Fifteen Notes on the State of the Markets

Fifteen Notes on the State of the Markets

1)? Start with the pessimists:


2)? Move to the optimists:

3) Hedge funds are getting outflows at present (and here), and August performance was pretty bad (and here — look at? “Splutter”).? I began toting up a list of notable losers, but it got too big.? One positive note, many of the large quant funds bounced back from their mid-August stress.

4)? When muni bonds get interesting, you know it’s a weird environment.? It starts with the fundamental mismatch of muni bonds.? Muni issuers want to lock in long term financing, but most investors want to invest shorter.? Along come some trusts that buy long bonds and sell short-dated participations against them, and hedge the curve risk with Treasuries.? When credit stress got high, long munis were sold because they could be, and long Treasuries rallied, which was the opposite of what was needed for a hedge.? (Note: hedging with Treasuries can work in normal markets, but fails utterly in panics, as happened in 1998.)? When the selling was done, in many cases high quality muni yields were high than Treasuries even before adjusting for taxes.? That didn’t last long, but munis are still a good deal here.

5) Large caps are outperforming small caps.? Foreign exposure that large caps have here is a plus.

6) Not all emerging markets are created equal.? Some are more likely to have trouble because they are reliant on foreign financing. (Latvia, Iceland, Bulgaria, Turkey, Romania)? Others are more likely to have trouble if the US economy slows down, because they export to us. (Mexico, Israel, Jordan, Thailand, Taiwan, Peru)? I would be more concerned about the first group.

7) Are global banks cheap?? Yes on an earnings basis, probably not on a book basis.? We need to see some writedowns here before the group gets interesting.

8) I’ve talked about SFAS 159 before, and you know I think it is a bad accounting rule.? This article from my friend Peter Eavis helps to point out some of the ways that it allows too much freedom to managements to revalue assets up.? What I would watch in financial companies is any significant increase in their need for financing, which could point out real illiquidity, even though the balance sheet might look strong; this one is tough because financials are opaque, and the cash flow statement is not so useful.? Poring over the SFAS 159 disclosures will be required as well.

9) As I have suggested, pension plans will probably end up with a decent amount of the hit from subprime lending, through their hedge fund-of-funds.

10) Hedge funds do better if the managers went to schools that had high average SAT scores?? I would not have guessed that.? Many of the best investors I have known were clever people who went to average schools.

11) My but bond trading has changed.? When I was a corporates manager, hedge funds weren’t a factor in trading.? Now they are 30% of the market.? Wow.? Surprises me that volatility isn’t higher.

12) Rich Bernstein of Merrill (bright guy) is getting his day in the sun.? His call for outperformance of quality assets seems to be happening.? Now the question is whether the cost of capital is going up globally or not.? If so, he says to avoid: “1) China, 2) emerging market infrastructure, 3) small stocks, 4) indebted U.S. consumers, 5) financial companies, 6) commodities and energy companies.“? Personally, I think the cost of capital is rising for companies rated BBB and below, which brings it back to the quality trade.

13) Econocator asks if markets have priced in a recession, and he says no. My problem with the analysis is that we would need 10-year Treasury yields in the 2.5% area to fully price it in by his measure, and that makes no sense, outside of a depression, and then, nothing is priced in.

14) Morningstar moves into options research.? Could be interesting, though Value line has had a similar publication, and I’m not sure that the market for publications like this is big enough.? They make a good point that most people use options wrong, and get the short end of the stick.

15) Oil is amazing, but wheat is through the roof.? I’ve seen articles about bread prices rising.? Fortunately, the cost of grain is a small part of the cost of foods that rely on grain.

With that, I bid you good night.

Eight Notes on Residential Real Estate

Eight Notes on Residential Real Estate

For those wanting a road map of where I am likely to post over the next few days, tonight is mortgages and real estate, tomorrow is speculation, and Friday should involve longer dated topics. For those that commented on the blog redesign, I want to say that I appreciated your comments, particularly the critical ones. In the next two months, I’ll be doing a minor redesign to fix some of the flaws that I introduced in the process. I’m not perfectly happy with the result, and it can be improved. Trivia: I co-edited the best high school yearbook in the nation back in 1979, so I do have some eye for design. It’s more of a question of the computer implementation.

