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.
I posted this on RealMoney on 5/6/2005, when everyone was screaming for the FOMC to stop raising rates because the “auto companies were?dying.”
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On Oct. 2, 2002, one week before the market was going to turn, the gloom was so thick you could cut it with a knife. What would blow up next?
A lot of heavily indebted companies are feeling weak, and the prices for their debt reflected it. I thought we were getting near a turning point; at least, I hoped so. But I knew what I was doing for lunch; I was going to the Baltimore Security Analysts’ Society meeting to listen to the head of the Richmond Fed, Al Broaddus, speak.
It was a very optimistic presentation, one that gave the picture that the Fed was in control, and don’t worry, we’ll pull the economy out of the ditch. When the Q&A time came up, I got to ask the second-to-last question. (For those with a Bloomberg terminal, you can hear Broaddus’s full response, but not my question, because I was in the back of the room.) My question (going from memory) went something like this:
I recognize that current Fed policy is stimulating the economy, but it seems to have impact in only the healthy areas of the economy, where credit spreads are tight, and stimulus really isn’t needed. It seems the Fed policy has almost no impact in areas where credit spreads are wide, and these are the places that need the stimulus. Is it possible for the Fed to provide stimulus to the areas of the economy that need it, and not to those that don’t?
It was a dumb question, one that I knew the answer to, but I was trying to make a point. All the liquidity in the world doesn’t matter if the areas that you want to stimulate have impaired balance sheets. He gave a good response, the only surviving portion of it I pulled off of Bloomberg: “There are very definite limits to what the Federal Reserve can do to affect the detailed spectrum of interest rates,” Broaddus said. People shouldn’t “expect too much from monetary policy” to steer the economy, he said.
When I got back to the office, I had a surprise. Treasury bonds had rallied fairly strongly, though corporates were weak as ever and stocks had fallen further. Then I checked the bond news to see what was up. Bloomberg had flashed a one-line alert that read something like, “Broaddus says don’t expect too much from monetary policy.” Taken out of context, Broaddus’s answer to my question had led to a small flight-to-safety move. Wonderful, not. Around the office, the team joked, “Next time you talk to a Fed Governor, let us know, so we can make some money off it?”
PS — ?Before Broaddus answered, he said something to the effect of: “I’m glad the media is not here, because they always misunderstand the ability of the Fed to change things.” ?A surprise to the Bloomberg, Baltimore Sun, and at least one other journalist who were there.
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And now to the present application:
My main point in posting this story is to point out the impotence of Fed policy in helping areas of the economy with compromised balance sheets. ?When credit spreads are wide, cuts in the fed funds rate do not appreciably affect the funding costs of firms deep in junk grade.
Beyond that, temporary injections of liquidity are meaningless, and that is all the major central banks of the world have done, together with words saying they will support the markets. ?Well, what happens after the market digests that, and the temporary injections of liquidity are gone. ?They will expect the Fed to stand and deliver something more permanent. ?Much as I have resisted this thought, and hate it in terms of public policy, the FOMC will cut rates at that point in time, and begin a loosening cycle. ?It’s the wrong thing to do, and won’t achieve the goals intended, but my view of Fed policy is that I must focus on will they will do, not what they should do.
So you have my change of view here and now. ?The central banks of our world have caved in to an unrealistic fear of what is going on in the fixed income markets. ?The next move of the Fed is to loosen. ?It will happen in 2007. ?Look for the areas of the economy that are healthy, and will benefit from cheap financing, because they will get it. ?The trade: buy high quality financial stocks. ?Time to overweight.
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.
So Moody’s tries to clean up its act, and finds itself shut out of rating most Commercial Mortgage-backed Securities [CMBS] deals? That’s not too surprising, and sheds light on the value of ratings to issuers and buyers. With issuers, it’s easy: Give me good ratings so that I can sell my bonds at low yields. With buyers, it is more complex: We do our own due diligence — we don’t fully trust the ratings, but they play into the risk management and capital frameworks that we use. We like the bonds to be highly rated, and misrated high even better, because we get to hold less capital against the bonds than if they were correctly rated, which raises our return on capital. Moody’s was always in third place behind S&P and Fitch in this market, so it’s not that big of a deal, but I bet Moody’s quietly drops the change.
The yields on loans are not only going up for LBOs like Archstone, leading to further deal delays, but yields are also rising on commercial real estate loans generally. Here is an example from one of the big deals. The risk appetite has shifted. Is it any surprise that equity REITs are off so much since early March? The deals just can’t get done at those high cap rates anymore.
