Real Estate and Mortgages – Page 47

Stressing Credit Stress

Posted on 6 September 2007 by David Merkel

How bad will the credit crunch be?? Will it last into 2008?? Will it be worse than LTCM?? Is this the end of structured finance as we know it?? My quick answers: Yes, maybe, and no.? Structured finance is too useful of a concept to regulate too heavily.? Ratings are also difficult to do without from a regulatory standpoint.? The concept of “buyer beware” must apply to fixed income managers inside regulated financial institutions.? Ratings are ratings and not guarantees; they supply useful summary data, but are no substitute for due diligence.

Now, the ratings agencies’ stocks have been pinched by the crisis.? I think that they will bounce back, and on more weakness, I could be a buyer.? That said, it is interesting to see them edge away from their aggressive ratings on CPDOs [constant proportion debt obligations], particularly as the prices sink.

There may be some upward drivers for the ratings agencies.? After all, investment grade bonds are being issued like mad.? (Another reason to favor high quality companies at present.)? The head of Deutsche Bank sees the market normalizing.? (And maybe if you borrow in euros, it is.)? On the other hand, high yield spreads are at a new record for the past few years, and distressed debt is finally arriving in size.? (Maybe enough to choke all the vultures?)? Risk is real for junk grade companies, and residential real estate related assets.? The willingness to take financial risk has normalized; now it is time for the market to go beyond normal to petrified.? Now, who can help us more with petrified than Jeremy Grantham?? He sounds the alarm on real estate related assets, junk obligations, and the equity markets.

Finally, I should have included this in my last post, but the short term debt markets are rough in the UK as well.? UK LIBOR hit a 10-year high recently.? When many of the various LIBORs of the world are showing signs of fear, it is possible that a larger trouble is at hand.? Until recently, all of the major central banks of the world were tightening, all at once.? With the exception of Japan, I expect them all to begin loosening soon, and begin accepting higher rates of inflation.? Perhaps I have my next investing theme?

