Media Credit: Bloomberg

Media Credit: Bloomberg

I get fascinated at how we never learn. Well, “never” is a little too strong because the following article from Bloomberg, Meet the 80-Year-Old Whiz Kid Reinventing the Corporate Bond had its share of skeptics, each of which had it right.

The basic idea is this: issue a corporate bond and then package it with a credit default swap [CDS] for the same corporate bond, with the swap cleared through a clearinghouse, which should have a AAA claims-paying ability.  Voila! You have created a AAA corporate bond.

Or have you?  Remember that bond X guaranteed by Y has many similarities to bond Y guaranteed by X, because both have to fail for there to be a default.  I used to help manage portfolios that had many different types of AAA bonds in them.  Some were natively AAA as governments, quasi-governments (really, Government Sponsored Enterprises) like Fannie and Freddie, or corporations.  Some were created by insurance guarantees from MBIA, Ambac, FGIC, or FSA.  Others were created via subordination, where the AAA portion took the losses only if they were greater than a highly stressed level.  Lesser lenders absorbed lesser losses in exchange for the ability to get a much greater yield if there was no default.

There is a lot of demand for AAA bonds if they have a high enough yield spread over Treasuries.  The amount of spread varies based on the structure, but greater complexity and greater credit risk tend to raise the spread needed.  Here are some simple examples: At one time, you could buy GE parent corporate bonds rated AAA, or GE Capital corporate bonds with an identical rating, but no guarantee from GE parent.  The GE Capital bonds always traded with more yield, even though the rating was identical.  AIG had a AAA credit rating, but its bonds frequently traded cheap to other AAA bonds because of the opacity of the financials of the firm (and among some bond managers, a growing sense that AIG had too much debt).

So how would one get a decent yield spread under this setup?  The CDS will have to require less spread to insure than the spread over Treasuries priced into the corporate bond.

How will that happen? Where does the willingness to accept the credit risk at a lower spread come from?  Note that the article doesn’t answer that question.  I will take a stab at an answer.  You could get a number of hedge funds trying to make money off of leveraging CDS for income, the excess demand forcing the CDS spread below that implied by the corporate bond.  Or, you could get a bid from synthetic Collateralized Debt Obligations [CDOs] demanding a lot of CDS for income.  I can’t think of too many other ways this could happen.

In either case, the CDS clearinghouse is dealing with weak counterparties in an event of default.  Portfolio margining should be capable of dealing with small negative scenarios like isolated defaults.  Where problems arise is when a lot of default and near defaults happen at once.  The article tells us what happens then:

ICE requires sellers of swaps to backstop their contracts with various margin accounts. If the seller fails to pay off, then ICE can tap a “waterfall” of margin funds to make the investor whole. In the event of a market crash, it can call on clearing members such as Citigroup and Goldman Sachs to pool their resources and fulfill swap contracts.

There’s still a danger that the banks themselves may be unable to muster cash in a crisis. But this shared responsibility marks a sea change from the bad old days when investors gambled their counterparties would make good on their contracts.

That shared responsibility is cold comfort.  Investment banks tend to be thinly capitalized, and even more so past the peak of a credit boom, when events like this happen.  Hello again, too big to fail.  Clearinghouses are not magic — they can fail also, and when they do, the negative effects will be huge.

Two more quotes from the article by those that “get it,” to reinforce my points:

The bond is a simple instrument with a debtor and creditor that’s proven its utility for centuries. The eBond inserts a third party into the transaction — the seller of the swap embedded in the security who now bears its credit risk.

Such machinations may be designed with good intentions, but they just further convolute the marketplace, says Turbeville, a former investment banker at Goldman Sachs.

“Why are we doing this? Is our society better off as a result of this innovation?” he asks. “You can’t destroy risk; you just move it around. I would argue that we have to reduce complexity and face the fact that it’s actually good for institutions to experience risks.”

and

“The way we make money for our clients is by assessing risk and generating risk-adjusted returns, and if you have a security that hedges that risk premium away, then why is it compelling? I would just buy Treasuries,” says Bonnie Baha, the head of global developed credit at DoubleLine Capital, a Los Angeles firm that manages about $56 billion in fixed-income assets. “This product sounds like a great idea in theory, but in practice it may be a solution in search of a problem.”

And, of course, fusing a security as straightforward as a bond with the notorious credit-default swap does ring a lot of alarms, says Phil Angelides, former chairman of the Financial Crisis Inquiry Commission, a blue-ribbon panel appointed by President Barack Obama in 2009 to conduct a postmortem on the causes of the subprime mortgage disaster. In September 2008, American International Group Inc. didn’t have the money to back the swaps it had sold guaranteeing billions of dollars’ worth of mortgage-backed securities. To prevent AIG’s failure from cascading through the global financial system, the U.S. Federal Reserve and the U.S. Treasury Department executed a $182 billion bailout of the insurer.