An old boss of mine used to say, “Liquidity is a ‘fraidy cat.” It’s never there when you really need it, and with residential mortgage finance now, the ability to refinance is being withdrawn at the very time it is needed most. What types of mortgages are now harder to get? No money down, Jumbo loans, Alt-A, more Alt-A, and you don’t have to mention subprime here, the pullback is pretty general, with the exception of conforming loans that are bought by Fannie and Freddie. For (perverse) fun, you can see how detailed the guidance to lenders can become.
Should it then surprise us if some buyers of mortgage loans have gotten skittish? No, they forced the change on the originators. A buyers strike. But maybe that’s not the right move now. Let me tell you a story. When I came to Provident Mutual in 1992, the commercial mortgage market was in a panic. The main lines of business of Provident Mutual, hungry for yield, had accepted low-ish spreads from commercial mortgages from 1989-1991, because it improved their yield incrementally. The Pension Division avoided commercial mortgages then, because they felt the risks were not being fairly compensated. In 1992, the head of the commercial mortgage area came to the chief actuary of the pension division, and told him that unless the Pension Division bought their mortgage flow, they would have to shut down, because the main lines couldn’t take any. The chief actuary asked what spreads he would get, and the spreads were high — 3% over Treasuries, much better than before. He asked about loan quality, and was told that they had never had such high quality loans; only the best deals were getting done because of the panic in the market. The chief actuary, the best actuarial businessman I have ever known grabbed the opportunity, and took the entire mortgage flow for the next two years, then stopped. (Saving the Mortgage Division was icing on the cake.) Spreads normalized; credit quality was only average, and the main lines of the company now wanted mortgages. The point of the story is this: the firms that will do best now are not the ones that refuse to lend, but the ones who lend to high quality borrowers at appropriate rates. It’s good to lend selectively in a panic.
Eventually the ARM mortgage reset surge will be gone. Really. We just have to slog through the next two years or so. This will lead to additional mortgage delinquencies and defaults. We’re not done yet. There is a lot of mis-financed housing out there, and unless the borrowers can refinance before the fixed rate period ends to a cheap-ish conventional loan, I don’t see how the defaults will be avoided. Remember houses are long-term assets. Long term assets require long-term financing. Floating rates don’t make it. Non-amortizing loans don’t make it.
Should it then surprise us that the downturn in housing prices is large? No. With all of the excess supply, from home sellers and homebuilders, current prices are not clearing most of the local real estate markets, and prices need to fall further. (Maybe we should offer citizenship to foreigners who buy US residential real estate worth more than $500,000. A win-win-win. Excess supply goes away. Current account deficit reduced. Wealthy foreigners get a safe place to flee, should they need it. 😉 )
As a result, the homebuilders are doing badly. They aren’t making money on the hgomes they build and the value of the land (and land options, JVs, etc.) that they bought during the frenzy is worth a lot less. Sunk costs are sunk, and though you lose money on an accounting basis, in the short run, it is optimal to builders to finish developments that they started.
Could I get John Hussman to like this Fed Model? It’s from the eminent Paul Kasriel, and it compares the earnings yield of residential real estate and Treasury yields, and he suggested in early June that residential real estate was overvalued. There are limitations here; no consideration of inflation and capital gains, no consideration of the spread of mortgage yields over Treasuries. The result is clear enough, though. Don’t own residential real estate when you can earn more in Treasuries than you can in rents. (I know real estate is local, frictional costs, etc., but it does give guidance at the margins.)
As I write this, I am listening to a replay of the RAM Holdings Conference Call that happened on Monday.? RAM Holdings did not have a good day in the market yesterday, losing 44.5%? of their market value.? What went wrong?
Investors are more attuned to subprime, and so the merest hint of trouble sends them running for the exits.
They are more attuned to CDOs, and so the merest hint of trouble sends them running for the exits.
They commented that premium volume might decline over the remainder of the year.
They only met the earnings estimate.
The cost of their soft capital facility has risen to LIBOR+200, the maximum, leading them to question whether they can’t replace the facility with something better.?? (My guess? No.)
The conference call focused on subprime, CDOs, and the more shadowy bits of their guarantees.
