I’m going to write this post backwards tonight, partly because going from specific to general may make more money for my readers tomorrow. Let’s go:
Did you know that there has been panic in closed-end loan participation funds? No? Well look here. Or look at this Excel file. Here’s the skinny: the average loan fund has only lost 0.47% of its net asset value since 8/10, but the average price has fallen by 6.30%. You can pick up a little less than 6% here, with modest risk, or a little more, if you are clever. Remember that the grand majority of loans here are senior and secured.
The Title insurers have gotten crushed. Here’s to the activists who bought a ton of LandAmerica in the 90s, something I advised against. Title volumes will slow. Wait for the home inventories to crest, and decline a little, then buy a basket of the Title companies.
I have a decent amount of exposure to Latin America in the portfolio. That Brazil and Mexico have been whacked has cost me, even though my companies are conservative.
The winds are blowing. Hurricane Dean is in the Gulf, and may do damage to Yucatan, and after that, oil infrastructure and Texas. Given the late start of the season, I would not begin to suggest that this will be a heavy loss year. Damages from Dean are still uncertain as well.
From the excellent Aaron Pressman, I offer you his insights off of Nicholas Taleb’s book The Black Swan: The Impact of the Highly Improbable. What I would point out here is that when times are unusual, a lot of things tend to be unusual. Credit events tend to be correlated, so when things go bad as in 2000-2002, many seemingly unrelated things go wrong at the same time, often due to correlations in the portfolios of the holders, particularly leveraged ones.
Having seen a decent amount in prime brokerage relationships at a medium-sized firm, I can only say that they are needed but overrated, and the conflicts of interest are significant.
I wish i were managing structured securities again. Buying AAA CMBS at LIBOR + 0.60%. That’s the best since LTCM! Pile it on! Hey, maybe we can lever it?! 😉
Onto credit issues. Fed funds futures are rising in price (down in yield) over the current credit woes. Canadian ABCP participants may have a good solution to their troubles. Convert the claims to longer dated floating rate paper, which can still be held by money market funds. Countrywide cut to BBB+, which effectively boots them from the CP market. Rescap goes to junk, but it should have been there already. If Countrywide survives you can make a lot of money in their unsecured debt. I’ll pass, thank you. I’d rather hold the equity. Anworth is also getting smashed in this environment.
I’ve begun portfolio triage here, and am debating what to sell, and buy, if anything.? More in my next post, if I have the strength tonight.? I’m feeling a little better, though the market is not helping.
Why the collapse of fixed commitments?? Consider what I wrote In RealMoney’s columnist conversation today:
Liquidity is the willingness of two parties to enter into fixed commitments, which can be measured by yield spreads, option prices, and bid-ask spreads. At present, the willingness to be on the giving liquidity side of the trade is declining. Even the willingness to do repos, which is pretty vanilla, has dried up. Roughly double the margin needs to be put up now to hold the same position. That dents the total buying power for what are arguably high quality assets — agency RMBS and the AAA portions of prime whole loans. This means that prices fall until balance sheet players with unencumbered cash find it sufficiently attractive to take on the mortgage assets.
I thought this era of unwinding leverage would arrive, and arrive it has. (That said, I did not expect that mortgage repo funding would be affected. That was a surprise.) I could never predict the time of the unwind, though, and though I have a decent amount of cash on hand, it can never be enough at the time.
One of the few bright sides here is that most of the real risk is concentrated in hedge funds, and hedge fund-of-funds. (Some pension plans are going to miss their actuarial funding targets dramatically.) Hopefully the investment banks with their swap books have done their counterparty analyses correctly, and didn’t cross hedge too much.
I’m still up for this year, but not by much. Perhaps I liked being intellectually wrong better while I made money on the broad market portfolio. Sigh.
Position: none
Could Countrywide fail?? It’s not impossible.? I had an excellent banking/financials analyst when I was a corporate bond manager, and she taught me that if you are a finance company, your ratings must allow you to issue commercial paper on an advantageous basis in order to be properly profitable.? If not, the optimistic outcome is a sale of the company to a stronger party.? The pessimistic outcome is failure.? We last tested this late in 2002 when we accumulated a boatload of Household International debt on weakness after they lost access to the CP markets, but had announced the merger with HSBC.? If you can make 12% in two months on bonds, you are doing well.? Paid for a lot of other errors that year.
But if Countrywide fails, the mortgage market is dead temporarily.? It would be a help after a year because of reduction in new mortgages, but in the short run, the rest of the market would have to digest the remains of Countrywide’s balance sheet.
Shall we briefly consult with the optimists?? Exhibit A is William Poole, who is more willing to speak his mind than most Fed Governors, for good and for ill.? He doesn’t see any effect on the “real economy” from the difficulties in the lending markets.? At the beginning of any lending crisis, that is true.? Difficulties happen in the “real economy” when current assets have a difficult time getting financed, and consumer durable purchases and capital investments get delayed because financing is not available at reasonable prices.? By year end, Poole will change his tune.
Now, I half agree with the Lex column in the Financial Times.? The level of screaming is far too loud for a decline of this magnitude. ? But that’s just looking at the stock price action.? The action in the debt markets in relative terms is more severe, and bodes ill for the equity markets eventually.? Remember, the debt markets are bigger than the equity markets.? Problems in the debt markets show up in the equity markets with a lag, as companies need financing.
One more optimist: private equity funds buying back LBO debt.? The steps of the dance have changed, gentlemen.? It is time to conserve liquidity, not deploy it.? The time to deploy is near the end of a credit bust, not near its beginning.
