Macroeconomics – Page 120

Private Equity — Operators or Glorified Condo-flippers?

Posted on 28 August 2007 by David Merkel

In commercial real estate, operators that are willing to “feed their properties” during bad times get respect, and sometimes even lower financing costs from those who lend to them.? In a similar vein, and perhaps it is making a virtue out of necessity, it was interesting to see KKR offer to pump money into their specialty finance affiliate.? Don’t get me wrong, they haven’t become altruists, but a longer-term orientation is refreshing, perhaps.
Arb spreads remain wide on deals though they have come back significantly recently.? For a gauge of that, simply look at a graph of the Merger Fund.
Who can get out of what?? Well, private equity [PE] got the Home Depot board to cave in to a lower offer.? Guess they needed the money.? But what of other private equity deals?? I suspect more will lower prices as well, but not all of them; some deals will break up.? But what of the banks committed to lending money on deals?? Many of them are doing all they can to get off the hook, but so many banks surrendered their flexibility to exit deals in order to get the business during the boom phase.? Now they are paying for it, or, at least, considering paying for it, since losses look like they will be 10-12% of the amount loaned, as they sell the loans to institutional investors.
“There is pressure to deploy,” said Ilan Nissan of law firm O’Melveny & Myers. “This business is about using resources to buy and sell companies. No one is making money by holding.“? To me, that what’s wrong with private equity.? If PE is just a larger version of condo-flippers, it has little reason to exist.? Improving operations and marketing would be far better things to do.
Somewhat off-topic, back to the Fed Model, since that deals with the tradeoff of debt for equity, much like PE firms do.? I felt that Dr. Hussman’s methods were mistaken, and so I commented over at A Dash of Insight:Even though his regression fit well, there were two things amiss. One, how many models did he try before he published his model? Did he do a specification search? When I did my model, I did only two passes over the data, and the first was accidental because I didn’t have a lengthy corporate yield series. The Moody’s series is one of the few that goes back a long way, and Bloomberg did not carry it. I wanted to use BBB corporates from the start, but could not find a series, so I did one pass with Treasuries.
http://alephblog.com/2007/07/09/the-fed-model/

Second, after doing the analysis, the rest of his results rely on an extrapolation from the recent past to the further past. Dr. Hussman is the one who argues that the 80s are unique, but that is a large part of the data that he uses to estimate his backcast. No matter how good the fit, it is not safe to do extrapolations. Too many structural things change over time in capitalist economies.

That’s all for now.? I might have the strength for one more post tonight.

Tickers mentioned: KFN HD

A “Sour Sixteen” Thoughts on the Real Estate Markets

Posted on 25 August 200726 August 2007 by David Merkel

Before I begin this evening, let me just mention that I have expanded my blogroll. These are the blogs that are on my RSS reader at present. As I add more, I will add them to my blogroll. One more thing before I start: the comeback on Friday was nice, but I don’t think this is the end of the troubles; the leverage issues still aren’t dealt with, though the money markets (CP, ABCP) may be getting reconciled in the short term. Tonight’s topic is the mortgage market:

Reduction in capacity is the rule of the day. Who is shrinking or disappearing? Lehman’s subprime unit, Thornburg (shrinking), Luminent (cash injection under distress), American Home (what were the auditors thinking?), Capital One (closing Greenpoint), Countrywide (layoffs), Accredited, HSBC’s US mortgage unit, and more.
Who has lost money? Who has decided to pony up more? Carlyle ponies up, Bank of China, speculators including Annaly, and many others, including IKB, BNP Paribas, and British, Japanese and Chinese banks. The losses are mainly a US phenomenon, but not exclusively so.
Thing is, in a credit crunch, before things settle down, everyone pays more. The CEO of Thornburg suggests that the mortgage markets aren’t functioning. Well, if excellent borrowers aren’t getting loans, he is correct. After risk control methods are refined, new capital finds the better underwriters, who underwrite better loans. For those with good credit, any imbalances should prove temporary.
Now what do you do if you are a surviving mortgage lender, and you can’t get enough liquidity to lend? Raise savings and CD rates. (A warning to readers: no matter how tempting, do not lend to mortgage lenders above any government guaranteed threshold on your deposits.)
Could the Truth in Lending Act cause loans to be rescinded? As I commented, If TILA claims are successful, there would probably be a breach of the reps & warranties made by the originator. I think there is a time limit on the reps and warranties though, and I’m not sure how long it is.
If a securitized loan has to be taken by the originator, the AAA part of the deal will prepay by that amount. Losses will be borne first by the overcollateralization account, and then the tranches, starting with the most junior, and then moving in order of increasing seniority. If a bank goes insolvent as a result of this, any claims against the bank by the securitization trust would be general claims against the bank.