“When you look at this corporate eBond, it’s strikingly similar to what was done with mortgages,” says Angelides, a Democrat who was California state treasurer from 1999 to 2007. “Credit-default swaps were embedded in mortgage-backed securities with the idea that they’d be made safe. But the risk wasn’t insured; it was just shifted somewhere else.”

The article rambles at times, touching on unrelated issues like index funds, capital structure arbitrage, and alternative liquidity structures for bonds.  On its main point the article leave behind more questions than answers, and the two big ones are:

  • Should a sufficient number of these bonds get issued, what will happen in a very large credit crisis?
  • How will these bonds get issued?  When spreads are tight, no one will want to do these because of the cost of complexity.  When spreads are wide, who will have the capital to offer protection on CDS in exchange for income?

I’m not a fan of financial complexity.  Usually something goes wrong that the originators never imagined.  I may not have thought of what will go wrong here, but I’ve given you several avenues where this idea may go, so that you can avoid losing.

Photo Credit: Chris Piascik

Photo Credit: Chris Piascik

Most formal statements on financial risk are useless to their users. Why?

  • They are written in a language that average people and many regulators don’t speak.
  • They often don’t define what they are trying to avoid in any significant way.
  • They don’t give the time horizon(s) associated with their assessments.
  • They don’t consider the second-order behavior of parties that are managing assets in areas related to their areas.
  • They don’t consider whether history might be a poor guide for their estimates.
  • They don’t consider the conflicting interests and incentives of the parties that direct the asset managers, and how their own institutional risks affect their willingness to manage the risks that other parties deem important.
  • They are sometimes based off of a regulatory view of what can/must be stated, rather than an economic view of what should be stated.
  • Occasionally, approximations are used where better calculations could be used.  It’s amazing how long some calculations designed for the pencil and paper age hang on when we have computers.
  • Also, material contract provisions that are hard to model/explain often get ignored, or get some brief mention in a footnote (or its equivalent).
  • Where complex math is used, there is no simple language to explain the economic sense of it.
  • They are unwilling to consider how volatile financial processes are, believing that the Great Depression, the German Hyperinflation, or something as severe, could never happen again.

(An aside to readers; this was supposed to be a “little piece” when I started, but the more I wrote, the more I realized it would have to be more comprehensive.)

Let me start with a brief story.  I used to work as an officer of the Pension Division of Provident Mutual, which was the only place I ever worked where analysis of risks came first, and was core to everything else that we did.  The mathematical modeling that I did in there was some of the best in the industry for that era, and my models helped keep us out of trouble that many other firms fell into.  It shaped my view of how to manage a financial business to minimize risks first, and then make money.

But what made us proudest of our efforts was a 40-page document written in plain English that ran through the risks that we faced as a division of our company, and how we dealt with them.  The initial target audience was regulators analyzing the solvency of Provident Mutual, but we used it to demonstrate the quality of what we were doing to clients, wholesalers, internal auditors, rating agencies, credit analysts, and related parties inside Provident Mutual.  You can’t believe how many people came to us saying, “I get it.”  Regulators came to us, saying: “We’ve read hundreds of these; this is the first one that was easy to understand.”

The 40-pager was the brainchild of my boss, who was the most intuitive actuary that I have ever known.  Me? I was maybe the third lead investment risk modeler he had employed, and I learned more than I probably improved matters.

What we did was required by law, but the way we did it, and how we used it was not.  It combined the best of both rules and principles, going well beyond the minimum of what was required.  Rather than considering risk control to be something we did at the end to finagle credit analysts, regulators, etc., we took the economic core of the idea and made it the way we did business.

What I am saying in this piece is that the same ideas should be more actively and fully applied to:

  • Investment prospectuses and reports, and all investment and insurance marketing literature
  • Solvency documents provided to regulators, credit raters, and the general public by banks, insurers, derivative counterparties, etc.
  • Risk disclosures by financial companies, and perhaps non-financials as well, to the degree that financial markets affect their real results.
  • The reports that sell-side analysts write
  • The analyses that those that provide asset allocation advice put out
  • Consumer lending documents, in order to warn people what can happen to them if they aren’t careful
  • Private pension and employee benefit plans, and their evil twins that governments create.

Looks like this will be a mini-series at Aleph Blog, so stay tuned for part two, where I will begin going through what needs to be corrected, and then how it needs to be applied.

Photo Credit: S@Z

Photo Credit: S@Z

I’ve been busier than ever of late — not much time to blog. Thus, a few notes:

1) Often the rate of change in a price can tell you something, particularly if the good in question is widely traded/held by a wide number of parties with different interests.  In this case, I am talking about crude oil prices, and the related set of prices that are cousins.

Overall demand for crude hasn’t shifted, and neither has supply.  Yes, there has been some buildup of inventories, and some key global players refuse to cut production in response to lower prices.  But the sharpness of the price move feels more like some large player(s) who were relying on a higher oil price finally hit their “stop loss” point, and their risk control desk is closing out the trade.

