’s why I have to ask what is wrong with it, or better, what is the next phase beyond it?

Truly, I don’t know for sure, but I will offer out my thinking process. We are seeing rising unemployment and inflation at the same time. The bond market is rallying, anticipating falling Fed funds rates, but not forecasting rising inflation rates. (Buy TIPs!) In the spirit of watch what they do not what they say, let’s review the relevant Fed data.

• Effective fed funds have averaged 4.01% since the last Fed meeting. Sloppy on the low side. I believe intentionally so.
• Still no permanent injection of liquidity since 5/3/07. This Fed likes unorthodox measures.
• The Fed has increased the size of the TAF auctions by 50%, to $30 Billion on 1/14, and 1/28.
• Since 8/8/07, my M3 proxy has run 8.4% not annualized, followed by MZM at 6.2%. M2 and the monetary base are anemic at 2.6% increases.
• Ergo, the Fed is relying on the willingness of the banks to extend credit for their loosening of the money supply, not their expansion of the monetary base.
• The forward curve has a sub-3% fed funds rate in 2008.
• Finally, Fed funds futures and options favor a 50 bp cut in late January.

We are in a period of asset deflation and consumer price inflation, so this is a difficult period to negotiate through. You can listen to facile comments from PIMCO; everyone is focused on economic weakness, and few are focused on rising inflation.

I think we get to a 3% Fed funds rate, but we don’t get much below it, because by that time, a 3% Fed funds rate will imply a negative real interest rate on the short end. Congress will have an implied inflationary bias, because the complaints will come more from asset deflation. They will kick nudge the Fed that way to the extent that they can.

The TED spread is not as wide as it once was, but it is still in a historically high range. Anything above 60 basis points implies stress. To reduce this the Fed has set up an auction facility, called the TAF. The TAF has been expanded, which allows for a greater variety of securities to be lent against. That’s the real novelty of the TAF. Not new liquidity but new collateral. That said, even the discount window is getting greater use. As a result, the Commercial Paper market is showing some life, even for asset backed commercial paper.

So, liquidity is increasing on the short end, to the point where a 1/4% cut in Fed funds has for practical purposes already happened. A formal 1/4% cut at the next FOMC meeting would do little except ratify what has already been done. Now there is weakness in the job market, and the PMI is signaling some weakness as well. The yield curve has moved down, particularly on the short end, to reflect expectations of more cuts from the Fed.

But TIPS yields are quiet, at least for now, and viewing the Fed as quasi-politicians, whose main goal in life is to avoid political pain, the path of least resistance is to loosen policy further. Fed funds futures and options are indicating the most likely outcome in on January 30th is a 50 basis point loosening. Ordinarily, because of the “gradualist” culture that has built up inside the Fed, I am reluctant to argue for loosenings other than 25 basis points. I think at this point, I have to argue for 50 basis points, but with the usual squishy language that pays heed to all potential threats, effectively saying, “But no more after this! Conditions are balanced!” We know better, though. The only real question is when rising consumer price inflation or a deteriorating Dollar (think of 1986) will be a sufficient counterweight to economic weakness.

The US Dollar is weak here, and that reflects the judgment of many actors as to the value of what they get paid back will be. My guess is that foreign investors sense that inflation is higher in the US than is stated in the Government’s statistics. Too many dollar claims (internal and external) chasing too few goods that they want to buy. What will dollar-denominated bonds be worth at maturity? (Judging by current yields, quite valuable for now.) And will the US Government allow significant US companies to be owned by the Chinese, or by Arabs? How free market is the US really? Will foreign governments stop policies that disfavor the purchase of US goods? Perhaps once they import enough inflation, they will.

With gold, crude oil, and a host of agricultural prices high, and with structural reasons for them to remain high, the FOMC won’t feel too happy as they cut rates. But cut they will, and then we get to see where the excess liquidity flows. Some will bail out banks, which will invest in safe instruments in areas of the economy not under threat. Loans in or near default will not be affected. Well, more on that later. Tonight’s post will be on credit issues.

In closing, a return to the problem that I posed at the beginning: So what’s wrong with the 3% Fed funds forecast, or better, what is the next phase beyond it? It could go several ways:

1. Rising price inflation and a deteriorating dollar lead to an end to the cycle, and the Fed funds rate either stops falling, or has to rise to squeeze out inflation.
2. Continuing asset deflation, and declining but still positive economic growth (as the government measures it) leads the Fed to continue to loosen, or stand pat in the face of rising consumer price inflation.
3. Liquidity difficulties in the banking system morph into solvency difficulties, leading pseudo-M3 and credit to contract (after all the banks are doing the heavy lifting here, not the Fed) and the Fed starts to loosen aggressively.
4. We get a “bolt for the blue” leading to something not currently predictable, but which leaves policymakers in a bind.
5. We muddle along, get to something near a 3% Fed funds rate, and continue to muddle (think of 1992-1993).

Personally, I favor scenario 2. And, for those that like to invest, TIPS are reasonably priced. Insurance against scenario 2 is inexpensive, and relatively high quality. But be wary, because particularly in a Presidential election year, there could be significant surprises (part of scenario 4).

Long VIPSX

I’m not sure what to title this piece as I begin writing, because my views are a little fuzzy, and by writing about them, I hope to sharpen them.  That’s not true of me most of the time, but it is true of me now.