So what does RAM Holdings do?? They reinsure the primary AAA financial guarantors.? They are the only AAA reinsurer that does not compete with the primary insurers.? Typically, they try to take an equal slice of all of the business that MBIA, Ambac, FGIC, FSA, and the three others produce each year.? In that sense, you can think of them as a small version of what the average of the financial guarantee industry would be like if it were a single company.? Unlike a P&C reinsurer, losses kick in only after a threshold is met, and then a lot of losses get paid, with RAM Holdings, the losses are pro-rata from the first dollar.? The primary insurers would have no advantage passing them bad business, because they would be more affected by the bad business.
I’m reviewing RAM Holdings as a possible purchase candidate.? If I were running a small cap fund, I would definitely start tossing some in now.? Why?? It’s trading at less than 35% of adjusted book value, and the balance sheet is good in my opinion, and the opinions of S&P and Moody’s.?? If I were running a hedge fund, I would buy RAM and short equal amounts of MBI, ABK, SCA and AGO.? Why?? If RAM is really in this much trouble, it is likely that MBIA, Ambac, Security Capital and Assured Guaranty are in the same trouble.
Aside from that, their subprime exposure is small-ish and seasoned.? Their CDO exposure is almost all AAA, with super-senior attachment points (i.e. non-guaranteed AAA bonds would have to lose it all before thet pay dollar one of guarantees).? Honestly, I’m probably more concerned about the BBB HELOC and closed-end second lien mortgage exposure.? I would need more data on that before I could act.
Then there’s Safety Insurance, which was up 12.0% on Monday.? What went right?
Unlike Commerce Group, which missed, they beat estimates handily.
They raised their dividend by 60%, from $1.00 to $1.60.
They announced a $30 million buyback (and they have the money to do it).
The asset side of their balance sheet carries little credit risk.
Now, Safety faces its challenges as the Massachusetts auto insurance market possibly partially deregulates, but Safety has successfully competed in a variety of different market regimes in the state.? The current management team has shown itself to be very adept at adjusting to changing conditions.
Even with change, Massachusetts will still be the most heavy handed state in the US with auto insurance.? It won’t attract a lot of new entrants.? And, it is possible that no change will happen… previous deregulatory plans have come and gone, though this one has more political clout behind it.
Safety is still cheap to me at 1.0x book value, and 7.6x 2008 estimated earnings.? I’m hanging around for more.
I know that Cramer and many others consider the news from the Bear Stearns call to be the financial equivalent of nuclear meltdown, but it’s not true: Exhibit 1 is the graphic above from The Wall Street Journal (full story here). If you look closely at the graph, junk bonds had a small positive return last week. That would not be true in a crisis.
So what is the crisis? The crisis is in the exotic stuff.
Subprime ABS [asset-backed securities]
Credit default swaps and other derivatives on Subprime ABS
LBO debt that some of the investment banks are stuck with.
Some high yield bonds and loans on deals that got done before the music stopped
Derivatives on broad classes of instruments like LCDX and CMBX.
But for the most part, for most high yield debt, almost all investment grade debt, and vanilla structured securities, the market is functioning. If anyone knows differently please contact me.Natively, I tend to be a skeptic and a bear. But I try to be a realist above all. I was managing a large portfolio of corporate bonds 2001-2003, and a large portfolio of CMBS (with a little ABS and RMBS) from 1998-2001. In 2002, the investment grade bond market shut down briefly on the mornings of two days, in July and October. (I remember my favorite broker saying to me each time, “The markets are offered without bid. What would you like to do? I had spare capital for the occasion and offered enough lowball bids to satisfy the extreme liquidity needs of the frightened.) At that time, the VIX and other systemic risk variables were thorough the roof. Those variables aren’t there now. After 9/11, the whole fixed income market was closed for five days, and even once it re-opened, it took two weeks to approach anything near normal. (People told me I was courageous/stupid to offer lowball bids on day two after the market reopened. They turned out to be good trades. I have stories from that period… as a bond manager, I am at my best in crisis mode.)
In 1998, when LTCM blew up, the bond market shut down. Only the highest quality stuff traded for about three weeks. I remember buying some AAA CMBS for almost 2% over Treasuries. We aren’t there at present; not even close.
Bear Stearns can make the statements that they did because they have a concentration in areas that are affected. They also want to make it look like as much of a market problem as possible, and not a Bear Stearns problem. For Bear Stearns, this very well could be the worst bond market for them in 22 years. Just not for the Street as a whole, at least not yet.
I write this not to make people bullish, but just to point out that characterizing the bond market as a whole is tough, and that things are rarely as bad as they seem. From my angle, I will say that I have seen it worse.