Full Disclosure: long DB

The Longer View, Part 3

Posted on 3 September 20074 September 2007 by David Merkel

August wasn’t all that bad of a month… so why were investors squealing? The volatility, I guess… since people hurt three times as much from losses as they feel good from gains, I suppose market-neutral high volatility will always leave people with perceived pain.
Need a reason for optimism? Look at the insiders. They see more value at current levels.
Need another good investor to follow? Consider Jean-Marie Eveillard. I’ve only met him once, and I can tell you that if you get the chance to hear him speak, jump at it. He is practically wise at a high level. It is a pity that Bill Miller wasn’t there that day; he could have learned a few things. Value investing involves a margin of safety; ignoring that is a recipe for underperformance.
Call me a skeptic on 10-year P/E ratios. I think it’s more effective to look at a weighted average of past earnings, giving more weight to current earnings, and declining weights as one goes further into the past. It only makes sense; older data deserves lower weights, because business is constantly changing, and older data is less informative about future profitability, usually.
I found these two posts on the VIX uncompelling. Simple comparisons of the VIX versus the market often lead to cloudy conclusions. I prefer what I wrote on the topic last month. When the S&P 500 is below the trendline, and the VIX is relatively high, it is usually a good time to buy stocks.
What does a pension manager want? He wwants returns that allow him to beat the actuarial funding target over the lifetime of the pension liabilities. If long-term high quality bonds allowed him to do that, then he would buy them. Unfortunately, the yield is too low, so the concept of absolute return strategies becomes attractive. Well, after the upset of the past six weeks, that ardor is diminished. As I have said before, to the extent that hedge funds seek stable, above average returns, they engage in yield-seeking behavior which prospers as credit spreads and implied volatilities fall, and fail when they rise. Eventually pension managers will realize that hedge fund returns cannot provide returns over the full length of the pension liability, in the same way that you can’t invest more than a certain amount of the pension assets in junk bonds.
Is productivity growth slowing? Probably. What may deserve more notice, is that we have larger cohorts entering the workforce for maybe the next ten years, and larger cohorts exiting as well, which will decrease overall productivity. Younger workers are less productive, middle-aged most productive, and older-aged in-between. With the Baby Boomers graying, productivity should fall in aggregate.
This is just a good post on sector data from VIX and More. It’s worth looking at the websites listed.
Economic weakness in the US doesn’t make oil prices fall? Perhaps it is because the US is important to the global economy, but not as important as it used to be. It’s not hard to see why: China and India are growing. Trade is growing outside of the US at a rapid pace. The US consumer is no longer the global consumer of last resort. Now we get to find out where the real resource shortages are, if the whole world is capitalist in one form or another.
Calendar anomalies might be due to greater macroeconomic news flow? Neat idea, and it seems to fit with when we get the most negative data.
Is investing a form of gambling? I get asked that question a lot, and my answer is in aggregate no, because the economy is a positive-sum game, but some investors do gamble as they invest, while others treat it like a business. Much depends on the attitude of the investor in question, including the time horizon and return goals that they have.
Massachusetts vs. the laws of economics. Beyond the difficulty of what to do with expensive cohorts in a public insurance system, I’ve heard that they are having difficulties that will make the system untenable in the long run… most of which boil down to antiselection, and inability to fight the force of aging Baby Boomers.
Rationality is one of those shibboleths that economists can’t abandon, or their mathematical models can’t be calculated. Bubbles are irrational, therefore they can’t happen. Welcome to the real world, gentlemen. People are limitedly rational, and often base their view of what is a good idea, off of what their neighbor thinks is a good idea, because it is a lot of work to think independently. Because it is a lot of work, people conserve on hard thinking, since it is a negative good. They maximize utility where utility includes not thinking too hard. Any surprise why we end up with bubbles? Groupthink is a lot easier than thinking for yourself, particularly when the crowd seems to be right.
Is China like the US with 120 years of delay? No, China has access to better technology. No, China does not have the same sense of liberty and degree of tolerance of difference. Its culture is far more uniform from an ethnic point of view. It also does not have the same degree of unused resources as the US did in the 1880s. Their government is in principle totalitarian, and allows little true freedom of religious expression, which is critical to a healthy economy, because people work for more than money/goods, but to express themselves and their ideals.
As I have stated before, prices are rising in China, and that is a big threat to global stability. China can’t continue to keep selling goods without receive goods back that their workers can buy.
The US needs more skilled immigrants. Firms will keep looking for clever ways to get them into the US, if the functions can’t be outsourced abroad.
It’s my view that dictators like Chavez possess less power than commonly imagined. They spend excess resources on their pet projects, while denying aid to the people whom they claim to rule for their benefit. With inflation running hard, hard currencies like the dollar in high demand, and the corruption of his cronies, I can’t imagine that Chavez will be around ten years from now.
Makes me want to buy Plum Creek, Potlach, or Rayonier. The pine beetle is eating its fill of Canadian pines, and then some, with difficult intermediate-term implications. More wood will come onto the market in the short run, depressing prices, but in the intermediate term, less wood will come to market. Watch the prices, and buy when the price of lumber is cheap, and prices of timber REITs depressed.
Pax Romana. Pax Americana. One went decadent and broke, the other is well on its way. I love my country, but our policies are not good for us, or the world as a whole. We intrude in areas of the world that are not our own, and neglect the proper fiscal and moral management of our own country.
Finally, it makes sense for economic commentators to make bold predictions, because there’s no such thing as bad publicity. Sad, but true, particularly when the audience has a short attention span. So where does that leave me? Puzzled, because I enjoy writing, but hate leading people the wrong way. I want to stay “low hype” even if it means fewer people read me. At least those who read me will be better informed, even if it means that the correct view of the world is ambiguous.

Tickers mentioned: PCH PCL RYN

Surveying Bond Management and Overall Financial Market Volatility

Posted on 29 August 2007 by David Merkel

A personal note before I begin: My oldest daughter left for college today.? A bright girl who plays the harp beautifully, she is studying harp at the University of Maryland.? She is a true “people person” and an artist, and her good character is known by all of her friends.? She’ll be commuting, so I won’t lose her entirely yet, but we will miss her way with the other children.? She will be a natural mother, unlike her mother and I, who just try hard.

Well, two off to college in a single year.? Good thing I’ve got six left, or I’d be lonely. 😀

It takes two to make a market.? During the panic, some bond managers increased their risk postures as the market sold off.? Here is another example.? I agree with this in principle, but I at this point, I would only have moved my risk posture from “most conservative” to 20% of the way to “most aggressive,” which I actually did get to in November 2001, and October 2002.? There is a lot of leverage to unwind, and so there is a lot of room for further widening.? Take for example, these graphs of lower investment grade, and junk spreads.? We are nowhere near the 2002 wide spreads, though for investment grade, I don’t see how we get there.? Credit metrics are pretty good, though banks are more opaque and questionable.

Bond management is a game where you are paid not to lose, because people are relying on you for safety, and then a modestly good return on their money.? Now, though the last article doesn’t treat Bill Gross well, in this article, he praises simplicity in investing, which I would heartily agree with.? The only thing that gives me a bit of pause there is that PIMCO is a quantitative bond management shop that has historically derived most of its excess returns from quantitative strategies that rely on the equivalent of selling deep out of the money options against their positions, and mean-reversion, and variety of other things.? When the ordinary relationships don’t work, PIMCO could be disproportionately hurt.

Though investment grade looks fine, junk is another thing; it could reach the 2002 wides.? As an example, aside from all of the high yield deals that would like to get done, and all of the LBO debt standing in line waiting to be funded, there are still entities like Calpine that want to emerge from bankruptcy.? Willingness to take risk is not what it was when the banks made their commitments, so they’ll have to take losses to move the loans off of their books.? That will help to back up spreads, as buyers will toss out other paper to buy the Calpine debt, if it comes at an attractive enough concession.