Onto real estate:

1) After a bubble bursts, it’s amazing the details that come out on the ethical lapses that transpired. With Countrywide, people were steered into loans that were worse than what they might have qualified for there or elsewhere. Now, they should have shopped around; I always do that on mortgage loans. That Countrywide is still facing problems after the Bank of America infusion might not be too surprising; companies that cut corners with their customers are more likely to be aggressive in their accounting practices. After the post-bailout bounce, the convertible preferred that Countrywide got is now under the $18 strike price.

CFC price chart

2) Can the mortgage crisis swallow a town?? Yes.? I know this personally, as some friends of mine on the Eastern Shore of Maryland are finding out right now.? They are not in one of the best areas, and demand has dropped off a cliff.? Entire neighborhoods near them are in bad shape, making everything else less salable.? They need to sell their home for medical reasons, and they can’t do it without taking a loss, which would impoverish them.

3) The internals of the housing market are now such that no one is arguing over the troubles faced.? Consider:

4) But won’t the President and Congress bail out strapped homeowners?? Tough task.? Current proposals are just dust on the scales, and doing anything big would be a budget-buster.? I agree with Accrued Interest; a bailout is bad policy.? I suspect one will happen anyway.? Washington, DC specializes in bad policy, if it wins votes.

5)? After a bubble bursts the second order effects can be quite significant.? Consider:

6) Now, I wonder if Merrill Lynch will have any significant hits from subprime.? I would expect it, but who can tell for sure?

7)? Was it such a good idea for the US government to promote home ownership so vigorously?? I have generally said no, and Caroline Baum questions the wisdom of the policy as well.

8) Finally, we keep them in a bubble to make sure that their theories on how the economy works do not get contaminated by data.? I’m partly kidding here, but the Fed is very optimistic that any spillover from residential real estate to the general economy will be light.? I think the effect will be moderate; it will definitely hurt, but not destroy the US economy.

Tickers mentioned: BAC CFC GS MER

Looking Beyond the US

Looking Beyond the US

So, what’s happening in the global economy?? Let’s start with the weak dollar.? As Fed policy tilts toward loosening, the already weak dollar hits a 15-year low, and is less than 2% from an all time low.? The carry trade currencies, the yen and the Swiss franc, rallied the most during the dollar sell-off.? (Here’s a good summary article on the carry trade.)

It’s not that foreigners are fleeing the dollar (unlike this article), though Treasuries are getting less attractive, because the dollar-based investments must be bought by someone.? That doesn’t mean the exchange rates don’t shift down in the process, though, and exports seem to be improving because of the weaker dollar.? Also, the idea that China would try to ruin the US through selling all of their dollar-based reserves is unlikely, though not impossible.? China is too big of a holder to sell without driving the dollar down massively, which would force down the value of their remaining holdings, and harm their ability to export to the US.

Besides, what would they trade into?? The US has the largest, most diverse debt markets in the world.? One reas
on why the US is the world’s reserve currency, despite all of its flaws, is that there is no other economy with a currency capable of filling the role.? Perhaps this article should have been titled, “Why isn’t the dollar falling more?” because the dollar has been falling, yet there are some things good about the dollar, and the US economy.

China is bumping up against the boundaries of its economy’s current capacity.? With few additional young laborers, wage rates are rising.? Inflation is now at a 10-year high.? That’s leading the government to tighten monetary policy.? Beyond that, it is raising the prices of their exports, which slowly forces inflation into the US and other trading partners.