PS — A final note. After any crisis, how does the fixed income market comes back? It start with trading of bonds that are high quality, high simplicity, and short in duration. As the crisis abates, bond managers get tempted by the high yields of bonds that are lower in quality, lower in simplicity, and longer in duration. As the risk appetite expands, eventually the whole bond market comes back.
Subprime lending is grabbing a lot of attention, but it is only a tiny portion of what goes on in our capital markets.? Tonight I want to talk about speculation in our markets, while largely ignoring subprime.
I have grown to like the blog Accrued Interest.? There aren?t many blogs dealing with fixed income issues; it fills a real void.? This article deals with bridge loans; increasingly, as investors have grown more skittish over LBO debt, investment banks have had to retain the bridge loans, rather than selling off the loans to other investors.? Google ?Ohio Mattress,? and you can see the danger here.? Deals where the debt interests don?t get sold off can become toxic to the investment banks extending the bridge loans.? (And being a Milwaukee native, I can appreciate the concept of a ?bridge to nowhere.?? Maybe the investment bankers should visit Milwaukee, because the ?bridge to nowhere? eventually completed, and made it to South Milwaukee.? Quite an improvement over nowhere, right? Right?!? Sigh.)
Also from Accrued Interest, the credit markets have some sand in the gears.? I remember fondly the pit in my stomach when my brokers called me on July 27th and October 9th, 2002, and said, ?The markets are offered without bid.? We?ve never seen it this bad.? What do you want to do??? I had cash on hand for bargains both times, but when the credit markets are dislocated, nothing much happens for a little while.? This was true after LTCM and 9/11 as well.
I?ve seen a number of reviews of Dr. Bookstaber?s new book.? It looks like a good one. As in the last point, when the markets get spooked, spreads widen dramatically,and trading slows until confidence returns.? More bad things are feared to happen than actually do happen.
I?m not a fan of shorting, particularly in this environment.? Too many players are short without a real edge.? High valuations are not enough, you need to have an uncommon edge.? When I short, that typically means an accounting anomaly.? That said, there is more demand for short ideas with the advent of 130/30 and 120/20 funds.? Personally, I think they are asking for more than the system can deliver.? Obvious shorts are full up, and inobvious shorts are inobvious for a reason; they aren?t easy money.
From the ?Too Many Vultures? file, Goldman announces a $12.5 billion mezzanine fund.? With so much money chasing failures, the prices paid to failures will rise in the short run, until the vultures get scared.
Finally, and investment bank that understands the risk behind CPDOs.? I have been a bear on these for some time; perhaps the rapidly rising spread environment might cause a CPDO to unwind?
Passive futures as a diversifier made a lot of sense before so many pension plans and endowments invested in it.? Recent returns have been disappointing, leading some passive investors to leave their investments in crude oil (and other commodities).? With less pressure on the roll in crude oil, the contango has lessened, which makes a passive investment in commodities, particularly crude oil, more attractive.
When trading ended on Friday, my oscillator ended at the fourth most negative level ever. Going back to 1997, the other bad dates were May 2006, July 2002 and September 2001. At levels like this, we always get a bounce, at least, so far.
We lost our NYSE feed on Bloomberg for the last 25 minutes of the trading day. Anyone else have a similar outage? I know Cramer is outraged over the break in the tape around 3PM, and how the lack of specialists exacerbated the move. Can?t say that I disagree; it may cost a little more to have an intermediated market, but if the specialist does his job (and many don?t), volatility is reduced, and panics are more slow to occur.
Perhaps Babak at Trader?s Narrative would agree on the likelihood of a bounce, with the put/call ratio so high.
The bond market on the whole responded rationally last week. There was a flight to quality. High yield spreads continued to move wider, and the more junky, the more widening. Less noticed: the yields on safe debt, high quality governments, agencies, mortgages, industrials and utilities fell, as the flight to quality benefitted high quality borrowers. Here?s another summary of the action on Thursday, though it should be noted that Treasury yields fell more than investment grade debt spreads rose.
Shhhhh. I?m not sure I should say this, but maybe the investment banks are cheap here. I?ve seen several analyses showing that the exposure from LBO debt is small. Now there are other issues, but the investment banks generally benefit from increased volatility in their trading income.
Comparisons to October 1987? My friend Aaron Pressman makes a bold effort, but I have to give the most serious difference between then and now. At the beginning of October 1987, BBB bonds yielded 7.05% more than the S&P 500 earnings yield. Today, that figure is closer to 0.40%. In October 1987, bonds were cheap to stocks; today it is the reverse.