Very interesting, Barry. Thanks for posting this. It’s just another reason why in securitization, it is better to be a AAA holder, or an equity holder. They have all of the rights — the AAAs when things are bad, and the equity when things are good to modestly bad.
Or, could Countrywide, and other lenders run into difficulties because they might have to buy back loans that they modify the terms, if they are pre-emptive in doing so, rather than reactive to a threatened default? On the other hand, modifications are generally allowed for true loss mitigation, or if they are loss neutral to the senior investors. But what if the servicer offers modification to someone with a subprime loan who really doesn’t need it? Not likely in this environment. Almost everyone who took out a subprime loan expected to refinance. Modification is just another way of getting there.

What could fiscal policy do to get us out of this mess? Maybe expand Fannie and Freddie, or FHA? Or have a bailout from some other entity, as Bill Gross or James Cramer might suggest? I’m a skeptic on this, as I posted at RealMoney on Thursday:

		David Merkel
		Every Little Help Creates a Great Big Hurt
		8/23/2007 5:09 PM EDT

So there are some that want the US Government to bail out homeowners. Need I remind them that on an accrual basis, we are running near record deficits? Never mind. In another 5-10 years, it won’t matter anymore, because foreigners will no longer fund the gaping needs of the US Government as the Baby Boomers retire.But so as not to be merely a critic, let me suggest an idea to aid the situation. Income tax futures. We could speculate on the amount the US Government takes in, and the IRS could use it for hedging purposes. One thing that I am reasonably sure of: tax rates will be higher ten years from now, and I would expect the futures to reflect that.

Position: long tax payments

Beautiful San Diego, where my in-laws live. What a morass of default and foreclosure, as is much of California. Good blog, by the way.
For those who have read me at RealMoney, the troubles in residential real estate came as no surprise to me, though many at Wall Street were either surprised, or feigning surprise.
One other easy way that we can tell that we are in a residential real estate bear market is the incidence of fraud. Face it, in a bear market, the scams play to the fear of people, whereas in a bull market, they play to their greed.
What effects will the increase in consumer debt, including mortgages, have on the economy? Well, the Fed Vice-Chairman wrote a piece on it, and the answer is most likely slower growth in consumer expenditure, and greater sensitivity of demand to interest rate movements.
What happens when the equity and debt markets get shaky? Commercial landlords in New York City and London get nervous. Personally, I wouldn’t be that concerned, but perhaps some of them overlevered? (Hey, remember how MetLife sold a large chunk of their NYC properties for record valuations? Good sales.)
How much value will get wiped away before the residential real estate bust is done? $200 billion to several trillion (implied as a worst case by the article)? I lean toward the several trillion figure, but not strongly.
Something that trips people up about the mortgage troubles, is that little has been taken in losses so far, why is there such a panic? Markets are discounting mechanisms, and they forecast the losses, and bring the currently expected present value of losses to reflect on the value of the securities. Beyond that, weak holders of mortgage securities panic and sell, exacerbating the fundamental movements.
Why are credit cards doing well when mortgages are doing badly? This is unusual. What it makes me think is that there is a class of homeowner out there thinking: “The mortgage? I’m dead, no way I can pay that. I have to look forward to renting in the future, and I don’t want to destroy access to my credit card.”
Finally, ending on an optimistic note: even if housing is so bad, in a global economy, it may not mean so much to the stock market. That’s my view at present, and why I am willing to be a moderate bull, even as I continue to do triage on my portfolio. (PS — that graph entitled, “Trouble at Home,” is scary.)

Fed Up with Impotent Monetary Policy

Posted on 23 August 2007 by David Merkel

So the Fed opens up the discount window, and drops the rate 0.5%, banks go gonzo, right?? Well, no, I wouldn’t call it a “brisk business.”? A lot of the “business” was in and out in short order, for average borrowings of $1.2 billion.? For the discount window of its own to make a real dent in monetary policy, we would need to see more than $10 billion of net borrowings, because the Fed is decreasing the monetary base by $10 billion through other actions.? As it is, after the discount rate was decreased, there was a flurry of action, and then nothing.? So, in order to keep the monetary base up, the Fed injects temporary liquidity of $17.25 million, the most in 2 weeks (i.e., since permanent temporary injections started).? Does this have a big impact on the Fed funds rate?? No, it closes out the day at 4.875%, which is close to the average level of 4.90% over the past two weeks.? The number looks big, but it is meaningless.? Look at the monetary base or one of the monetary aggregates; they haven’t moved much.? Should we expect a lot of incremental economic action of out of this?? I don’t think so.

