Category: Stocks

Cruising Across Our Speculative Markets

Cruising Across Our Speculative Markets

Posted on by David Merkel

Quants have it tough.? Few in the investment world really understand what you do, and even fewer outside that world.? To many investment managers, quants are the guys nipping at their heels, clipping their returns, and questioning the need for fundamental analysis.? There comes a kind of schadenfreude when their models blow up, where qualitative mangers get to say, “See, I knew it was too good to be true,” and in the newspapers, a kind of bewilderment at eggheads whose models failed them.

I write this as a hybrid.? I am a qualitative investor that uses quantitative models to aid my processes.? As such, I was hurt, but not badly, but recent market troubles.? Any class of models can be overused, and the factors common to most quant models indeed became overused recently.? Truth is, the models don’t vary that much from quant shop to quant shop, because the market anomalies are well known.? Many of these funds held the same stocks, as seen in hindsight.? Should it surprise us that their results were correlated?

In a situation like this, success tends to breed more success, for a time, as more money gets applied to these strategies.? The statisticians should noticed the positive autocorrelation in excess returns, rather than randomness, which should have tipped them off to to much money entering the trade.? But no.? There was another calculation that could have been done as well, estimating the prospective return from new trades, which was declining as the trades got more popular.? My view is that a quant should estimate the riskiness of his strategy, and compare the returns to those available on junk bonds.? When the return is less than that available from a single-B bond, it’s time to start collapsing the trade.? (What, they won’t pay you to hold cash?? No wonder….)


On a different topic, consider mark-to-model.? I’ve said it before, but Accrued Interest said it better when it said that mark-to-model is unavoidable.? Most bonds in the market do not have a bid at any given time.? Most bonds are bought and held; beyond that, there are multiple bonds for a given company, versus one class of common stock.? The common stock will be liquid, and the bonds merely fungible.? It is even more true for structured securities, where the classes under AAA are very thin.? The AAAs may trade, classes with lower credit ratings rarely do.

Now the same argument is true when looking at a whole investment bank.? How do you mark positions that never trade, and here there is no readily indentifiable bid or ask?? You use a model that is built from things that do trade.? Sad thing is, there isn’t just one model, and there isn’t just one set of assumptions.? It is likely that the investment banks of our world, together with those they deal with, have marked illiquid securities to their own advantage.? Assets marked high, liabilities low.? Aggregate it across all parties, and the whole is worth more than the parts, due to mismarking.

Now for a tour of unrelated items:

  1. There is something about a spike in volume that reveals weaknesses in back offices.? For derivative trading, where there is still a lot of paper changing hands, that is no surprise.
  2. Prime brokerage is an interesting concept.? They bring a wide variety of services to hedge funds, but also compete in a number of ways.? At my last firm, I never felt that we got much out of our prime brokerage relationships for what we paid.? They provided liquidity at times, but not often enough.? Executions were poor as well.
  3. The market sneezes, and we worry about jobs on Wall Street.? Par for the course.? What is unusual here is that few bodies were cut 2001-2003, so pruning may be overdue.? It may be worse because the structured product markets are under stress.
  4. Catastrophe bonds are opaque to most, and Michael Lewis did us a favor by writing this.? That said, though this article begins by suggesting that 2007 will be an above average hurricane season, I ask, “What if it is not?”? It is rare for the hurricane season to shift halfway through the season.? It may be time to buy RNR, FSR, MRH and IPCR.? But regarding cat bonds, they are issued by knowledgeable insurers.? After issue, there are dedicated hedge funds that trade them, taking advantage of less knowledgeable holder, who only originally showed up for the extra yield.
  5. A break in the market affects obscure asset classes as well.? If wealthy hedge fund managers are the marginal buyers of art, and they are getting pinched now, the art market should follow.
  6. Message to Mish: If Bill Gross is shilling for a PIMCO bailout, we are all in trouble.? If the prime mortgage market and the agencies are in trouble, then I can’t think of anyone in the US that will not feel the pain.? I think Bill Gross is speaking his mind here, much as I think that Fed funds rate cuts are not needed, though I also think that they will happen, and soon.
  7. Many emerging debt markets are in better shape than the US, because their current accounts are in better order.? Now, as for this article, Brazil might be okay, but Turkey is not in a stable place here because of their current account deficits, and I would be careful.
  8. Finally we are getting real volatility.? I like that.? It helps keep us honest, and shakes out weak holders and shorts.

See you tomorrow, DV.

Tickers mentioned: IPCR, MRH, FSR, RNR

My Newest Insurance Holding

My Newest Insurance Holding

Posted on by David Merkel

Earlier today I wrote at Realmoney:

Good Things Come in Small Packages

8/29/2007 11:49 AM EDT

Every now and then, the market serves up a bargain that is hard to realize, because trading liquidity is poor. I was acquiring this stock for just me, and it took ten days for me to do it. (If at the end of this, you want to buy some, use limit orders. Do not use a market order, and do your own due diligence, please.) National Atlantic Holdings is a small (primarily) personal lines insurer selling almost entirely in New Jersey. No debt. 6.9x 2007 and 2008 earnings, 69% of tangible book. It has relatively defensible boundaries in its lines of business, though no one is totally immune from the dangers of over-competition in the personal lines marketplace. I have met management, and I think that they are competent.