How about the pessimists?? Start with Veryan Allen at Hedge Fund.? He tells us that volatility is normal, and that it often drags the good down with the bad.? The difference is risk control, and the good don’t die, and bounce back after the bad die.? Now let’s look at the rogues’ gallery du jour. Who is getting killed?? Pirate Capital, Basic Capital, and let’s mention the Goldman Sachs funds again because the leverage was higher than expected.? Toss in an Austrialian mortgage lender for fun, not.? Consider those that are trying to remove money from hedge funds.? It may not be as severe as possible, but it could really be severe.? Investors, even most institutional investors, are trend followers.
Five unrelated notes to end this post:
Could this be the end of the credit ratings agencies?? I don’t think so.? It might broaden the oligopoly, and weaken it, but ratings are an inescapable facet of finance.? Ratings go through cycles of being good and bad, but people need opinions that are standardized about the riskiness of securities.? Go ahead, ban all of the existing ratings agencies now.? Within five years, debt buyers and regulators will have recreated them.
What is funny about this article from the Wall Street Journal is that they mix some residential mortgage REITs into an article on commercial mortgage REITs.? DFR and FBR both are residential mortgage REITs.? There may be more there too, but I haven’t checked.
If you can’t trust your money market funds, what can you trust?? I was always a little skeptical about asset backed commercial paper [ABCP] when it first arrived, but it survived 2000-2003, and I forgot about it.? Now it comes back to bite.? Some programs will extend maturities.? Some backup payers will pay, and some won’t.? Fortunately, it is not ubiquitous in money market funds, but it is worth looking for, if you have a lot in money market funds.
How rapid has this 1,000 point decline in the Dow been?? Pretty fast, though 1,000 points is smaller in percentage terms than it used to be.
It’s late, so I’m going to post on my portfolio tomorrow.? I’ll give you the skinny now.? I’m evaluating the balance sheets and cash flow statements of stocks in my portfolio, and I am starting with those I have lost the most on, and evaluating their survivability under rough conditions.? I have some good ideas already, but I fear that I am too late; some names are so cheap, though leveraged (DFR is a good example), that it is hard to tell what the right decision is.? I will be making some trades, though, no doubt.
I’m worried.? That doesn’t happen often.? Over the years, I have trained myself to avoid both worry and euphoria.? That has been tested on a number of occasions, most recently 2002, when I ran a lot of corporate bonds.? Ordinary risk control disciplines will solve most problems eventually, absent war on your home soil, rampant socialism, and depression.? I like my methods, and so I like my stocks that come from my methods, even when the short term performance is bad.? Could this be the first year in seven that I don’t beat the S&P 500?? Sure could, though I am still ahead by a few percentage points.
Let’s start with the central banks.? I don’t shift my views often, so my change on the Fed is meaningful.? But how much impact have the temporary injections of liquidity had?? Precious little so far.? Yes, last I looked, Fed funds were trading below 5%; banks can get liquidity if they need it, but credit conditions are deteriorating outside of that.? (more to come.)? I don’t believe in the all-encompassing view of central banking espoused by this paper (I’d rather have a gold standard, at least it is neutral), but how much will full employment suffer if most non-bank lenders go away?
Why am I concerned? Short-term lending on relatively high quality collateral is getting gummed up.? You can start with the summary from Liz Rappaport at RealMoney, and this summary at the Wall Street Journal’s blog.? The problems are threefold.? You have Sentinel Management Group, a company that manages short term cash for entities that trade futures saying their assets are illiquid enough that they can’t meet client demands for liquidity.? Why?? The repurchase (repo) market has dried up.? The repurchase market is a part of the financial plumbing that you don’t typically think about, because it always operates, silently and quietly.? Well, from what I have heard, the amount of capital to participate in the repo market for agency securities, and prime AAA whole loan MBS has doubled.? 1.5% -> 3%, and 5% -> 10%, respectively.? Half of the levered buying power goes away.? No surprise that the market has been whacked.
Second, away from A1/P1 non-asset-backed commercial paper, conditions on the short end have deteriorated.? As? I have said before, complexity is being punished and simplicity rewarded.? High-quality companies borrowing to meet short-term needs are fine, for now.? But not lower-rated borrowers, and asset-backed borrowers.? Third, our friends in Canada have their own problems with asset-backed CP.? Interesting how Deutsche Bank did not comply with the demand for backup funding.? Could that be a harbinger of things to come in the US?
It’s a mess.? I’ve done the math for my holdings of Deerfield Capital, and they seem to have enough capital to meet the increased margin requirements.? But who can tell?? Truth is, a mortgage REIT is a lot less stable than a depositary institution.? Repo funding is not as stable as depositary funding.? There will come a point in the market where it will rationalize when companies with balance sheets find the mortgage securities so compelling, that the market clears. After that, the total mortgage market will rationalize, in order of increasing risk.? Fannie and Freddie will help here.? They support the agency repo market, but the AAA whole loan stuff is another matter.? Everyone in the mortgage business except the agencies is cutting back their risk here.
By now, you’ve probably heard of mark-to-model, versus mark-to market.? The problem is that mark-to-model is inescapable for illiquid securities.? They trade by appointment at best, and so someone has to estimate value via a model of some sort.? The alternative is that since there are no bids, you mark them at zero, but that will cause equity problems for those buying and selling hedge fund shares.? This is a problem with no solution, unless you want to ban illiquid securities from hedge funds.? (Then where do they go?)
Why am I underperforming now?? Value temporarily is doing badly because stocks with low price-to-cash-flow are getting whacked, because the private equity bid has dried up.? That’s the stuff I traffic in, so, yeah, I’m guilty.? That doesn’t dissuade me from the value of my methods in the long run.
Might there be further liquidity troubles in asset classes favored by hedge funds?? Investors tend to be trend followers, so? yes, as redemptions pile up at hedge funds, risky assets will get liquidated.? Equilibrium will return when investors with balance sheets tuck the depreciated assets away.