Onto the Commercial Paper Market.? CP outstanding had its biggest weekly drop since 2000. It is down almost 10% over the past two weeks.? Most of the decrease is asset-backed CP.? Bill Gross declares that the ABCP market is “history.”? He’s wrong.? Again.? ABCP will remain but with safer classes of asset-backed securities, wider spreads, and larger margins of safety, at least until the next lust for yield comes upon us. ;)? As it is, the safer parts of the ABCP market are beginning to function normally, albeit at higher spreads.

Things can get bad in the ABCP market, particularly if you are an issuer that doesn’t have a big balance sheet.? That’s what happened to Canada’s Coventree.? For banks issuing ABCP, it should not be as big of a problem; many banks will step up and make up the loss.? If the risk is $891 billion in commercial paper, I would be surprised if the losses were more than 2% of that amount.? At $18 billion, that is no threat to the system, though some rogue money market funds might get whacked.

Now corporate bond issuance is returning, though some of it is replacing CP.? I expect that effect to stop soon.? Things are returning to normal in corporates, though high yield will take more time.

This article helps point out that the Fed, though still powerful, has reduced powers because less of the financial system consists of depositary institutions. ABS and mutual funds have picked up the slack.? What that implies is that ordinary bond buyers are willing to take on the risks that depositary institutions once did.? That reduces the power of the Fed.

As for this article, I’m sure Fed Governors are thinking, “What’s next?? Are we just running from fire to fire, or is there a systemic way to restore order?”? I’m not so sure here.? I think a permanent injection of liquidity would do it, temporarily, but there are so many places where leverage got too great that are in loss positions now.? For the Fed, the only real question should be, how much did our banks lend to the overleveraged?

From Michael Sesit at Bloomberg, there are four things for the central banks to do in order to avert the crises: The world’s major central banks face four challenges as they strive to prevent the global financial system from unraveling and growth from stagnating: Acting in a concerted manner; improving transparency; deciding who gets bailed out and who doesn’t; and making sure whatever monetary medicine is administered doesn’t come with destabilizing side effects.

All four are not easy.? I would argue that the last two are the most important, but that it is very difficult to legally discriminate between who needs it and who doesn’t.? Destabilizing side effects are part and parcel of monetary policy.? To the degree that the Fed can discriminate, it will eventually run the risk of being view as unfairly discriminatory, and unelected as well.

So, I don’t see much happening here from monetary policy.? It is simply a question of how the excess leverage presents itself through the financial system.? So far, it has served up some notable troubles, the question is how much more before it burns out.? With residential housing prices sagging it may persist for a long while, until the Fed debases the currency such that debtors can pay back their debts in devalued terms.? It almost reminds me of the bimetalism of the late 19th century; debasing the currency to let a wide number of debtors off the hook.? Well, if the Fed doesn’t do it, maybe Congress will.? After all, Congress can do something targeted,and live with the political heat.? The Fed risks its independence if they look like they behave on behalf of the the few, nor the many.

Money Market Malaise

Posted on 23 August 200723 August 2007 by David Merkel

There was a decent amount of attention paid to this blog post from the WSJ Marketbeat blog. The sentiment for a cut from the bond and futures markets stems from the concept that what the Fed has done is inadequate to reliquefy the areas that they are targeting. Banks will face significant lending losses, and economic growth will stop, unless the FOMC acts in a major way. We are still waiting (since 5/3) for a permanent injection of liquidity, and we have until Thursday night to see how much good the discount window action has done.
From the “not much good” camp, what good is it if healthy institutions pick up additional excess liquidity at rates above where they could they could borrow unsecured for 5 years in the bond market? Bank of America did not need the discount window down by 0.5% in order to take a stake in Countrywide.
Here’s the current problem. It has been difficult for marginal borrowers to borrow in the Commercial Paper [CP] markets. Even strong names like American Express and Lincoln National went to the bond market to pay off maturing CP. But if you were a lower rated company, things were worse, like H&R Block, or GMAC, things are considerably worse. All they can rely on is pre-existing credit lines. After that, they are dependent on the kindness of strangers.
Now, there is some hint that the troubles in ABCP are becoming more nuanced. Conduits with the highest quality collateral are getting rolled over. But how bad is it for real offenders? It is one of those cases where the ratings agencies are playing catch-up, let us say. Moves from AAA to CCC? Yes. Breathtaking. Sure ruins their ratings migration tables.
For those with time, for a relatively complete article explaining some of the problems that money market funds face from subprime, look here. The risk isn’t the same risk as from asset-backed CP [ABCP] per se, but seems to stem from buying AAA floating rate bonds from CDOs owning tranches of subprime ABS.
Those worrying about the carry trade blowing up can rest for a while. The Bank of Japan decided not to tighten. Japanese lending rates remain low a while longer, and the party goes on. I guess it will take the importation of inflation to make that change.
Beware easy certainties. Just because the Fed cuts does not mean the market will rise, or that if it doesn’t cut, it will fall. On average, it is true the 6 months after a first cut, the market rises, and almost always rises after a full year the first cut.
I previously asked who could benefit from incremental US dollar liquidity. I came up with a few possibilities, but one I did not come up with was Hong Kong, with their link to the US Dollar on one side, and their link to Chinese growth on the other. It is certainly worth a thought.