I could be wrong here, but paper barrels of oil trade more rapidly than physical shifts in net demand, and risk control and margin desks will force moves that are non-economic.  Wait.  Surviving is economic, even at the cost of forgoing potential profits.

We’ll see how this shakes out over the next few months.  There’s a lot of pain for pure play producers, and those that aid them.  I particularly wonder at governments that rely on crude exports to support their budgets… they may not cut, but what will they do, if they don’t have reserves?  Cuts will have to come from economic players initially.  It make take a revolt to affect non-economic governmental entities.

All that said, sharp price moves tend to mean-revert, slow moves tend to persist, so be wary of too much bearishness here.

2) An article in yesterday’s Wall Street Journal was entitled Bond Funds Load Up on Cash.  This qualifies for the “Dog Bites Man” award, as it puts forth the conventional wisdom that interest rates must rise soon.

That drum has been banged so frequently that it is wearing out.  We’re not seeing the pickup in lending necessary to convince us that the economy needs higher real interest rates so that more savings would be available to be lent out.

Also, some managers may be running a barbell, holding more cash and long debt, and not so many intermediate securities.  This would be logical, because a barbelled portfolio does better in volatile markets — it’s ready for inflation and deflation, while giving up yield should times remain stable.

All for now.  Maybe when my busy time is done, I’ll write about it.

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Photo Credit: Ron

There’s a significant problem when you are a supremely big and connected financial institution: your failure will have an impact on the financial system as a whole.  Further, there is no one big enough to rescue you unless we drag out the public credit via the US Treasury, or its dedicated commercial paper financing facility, the Federal Reserve.  You are Too Big To Fail [TBTF].

Thus, even if you don’t fit into ordinary categories of systematic risk, like a bank, the government is not going to sit around and let you “gum up” the financial system while everyone else waits for you to disburse funds that others need to pay their liabilities.  They will take action; they may not take the best action of letting the holding company fail while bailing out only the connected and/or regulated subsidiaries, but they will take action and do a bailout.

In such a time, it does no good to say, “Just give us time.  This is a liquidity problem; this is not a solvency problem.”  Sorry, when you are big during a systemic crisis, liquidity problems are solvency problems, because there is no one willing to take on a large “grab bag” of illiquid asset and liquid liabilities without the Federal Government being willing to backstop the deal, at least implicitly.  The cost of capital in a financial crisis is exceptionally high as a result — if the taxpayers are seeing their credit be used for semi-private purposes, they had better receive a very high penalty rate for the financing.

That’s why I don’t have much sympathy for M. R. Greenberg’s lawsuit regarding the bailout of AIG.  If anything, the terms of the bailout were too soft, getting revised down once, and allowing tax breaks that other companies were not allowed.  Without the tax breaks and with the unamended bailout terms, the bailout was not profitable, given the high cost of capital during the crisis.  Further, though AIG Financial products was the main reason for the bailout, AIG’s domestic life subsidiaries were all insolvent, as were their mortgage insurers, and perhaps a few other smaller subsidiaries as well.  This was no small mess, and Greenberg is dreaming if he thought he could put together financing adequate to keep AIG afloat in the midst of the crisis.

Buffett was asked to bail out AIG, and he wouldn’t touch it.  Running a large insurer, he knew the complexity of AIG.  Having run off much of the book of Gen Re Financial Products, he knew what a mess could be lurking in AIG Financial Products.  He also likely knew that AIG’s P&C reserves were understated.

For more on this, look at my book review of The AIG Story, the book that tells Greenberg’s side of the story.

To close: it’s easy to discount the crisis after it has passed, and look at the now-solvent AIG as if it were a simple thing for them to be solvent through the crisis.  It was no simple thing, because only the government could have provided the credit, amid a cascade of failures.  (That the failures were in turn partially caused by bad government policies was another issue, but worthy to remember as well.)

Spot the failure

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Jason Zweig at the Wall Street Journal had a very good piece on whether to follow Bill Gross as he goes from Pimco to Janus.  Let me quote one paragraph:

Morningstar estimates that over the past five years, the average investor fell behind Pimco Total Return’s 5.6% annual gain by 1.6 points a year—largely as a result of buying high and selling low. That gap is among the widest of any large bond fund; at the Vanguard Total Bond Market Index Fund, for example, investors have earned returns only 0.4 point lower than those of the portfolio itself.

In the short run, this offers a reason to follow Bill Gross to Janus.  He is starting with a clean slate, and will be able to implement positions that seem attractive to him that would not have been attractive at Pimco because they would have been too small.  Managing less money lets Bill Gross be more choosy.

Second, in the short run, growth in bond assets at Janus will temporarily push up the prices of bonds held by Janus.  Those that get in early would benefit from that if bond assets grow under the management of Bill Gross.  Just keep your eye on when assets stop growing if you are buying for that speculative reason.