Finally, to end on a positive note.? Someone has to be doing well here, right?? Yes, the Chinese.? Given the inflation happening there, and the general boom that they are experiencing, perhaps it is not so much of a surprise.
With that, that’s all for the evening.? I have more to say, but I am still not feeling well, and am a little depressed over the performance of my portfolio, and a few other things.? I hope that things are going better for you; may God bless you.
There are several ways I would like to go from here in my short-term plan for this blog.? One is to focus on the stress in credit markets.? Second is to post on the macroeconomics surrounding these changes.? Third is to point at the oddball stuff that I am seeing away from points one and two.? Last would be portfolio strategy at this point in time.? From a conversation with my friend Cody Willard today, where we went over many of these topics and more, what I believe every investor should do right now is look at every asset in his portfolio, and ask two questions:? What happens if this asset can’t get financing on attractive terms, and would this asset benefit from any reflationary moves by the global central banks.? That’s the direction that I am heading.? Tonight, I hope to go through stress in the credit markets, and maybe macroeconomics.? I haven’t been feeling so well, so I’ll see what I can do.
Let’s start with Rick Bookstaber, who recently started his own blog, after writing a well-regarded new book that I haven’t read yet.? He sees the risks with the quant funds: leverage, similar strategies, and the carrying capacity of the strategies.? Very similar to my ecological view of the markets.? Move over to the CASTrader blog, a nifty blog that I cited on my Kelly Criterion pieces.? He also subscribes to the Adaptive Markets Hypothesis, as I do.? He also makes a carrying capacity-type argument, that the quants got too big for the markets that they were trying to extract excess profits from.? Any strategy can be overdone.? Then go to Zero Beta.? The hidden variable that the quants perhaps ignored was leverage, which affects the ability of holders to control an asset under all conditions.? Leverage creates weak holders, or in the case of shorts, weak shorts.? Visit Paul Kedrosky next.? I sometimes talk about “fat tails,” and yes, looking at distributions of asset returns, they can seem to be fat tailed, but regime shifting is another way to look at it.? Assets shift between two modes:? Normal and Crisis.? In normal, the going concern aspect gets valued more highly.? In crisis, the liquidation aspect gets valued more highly.
Is 1998 the right analogy for the markets?? FT Alphaville gets it right; the main difference is that the funding positions of the US and emerging Asia are swapped.? We need capital from the emerging markets now; in 1998, it was flipped. Is 1970 the right analogy?? I hope not.? ABCP in credit affected areas should be small enough that the overall commerical paper market should not be affected, and money markets should be okay.? But it troubles me to even wonder about this.? Finally, CDS counterparty risk — it is somewhat shadowy, so questions are unavoidable.? The question becomes how well the investment banks enforce their margin agreements.? My suspicion is that they will enforce them well, particularly in this environment.? But what that means (coming full circle) is that speculators on the wrong side of trades will get liquidated, adding to current market volatility.
I’m going to try to put in two posts this evening — this one on recent activity, and one on the Fed, to try to address the commentary that my last post generated.
Central Banking in the Forefront?
Let’s start with the state of monetary policy.? Is it easy or tight?? It’s in-between.? The monetary base is growing at maybe a 3% rate yoy.? The Fed has not done a permanent injection of liquidity in over 3 months.? MZM and M2 are around 5%, and my M3 proxy is around 8%.? But FOMC policy is compromised by the willingness of foreigners to finance the US Current account deficit, and cheaply too.? The increase in foreign holdings of US debt is roughly equal to the increase in M2.? That provides a lot of additional stimulus that the Fed can’t undo.
So what have the Central Banks done lately? Barry does a good job of summarizing the actions, all of which are temporary injections of liquidity, together with statements of support for the markets.? So why did short-term lending rates to banks spike?? My guess is that there were a few institutions that felt the need to shore up their balance sheets by getting some short-term liquidity.? I’m a little skeptical of the breadth of this crisis, but if anything begins to make me more concerned, it is that some banks in the Federal Reserve System needed liquidity fast.? Also, some banks needed quick liquidity from the unregulated eurodollar markets.? But who?? Inquiring minds want to know… 😉
So, over at FT Alphaville they wonder, but in a different way.? What do central bankers know that we don’t?? My usual answer is not much, but I am wondering too.? Panicked calls from investment bank CEOs?? Timothy Geithner worrying about systemic risk?? Maybe, but not showing up in swap spreads, yet.? Calls from commercial bankers asking for a little help?? Maybe.? I don’t know.? I wonder whether we’ve really felt enough pain in order to deserve a FOMC cut.? We haven’t even had a 10% correction in the market yet.? Obviously, But some think we’ve had enough pain.? But inflation is higher than the statistics would indicate, and is slowly getting driven higher by higher inflation abroad, some of which is getting transmitted here.? Not a fun time to be a central banker, but hey, that’s why they pay them the big money, right? 🙂
More notable, perhaps, are the extreme swings in stock prices. Many market-neutral strategies are underperforming here.? (Stock market-neutral does not mean credit market-neutral.)? Statistical arbitrage strategies were crowded trades.? Truth is, to a first approximation, even though almost all of the quant models were proprietary, they were all pretty similar.? Academic research on anomalies is almost freely available to all.? Two good quants can bioth start fresh, but they will end up in about the same place.
Insider buying is growing in financial stocks, after the market declines.? I like it.? My next major investment direction is likely overweighting high quality financials, but the timing and direction are uncertain.
Finally, from the Epicurean Dealmaker (neat blog. cool name too.), how do catastrophic changes occur?? I love nonlinear dynamics, i.e., “chaos theory.”? I predicted much of what has been happening two years ago at RealMoney, but I stated the the timing was uncertain.? It could be next month, it could be a decade at most.? The thing is, you can’t tell which straw will break the camel’s back.? I like being sharp rather than fuzzy, but I hate making sharp predictions if I know that the probability of my being wrong is high.? In those cases, I would rather give a weak signal, than one that could likely be wrong.