In situation like this, one would expect municipal [muni] bonds to be a haven, and largely, they are, partly because they are one of the few areas not touched by foreign capital.? But I was genuinely surprised when I read this article.? Muni arbitrage?? Okay, it comes from one simple insight muni investors want low volatility, which means short duration bonds, while most municipalities want to lock in long term funding.? After all, most of their projects are long term in nature.? Muni hedge funds (sigh) step in to fill the gap, buying long dated bonds, and selling short bonds against them to muni investors, clipping a yield spread in the process.? Worked fine for a while, but the hedge funds warped the market by their own participation, and played for yield spreads that were too low for the risks involved.? As the market normalized, they got hurt, and some aggressive selling of the long end happened.? Now, long munis are probably a good deal.? For taxable accounts, they make sense, if your time horizon is long enough.

During financial stress, financial journalists may get a little over the top.? Comparing Ken Lewis to JP Morgan is an example.? First, the rescue is not that big, relative to Countrywide’s total liquidity needs.? Second, Countrywide, even if it failed, would not have that big of an impact on the total US financial system; it’s just not that big.? Would it be inconvenient?? Yes.? A bother for the regulators?? Sure.? But it would not appreciably affect the average financial institution, and it would inject some needed caution into those that lend to less secure entities.? Third, in a real rescue, far more capital is hazarded; honestly, the Fed did more by opening the discount window, pitiful as that was… it offered unlimited liquidity to (ahem) “quality” assets at a price.? (Quality has been redefined for now.)

At a time like this, a bevy of survey articles come out to describe what has gone wrong.? Some tell of how aggressive players overplayed their hands as the willingness to take risk dried up.? In this case, they boil it down to bad lending models, whether subprime mortgages, bank debt for LBOs, or internal leverage inside hedge funds.? Other articles point at historical analogies, looking for something that might tell when the crisis will end.? The two years compared, 1987 (dynamic portfolio hedging) and 1998 (LTCM), do offer some help, but are not adequate to deal with an overall mortgage lending problem, and a large external debt, getting larger through the current account deficit.

Is information failure the best way to describe it?? I don’t know; there were a lot of savvy people (myself included) who could see this coming, but could not put a date on it.? Toward the end of almost any bull market, underwriting gets sloppy, and the mess that it leaves usually persists until early in the next bull phase.? That’s the nature of human beings, and the markets they create.

As I have stated before, central bank policy can help marginal entities refinance, but is no good at aiding balance sheets that are truly broken.? As you analyze your own assets, be sure to ask which entities need financing over the next two to three years, and how badly they need the help.? Don’t play with companies that are at the mercy of the capital markets.? Even if in the short run, after a volatility event, stocks tend to do well, there may be more volatility events than just one.? This first one is over financing; there will be defaults later.? Be ready for the volatility that will come from them.

Tickers mentioned: CPNLQ BAC CFC

Special Favors from the Federal Reserve

Posted on 28 August 200729 August 2007 by David Merkel

I like writing about the Federal Reserve because I understand it well, but this is beginning to make me tired. Here goes:

There are some who believe that the Fed will not cut rates soon. I half agree with them, because the Fed should not cut rates here. Let bad loans get their due punishment. That said, that ‘s not the way the Fed has acted for almost 80 years. Given that the Fed has to interact with politicians and businessmen, they are going to get a lot of negative feedback if they don’t loosen the fed funds rate. I general, the Fed caves to political pressure. This Fed is doing it now, but just in small steps, while they console themselves that they haven’t moved yet.
On the surface, not much happened with the reduction in the discount rate. But the real story boils down to a willingness of the Fed to accept classes of securities that previously they would not. This includes ABCP. Beyond that, the Fed is allowing several large banks to lend beyond prior limits to their securities affiliates. This allows the banks to lever up more, and in relatively risky business. I am waiting to hear of charges of favoritism; failing that, of irresponsibility of the Fed in overseeing bank solvency of some of the largest banks.
The actions that the Fed takes now will shape the next financial crisis. Where it loosens, leverage will flow to healthy areas that can absorb it until they become glutted as well.
US T-bills have righted themselves, but i was surprised to see that Canadian T-bills went through a similar mishap. Oh well, they had ABCP also.
SIVs are one issuer of ABCP, and many of them are doing badly now. I would not be too quick to rescue them, or be too optimistic about their ability to make good a maturity. The assets in the SIVs that have gone bad are not likely to turn around quickly. Next cycle, we will be more careful about what we lend against, until we commit the same error in a new way.

I hope the Fed’s actions so far will be enough, but I believe that they will have to do more.

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

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.

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.