Asset Backed Commercial Paper [ABCP].?? We’re going to hear a lot more about this, and soon.? The Wall Street Journal leads off today with an article on how money market funds are scampering to buy T-bills, and don’t want to touch A2/P2 paper, or any ABCP, no matter how high quality, which is half of the CP market.? Bloomberg provides this summary as well, highlighting that as ABCP conduits collapse the relatively high quality securities that they are financing will need to make their way onto the balance sheets of other investors.? The ABCP conduits can extend their maturities 30-45 days or so, but unless conditions improve in a month or two, there will be a lot of paper brought to the market as the ABCP conduits collapse.? Some of those assets can be financed at 5.75% at the discount window, so maybe the Fed can brake some of the damage.? On the other hand, the National Bank of Canada bought C$2 billion of ABCP from its company’s money market funds.? Much of the rest of ABCP in Canada is converting the obligations into long-dated floating rate notes, which is a correct way to finance longer dated paper.
Yesterday, the Wall Street Journal explained why the FOMC moved the discount rate.? A large portion of the argument is the demand for T-bills from money market funds sending T-bill yields temporarily below 1%, and settling yesterday a little above 3%.? Anytime the spread between Treasury bill yields and Eurodollar yields (offshore dollar bank lending rates) gets too great, there is a lack of confidence in the banking system.? The discount rate will do something to help here, but only a cut in Fed funds will get the speculative juices going, for good and for ill.? As it stands, yesterday, at 2.40%, the TED [Treasury-Eurodollar] spread is the highest it has been since the crash in 1987, when it hit nearly 3%.
One final note: orthodox economic theory says that crises can be stopped by a large economic actor (today, a central bank) being willing to lend unlimitedly with good collateral at a penalty rate.? What that implies is that some parties will go under, for whom the penalty rate is too high.? This keeps discipline in the system, while still rescuing the system.? Unfortunately, that is not true today.? 5.75% is inadequate compensation for many of the risks taken on by the Federal Reserve through the discount window.? It may rescue some marginal entities, but it will promote inflation and moral hazard.
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.
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.
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.
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.
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.
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.
Not many of my posts generate a large number of quality responses.? Rather than respond in the comments area, I thought I would make this a separate post.? My views on the Fed are eclectic, and a little quirky, because I am a skeptic about the power of central banking generally, on both the upside and the downside.? I’ve done fairly well as a bond manager using my views of the Fed to add some value.? (I’m not a bond manager now, though I would like to run a bond fund again at some point.)
First let’s clear the decks.? I am not short.? I am not underinvested in stocks, or private equity.? I am also a “lone wolf.”? I don’t work for anyone.? When I worked for my prior employer, what I posted here and at RealMoney often disagreed with the view of the owner/founder (a genuinely good fellow, and a bright guy).? What I said, I said on two levels.? First, what should be: maintain a tight-ish monetary? policy, because the crisis is nothing the the Fed should be concerned about.? I care about public policy.? I don’t like inflation, which is very understated by the PCE, and understated by the CPI, for reasons that I have stated previously.? I also don’t agree with the concept of core inflation.? If you want to remove volatility, trim the mean, or use a median.? But excluding whole classes of goods is bogus, particularly when their removal lowers the CPI by a lot.
My view is that the temporary injections of liquidity will fail.? There will be enough demand for additional short term liquidity that the Fed will have to begin making permanent injections of liquidity into the system, and eventually cut the Fed funds rate.? Once you cross the intellectual barrier of providing enough incremental liquidity to keep the system afloat, you have committed to an uncertain course of action that will likely lead to rate cuts eventually.? If the goal of monetary policy shifts, so will the direction of policy, usually.
Has the Fed lost control of monetary policy?? Yes and no.? Yes, if they continue to do business the way they do now.? No, if they want to get ugly, and restrict the ways the banks do business, either through regulation or through a modification of the risk-based capital rules.? Even so, what can they do about stimulus via foreign purchases of US debts?? Not much, and even the US Treasury would have a hard time there.
Why have the markets been so good for 25 years? I have five reasons:
Demographics — the Baby Boomers entered their most productive years.
Easy Federal Reserve — after the overshoot of policy in the early 80s, the Fed was far more activist and willing (particularly under Greenspan) to throw liquidity at problems that should be liquidated by the free markets.
Capitalism — Almost every nation is Capitalist now, even if it is crony Capitalism.
Deregulation — business benefited from deregulation under Reagan (and no one else).
Free-ish Trade — Trade isn’t really free, but many nations are more willing to compete globally, and the deflationary effects of that competition have been a real benefit.
Finally, I am still thinking about what will benefit from a shift in Fed policy.? I mentioned high quality financials.? To me, that means companies like Hartford (or maybe PRU), which I don’t own at present.? Maybe Wells Fargo?? I’m not sure, but it would have to be institutions that have suffered a real price setback, where a permanent impairment of capital is unlikely.? But what other industries will benefit from lower financing rates?? That is the $64 billion question, and with that, I bid you good night.
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.