Now, a trailing indicator is mutual fund flows. Selling equities and high yield? No surprise. Most retail investors shut the barn door after the cow has run off.
Deals get scrapped, at least for now, and the overall risk tenor of the market shifts because player come to their senses, realizing that the risk is higher than the reward. El-Erian of Harvard may suggest that we have hit upon a regime change, but I would argue that such a judgment is premature. We have too many bright people looking for turning points, which may make a turning point less likely.
Are we really going to have credit difficulties with prime loans? I have suggested as much at RealMoney over the past two years, to much disbelief. Falling house prices will have negative impacts everywhere in housing. Still, it more likely that Alt-A loans get negative results, given the lower underwriting standards involved.
How much risk do hedge funds pose to the financial system?? My view is that the most severe risks of the financial system are being taken on by hedge funds.? If these hedge funds are fully capitalized by equity (not borrowing money or other assets), then there is little risk to the financial system.? The problem is that many do finance their positions, as has been seen in the Bear Stearns hedge funds, magnifying the loss, and wiping out most if not all of the equity.
There is a tendency with hedge funds to hedge away ?vanilla risks? (my phrase), while retaining the concentrated risks that have a greater tendency to be mispriced.? I want to get a copy of Richard Bookstaber?s new book that makes this point.? Let?s face it.? Most hedging is done through liquid instruments to hedge less liquid instruments with greater return potential.? Most hedge funds are fundamentally short liquidity, and are subject to trouble when liquidity gets scarce (which ususally means, credit spreads rise dramatically).
Every investment strategy has a limit as to how much cash it can employ, no matter how smart the people are running the strategy.? Inefficiencies are finite.? Now Renaissance Institutional is feeling the pain.? My greater question here is whether they have pushed up the prices of assets that they own to levels not generally supportable in their absence, simply due to their growth in assets?? Big firms often create their own mini-bubbles when they pass the limit of how much money they can run in a strategy.? Asset growth is self-reinforcing to performance, until you pass the limit.
I have seen the statistic criticized, but it is still true that we are at a high for short interest.? When short interest gets too high, it is difficult but not impossible for prices to fall a great deal.? The degree of short interest can affect the short-term price path of a security, but cannot affect the long term business outcome.? Shorts are ?side bets? that do not affect the ultimate outcome (leaving aside toxic converts, etc.).
Doug Kass takes a swipe at easy credit conditions that facilitated the aggressive nature of many hedge funds.? This is one to lay at the feet of foreign banks and US banks interested in keeping their earnings growing, without care for risk.
Should you be worried if you have an interest in the equity of CDOs?? (Your defined benefit pension plan, should you have one, may own some of those?)? At present the key factors are these? does the CDO have exposure to subprime or Alt-A lending, home equity lending, or Single-B or lower high yield debt?? If so, you have reason to worry.? Those with investment grade debt, or non-housing related Asset-backed securities have less reason to worry.
There have been a lot of bits and bytes spilled over mark-to-model.? I want to raise a slightly different issue: mark-to-models.? There isn?t just one model, and human nature being what it is, there is a tendency for economic actors to choose models that are more favorable to themselves.? This raises the problem that one long an illiquid asset, and one short an illiquid asset might choose different values for the asset, leading to a deadweight loss in aggregate, because when the position matures, on net, a loss will be taken between the two parties.? For a one-sided example of this you can review Berky?s attempts to close out Gen Re?s swap book; they lost a lot more than they anticipated, because their model marks were too favorable.
If you need more proof of that point, review this article on how hedge funds are smoothing their returns through marks on illiquid securities.? Though the article doesn?t state that thereis any aggregate mis-marking, I personally would find that difficult to believe.
If you need still more proof, consider this article.? The problem for hedge fund managers gets worse when illiquid assets are financed by debt.? At that point, variations in the marked prices become severe in their impacts, particularly if debt covenants are threatened.
Regarding 130/30 funds, particularly in an era of record shorting, I don?t see how they can add a lot of value.? For the few that have good alpha generation from your longs, levering them up 30% is a help, but only if your shorting discipline doesn?t eat away as much alpha as the long strategy generates.? Few managers are good at both going long and short.? Few are good at going short, period.? One more thing, is it any surprise that after a long run in the market, we see 130/30 funds marketed, rather than the market-neutral funds that show up near the end of bear markets?