India is facing similar difficulties.? Wages are rising rapidly, amid rapid real growth, putting pressure on interest rates to rise.? In one sense, this is what you get for taking back US assets in exchange for selling goods and services to the US.? So long as your labor pool appears inexhaustible, you can avoid inflation at home, because you aren’t paying new workers much.? But when workers become more scarce, the absence of imported goods for those workers to buy means that there will be inflation.? Also, excess dollar reserves often produce excess credit, if the central bank allows the money supply to grow from the dollar reserves, which can lead to credit-induced inflation.

Final quick notes:

In summary, we are in a situation where the dollar is likely to remain weak.? If currency calm returns, the carry-trade currencies will do badly, but if volatility picks up, the opposite will happen.? (I can make a case either way.)? China and India are on fire, and the developed nations are largely on ice.? We are living in interesting times; in the long run, the development of the poorer areas of the world will be a big plus, particularly for US agriculture and resource extraction industries, but there will be bumps along the way.? Keep your positions flexible enough to be able to benefit from volatility; I sense we are entering a more volatile period.

My 9/11 Experience

My 9/11 Experience

Six years ago, I was a neophyte (2 months) corporate bond manager, also doing mortgage bonds, and nominally Chief Investment Officer of a medium-sized life insurance company. I was leading our asset management team through a merger with another firm as well. On 9/11, I was going to have a meeting with my new bosses and the management of our one and only life insurance client.

I was running a little late, so I got to the office as the first tower fell. I talked with a few of my brokers, and concluded that nothing would be trading today. After the second tower fell, our offices were crowded from people in the insurance company watching the spectacle on CNBC. I told my staff to prepare a broad threat report, describing what parts of our portfolio would be harmed by the events; after that, they could go home and grieve. (Our KBW coverage died that day; he was a good fellow.) I went to the meeting, where we canceled our agenda, and I gave a brief threat report, and told them they would have full threat report every day at 4PM until the markets normalized. Aside from owning part of a mortgage on a building near the World Trade Center (One Liberty Plaza) which was rumored to be leaning (not true), the problems were pretty light; liquidity was adequate.

That evening I showed my family video clips from the Internet, and explained what had happened. We’re a pretty matter of fact bunch, so they took it in stride, and realized that the world had changed for the worse.
Because of the merger, the portfolio was relatively high quality. Good thing, too. The markets were closed for the whole week, and reopened the next week. Bond markets are networks, and so, they come back proportionally to the square of the nodes. After one week, the bond market was half functional. After two weeks, 80% functional. After three weeks, 100% functional. We started trading sooner than most, and offered liquidity in exchange for good deals. When our merger closed on 9/30, was began a massive down-in-credit trade, buying bonds in sectors most affected by the disaster. Our logic was that the terrorist event was a “one off” matter where the highjackers got really lucky, and that the odds of a second event were nil, now that the US was on alert.

When I went to a Chief investment Officer’s forum in October, there was a “closed door” meeting with “peer companies” to discuss problems and strategies. One of the early questions was how investment strategy had changed since 9/11. I was the odd man out. We were the only one in the room taking more risk. Everyone else was running up-in-credit trades, and avoiding affected sectors. Not only did I get a “you’re weird” look from the other participants, but I got the “you’re irresponsible” look as well. Not fun.

We continued the down-in-credit trade for another month until we had gone as far as we thought prudent. Then our client came to us and said that the ratings agency heard what we were doing, and told us to knock it off, or face a downgrade. We were done, so we agreed. By this time, it was mid-November. By December, a little more willingness to take risk took hold, and by the first quarter of 2002, there was a full-fledged scramble for yield. We sold into it, doing a massive up-in-credit trade that left the portfolio higher quality than it was prior to 9/11, and giving us room for the upset that would happen as Worldcom went down, and the corporate bond markets doing a double dip in late July and early October. We played the risk cycle very well.


There are four investment points here:

  • Don’t follow the crowds during panics.
  • Don’t follow the crowds during manias.
  • Know your limits. No matter how good an idea will work out eventually, don’t overplay it, because the market can be crazy longer than you can stay solvent.
  • After a panic event, analyze what has truly changed, and ask what things will be like when the next steady state comes, and how long it will likely take to get there.