A third potential reason to follow Gross depends on how much Pimco continues to use his quantitative strategies.  If Pimco abandons them (unlikely, but not impossible), Janus would get the chance to use them on much less money, which would make the excess returns greater.  If I were considering this as a reason, I would watch the turnover in Pimco’s main funds, and see if certain classes of assets disappear.

My last point here is that the abilities of Bill Gross will do better managing less money, but the effect won’t be so great if he is competing with Pimco to implement the same strategies.  At minimum, he’s not likely to do worse than at Pimco, and in the short-run, there are some reasons why he will likely do better.

PS — please remember that Bill Gross has two hats: the showman and the quant.  The quant makes money for clients while the showman entertains them.  The showman opines about the Fed, politics, etc.  That can get investors interested because it sounds clever, but that is not how Bill Gross makes money.

This brings up one more point.  If you do decide to invest with him at Janus, review the prospectus to see what degree of flexibility with derivatives Gross will have.  If it similar to what he had at Pimco, he is likely following the same strategy.

Photo Credit: Matt Cavanagh

Photo Credit: Matt Cavanagh

There is a saying in the markets that volatility is not risk. In general this is true, and helps to explain why measures like beta and standard deviation of returns do not measure risk, and are not priced by the market. After all, risk is the probability of losing money, and the severity thereof.

It’s not all that different from the way that insurance underwriters think of risk, or any rational businessman for that matter. But just to keep things interesting, I’d like to give you one place where volatility is risk.

When overall economic conditions are serene, many people draw the conclusion that it will stay that way for a long time. That’s a mistake, but that’s human nature. As a result, those concluding that economic conditions will remain serene for a long time decide to take advantage of the situation and borrow money.

When volatility is low, typically credit spreads are low. Why not take advantage of cheap capital? Well, I would simply argue that interest rates are for a time, and if you don’t overdo it, paying interest can be managed. But what happens if you have to refinance the principal of the loan at an inopportune time?

When volatility and interest spreads are low for you, they are low for a lot of other people also. Debt builds up not just for you, but for society as a whole. This can have the impact of pushing up prices of the assets purchased using debt. In some cases, the rising asset prices can attract momentum buyers who also borrow money in order to own the rising assets.

This game can continue until the economic yield of the assets is less than the yield on the debt used to finance the assets. Asset bubbles reach their breaking point when people have to feed cash to the asset beyond the ordinary financing cost in order to hold onto it.

In a situation like this, volatility becomes risk. Too many people have entered into too many fixed commitments and paid too much for a group of assets. This is one reason why debt crises seem to appear out of the blue. The group of assets with too much debt looks like they are in good shape if one views it through the rearview mirror. The loan-to-value ratios on recent loans based on current asset values look healthy.

But with little volatility in some subsegment of the overly levered assets, all of a sudden a small group of the assets gets their solvency called into question. Because of the increasing level of cash flows necessary to service the debt relative to the economic yield on the assets, it doesn’t take much fluctuation to make the most marginal borrowers question whether they can hold onto the assets.

Using an example from the recent financial crisis, you might recall how many economists, Fed governors, etc. commented on how subprime lending was a trivial part of the market, was well-contained, and did not need to be worried about. Indeed, if subprime mortgages were the only weak financing in the market, it would’ve been self-contained. But many people borrowed too much chasing inflated values of residential housing.  As asset values fell, more and more people lost willingness to pay for the depreciating assets.

We’ve had other situations like this in our markets. Here are some examples:

  • Commercial mortgage loans went through a similar set of issues in the late 80s.
  • Lending to lesser developed countries went through similar set of issues in the early 80s.
  • The collateralized debt obligation markets seem to have their little panics every now and then. (late 90s, early 2000s, mid 2000s, late 2000s)
  • During the dot-com bubble, too much trade finance was extended to marginal companies that were burning cash rapidly.
  • The roaring 20s were that way in part due to increased debt finance for corporations and individuals.

At the peak some say, “Nobody rings a bell.” This is true. But think of the market peak as being like the place where the avalanche happened 10 minutes before it happened. What set off the avalanche? Was it the little kid at the bottom of the valley who decided to yodel? Maybe, but the result was disproportionate to the final cause. The far more amazing thing was the development of the snow into the configuration that could allow for the avalanche.

This is the way things are in a heavily indebted financial system. At its end, it is unstable, and at its initial unwinding the proximate cause of trouble seems incapable of doing much harm. But to give you another analogy ask yourself this: what is more amazing, the kid who knocks over the first domino, or the team of people spending all day lining up the huge field of dominoes? It is the latter, and so it is amazing to watch large groups of people engaging in synchronized speculation not realizing that they are heading for a significant disaster.

As for today, I don’t see the same debt buildup has we had growing from 2003 to 2007. The exceptions maybe student loans, parts of the energy sector, parts of the financial sector, and governments. That doesn’t mean that there is a debt crisis forming, but it does mean we should keep our eyes open.