Investors like yield.? This is true of institutional investors as well as retail investors.? Yield by its nature is a promise, offering certainty, whereas capital gains and losses are ephemeral.? This is one reason why I prefer high quality investments most of the time in fixed income investing.? I will happily make money by avoiding capital losses, while accepting less income in speculative environments.? Most investors aren?t this way, so they take undue risk in search of yield.? There is an actionable investment idea here!? Create the White Swan bond fund, where one invests in T-bills, and write out of the money options on a variety of fixed income risks that are directly underpriced in the fixed income markets, but fairly priced in the options markets.? Better, run an arb fund that attempts to extract the difference.
Most of the time, I like corporate floating rate loan funds.? They provide a decent yield that floats of short rates, with low-ish credit risk.? But in this environment, where LBO financing is shaky, I would avoid the closed end funds unless the discount to NAV got above 8%, and I would not put on a full position, unless the discount exceeded 12%.? From the article, the fund with the ticker JGT intrigues me.
This article from Information Arbitrage is dead on.? No regulator is ever as decisive as a margin desk.? The moment that a margin desk has a hint that it might lose money, it moves to liquidate collateral.
As I have said before, there are many vultures and little carrion.? I am waiting for the vultures to get glutted.? At that point I could then say that the liquidity effect is spent. Then I would really be worried.
Retail money trails.? No surprise here.? People who don?t follow the markets constantly get surprised by losses, and move to cut the posses, usually too late.
One more for Information Arbitrage.? Hedge funds with real risk controls can survive environments like this, and make money on the other side of the cycle.? Where I differ with his opinion is how credit instruments should be priced.? Liquidation value is too severe in most environments, and does not give adequate value to those who exit, and gives too much value to those who enter.? Proper valuation considers both the likelihood of being a going concern, and being in liquidation.
That?s all in this series.? I?ll take up other issues tomorrow, DV.? Until then, be aware of the games people play when there are illiquid assets and leverage? definitely a toxic mix.? In this cycle, might simplicity will come into vogue again?? Could balanced funds become the new orthodoxy?? I?m not holding my breath.
A smaller piece to end this series.? If you have read all four parts of the series, you won’t need to read the compilation post that I am putting together for Barry Ritholtz at The Big Picture, so that he can use it in his linkfest.
Regarding 130/30 funds, particularly in an era of record shorting, I don’t see how they can add a lot of value.? For the few that have good alpha generation from your longs, levering them up 30% is a help, but only if your shorting discipline doesn’t eat away as much alpha as the long strategy generates.? Few managers are good at both going long and short.? Few are good at going short, period.? One more thing, is it any surprise that after a long run in the market, we see 130/30 funds marketed, rather than the market-neutral funds that show up near the end of bear markets?
Investors like yield.? This is true of institutional investors as well as retail investors.? Yield by its nature is a promise, offering certainty, whereas capital gains and losses are ephemeral.? This is one reason why I prefer high quality investments most of the time in fixed income investing.? I will happily make money by avoiding capital losses, while accepting less income in speculative environments.? Most investors aren’t this way, so they take undue risk in search of yield.? There is an actionable investment idea here!? Create the White Swan bond fund, where one invests in T-bills, and write out of the money options on a variety of fixed income risks that are directly underpriced in the fixed income markets, but fairly priced in the options markets.? Better, run an arb fund that attempts to extract the difference.
Most of the time, I like corporate floating rate loan funds.? They provide a decent yield that floats of short rates, with low-ish credit risk.? But in this environment, where LBO financing is shaky, I would avoid the closed end funds unless the discount to NAV got above 8%, and I would not put on a full position, unless the discount exceeded 12%.? From the article, the fund with the ticker JGT intrigues me.
This article from Information Arbitrage is dead on.? No regulator is ever as decisive as a margin desk.? The moment that a margin desk has a hint that it might lose money, it moves to liquidate collateral.
As I have said before, there are many vultures and little carrion.? I am waiting for the vultures to get glutted.? At that point I could then say that the liquidity effect is spent. Then I would really be worried.
Retail money trails.? No surprise here.? People who don’t follow the markets constantly get surprised by losses, and move to cut the posses, usually too late.
One more for Information Arbitrage.? Hedge funds with real risk controls can survive environments like this, and make money on the other side of the cycle.? Where I differ with his opinion is how credit instruments should be priced.? Liquidation value is too severe in most environments, and does not give adequate value to those who exit, and gives too much value to those who enter.? Proper valuation considers both the likelihood of being a going concern, and being in liquidation.
I know that Cramer and many others consider the news from the Bear Stearns call to be the financial equivalent of nuclear meltdown, but it’s not true: Exhibit 1 is the graphic above from The Wall Street Journal (