Full disclosure: long LNC

The Fed is Hopeful (oh, that h-word…)

Posted on 21 August 2007 by David Merkel

Only time for one post tonight.? I had a late meeting with some men from my church.? Away from that, my oldest son goes to college for the first time tomorrow, to St. John’s in Annapolis.? I will miss him, even though I will see him most weekends; he is a joy of a child to be around, and a really sharp thinker.? As an intern, he has impressed two investment firms with his acumen.? But what I will miss most is his good character.

Into the fray, then.? It’s the WSJ’s word, but is the Fed genuinely hopeful?? If so, it’s on scant evidence.? Away from that, you have Governor Lacker, who tends to be a hawk, saying that it is the effect of the financial markets on the economy will drive Fed policy, not any volatility in the credit markets themselves.? Well, the present dislocation is worse than LTCM in many ways already.? LTCM did not gum up the mortgage repo market, or money market funds.? As it is, Central banks are still showing themselves willing (minus the Bank of England) to engage in a series of short term injections of liquidity.

Why are money markets doing badly?? Asset-backed commercial paper [ABCP] makes up 50% of all money market fund assets, and those claims will have to be rolled over the next 1-3 months.? At a time like like this, the lack of alternatives is driving money market funds to grab T-bills and highly rated CP, even as those with higher ABCP exposure wonder what will happen if the ABCP conduits extend the obligation, and at the end of the extension period, are still inverted?? What will those that have to provide liquidity or credit support do?? This problem is not limited to the US; there have also been problems in Canada and Britain, but banks operating there have stepped up and taken the hit themselves.? Altruistic in the short run, but regulators and business partners have long memories, even when it is only implied promises getting broken.? (Hey, maybe the Fed can open up the discount window to non-bank ABCP conduits.? Please don’t… 🙁 )

At a time like this, is it any surprise that the guy who created the money market fund is saying that the concept has been abused?? It was not meant to fund speculators in risky asset classes.? Not all ABCP does that, but that is what some of them are proving to be now.? But, perhaps it is fitting in its own warped way.? The introduction of money market funds (and the elimination of regulation Q, a ceiling on credited interest rates) helped prolong the inflation of the 70s, because the Fed couldn’t control liquidity the way that it used to; money market funds just kept supplying liquidity at interest rates investors found attractive.

So, how tight is US monetary policy?? If you gauge it by T-bills, pretty tight.? At every percentage rise in the Treasury less fed funds spread like this, the Fed has loosened.? It could be different this time, but if so, the markets will be jolted, and by markets, I mean the debt markets, the money markets, etc.? The stock market will be down too, but that will be the least of our worries.? Even now, other types of consumer lending are starting to tighten.? With the markets already discounting a 50 basis point decrease in September, those markets will be tighter still if the Fed sounds like Governor Lacker.

So things are bad in the US.? How about elsewhere?? WestLB CEO Alexander Stuhlmann says that he sees an increasing reluctance to lend to German banks.? The Bank of England lent to Barclays plc at a penalty rate at their discount window, and supposedly for no big reason.? (I hope the reason is innocent incompetence… I’m a shareholder.? Oops, there’s the h-word again, and it’s me.)

The carry trade is getting squeezed, partly because currency option volatilities are rising.? How does this work?? Think of it this way.? The carry trade works by borrowing in a low interest currency, and investing in a high interest currency.? Assume for a moment that I approximately matched the maturities of the two trades (risk control!), but that I wanted downside protection from the trade going wrong, so I would buy an option that would stop me out at a certain level of loss (again, attempting to match trade maturity).? The higher the option volatility goes, the more costly it is to limit the risk on my trade, so as option volatility rises, the willingness to do the carry trade falls.