Many Hedge Funds are Systematically Short Liquidity
8/9/2007 5:43 PM EDT
You can look at Cramer’s two pieces here and here that deal with the logjam in the bond markets. Now, there are problems that are severe, as in the exotic portions of the market. There are problems in investment grade corporate bonds in the cash market, but spreads haven’t moved anywhere nearly as much as they did in 2002. The synthetic (default swap) portion of the market is having greater problems. Oddly, though high yield cash spreads have moved out, they still aren’t that wide yet either compared to 2002. The problems there are in the CDS, and hung bridge loans.
Most hedge funds that try to generate smooth returns are systemically short liquidity and volatility. If these funds are blowing up, like LTCM in 1998, then liquidity will be tight in the derivative markets, but the regular cash bond markets won’t be hurt so bad.
I agree with Michael Comeau with a twist… this may end up being good for the equity markets eventually, but in the short run, it is a negative.
Let me try to expand a little more here. A good place to start is Cramer’s last piece of the day. Part of what he said was:
But first you have to recognize that I am not talking about opportunity. We need the Fed simply to issue a statement like it did in 1987, that it would provide all of the liquidity necessary to get things moving in the credit markets.
All of those who think the Fed is helpless are as clueless as the Fed. A statement like that would eliminate the fear all over town that committing capital is going to wipe your firm out.
The European action seemed desperate today, but it’s a bit of a desperate time, and they did what is right.
If we had made the right call on Tuesday at the Fed, we would have maneuverability over the next month to help.
Now we can’t. Not for another couple of months, [sic]
Unfortunately, Cramer is wrong here. The ECB only did a temporary injection of funds, which will disappear. The Fed also did a similar temporary injection of funds today, which brought down where Fed funds were trading. It will disappear as well, but both the ECB and Fed can make adjustments as they see fit. There isn’t any significant difference between the actions.
There have been notable failures and impairments, for sure. Let’s run through the list: the funds at BNP Paribas, funds at AXA, Oddo, Sowood and IKB, Goldman Sachs, Tykhe Capital, and Highbridge (and more). With this help from DealBreaker (most of the comments are worth reading also), I would repeat that most hedge funds that try to generate smooth returns are systemically short liquidity and volatility. Another way of saying it is that they have a hidden short in credit quality, and this short is biting bigtime.
Okay, I’ve listed a lot of the practical failures, but what classes of hedge fund investments are getting hurt? Primarily statistical arbitrage and event-driven. (Oh, and credit-based as well, but I don’t have any articles there.) The computer programs at many stat arb shops have not done well amid the volatility, and there have have been significant M&A deals that have come into question, like MGIC-Radian. Merger arbitrage had a bad July, and looking at the Merger Fund, August looks to be as bad. (Worrisome, because merger arb correlates highly with total market confidence.) As for statistical arb, I know a few people at Campbell & Company. They’re bright people. Unfortunately, when regimes shift, often statistical models are bad at turning points. Higher volatility, bad credit, and the illiquidity that they engender doom many statistical models of the market.
So, how bad is credit now? If you are talking about securitized products and derivatives, the answer is extremely bad. If you are talking about high yield loans to fund LBOs, very bad, and my won’t some the investment banks take some losses there (but they won’t get killed). High yield bonds, merely bad — spreads have widened, but not nearly as much as in 2002. Same for investment grade corporates, except less so. Now the future, like say out to 2010, may prove to be even worse in terms of aggregate default rates of corporates, because more of the total issuance is high yield. This is just something to watch, because it may imply a stretched-out scenario for corporate credit losses.
The Dreaded Subprime
Subprime mortgage lending has had poor results. I would even argue that early 2007 originations could be worse than the 2006 vintage. This has spilled over into many places, but who would have expected money market funds? The asset-backed commercial paper [ABCP] market is a small slice of the total commercial paper market, and those financing subprime mortgage receivables are smaller still. The conduits that do this financing have a number of structural protections, so it should not be a big issue. The only thing that might emerge is if some money market fund overdosed on subprime ABCP. I’m not expecting any fund to “break the buck,” but it’s not impossible.
I generally like the writings of Dan Gross. He is partially right when he says that the effects of subprime lending are not contained. Many different institutions are getting nipped by the problem. But I think what government officials mean by contained is different. They are saying that they see no systemic risk from the problem, which may be correct, so long as the aggregate reduction in housing prices does not cause a cascade of failure in the mortgage market, which I view as unlikely.
Perhaps we should look at a bull on subprime lending? Not a big bull, though. Wilbur Ross has lent $50 million to American Home Mortgage on the most senior level possible. That’s not a very big risk, but he does see a future for subprime lending, if one is patient, and can survive the present slump.
A note on Alt-A lending. There’s going to be a bifurcation here; not all Alt-A lending is the same. As S&P and the other rating agencies evaluate loan performance, they will downgrade the deals with bad performance, and leave the good ones alone. The troubles here will likely be as big as those in subprime. Perhaps the lack of information on lending is the crucial issue. Colloquially, never buy a blind pool, or a pig in a poke. Information is supremely valuable in lending, and often incremental yield can’t compensate.
In a situation like this, simplicity is rewarded. Complexity is always punished in a liquidity crisis. Bidders have better thing sto do in a crisis than to figure out fair value for complex instruments when simpler ones are under question.
Another aspect of liquidity is the investment banks. As prime brokers, their own risk control mechanisms cause them to liquidate marginal borrowers whose margin has gotten thin. This protects them at the risk of making the crisis worse for everyone else as the prices of risky asset declines after liquidations. Other investors might then face their own margin calls. The cycle eventually burns out, but only after many insolvencies. My guess: none of the investment banks go under.