The dirty truth is that some investments in this life are sold, and not bought.  The prime reason for this is that many people are not willing to learn enough to save and invest on their own.  Instead, they rely on others to corral them and say, “You ought to be saving and investing.  Hey, I’ve got just the thing for you!”

That thing could be:

  • Life Insurance
  • Annuities
  • Front-end loaded mutual funds
  • Illiquid securities like Private REITs, LPs, some Structured Notes
  • Etc.

Perhaps the minimal effort necessary to avoid this is to seek out a fee-only financial planner, and ask him to set up a plan for you.  Problem solved, unless…

Unless the amount you have is so small that when look at the size of the financial planner’s fee, you say, “That doesn’t work for me.”

But if you won’t do it yourself, and you can’t find something affordable, then the only one that will help you (in his own way) is a commissioned salesman.

Now, to generate any significant commission off of a financial product, there have to be two factors in place: 1) the product must be long duration, and 2) it must be illiquid.  By illiquid, I mean that either you can’t easily trade it, or there is some surrender charge that gets taken out if the contract is cashed out early.

The long duration of the contract allows the issuer of the contract the ability to take a portion of its gross margins over life of the contract, and pay a large one-time commission to the salesman.  The issuer takes no loss as it pays the commission, because they spread the acquisition cost over the life of the contract.  The issuer can do it because it has set up ways of recovering the acquisition cost in almost all circumstances.

Now in some cases, the statements that the investor will get will explicitly reveal the commission, but that is rare.  Nonetheless, to the extent that it is required, the first statement will reveal how much the contractholder would lose if he tries to cash out early.  (I think this happens most of the time now, but it would not surprise me to find some contract where that does not apply.)

Now the product may or may not be what the person buying it needed, but that’s what he gets for not taking control of his own finances.  I don’t begrudge the salesman his commission, but I do want to encourage readers to put their own best interests first and either:

  • Learn enough so that you can take care of your own finances, or
  • Hire a fee-only planner to build a financial plan for you.

That will immunize you from financial salesmen, unless you eventually become rich enough to use life insurance, trusts, and other instruments to limit your taxation in life and death.

Now, I left out one thing — there are still brokers out there that make their money through lots of smallish commissions by trading a brokerage account of yours aggressively, or try to sell you some of the above products.  Avoid them, and let your fee-only planner set up a portfolio of low cost ETFs for you.  It’s not sexy, but it will do better than aggressive trading.  After all, you don’t make money while you trade; you make it while you wait.

If you don’t have a fee only planner and still want to index — use half SPY and half AGG, and add funds periodically to keep the positions equal sized.  It will never be the best portfolio, but over time it will do better than the average account.

One final note before I go: with insurance, if you want to keep your costs down, keep your products simple — use term insurance for protection, and simple deferred annuities for saving (though I would buy a bond ETF rather than insurance in most cases).  Commissions go up with product complexity, and so do expenses.  Simple products are easy to compare, so that you know that you are getting the best deal.  Unless you are wealthy, and are trying to achieve tax savings via the complexity, opt for simple insurance products that will cover basic needs.  (Also avoid product riders — they are really expensive, even though the additional premiums are low, the likely benefits paid are lower still.)

This is the continuation of The Shadows of the Bond Market’s Past, Part I.  If you haven’t read part I, you will need to read it.  Before I start, there is one more thing I want to add regarding 1994-5: the FOMC used signals from the bond markets to give themselves estimates of expected inflation.  Because of that, the FOMC overdid policy, because the dominant seller of Treasuries was not focusing on the economy, but on hedging mortgage bonds.  Had the FOMC paid more attention to what the real economy was doing, they would not have tightened so much or so fast.  Financial markets are only weakly representative of what the real economy is doing; there’s too much noise.

All that said, in 1991 the Fed also overshot policy on the other side in order to let bank balance sheets heal, so let it not be said that the Fed only responds to signals in the real economy.  (No one should wonder who went through the financial crisis that the Fed has an expansive view of its mandate in practice.)

October 2001

2001 changed America.  September 11th led to a greater loosening of credit by the FOMC in order to counteract spreading unease in the credit markets.  Credit spreads were widening quickly as many lenders were unwilling to take risk at a time where times were so unsettled.  The group that I led took more risk, and the story is told here.  The stock market had been falling most of 2001 when 9/11 came.  When the markets reopened, it fell hard, and rallied into early 2002, before falling harder amid all of the scandals and weak economy, finally bottoming in October 2002.

The rapid move down in the Fed funds rate was not accompanied by a move down in long bond yields, creating a very steep curve.  There were conversations among analysts that the banks were healthy, though many industrial firms, like automobiles were not.  Perhaps the Fed was trying to use housing to pull the economy out of the ditch.  Industries that were already over-levered could not absorb more credit from the Fed.  Unemployment was rising, and inflation was falling.