Chinese Inflation? ? As I’ve said before, that is a threat to the recycling of the US current account deficit, and also a threat to US inflation levels.? Could that keep the FOMC from loosening?? Not yet.? We need to see more pain here.

Finally, from the “don’t bite the hand that feeds you file,” the Bush Administration is worrying about the impact of sovereign wealth funds exerting undue influence on the US.? Oh, please, you worry about this now, after expanding our current account deficit like mad?!? At this point, the US has few options but to sell assets to all but dedicated enemies of the US; if we are not willing to cut back our current account deficit in other ways, and our debt becomes unattractive, there are two choices, let the dollar fall until US goods become compelling (with rising interest rates and inflation), or let them buy our assets.? We can’t freeload on the rest of the world forever (though we did sell much of the toxic CDO waste to unsuspecting naifs, we just don’t know who yet), eventually we will have to be willing to sell away large stakes in major US corporations.? (Or maybe all the surplus homes! 😀 )

Full disclosure: long BCS

The Central Banks are Worried, or at Least, They Should Be Worried

Posted on 21 August 2007 by David Merkel

Asset Backed Commercial Paper [ABCP].?? We’re going to hear a lot more about this, and soon.? The Wall Street Journal leads off today with an article on how money market funds are scampering to buy T-bills, and don’t want to touch A2/P2 paper, or any ABCP, no matter how high quality, which is half of the CP market.? Bloomberg provides this summary as well, highlighting that as ABCP conduits collapse the relatively high quality securities that they are financing will need to make their way onto the balance sheets of other investors.? The ABCP conduits can extend their maturities 30-45 days or so, but unless conditions improve in a month or two, there will be a lot of paper brought to the market as the ABCP conduits collapse.? Some of those assets can be financed at 5.75% at the discount window, so maybe the Fed can brake some of the damage.? On the other hand, the National Bank of Canada bought C$2 billion of ABCP from its company’s money market funds.? Much of the rest of ABCP in Canada is converting the obligations into long-dated floating rate notes, which is a correct way to finance longer dated paper.

Yesterday, the Wall Street Journal explained why the FOMC moved the discount rate.? A large portion of the argument is the demand for T-bills from money market funds sending T-bill yields temporarily below 1%, and settling yesterday a little above 3%.? Anytime the spread between Treasury bill yields and Eurodollar yields (offshore dollar bank lending rates) gets too great, there is a lack of confidence in the banking system.? The discount rate will do something to help here, but only a cut in Fed funds will get the speculative juices going, for good and for ill.? As it stands, yesterday, at 2.40%, the TED [Treasury-Eurodollar] spread is the highest it has been since the crash in 1987, when it hit nearly 3%.

Now, why did Deutsche Bank borrow at the discount window?? Borrowing hardly strikes me as supporting the actions of the Federal Reserve, regardless of what DB says.? Now the ECB at this point is in no mood to raise rates.? As it is, the ABCP problem has forced the bailout of the Sachsen Landesbank.? What will break next?

This isn’t pretty, and while I think Jim Griffin is being too optimistic about how this crisis will turn out, it is worth noting that when lots of stocks hit new lows, it is often a good time to be investing.

One final note: orthodox economic theory says that crises can be stopped by a large economic actor (today, a central bank) being willing to lend unlimitedly with good collateral at a penalty rate.? What that implies is that some parties will go under, for whom the penalty rate is too high.? This keeps discipline in the system, while still rescuing the system.? Unfortunately, that is not true today.? 5.75% is inadequate compensation for many of the risks taken on by the Federal Reserve through the discount window.? It may rescue some marginal entities, but it will promote inflation and moral hazard.

That’s all for tonight, I’m beat.

Full disclosure: long DB

The Longer View, Part 1

Posted on 18 August 2007 by David Merkel

Here are some posts that have caught my attention over the last month, but I never commented on because of the increase in volatility placed more of a premium on covering current events.