Finally, let’s end on an optimistic note, and who to do that better than Jim Griffin? As I said before, simplicity is valued in a situation like this, and stocks in aggregate are simple. As he asks at the end of his piece, “What are you going to buy if you sell stocks?” I agree; there will be continued problems in the synthetic and securitized debt markets, but if you want to be rewarded for risk here, equities offer reasonable compensation for the risks taken. Just avoid the areas in financials and hombuilders/etc, that are being taken apart here. The world is a much larger place than the US & European synthetic and securitized debt markets, and there are places to invest today. Just insist on a strong balance sheet.
This piece is a little dated, but I’m using it to illustrate the nature of consumer surveys in the US.? If rates have been rising, those polled extrapolate the current trend.? As it was, that particular poll was close to the short-term turning point on inflation expectations.? I feel more comfortable trying to tease out inflation expectations by looking at the relative spread of TIPS to nominal bonds.? Right now, that’s not moving much.
I’m already on record that I don’t like the concept of core inflation, and that I think current methods of measuring inflation understate it, though now I would say only by 1%/year.? But regarding core inflation, there are many who say there are better ways to remove volatility from the estimation of central tendency.? Use of a median or trimmed mean are superior methods to excluding whole classes of goods, like food and energy, which conveniently have been rising faster than most other good in the CPI.
Inflation is rising in many places.? New Zealand is one example.? This is one of those temporarily self-reinforcing situations where foreign investors are willing to invest because of high nominal rates, while discounting any possibility of the currency moving against them.? In the short run, the more people who believe this, the less likely that an adjustment occurs.? But the additional liquidity stimulates the economy, raises inflation, and makes the central bank want to tighten more, leading to higher rates in which foreign investors want to invest.? It will only break when the high rates slow the NZ economy to a crawl, or, for some unexpected reason, the currency starts depreciating, and it feeds on itself.? Personally, I would not be long the Kiwi.
The Economist has noticed many of the same trends, adding in Latvia and Iceland to NZ.? In the short run, so long as foreign investors have confidence in the currencies of these three nations, their central banks are impotent.? But in some sort of crisis that would disrupt global capital flows, all of these currencies would be at risk.? No telling when that will happen, but once the adjustment happens, like those who borrowed at teaser rates, they will be sorry they invested in high interest rate currencies, and borrowed in low interest rate currencies.
China.? Easy to underestimate.? Easy to overestimate.? Hard to get a fair picture.? Their Central bank keeps tightening, but doesn’t let the currency adjust upward.? As a result, inflation keeps rising there… too much credit is chasing too few goods produced for domestic consumption. (Diseases affecting pigs, and high grain prices don’t help.? Food is a larger portion of the budget of the average person in China.)? Exports dominate Chinese economic policy, and with an dirty-floating undervalued currency, trade surpluses build up almost everywhere, except the Middle East and Japan.? The Chinese economy keeps rolling ahead, growing at near-record rates if you can believe the statistics.? (Which I largely believe, the current account surpluses don’t lie.)? That has costs, though.? There are costs to the environment, food safety, working conditions, etc.? The communist party has in some ways transformed themselves in a bunch of crony capitalists.? Those at the top get the favors, and the rest trickles down, but not as well as in the US.? In the short run, that can produce amazing economic results, but can’t produce a society that is truly creative, and self-sustainingly productive.? What will happen to China when it no longer has incremental cheap labor to deploy?? Productivity will drop?? Already I am hearing of some manufacturers decamping to Vietnam, and other cheaper places.
The reported US Government deficit is shrinking.? Good as far as that goes.? Corporate taxes are filling much of the gap.? We still have the Iraq/Afghanistan Wars off-budget, and Social Security on budget, both of which reduce the true size of the deficit.? On an accrual basis, counting everything in, we are running deficits at near record levels.? Promises are being made for the future the aren’t getting counted today.? Corporations would have to accrue them, but the government does not.
Why do I like most but not all emerging markets here?? They are better managed on both fiscal and monetary bases than many developed economies, and capitalism is finally becoming a sustainable ideology.? That’s why amid the rise in credit spreads for junk grade corporations here in the US, many emerging market spreads have tightened.? Going back to points 3 and 4 above, those that don’t have strong fiscal and monetary policies, like Turkey, may very well get whacked, after a disruption in capital flows, war, or some event that changed the willingness of investors to take currency or sovereign risk.
What if we try to get away from currencies, and focus on commodities instead?? Metal scrap prices are robust.? Aluminum beer kegs are getting sold for scrap, among other things.? In another place, Historian Niall Ferguson tells us that we should not worry about running out of oil, but out of arable land for farming.? Personally, I’m not worried about either.? Rising food prices will slow the development on arable land, and in some cases, redevelop land for farming.? Further, contrary to the over-estimated Malthus (whose great contribution in life was giving inspiration to Darwin), we have been able to grow agricultural productivity considerably faster than population, in areas where capitalism is allowed to thrive.? That said, I am bullish on the prices of food products; in the short run, there will be more excess demand.
So Moody’s tries to clean up its act, and finds itself shut out of rating most Commercial Mortgage-backed Securities [CMBS] deals? That’s not too surprising, and sheds light on the value of ratings to issuers and buyers. With issuers, it’s easy: Give me good ratings so that I can sell my bonds at low yields. With buyers, it is more complex: We do our own due diligence — we don’t fully trust the ratings, but they play into the risk management and capital frameworks that we use. We like the bonds to be highly rated, and misrated high even better, because we get to hold less capital against the bonds than if they were correctly rated, which raises our return on capital. Moody’s was always in third place behind S&P and Fitch in this market, so it’s not that big of a deal, but I bet Moody’s quietly drops the change.