There was no bad result to this time of loosening — another surprise would lurk until mid-2004, when finally the loosening would go away.  By that time, the stock market would be much higher, about as high as it was in October 2001, and credit spreads tighter.

July 2004

At the end of June 2004, the FOMC did its first hike of what would be 17 1/4% rises in the Fed funds rate which would be monotony interspersed with hyper-interpretation of FOMC statement language adjustments, mixed with the wonder of a little kid in the back seat, saying, “Daddy, when will we get there?”  The FOMC had good reason to act.  Inflation was rising, unemployment was falling, and they had just left the policy rate down at 1% for 12 straight months.  In the midst of that in June-August 2003, there was a another small panic in the mortgage bond market, but this time, the FOMC stuck to its guns and did not raise rates, as they did for something larger in 1994.

With the rise in the Fed funds rate to 1 1/4%, the rate was as high as it was when the recession bottomed in November 2002.  That’s quite a long period of low rates.  During that period, the stock market rallied vigorously, credit spreads tightened, and housing prices rallied.  Long bonds stayed largely flat across the whole period, but still volatile.

There were several surprises in store for the FOMC and investors as  the tightening cycle went on:

  1. The stock market continued to rally.
  2. So did housing.
  3. So did long bonds, at least for a time.
  4. Every now and then there were little panics, like the credit convexity panic in May 2005, from a funky long-short CDO bet.
  5. Credit complexity multiplied.  All manner of arbitrage schemes flourished.  Novel structures for making money off of credit, like CPDOs emerge.  (The wisdom of finance bloggers as skeptics grows.)
  6. By the end, the yield curve invests the hard way, with long bonds falling a touch through the cycle.
  7. Private leverage continued to build, and aggressively, particularly in financials.
  8. Lending standards deteriorated.

We know how this one ended, but at the end of the tightening cycle, it seemed like another success.  Only a few nut jobs were dissatisfied, thinking that the banks and homeowners were over-levered.  In hindsight, FOMC policy should have moved faster and stopped at a lower level, maybe then we would have had less leverage to work through.

June 2010

15 months after the bottom of the crisis, the stock market has rallied dramatically, with a recent small fall, but housing continues to fall in value.  There’s more leverage behind houses, so when the prices do finally fall, it gains momentum as people throw in the towel, knowing they have lost it all, and in some cases, more.  For the past year, long bond yields have gone up and down, making a round-trip, but a lot higher than during late 2008.  Credit spreads are still high, but not as high as during late 2008.

Inflation is low and volatile, unemployment is off the peak of a few months earlier, but is still high.  Real GDP is growing at a decent clip, but fitfully, and it is still not up to pre-crisis levels.  Aside from the PPACA [Obamacare], congress hasn’t done much of anything, and the Fed tries to fill the void by expanding its balance sheet through QE1, which ended in June 2010. Things feel pretty punk altogether.

The FOMC can’t cut the Fed funds rate anymore, so it relies on language in its FOMC Statement to tell economic actors that Fed funds will be “exceptionally low” for an “extended period.”  Four months from then, the QE2 would sail, making the balance sheet of the Fed bigger, but probably doing little good for the economy.

The results of this period aren’t fully known yet because we still living in the same essential macro environment, with a few exceptions, which I will take up in the final section.

August 2014

Inflation remains low, but may finally be rising.  Unemployment has fallen, much of it due to discouraged workers, but there is much underemployment.  Housing has finally gotten traction in the last two years, but there are many cross-currents.  The financial crisis eliminated move-up buyers by destroying their equity.  Stocks have continued on a tear, and corporate credit spreads are very tight, tighter than any of the other periods where the yield curve was shaped as it is now.  The long bond has had a few scares, but has confounded market participants by hanging around in a range of 2.5%- 4.0% over the last two years.

There are rumblings from the FOMC that the Fed funds rate may rise sometime in 2015, after 72+ months hanging out at 0%.  QE may end in a few more months, leaving the balance sheet of the Fed at 5 times its pre-crisis size.  Change may be upon us.

This yield curve shape tends to happen over my survey period at a time when change is about to happen (4 of 7 times — 1971, 1977, 1993 and 2004), and one where the FOMC will raise rates aggressively (3 of 7 times — 1977, 1993 and 2004) after fed funds have been left too low for too long.  2 out of 7 times, this yield curve shape appears near the end of a loosening cycle (1991 and 2001).  1 out of 7 times it appears before a deep recession, as in 1971. 1 out of 7 times it appears in the midst of an uncertain recovery — 2010. 3 out 7 times, inflation will rise significantly, such as in 1971, 1977 and 2004.