Will we ditch GAAP accounting for IFRS?? Personally, I don’t want to learn a new set of rules, but if it improves our ability to invest in a more global era, then maybe it will be a good thing.
Do we care if we have auditors or not?? BDO Seidman recently got hit for damages of $521 million.? If this damage amount stands, it will bankrupt them, and possibly eliminate the #5 auditor in the US.? My argument here is not over guilt, but merely the size of the award.? That said, if the damage amount stands my solution would be to award 30% of the ownership of BDO Seidman to the plaintiffs.? Let them earn it through shared profits.
Peter Bernstein takes my side in the understating inflation debate.? As I have said before, if you want to smooth inflation, use the median or the trimmed mean, which is more statistically robust than excluding food and energy.
Jeff Matthews comments on how many companies that paid large special dividends, or bought back too much stock are regretting it in this environment.? What should they say to shareholders, but won’t?? I’ve said that for years at RealMoney, but during a boom phase, who listens?
I found it fascinating that private issuances of equity via 144A are exceeding IPOs at present.? Only the big institutions get to invest, and they can only trade it to each other.? I experienced that as a bond manager, but for equities, this is new, and a growing thing.? Question: most trading will then be negotiated block trades as in the bond market.? If a mutual or hedge fund buys one of these 144A issues, how do they price it?? With bonds, it doesn’t usually matter as much, because things usually move slowly, but with equities?
Can we time the value premium?? (I.e., when do we invest in growth versus value?)? The answer seems to be no.? Value strategies work about two-thirds of the time, which makes them dominant, but not so much so as to overcome the more sexy growth investing.? This allows the anomaly to continue.? The end of the article concludes: The bottom line for investors is that the prudent strategy is to ignore the calls to action you hear from Wall Street and the media and adhere to your investment plan. The only actions you should be taking are to rebalance your portfolio and to harvest losses when that can be done in a tax-efficient manner.? I like it.
I’ll say it again.? Be careful with ETNs.? They may have tax advantages versus ETFs, but the hidden risk is that the sponsor of the ETN goes bankrupt, in which case you are a general creditor.? With an ETF, bankruptcy of the sponsor should pose little risk.
Hit me again, please.? If financials didn’t hurt me recently, then it was cyclicals.? Ouch.? Both are at risk, but for different reasons.? Financials, because of a fear of systemic risk.? Cyclicals, because of a fear of a slowdown stemming from an impaired financial system being unwilling/unable to lend.

I’ll try to post on the other half of this on Monday.? Have a great Sunday.

A Baker’s Dozen on Current Issues in the Markets

Posted on 18 August 2007 by David Merkel

If I have the energy this evening, I’ll put up two posts: the first on the near-term, and the second on longer-dated issues.? Then, next week on Monday, I hope to continue addressing the balance sheets of the companies in my portfolio.? I still believe that credit quality will not in general improve, but that companies that can benefit from additional financing and obtain it will be the best off in this environment.

First a few macro pieces.? I usually don’t comment on Nouriel Roubini.? To me, he seeks too much publicity.? Is the present situation worse than LTCM?? Yes and no.? Yes, the entire housing market and housing finance areas are affected, as well as some levered areas in corporate credit — CDOs and loans to private equity.? No, at least not yet.? During LTCM, the solvency of at least one major investment bank (the rumor is Lehman) nearly went down.? That would have been worse than what we have at present by a fair margin.
This piece from Paul Kasriel is interesting.? He brings up the correlation of seemingly unrelated asset classes, and hits the nail on the head by explaining that it id the owners of many risky classes of securities that are forced to sell due to margin calls that drives the rise in correlations.? Then he makes another hit on a favorite topic of mine, Chinese inflation.? That is the greatest threat to the value of the US Dollar and the end of Chinese stimulation of the US through the recycling of the current account deficit.? (At an ISI Group lunch late in 2006, I suggested that Chinese inflation was the greatest threat to the global economy.? Jason Trennert thought it was amusing.)
I disagree a little with this otherwise useful piece from Investment Postcards.? In the middle of the graphic it reads “Subordinate bonds (junk-bond quality) on balance sheet.”? Usually not true.? Banks are typically more senior in the financing structure, unless they originated the loans themselves, and retain the equity residual.? In the first case, there is low probability of a large loss.? In the second case, a high probability of a more modest loss.
Countrywide has certainly scared a number of people, including depositors.? First time I’ve seen anything resembling a bank (S&L) run in a while.? Here’s a quick summary on what went wrong.
Now, US mortgage lenders are not the only ones having trouble, but also those in the UK.? Part of the issue there is that a larger part of their mortgage finance is adjustable rate, which makes rising short rates proportionately more painful there.? Maybe the Bank of England, which has been among the more aggressive inflation fighters, will have to loosen soon.
One problem with securitization is that that legal documents are complex, and arguments over which party has what right become more common when deals go bad.? I’m no lawyer, but expect to see more situations like this one between CSFB and American Home.
Okay, a rundown.? What markets have been hit so far?? Emerging markets, real estate and funds that invest in real estate,? merger arbitrage and LBOs, art, many hedge funds (an article on the demise of Sowood), high yield debt, and the stock market globally.? I’m sure I’ve missed some, but I can’t remember a time when so many implied volatilities went up so much at the same time.
What’s not hurt as much?? Life insurance companies, though you sure can’t tell it from their stock prices.? I like Life the best of all my insurance sub-industries.? This area will come back sooner than most financials.
What might have scared the FOMC most?? The move in T-bills.? It was the biggest rally over one or two days ever, as the Wall Street Journal concludes, that is panic.? Such an incredible bid for safety demonstrated a lack of confidence in the banking system, as well as other riskier elements of the markets.? It’s rare for T-bills and LIBOR to get so out of whack.
But maybe things aren’t that bad, after all, US corporate earnings are rolling ahead at over a 10% rate.? I can live with that.
Is Citadel a rescuer of Sentinel, or a rogue-ish clever firm that took advantage of panic at weakly managed Sentinel? Penson argues for the latter, but if there were multiple bids considered, it may be a difficult case for Penson to prove.? I would guess that Sentinel is toast, and that their clients will take most of the financial hits.
Now, will the carry trade finally blow up?? After the move in the yen on Thursday, some thought so.? Some felt that it would plunge the world into a deflationary collapse.? I don’t think it will be that bad, but it will lead to inflation in the US, and an increase in the purchasing power of Asia and OPEC, at the expense of the US and a host of smaller countries (NZ, Iceland, etc.).? The parallels to LTCM are interesting; that’s the last time the carry trade got blown out.
Finally, Hurricane Dean.? I wasn’t so bold two days ago, but I felt that damage to the US would be limited.? I’m more certain of that now.? (Someone tell the Louisiana Governor that there is no bullseye on her state.)? I’m an amateur meteorologist, but what I do in situations like this is measure the deviation of the track of the storm from the forecast.? In my experience, deviations tend to persist.? That told me that Dean was likely to miss Texas.? That’s more likely now; bad news for Mexico.? Pray for those in harm’s way.