The yields on loans are not only going up for LBOs like Archstone, leading to further deal delays, but yields are also rising on commercial real estate loans generally. Here is an example from one of the big deals. The risk appetite has shifted. Is it any surprise that equity REITs are off so much since early March? The deals just can’t get done at those high cap rates anymore.
An old boss of mine used to say, “Liquidity is a ‘fraidy cat.” It’s never there when you really need it, and with residential mortgage finance now, the ability to refinance is being withdrawn at the very time it is needed most. What types of mortgages are now harder to get? No money down, Jumbo loans, Alt-A, more Alt-A, and you don’t have to mention subprime here, the pullback is pretty general, with the exception of conforming loans that are bought by Fannie and Freddie. For (perverse) fun, you can see how detailed the guidance to lenders can become.
Should it then surprise us if some buyers of mortgage loans have gotten skittish? No, they forced the change on the originators. A buyers strike. But maybe that’s not the right move now. Let me tell you a story. When I came to Provident Mutual in 1992, the commercial mortgage market was in a panic. The main lines of business of Provident Mutual, hungry for yield, had accepted low-ish spreads from commercial mortgages from 1989-1991, because it improved their yield incrementally. The Pension Division avoided commercial mortgages then, because they felt the risks were not being fairly compensated. In 1992, the head of the commercial mortgage area came to the chief actuary of the pension division, and told him that unless the Pension Division bought their mortgage flow, they would have to shut down, because the main lines couldn’t take any. The chief actuary asked what spreads he would get, and the spreads were high — 3% over Treasuries, much better than before. He asked about loan quality, and was told that they had never had such high quality loans; only the best deals were getting done because of the panic in the market. The chief actuary, the best actuarial businessman I have ever known grabbed the opportunity, and took the entire mortgage flow for the next two years, then stopped. (Saving the Mortgage Division was icing on the cake.) Spreads normalized; credit quality was only average, and the main lines of the company now wanted mortgages. The point of the story is this: the firms that will do best now are not the ones that refuse to lend, but the ones who lend to high quality borrowers at appropriate rates. It’s good to lend selectively in a panic.
Eventually the ARM mortgage reset surge will be gone. Really. We just have to slog through the next two years or so. This will lead to additional mortgage delinquencies and defaults. We’re not done yet. There is a lot of mis-financed housing out there, and unless the borrowers can refinance before the fixed rate period ends to a cheap-ish conventional loan, I don’t see how the defaults will be avoided. Remember houses are long-term assets. Long term assets require long-term financing. Floating rates don’t make it. Non-amortizing loans don’t make it.
Should it then surprise us that the downturn in housing prices is large? No. With all of the excess supply, from home sellers and homebuilders, current prices are not clearing most of the local real estate markets, and prices need to fall further. (Maybe we should offer citizenship to foreigners who buy US residential real estate worth more than $500,000. A win-win-win. Excess supply goes away. Current account deficit reduced. Wealthy foreigners get a safe place to flee, should they need it. 😉 )
As a result, the homebuilders are doing badly. They aren’t making money on the hgomes they build and the value of the land (and land options, JVs, etc.) that they bought during the frenzy is worth a lot less. Sunk costs are sunk, and though you lose money on an accounting basis, in the short run, it is optimal to builders to finish developments that they started.
Could I get John Hussman to like this Fed Model? It’s from the eminent Paul Kasriel, and it compares the earnings yield of residential real estate and Treasury yields, and he suggested in early June that residential real estate was overvalued. There are limitations here; no consideration of inflation and capital gains, no consideration of the spread of mortgage yields over Treasuries. The result is clear enough, though. Don’t own residential real estate when you can earn more in Treasuries than you can in rents. (I know real estate is local, frictional costs, etc., but it does give guidance at the margins.)
As I write this, I am listening to a replay of the RAM Holdings Conference Call that happened on Monday.? RAM Holdings did not have a good day in the market yesterday, losing 44.5%? of their market value.? What went wrong?
Investors are more attuned to subprime, and so the merest hint of trouble sends them running for the exits.
They are more attuned to CDOs, and so the merest hint of trouble sends them running for the exits.
They commented that premium volume might decline over the remainder of the year.
They only met the earnings estimate.
The cost of their soft capital facility has risen to LIBOR+200, the maximum, leading them to question whether they can’t replace the facility with something better.?? (My guess? No.)
The conference call focused on subprime, CDOs, and the more shadowy bits of their guarantees.
So what does RAM Holdings do?? They reinsure the primary AAA financial guarantors.? They are the only AAA reinsurer that does not compete with the primary insurers.? Typically, they try to take an equal slice of all of the business that MBIA, Ambac, FGIC, FSA, and the three others produce each year.? In that sense, you can think of them as a small version of what the average of the financial guarantee industry would be like if it were a single company.? Unlike a P&C reinsurer, losses kick in only after a threshold is met, and then a lot of losses get paid, with RAM Holdings, the losses are pro-rata from the first dollar.? The primary insurers would have no advantage passing them bad business, because they would be more affected by the bad business.
I’m reviewing RAM Holdings as a possible purchase candidate.? If I were running a small cap fund, I would definitely start tossing some in now.? Why?? It’s trading at less than 35% of adjusted book value, and the balance sheet is good in my opinion, and the opinions of S&P and Moody’s.?? If I were running a hedge fund, I would buy RAM and short equal amounts of MBI, ABK, SCA and AGO.? Why?? If RAM is really in this much trouble, it is likely that MBIA, Ambac, Security Capital and Assured Guaranty are in the same trouble.
Aside from that, their subprime exposure is small-ish and seasoned.? Their CDO exposure is almost all AAA, with super-senior attachment points (i.e. non-guaranteed AAA bonds would have to lose it all before thet pay dollar one of guarantees).? Honestly, I’m probably more concerned about the BBB HELOC and closed-end second lien mortgage exposure.? I would need more data on that before I could act.