My tentative conclusion is this… the fed funds rate has been too low for too long, and we will see a rapid rise in rates, unless the weak economy chokes it off because it can’t tolerate any significant rate increases.  One final note before I close: when the tightening starts, watch the long end of the yield curve.  I did this 2004-7, and it helped me understand what would happen better than most observers.  If the yield of the long bond moves down, or even stays even, the FOMC probably won’t persist in raising rates much, as the economy is too weak.  If the long bond runs higher, it might be a doozy of a tightening cycle.

And , for those that speculate, look for places that can’t tolerate or would  love higher short rates.  Same for moves in the long bond either way, or wider credit spreads — they can’t get that much tighter.

This is an unusual environment, and as I like to say, “Unusual typically begets unusual, it does not beget normal.”  What I don’t know is how unusual and where.  Those getting those answers right will do better than most.  But if you can’t figure it out, don’t take much risk.

Simulated Constant Maturity Treasury Yields 8-1-14_24541_image001

 

Source: FRED

Above is the chart, and here is the data for tonight’s piece:

DateT1T3T5T7T10T20T30AAABAASpdNote
3/1/713.694.505.005.425.705.946.01*7.218.461.25High
4/1/775.446.316.797.117.377.677.738.049.071.03Med
12/1/914.385.396.196.697.097.667.708.319.260.95Med
8/1/933.444.365.035.355.686.276.326.857.600.75Med
10/1/012.333.143.914.314.575.345.327.037.910.88Med
7/1/042.103.053.694.114.505.245.235.826.620.80Med
6/1/100.321.172.002.663.203.954.134.886.231.35High
8/1/140.130.941.672.162.523.033.294.184.750.57Low

Source: FRED   |||     * = Simulated data value  |||  Note: T1 means the yield on a one-year Treasury Note, T30, 30-year Treasury Bond, etc.

Above you see the seven yield curves most like the current yield curve, since 1953.  The table also shows yields for Aaa and Baa bonds (25-30 years in length), and the spread between them.

Tonight’s exercise is to describe the historical environments for these time periods, throw in some color from other markets, describe what happened afterward, and see if there might be any lessons for us today.  Let’s go!

March 1971

Fed funds hits a local low point as the FOMC loosens policy under Burns to boost the economy, to fight rising unemployment, so that Richard Nixon could be reassured re-election.  The S&P 500 was near an all-time high.  Corporate yield spreads  were high; maybe the corporate bond market was skeptical.

1971 was a tough year, with the Vietnam War being unpopular. Inflation was rising, Nixon severed the final link that the US Dollar had to Gold, an Imposed wage and price controls.  There were two moon landings in 1971 — the US Government was in some ways trying to do too much with too little.

Monetary policy remained loose for most of 1972, tightening late in the years, with the result coming in 1973-4: a severe recession accompanied by high inflation, and a severe bear market.  I remember the economic news of that era, even though I was a teenager watching Louis Rukeyser on Friday nights with my Mom.

April 1977

Once again, Fed funds is very near its local low point for that cycle, and inflation is rising.  After the 1975-6 recovery, the stock market is muddling along.  The post-election period is the only period of time in the Carter presidency where the economy feels decent.  The corporate bond market is getting close to finishing its spread narrowing after the 1973-4 recession.

The “energy crisis” and the Cold War were in full swing in April 1977.  Economically, there was no malaise at the time, but in 3 short years, the Fed funds rate would rise from 4.73% to 17.61% in April 1980, as Paul Volcker slammed on the brakes in an effort to contain rising inflation.  A lotta things weren’t secured and flew through the metaphorical windshield, including the bond market, real GDP, unemployment, and Carter’s re-election chances.  Oddly, the stock market did not fall but muddled, with a lot of short-term volatility.

December 1991

This yield curve is the second most like today’s yield curve.  It comes very near the end of the loosening that the FOMC was doing in order to rescue the banks from all of the bad commercial real estate lending they had done in the late 1980s.  A wide yield curve would give surviving banks the ability to make profits and heal themselves (sound familiar?).  Supposedly at the beginning of that process in late 1990, Alan Greenspan said something to the effect of “We’re going to give the banks a lay-up!”  Thus Fed funds went from 7.3% to 4.4% in the 12 months prior to December 1991, before settling out at 3% 12 months later.  Inflation and unemployment were relatively flat.

1991 was a triumphant year in the US, with the Soviet Union falling, Gulf War I ending in a victory (though with an uncertain future), 30-year bond yields hitting new lows, and the stock market hitting new all time highs.  Corporate bonds were doing well also, with tightening spreads.

What would the future bring?  The next section will tell you.

August 1993

This yield curve is the most like today’s yield curve.  Fed funds are in the 13th month out of 19 where they have been held there amid a strengthening economy.  The housing market is doing well, and mortgage refinancing has been high for the last three years, creating a situation where those investing in mortgages securities have a limited set of coupon rates that they can buy if they want to put money to work in size.