A Moment of Minsky?

Posted on 18 August 20077 July 2010 by David Merkel

Sometimes I think that the Keynesian and Austrian Schools of economic thought can be merged into a consistent synthesis that would disagree about the goals of policy, but largely agree on how economies work.? One of the men that would help promote such an idea would be Hyman Minsky.

One of the beauties of capitalist economies is that they are dynamically unstable.? Businessmen as a whole for a variety of reasons tend to over- and underestimate the desirability of doing business as a group.? There at least two reasons for this.? First, there is trend-following, because success by one businessman causes others to try it, until it is overdone, then a large number of businessmen drop out, setting the stage for the next cycle.? Second there are shocks correlated across the system, whether it is monetary policy (too high/low for too long), tariffs, tax changes, wars, technological shifts, etc.

This instability is actually a plus for the system, because each period of failure creates the seeds for the next round of success, as vulture investors pick over the assets of failed firms and redeploy them to longer lasting practical uses.? The decks have to be cleared of bad ideas every now and then, or else the marginal efficiency of capital declines, along with overall interest rates.

But central banks prolong cycles by bailing out marginal ideas and not letting them purge, also creating a culture where risk is not respected, because the central bank will ride to the rescue.? Today, we are at such a “Minsky Moment,” where we rescue the marginal, and overleverage some currently healthy segments of the economy, while housing-related and high-yield related items die a lingering death.? We will likely set up the seeds of the next bubble in the next year, while we reconcile only the most egregious of business ideas.? (Amazing how many real estate agents and mortgage loan brokers there are, huh?? Same for investment bankers… time to redirect these bright people to solving operational business problems, and away from financing issues.)

Now, maybe this time we run into the brick wall, where inflation rises amid weak business conditions, as it did in the 70s.? At that point, the economy will take the pain.? Bernanke will keep the economy from a 30s experience, but possibly at the price of a 70s experience.? After all, which would you rather have, depression or stagflation??? Both are unpopular words, and I hate dragging them out, but if the price of avoid Depression is Stagflation, the present FOMC will take that cost.

The FOMC as a Social Institution, Part 2

Posted on 17 August 2007 by David Merkel

Part 1 of this unintended series came two weeks ago, when the FOMC was resolute that there were no problems in the markets that could potentially har,m the economy.? Then, one week later, after the FOMC showed that it was willing to toy around with temporary liquidity, I knew that I had to change my FOMC opinion, and rapidly.? It’s akin to a situation where someone protests their virtue, but cheats a little; at that point the question become how far he will go.? With the FOMC, a small change in temporary liquidity would not convince the banks of the seriousness of the FOMC, and would engender no additional confidence.? Given that the FOMC showed that it wanted to fix the problem, it had to ask the question, “What’s the minimum we can do to make the problem go away?”? Or at least, get the problem away from the Fed’s door?