Risks:

  • Up against larger companies that may be more aggressive in pricing.
  • Though NJ is good at present for insurance, the legal system has delivered some nasty surprises in the past.
  • Small insurers are subject to the “Law of Small Numbers,” which means that a small number of untoward events can knock the earnings for a loop.
  • They have missed earnings more frequently than many investors would like. There are a lot of burned value investors here.

    • There’s more, but these are the basic points that you can begin with as you do your own due diligence.

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

    Position: long NAHC

    Now for the rest of the story: my average cost is $9.60, and I would not recommend buying above $9.75. There has been some big player liquidating his stake at prices under $10, and I am not sure that he is done. There are significant buyers underneath $9.60, but as with many traders they don’t automatically buy when the sellers arrive there. They let the market sag, and then slowly suck in shares at the bid, while letting the bid back up.

    I mentioned the law of small numbers above. Well, that can work two ways. When the small numbers result in few claims in a quarter, the stock can pop, and it gets even better if it happens a few times in a row — then a pattern gets inferred by investors, and often wrongly so, but the price runs then.

    There is another risk I did not mention above. They are entering a new state, Texas, and new lines (though not in a big way) in New Jersey. I always worry when insurers do that, because they tend to underestimate the risks involved. That said, NAHC tends to be conservative here, and that ameliorates the risk. That, and the CEO own 13% of the company; he has grown it himself, and doesn’t want to spoil what he has built.

    Beyond that, their asset portfolio is clean, in my opinion. Their business in NJ depends on partner agents who primarily market to the wealthy of NJ, and try to cover their full insurance needs through package policies that cover their personal insurance needs, and sometimes their business insurance needs. This allows NAHC to compete away from Progressive and GEICO.

    Again, there is more to this story, but please do your own due diligence, and if you do buy, be price-sensitive, and don’t use a market order.

    Full disclosure: long NAHC

    Tickers mentioned: NAHC, PGR

    Surveying Bond Management and Overall Financial Market Volatility

    Surveying Bond Management and Overall Financial Market Volatility

    Posted on by David Merkel

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

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

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

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

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

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

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

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

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

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

    Tickers mentioned: CPNLQ BAC CFC

    A “Sour Sixteen” Thoughts on the Real Estate Markets

    A “Sour Sixteen” Thoughts on the Real Estate Markets

    Posted on by David Merkel

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

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

      Very interesting, Barry. Thanks for posting this. It’s just another reason why in securitization, it is better to be a AAA holder, or an equity holder. They have all of the rights — the AAAs when things are bad, and the equity when things are good to modestly bad.

    6. Or, could Countrywide, and other lenders run into difficulties because they might have to buy back loans that they modify the terms, if they are pre-emptive in doing so, rather than reactive to a threatened default? On the other hand, modifications are generally allowed for true loss mitigation, or if they are loss neutral to the senior investors. But what if the servicer offers modification to someone with a subprime loan who really doesn’t need it? Not likely in this environment. Almost everyone who took out a subprime loan expected to refinance. Modification is just another way of getting there.
    7. What could fiscal policy do to get us out of this mess? Maybe expand Fannie and Freddie, or FHA? Or have a bailout from some other entity, as Bill Gross or James Cramer might suggest? I’m a skeptic on this, as I posted at RealMoney on Thursday:

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

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

      Position: long tax payments

    8. Beautiful San Diego, where my in-laws live. What a morass of default and foreclosure, as is much of California. Good blog, by the way.
    9. For those who have read me at RealMoney, the troubles in residential real estate came as no surprise to me, though many at Wall Street were either surprised, or feigning surprise.
    10. One other easy way that we can tell that we are in a residential real estate bear market is the incidence of fraud. Face it, in a bear market, the scams play to the fear of people, whereas in a bull market, they play to their greed.
    11. What effects will the increase in consumer debt, including mortgages, have on the economy? Well, the Fed Vice-Chairman wrote a piece on it, and the answer is most likely slower growth in consumer expenditure, and greater sensitivity of demand to interest rate movements.
    12. What happens when the equity and debt markets get shaky? Commercial landlords in New York City and London get nervous. Personally, I wouldn’t be that concerned, but perhaps some of them overlevered? (Hey, remember how MetLife sold a large chunk of their NYC properties for record valuations? Good sales.)
    13. How much value will get wiped away before the residential real estate bust is done? $200 billion to several trillion (implied as a worst case by the article)? I lean toward the several trillion figure, but not strongly.
    14. Something that trips people up about the mortgage troubles, is that little has been taken in losses so far, why is there such a panic? Markets are discounting mechanisms, and they forecast the losses, and bring the currently expected present value of losses to reflect on the value of the securities. Beyond that, weak holders of mortgage securities panic and sell, exacerbating the fundamental movements.
    15. Why are credit cards doing well when mortgages are doing badly? This is unusual. What it makes me think is that there is a class of homeowner out there thinking: “The mortgage? I’m dead, no way I can pay that. I have to look forward to renting in the future, and I don’t want to destroy access to my credit card.”
    16. Finally, ending on an optimistic note: even if housing is so bad, in a global economy, it may not mean so much to the stock market. That’s my view at present, and why I am willing to be a moderate bull, even as I continue to do triage on my portfolio. (PS — that graph entitled, “Trouble at Home,” is scary.)
    Triage, Part 2