It was not a consensus view at the time, but the idea that not much had changed permanently proved to be a valuable idea. Capitalist economies tend to be resilient, bending but not breaking. With that, guard your emotions, and try to be analytical toward investing, even when times are abnormal, and people think you are nuts.

The Road from Here to Stagflation

The Road from Here to Stagflation

Cramer again.? This time I disagree more, because he is talking about the Fed.? He has five views of the Fed that he hates.? Let me take them in order:

1) The Fed doesn’t matter — It depends.? In the short run, when the Fed loosens, healthy assets get stimulated, but damaged assets don’t.? In the intermediate run, companies get financing from healthy financials to reconcile dud assets that were misfinanced, but the process takes time, maybe a year or two.


2) The Fed is pushing on a string — Initially, it will look like that is true.? It almost always does. Things that are viewed as problems now will not be helped by the initial effects of Fed policy.

3) The economy won’t react to the Fed, no matter what — Cramer is right to dis this one.? The Fed will revive nominal growth after a year or two.? The hard question is how much comes from inflation, and how much comes from real growth.

4) The dollar collapses because of cuts — Here I disagree with Cramer.? The dollar will decline.? Interest rates are a more powerful factor than GDP growth in exchange rates, because financial transactions are larger than trade in goods by an order of magnitude.

5) The Fed doesn’t want to do anything and doesn’t have to do anything — Well, true on its face, but the Fed is a political creature.? It responds to market signals, and it has signaled that it wants to “solve this problem.”? Cramer is correct here.? The Fed will act; the only question is how much.

But ask yourself a different question. How could the Fed break the logjam in the commercial paper market, particularly ABCP?? I clipped a lot of articles on this.? There is a lot of CP maturing (maybe $140 billion) in the next week or so.? It is not the banks that are so much at risk, though some will have to collapse conduits and bring asset back onto their balance sheets, lowering capital ratios. ? The non-banks are the ones getting smashed, and the banks may have modest exposure to their woes.? Information Arbitrage has it right when he says that this is a case of misfinancing assets.? (Hey, maybe the Fed could directly monetize ABCP by buying it instead of Treasury notes.? No, no, please don’t… 🙁 )

Now, how much will the FOMC cut rates?? Unusually modest for PIMCO, they call for 1% by 2008.? (They never met a rate cut that they didn’t like.)? Fed Governor Plosser suggests that they have other tools they can use, without cutting the Fed funds rate. The ever-smart Jim Griffin concludes that the main risk to the Fed at present is inaction, and I agree.? At a time like this, the FOMC must do something notable, or the political heat cranks up.? Then again, we can look at the Treasury bond market as a whole, and easily conclude that at least 1% of loosening is in the foreseeable future.? As Caroline Baum puts it, “The fact that the funds rate is hovering so far above the rest of the yield curve is the most obvious sign that policy is tight. Yet Fed officials seem determined to see evidence of it in the real economy before they relent.”

Four quick notes before I end:

  1. Remember that Fed funds futures are typically only good for predicting the next meeting, and nothing beyond that.
  2. There’s still a lot of subprime debt to be reconciled in money market funds.
  3. Central banks are supposed to help with illiquidity but not insolvency.? At the edges, this is not so clear.? Illiquidity can lead to insolvency if bank capital levels are inadequate.
  4. An excellent summary article on all of this from the Bank of International Settlements, the central bankers’ central bank.

My summary: the FOMC will cut in September, and because monetary policy works slowly, they will be politically forced into more cuts than they would like, until signs of rising inflation cuts off the cuts sometime in 2008-9.? The yield curve will be much wider then, and then the hard choices faced in the 1970s will reappear, along with the s-word: stagflation.? I hesitate to use the word, because it is so sensationalistic, but I feel that we are headed there, slowly but surely.