Here’s the problem, though.? In a credit crisis, there is variation in how much trouble each firm is in.? When the FOMC provides liquidity, it stimulates healthy firms and provides no stimulus at all to firms that will die, because the credit spreads to those firms are too wide, assuming that anyone will lend at all to them.? It’s the marginal firms that benefit the most from a change in Fed policy to loosening.? The earlier the FOMC acts in a credit crisis, the fewer marginal firms go under.? The lowering of short term rates convinces lenders that the marginal firms can be refinanced at lower rates, and after some fitful action, the weak but not dead survive (and their stocks fly).? Also, the earlier the FOMC acts, the more moral hazard it creates, because the markets know that the FOMC will rescue them, and so they take risk to excess.

Now, a lowering of the discount rate, and encouragement to use it,? does several things.? Unlike Fed funds, lower quality collateral can be lent against.? The encouragement to borrow reduces the stigma; it tells the bankers that the regulators won’t cast a jaundiced eye on borrowing.? (Previously bankers would worry about that.)? That will to some degree reliquefy the market for riskier assets, but given that credit spreads have blown out for a wide variety of Asset-, Residential Mortgage-, and Commercial Mortgage-Backed securities, how much will 1/2% on the discount rate do?? My guess: not much.

Now, the change in the bias does more.? It shows that the FOMC will start permanently loosening Fed funds, probably at the September meeting, unless conditions worsen soon.? They still haven’t injected any permanent liquidity yet, aside from what little the discount window will bring, so some marginal firms will continue to deteriorate until then.

That they did a rare intermeeting announcement highlights the FOMC’s commitment to reliquefying the economy.? They are into the game with both feet, betting their socks and underwear. 😉

Here’s my projection, then.? There are still a lot of hedge funds that are presently alive that will die in the next six months. Housing prices will continue to go down, dragging down hedge funds and financial institutions with overcommitments to alt-A loans and home equity loans.? There will be howls of pain from them and their lenders, which will goad the FOMC into loosening more than is currently believed.? I see a 3% Fed funds target rate at some point in 2008, barring a US Dollar crisis (possible), or inflation (however well-massaged) convincingly exceeding 3%.

A few final points before I end. The communication of Governor Poole certainly could have been handled better.? We got a real whipsaw in the markets as a result.? I have mentioned in the past that he is often out of step on the hawkish side; this was another example.? But for the repudiation to come so quickly was astounding.? As it was, the New York (read, Wall Street) and San Francisco (read, Countrywide) Regional Federal Reserve Banks sponsored the actions, and all but Poole’s district, St. Louis, went along, and asked for cuts in the discount rate.? St. Louis, caught off guard, belatedly asks for the same thing but starting Monday, not today.

Now, do I favor this from a public policy standpoint?? No.? Let the system purge, that risk once again gets respected.? You can hear the indignation on some market participants, like my friend Cody Willard, and Allan Sloan at Fortune, who wonder why we bail out extreme risk takers.? (My take, the extreme risk takers will still get purged, but the marginal ones won’t.)? Others, like Larry Kudlow, and perhaps Rich Karlgaard at Forbes, wring their hands over moral hazard, but say it has to be done this time to preserve the economy.? Then you have clever realpolitik coming from Caroline Baum of Bloomberg (written before today’s moves), who says that Bernanke will do all he can to prevent another Depression.? Beyond that, we get booyahs from Cramer, PIMCO, and a few others.

So here we are, two weeks later.? The stock market is lower. Yields on the highest quality debt is lower, and low quality yields are higher.? Option volatilities for almost all asset classes are much higher.? The separation of firms viewed as marginal now will continue to get separated into two piles, dead and survived.? In the last FOMC loosening cycle it took three years to get there, from March of 2000 to the spring of 2003, when the high yield market realized the crisis was past.? And housing was flying.? Amazing what reliquefication can do for a healthy sector, and creating the next bubble too.

This won’t be over in a short amount of time.? Look for quality firms that can benefit from lower funding costs, and toss out firms where additional financing is needed, but won’t be available because of high credit spreads, devalued collateral, etc.? Buy some TIPS too, and maybe some yen [FXY] and swiss francs [FXF].? Dollar purchasing power will continue its decline.