An aside before I go on — 1989 through 1993 was the era of clever mortgage bond managers, as CMOs sliced and diced bundles of mortgage payments so that managers could make exotic bets on moves in interest and prepayment rates.  Prior to 1994, it seemed the more risk you took, the better returns were.  The models that most used were crude, but they thought they had sophisticated models.  The 1990s were an era where prepayment occurred at lower and lower thresholds of interest rate savings.

As short rates stayed low, long bonds rallied for two reasons: mortgage bond managers would hedge their portfolios by buying Treasuries as prepayments occurred.  They did that to try to maintain a constant degree of interest rate sensitivity to overall moves in interest rates.  Second, when you hold down short rates long enough, and you give the impression that they will stay there (extended period language was used — though no FOMC Statements were made prior to 1994), bond managers start to speculate by buying longer securities in an effort to clip extra income.  (This is the era that this story (number 2 in this article) took place in, which is part of how the era affected me.)

At the time, nothing felt too unusual.  The economy was growing, inflation was tame, unemployment was flat.  But six months later came the comeuppance in the bond market, which had some knock-on effects to the economy, but primarily was just a bond market issue.   The FOMC hiked the Fed funds rate in February 1994 by one quarter percent, together with a novel statement issued by Chairman Greenspan.  The bond market was caught by surprise, and as rates rose, prepayments fell.  To maintain a neutral market posture, mortgage bond managers sold long Treasury and mortgage bonds, forcing long rates still higher.  In the midst of this the FOMC began raising the fed funds rate higher and higher as they feared economic growth would lead to inflation, with rising long rates a possible sign of higher expected inflation.  The FOMC raises Fed fund by 1/2%.

In April, thinking they see continued rises in inflation expectation, they do an inter-meeting surprise 1/4% raise of Fed funds, followed by another 1/2% in May.  It is at this pint that Vice Chairman McDonough tentatively realizes [page 27] that the mortgage market has now tightly coupled the response of the long end of the bond market to the short end the bond market, and thus, Fed policy.  This was never mentioned again in the FOMC Transcripts, though it was the dominant factor moving the bond markets.  The Fed was so focused on the real economy, that they did not realize their actions were mostly affecting the financial economy.

FOMC policy continued: Nothing in July, 1/2% rise in August, nothing in September, 3/4% rise in November, nothing in December, and 1/2% rise in February 1995, ending the tightening. In late December 1994 and January of 1995, the US Treasury and the Fed participated in a rescue of the Mexican peso, which was mostly caused by bad Mexican economic policy, but higher rates in the US diminished demand for the cetes, short-term US Dollar-denominated Mexican government notes.

The stock market muddled during this period, and the real economy kept growing, inflation in check, and unemployment unaffected.  Corporate spreads tightened; I remember that it was difficult to get good yields for my Guaranteed Investment Contract [GIC] business back then.

But the bond markets left their own impacts: many seemingly clever mortgage bond managers blew up, as did the finances of Orange County, whose Treasurer was a mortgage bond speculator.  Certain interest rate derivatives blew up, such as the ones at Procter & Gamble.  Several life insurers lost a bundle in the floating rate GIC market; the company I served was not one of them.  We even made extra money that year.

The main point of August 1993 is this: holding short rates low for an extended period builds up imbalances in some part of the financial sector — in this case, it was residential mortgages.  There are costs to providing too much liquidity, but the FOMC is not an institution with foresight, and I don’t think they learn, either.

This has already gotten too long, so I will close up here, and do part II tomorrow.  Thanks for reading.

This should be short.  Remember that credit and equity volatility are strongly related.

I am dubious about conditions in the bank loan market because Collateralized Loan Obligations [CLOs] are hot now and there are many that want to take the highest level of risk there.  I realize that I am usually early on credit issues, but there are many piling into CLOs, and willing to take the first loss in exchange for a high yield.  Intermediate-term, this is not a good sign.

Note that corporations take 0n more debt when rates are low.  They overestimate how much debt they can service, because if rates rise, they are not prepared for the effect on earnings per share, should the cost of the debt reprice.

It’s a different issue, but consider China with all of the bad loans its banks have made.  They are facing another significant default, and the Chinese Government looks like it will let the default happen.  That will not likely be true if the solvency of one of their banks is threatened, so keep aware as the risks unfold.

Finally, look at the peace and calm of low implied volatilities of the equity markets.  It feels like 2006, when parties were willing to sell volatility with abandon because the central banks of our world had everything under control.  Ah, remember that?  Maybe it is time to buy volatility when it is cheap.  Now here is my question to readers: aside from buying long Treasury bonds, what investments can you think of that benefit from rising implied volatility and credit spreads, aside from options and derivatives?  Leave you answers in the comments or email me.

This will sound weird, but I am not as much worried about government bond rates rising, as I am with credit spreads rising.  Again, remember, I am likely early here, so don’t go nuts applying my logic.

PS — weakly related, also consider the pervasiveness of BlackRock’s risk control model.  Dominant risk control models may not truly control risk, because who will they sell to?  Just another imbalance of which to be wary.