Then there’s Safety Insurance, which was up 12.0% on Monday.? What went right?
Unlike Commerce Group, which missed, they beat estimates handily.
They raised their dividend by 60%, from $1.00 to $1.60.
They announced a $30 million buyback (and they have the money to do it).
The asset side of their balance sheet carries little credit risk.
Now, Safety faces its challenges as the Massachusetts auto insurance market possibly partially deregulates, but Safety has successfully competed in a variety of different market regimes in the state.? The current management team has shown itself to be very adept at adjusting to changing conditions.
Even with change, Massachusetts will still be the most heavy handed state in the US with auto insurance.? It won’t attract a lot of new entrants.? And, it is possible that no change will happen… previous deregulatory plans have come and gone, though this one has more political clout behind it.
Safety is still cheap to me at 1.0x book value, and 7.6x 2008 estimated earnings.? I’m hanging around for more.
Subprime lending is grabbing a lot of attention, but it is only a tiny portion of what goes on in our capital markets.? Tonight I want to talk about speculation in our markets, while largely ignoring subprime.
I have grown to like the blog Accrued Interest.? There aren?t many blogs dealing with fixed income issues; it fills a real void.? This article deals with bridge loans; increasingly, as investors have grown more skittish over LBO debt, investment banks have had to retain the bridge loans, rather than selling off the loans to other investors.? Google ?Ohio Mattress,? and you can see the danger here.? Deals where the debt interests don?t get sold off can become toxic to the investment banks extending the bridge loans.? (And being a Milwaukee native, I can appreciate the concept of a ?bridge to nowhere.?? Maybe the investment bankers should visit Milwaukee, because the ?bridge to nowhere? eventually completed, and made it to South Milwaukee.? Quite an improvement over nowhere, right? Right?!? Sigh.)
Also from Accrued Interest, the credit markets have some sand in the gears.? I remember fondly the pit in my stomach when my brokers called me on July 27th and October 9th, 2002, and said, ?The markets are offered without bid.? We?ve never seen it this bad.? What do you want to do??? I had cash on hand for bargains both times, but when the credit markets are dislocated, nothing much happens for a little while.? This was true after LTCM and 9/11 as well.
I?ve seen a number of reviews of Dr. Bookstaber?s new book.? It looks like a good one. As in the last point, when the markets get spooked, spreads widen dramatically,and trading slows until confidence returns.? More bad things are feared to happen than actually do happen.
I?m not a fan of shorting, particularly in this environment.? Too many players are short without a real edge.? High valuations are not enough, you need to have an uncommon edge.? When I short, that typically means an accounting anomaly.? That said, there is more demand for short ideas with the advent of 130/30 and 120/20 funds.? Personally, I think they are asking for more than the system can deliver.? Obvious shorts are full up, and inobvious shorts are inobvious for a reason; they aren?t easy money.
From the ?Too Many Vultures? file, Goldman announces a $12.5 billion mezzanine fund.? With so much money chasing failures, the prices paid to failures will rise in the short run, until the vultures get scared.
Finally, and investment bank that understands the risk behind CPDOs.? I have been a bear on these for some time; perhaps the rapidly rising spread environment might cause a CPDO to unwind?
Passive futures as a diversifier made a lot of sense before so many pension plans and endowments invested in it.? Recent returns have been disappointing, leading some passive investors to leave their investments in crude oil (and other commodities).? With less pressure on the roll in crude oil, the contango has lessened, which makes a passive investment in commodities, particularly crude oil, more attractive.
When trading ended on Friday, my oscillator ended at the fourth most negative level ever. Going back to 1997, the other bad dates were May 2006, July 2002 and September 2001. At levels like this, we always get a bounce, at least, so far.
We lost our NYSE feed on Bloomberg for the last 25 minutes of the trading day. Anyone else have a similar outage? I know Cramer is outraged over the break in the tape around 3PM, and how the lack of specialists exacerbated the move. Can?t say that I disagree; it may cost a little more to have an intermediated market, but if the specialist does his job (and many don?t), volatility is reduced, and panics are more slow to occur.
Perhaps Babak at Trader?s Narrative would agree on the likelihood of a bounce, with the put/call ratio so high.
The bond market on the whole responded rationally last week. There was a flight to quality. High yield spreads continued to move wider, and the more junky, the more widening. Less noticed: the yields on safe debt, high quality governments, agencies, mortgages, industrials and utilities fell, as the flight to quality benefitted high quality borrowers. Here?s another summary of the action on Thursday, though it should be noted that Treasury yields fell more than investment grade debt spreads rose.
Shhhhh. I?m not sure I should say this, but maybe the investment banks are cheap here. I?ve seen several analyses showing that the exposure from LBO debt is small. Now there are other issues, but the investment banks generally benefit from increased volatility in their trading income.
Comparisons to October 1987? My friend Aaron Pressman makes a bold effort, but I have to give the most serious difference between then and now. At the beginning of October 1987, BBB bonds yielded 7.05% more than the S&P 500 earnings yield. Today, that figure is closer to 0.40%. In October 1987, bonds were cheap to stocks; today it is the reverse.
Now, a trailing indicator is mutual fund flows. Selling equities and high yield? No surprise. Most retail investors shut the barn door after the cow has run off.
Deals get scrapped, at least for now, and the overall risk tenor of the market shifts because player come to their senses, realizing that the risk is higher than the reward. El-Erian of Harvard may suggest that we have hit upon a regime change, but I would argue that such a judgment is premature. We have too many bright people looking for turning points, which may make a turning point less likely.
Are we really going to have credit difficulties with prime loans? I have suggested as much at RealMoney over the past two years, to much disbelief. Falling house prices will have negative impacts everywhere in housing. Still, it more likely that Alt-A loans get negative results, given the lower underwriting standards involved.