    Triage, Part 2

    Posted on by David Merkel

    In the first round of triage I went through the first third of my portfolio. Now is the time for the second third; definitely a more positive experience, together with my changes on the first third, after further reflection.
    The Dead ? Companies with bad balance sheets, but have been whacked so bad that it is still worth playing

    • Jones Apparel
    • Deerfield Capital

    If they rally a lot more, I am out.

    Walking Wounded ? Companies with okay balance sheets that we feed more cash to

    • Lafarge
    • Industrias Bachoco
    • YRC Worldwide [moved from The Dead]

    Seemingly healthy that might have financing problems ? Sold

    • Lithia Automotive
    • Group 1 Automotive

    Uncertain as of yet

    Sara Lee

    Don’t know what to do here. Balance sheet has issues but profitability is improving as the turnaround progresses.

    Healthy companies that we leave alone

    • Barclays plc (Moved from Uncertain as of yet — Capital levels are seemingly adequate.)
    • Deutsche Bank
    • Mylan Labs
    • Cimarex Energy
    • Nam Tai
    • Arkansas Best
    • Bronco Drilling
    • Vishay Intertechnology
    • Aspen Holdings
    • Safety Insurance
    • Lincoln National
    • Assurant

    Safe New Names Bought

    • PartnerRe
    • National Atlantic [Did not get a full position on, was too stubborn about levels… not buying here.]

    So, there’s the triage with one third to go — I have not done the companies with my largest gains, which I presume to be in better shape. At this point, I’m relatively happy with what I have.

    PS — As to my methods, the main parts are reviews of the balance sheets and cash flow statements. It’s basic bond analysis, asking how likely it is that future cash flows will be able to cover the debts in question. At present, I am looking to hold companies that can survive a crisis. With the reservations noted above, most of this portfolio can do so.
    Full Disclosure: Long JNY DFR LR IBA YRCW SLE BCS DB MYL XEC NTE ABFS BRNC VSH AHL AIZ LNC SAFT PRE NAHC

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

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

    Posted on by David Merkel

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

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

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

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

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

    That’s all for tonight, I’m beat.

    Full disclosure: long DB

    The Longer View, Part 1

    The Longer View, Part 1

    Posted on by David Merkel

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

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

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

    A Baker’s Dozen on Current Issues in the Markets

    A Baker’s Dozen on Current Issues in the Markets

    Posted on by David Merkel

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

    1. 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.
    2. 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.)
    3. 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.
    4. Countrywide has certainly scared a number of people, including depositors.? First time I’ve seen anything resembling a bank (S&L) run in a while.? Here’s a quick summary on what went wrong.
    5. 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.
    6. 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.
    7. Okay, a rundown.? What markets have been hit so far?? Emerging markets, real estate and funds that invest in real estate,? merger arbitrage and LBOs, art, many hedge funds (an article on the demise of Sowood), high yield debt, and the stock market globally.? I’m sure I’ve missed some, but I can’t remember a time when so many implied volatilities went up so much at the same time.
    8. 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.
    9. 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.
    10. But maybe things aren’t that bad, after all, US corporate earnings are rolling ahead at over a 10% rate.? I can live with that.
    11. Is Citadel a rescuer of Sentinel, or a rogue-ish clever firm that took advantage of panic at weakly managed Sentinel? Penson argues for the latter, but if there were multiple bids considered, it may be a difficult case for Penson to prove.? I would guess that Sentinel is toast, and that their clients will take most of the financial hits.
    12. 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.
    13. Finally, Hurricane Dean.? I wasn’t so bold two days ago, but I felt that damage to the US would be limited.? I’m more certain of that now.? (Someone tell the Louisiana Governor that there is no bullseye on her state.)? I’m an amateur meteorologist, but what I do in situations like this is measure the deviation of the track of the storm from the forecast.? In my experience, deviations tend to persist.? That told me that Dean was likely to miss Texas.? That’s more likely now; bad news for Mexico.? Pray for those in harm’s way.
    The FOMC as a Social Institution, Part 2

    The FOMC as a Social Institution, Part 2

    Posted on by David Merkel

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

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

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

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

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

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

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

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

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

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

    Theme: Overlay by Kaira.