Let’s start with a good article from Dr. Jeff.  It’s a good article because it is well-thought out, and pokes at an insipid phrase “behind the curve.”  In one sense, I don’t have an opinion on whether the FOMC is behind the curve or not.  My opinions have been:

• The Fed should not try to reflate dud assets, and the loans behind them, because it won’t work.
• The Fed will lower Fed funds rates by more than they want to because they are committed to reflating dud assets, and the loans behind them.
• The Fed is letting the banks do the heavy lifting on the extension of credit, because they view their credit extension actions as temporary, and thus they don’t do any permanent injections of liquidity.  (There are some hints that the banks may be beginning to pull back, but the recent reduction in the TED spread augurs against that.)
• Instead, they try novel solutions such as the TAF.  They will provide an amount of temporary liquidity indefinitely for a larger array of collateral types, such as would be acceptable at the discount window.
• We will get additional consumer price inflation from this.
• We will continue to see additional asset deflation because of the overhang of vacant homes; the market has not cleared yet.  Commercial real estate is next.  Consider this fine post from the excellent blog Calculated Risk.
• The Fed will eventually have to choose whether it is going to reflate assets, or control price inflation.  Given Dr. Bernanke’s previous statements on the matter, wrongly ascribing to him the name “Helicopter Ben,” he is determined not to have another Depression occur on his watch.  I think that is his most strongly held belief, and if he feels there is a modest risk of a Depression, he will keep policy loose.
• None of this means that you should exit the equity markets; stick to a normal asset allocation policy.  Go light on financials, and keep your bonds short.  Underweight the US dollar.
• I have not argued for a recession yet, at least if one accepts the measurement of inflation that the government uses.

Now, there continue to be bad portents in many short-term lending markets.  Take for example, this article on the BlackRock Cash Strategies Fund.  In a situation where some money market funds and short-term income funds are under stress, the FOMC is unlikely to stop loosening over the intermediate term.

Clearly there are bad debts to be worked through, and the only way that they get worked out is through equity injections.  Think of the bailing out of money market funds and SIVs (not the Super-SIV, which I said was unlikely to work), or the Sovereign Wealth Fund investments in some of the investment banks.

Now, one of my readers asked me to opine on this article by Peter Schiff, and this response from Michael Shedlock.  Look, I’m not calling for a depression, or stagflation, at least not yet.  At RealMoney, my favored term was “stagflation-lite.”  Some modest rise in inflation while the economy grows slowly in real terms (as the government measures it).   A few comments on the two articles:

•  First, international capital flows from recycling the current account deficit provide more stimulus to the US economy than the FOMC at present.  Will they stop one day?  Only when the US dollar is considerably lower than now, and they buy more US goods and services than we buy from them.
• Second, the Federal Reserve can gain more powers than it currently has.  If this situation gets worse, I would expect Congress to modify their charter to allow them to buy assets that it previously could not buy, to end the asset deflation directly, at a cost of more price inflation, and spreading the lending losses to all who hold longer-term dollar-denominated assets.  If not Congress, there are executive orders in the Federal Register already for these actions.
• Third, in a crisis, the FOMC would happily run with a wide yield curve — they will put depositary institution solvency ahead of purchasing power.
• Fourth, the Fed can force credit into the economy, but not at prices they would like, or on terms that are attractive.  In a crisis, though, anything could happen.
• Fifth, I don’t see a crisis happening.  It is in the interests of foreign creditors to stabilize the US, until they come to view the US as a “lost cause.”  Not impossible, but unlikely.  The flexible nature of the US economy, with its relatively high levels of freedom, make the US a destination for capital and trade.  The world needs the flexible US, less than it used to, but it still needs the US.

One final note off of the excellent blog Naked Capitalism.  They note, as I have, that the FOMC hasn’t been increasing the monetary base.  From RealMoney:

		David Merkel
		The Fed Has Shifted the Way it Conducts Monetary Policy
		12/21/2007 11:56 AM EST

Good post over at Barry’s blog on monetary policy. Understanding monetary policy isn’t hard, but you have to look at the full picture, including the presently missing M3. I have a proxy for M3 — it’s total bank liabilities from the H8 report –> ALNLTLLB Index for those with a BB terminal. It’s a very good proxy, though not perfect. Over the last years, it has run at an annualized 9.4%. MZM has grown around 12.8%. The monetary base has grown around 3%, and oddly, has not been spiking up the way it usually does in December to facilitate year-end retail.

The Fed is getting weird. At least, weird compared to the Greenspan era. They seem to be using regulatory policy to allow the banks to extend more credit, while leaving the monetary base almost unchanged. This is not a stable policy idea, particularly in an environment where banks are getting more skittish about lending to each other, and to consumers/homebuyers.

This has the odor of trying to be too clever, by not making permanent changes, trying to manage the credit troubles through temporary moves, and not permanently shifting policy through adding to the monetary base, which would encourage more price inflation. But more credit through the banks will encourage price inflation as well, and looking at the TED spread, it seems the markets have given only modest credit to the Fed’s temporary credit injections.

I am dubious that this will work, but I give the Fed credit for original thinking. Greenspan would have flooded us with liquidity by now. We haven’t had a permanent injection of liquidity in seven months, and that is a long time in historical terms. Even in tightening cycles we tend to get permanent injections more frequently than that.

Anyway, this is just another facet of how I view the Fed. Watch what they do, not what they say.

Position: noneThe Naked Capitalism piece extensively quotes John Hussman.  I think John’s observations are correct here, but I would not be so bearish on the stock market.

After all of this disjointed writing, where does that leave me? Puzzled, and mostly neutral on my equity allocations.  My observations could be wrong here.  I’m skeptical of the efficacy of Fed actions, and of the willingness of foreigners to extend credit indefinitely, but they are trying hard  to reflate dud assets (and the loans behind them) now.  That excess liquidity will find its way to healthy assets, and I think I own some of those.