How much risk do hedge funds pose to the financial system?? My view is that the most severe risks of the financial system are being taken on by hedge funds.? If these hedge funds are fully capitalized by equity (not borrowing money or other assets), then there is little risk to the financial system.? The problem is that many do finance their positions, as has been seen in the Bear Stearns hedge funds, magnifying the loss, and wiping out most if not all of the equity.
There is a tendency with hedge funds to hedge away ?vanilla risks? (my phrase), while retaining the concentrated risks that have a greater tendency to be mispriced.? I want to get a copy of Richard Bookstaber?s new book that makes this point.? Let?s face it.? Most hedging is done through liquid instruments to hedge less liquid instruments with greater return potential.? Most hedge funds are fundamentally short liquidity, and are subject to trouble when liquidity gets scarce (which ususally means, credit spreads rise dramatically).
Every investment strategy has a limit as to how much cash it can employ, no matter how smart the people are running the strategy.? Inefficiencies are finite.? Now Renaissance Institutional is feeling the pain.? My greater question here is whether they have pushed up the prices of assets that they own to levels not generally supportable in their absence, simply due to their growth in assets?? Big firms often create their own mini-bubbles when they pass the limit of how much money they can run in a strategy.? Asset growth is self-reinforcing to performance, until you pass the limit.
I have seen the statistic criticized, but it is still true that we are at a high for short interest.? When short interest gets too high, it is difficult but not impossible for prices to fall a great deal.? The degree of short interest can affect the short-term price path of a security, but cannot affect the long term business outcome.? Shorts are ?side bets? that do not affect the ultimate outcome (leaving aside toxic converts, etc.).
Doug Kass takes a swipe at easy credit conditions that facilitated the aggressive nature of many hedge funds.? This is one to lay at the feet of foreign banks and US banks interested in keeping their earnings growing, without care for risk.
Should you be worried if you have an interest in the equity of CDOs?? (Your defined benefit pension plan, should you have one, may own some of those?)? At present the key factors are these? does the CDO have exposure to subprime or Alt-A lending, home equity lending, or Single-B or lower high yield debt?? If so, you have reason to worry.? Those with investment grade debt, or non-housing related Asset-backed securities have less reason to worry.
There have been a lot of bits and bytes spilled over mark-to-model.? I want to raise a slightly different issue: mark-to-models.? There isn?t just one model, and human nature being what it is, there is a tendency for economic actors to choose models that are more favorable to themselves.? This raises the problem that one long an illiquid asset, and one short an illiquid asset might choose different values for the asset, leading to a deadweight loss in aggregate, because when the position matures, on net, a loss will be taken between the two parties.? For a one-sided example of this you can review Berky?s attempts to close out Gen Re?s swap book; they lost a lot more than they anticipated, because their model marks were too favorable.
If you need more proof of that point, review this article on how hedge funds are smoothing their returns through marks on illiquid securities.? Though the article doesn?t state that thereis any aggregate mis-marking, I personally would find that difficult to believe.
If you need still more proof, consider this article.? The problem for hedge fund managers gets worse when illiquid assets are financed by debt.? At that point, variations in the marked prices become severe in their impacts, particularly if debt covenants are threatened.
Regarding 130/30 funds, particularly in an era of record shorting, I don?t see how they can add a lot of value.? For the few that have good alpha generation from your longs, levering them up 30% is a help, but only if your shorting discipline doesn?t eat away as much alpha as the long strategy generates.? Few managers are good at both going long and short.? Few are good at going short, period.? One more thing, is it any surprise that after a long run in the market, we see 130/30 funds marketed, rather than the market-neutral funds that show up near the end of bear markets?
Investors like yield.? This is true of institutional investors as well as retail investors.? Yield by its nature is a promise, offering certainty, whereas capital gains and losses are ephemeral.? This is one reason why I prefer high quality investments most of the time in fixed income investing.? I will happily make money by avoiding capital losses, while accepting less income in speculative environments.? Most investors aren?t this way, so they take undue risk in search of yield.? There is an actionable investment idea here!? Create the White Swan bond fund, where one invests in T-bills, and write out of the money options on a variety of fixed income risks that are directly underpriced in the fixed income markets, but fairly priced in the options markets.? Better, run an arb fund that attempts to extract the difference.
Most of the time, I like corporate floating rate loan funds.? They provide a decent yield that floats of short rates, with low-ish credit risk.? But in this environment, where LBO financing is shaky, I would avoid the closed end funds unless the discount to NAV got above 8%, and I would not put on a full position, unless the discount exceeded 12%.? From the article, the fund with the ticker JGT intrigues me.
This article from Information Arbitrage is dead on.? No regulator is ever as decisive as a margin desk.? The moment that a margin desk has a hint that it might lose money, it moves to liquidate collateral.
As I have said before, there are many vultures and little carrion.? I am waiting for the vultures to get glutted.? At that point I could then say that the liquidity effect is spent. Then I would really be worried.
Retail money trails.? No surprise here.? People who don?t follow the markets constantly get surprised by losses, and move to cut the posses, usually too late.
One more for Information Arbitrage.? Hedge funds with real risk controls can survive environments like this, and make money on the other side of the cycle.? Where I differ with his opinion is how credit instruments should be priced.? Liquidation value is too severe in most environments, and does not give adequate value to those who exit, and gives too much value to those who enter.? Proper valuation considers both the likelihood of being a going concern, and being in liquidation.
That?s all in this series.? I?ll take up other issues tomorrow, DV.? Until then, be aware of the games people play when there are illiquid assets and leverage? definitely a toxic mix.? In this cycle, might simplicity will come into vogue again?? Could balanced funds become the new orthodoxy?? I?m not holding my breath.