Private Equity Financing: Thinking Long-Term Versus Short-Term

Private Equity Financing: Thinking Long-Term Versus Short-Term

Early on Monday, Cramer put up a piece called, “KKR: Cut the Hubris, Start the Healing.” Good piece generally, but it got me thinking. One reason I was an effective corporate bond manager was the way that I treated my brokers. I had a few rules:

  • My brokers must always be paid. Doing me favors is nice, but I want your long term loyalty, and confidentiality.
  • If a broker makes a mistake in your favor, give him back a portion of the error if he asks (20%-30% of the price difference).
  • Hold good on my commitments, even if it hurts.
  • If the broker is way out of the market context, tell him. It earns loyalty.
  • Use brokers to their highest ability levels. Know who is sharp in a given market, and use them there. Don’t waste their time on names they don’t know.
  • If their risk control desk is forcing them to kick out a position, try to help them. This is an Androcles and the Lion situation, so be a good Androcles. They will often offer you some good deals for helping them, beyond that, that will help you when you need it.
  • Don’t take advantage of them in obvious ways. If you must flip newly issued bonds, do it through the syndicate (with a polite explanation that your analyst doesn’t like the deal, or that your risk controls are forcing you), or through a quiet third party.
  • Be as transparent as possible without giving away the real secrets of what you are doing. You can get better execution if they know you are not acting on private information that they don’t possess.
  • Be sharp. Show them that they can’t take advantage of you, but don’t be arrogant about it. Let your performance speak for itself.

That was a long digression, but here’s the point: focus on the long term value of the business relationship. Most bond managers and traders are very short term in their orientation, and it keeps the Street wary of them. The Street holds them at arm’s length, and the handshake is not friendship, but a check for weapons up the sleeve, as in the old days.

So what does this have to do with private equity and the banks? The private equity firms that have financing guaranteed by the banks have the banks over a barrel. At the same time, their deals are delayed, because the banks are dragging their feet. The solution isn’t hard, but it means that the private equity firms must give up a little in the short run to get the long run. Give up 20-30% of the loss that the banks are taking in order to soften the blow. Do it in a way that allows the banks to spread the loss, if you are clever enough, by agreeing to covenants, or other non-interest-rate means of improving the position of the banks.
The banks will groan, but they know that this is the best that they will get, and will take the deal. The log jams will begin to break, and the market will return to “normal,” though with more covenants and fewer guarantees on future deals. That is, until the next craze hits.

Therefore, I wasn’t surprised when KKR agreed to a minimum EBITDA covenant (earnings available to pay the creditors). That’s what is needed to allow the banks to “save face,” and do the deal. There are a lot of pending commitments in the loan market, perhaps as high as $540 billion. If you are a major private equity firm, and you have multiple deals being held up, these small compromises will grease the skids for not only today’s deal, but all of the deals in the pipeline. For those few that don’t compromise, yes, the deal will get done eventually, but you will sour relationships on the Street.

Now, the banks may get some help as they seek financing for the deals. This is one place where the vultures are lining up. Private equity, hedge funds, hedge fund-of-funds, and banks are setting up funds to take advantage of the dislocation. This “crisis” will likely resolve more easily than the troubles over in mortgage finance.
In closing, five more random bits on private equity:

  1. When I look at the stock chart of Blackstone, it makes me want to find a black stone and toss it in to a pond to watch it sink. Quite an untimely stock offering.
  2. The rise in financing rates will cost private equity on future deals, and as they try to harvest their existing deals when they come to maturity.
  3. Now, private equity funds with uncommitted capital can benefit by purchasing deals cheaply from firms that are exiting.
  4. Here is an excellent article from Going Private on the concept of liquidity within private equity financing. It’s long but good, and my commentary can’t improve on it, so enjoy it.
  5. Finally, private equity is concerned about financing, but should be concerned the possibility of recession as well. After all, junk bonds and bank debt are very sensitive to slowdowns in economic activity.


As I said to a friend of mine once, it often pays to give up a little to get long term advantages. Private equity needs to show a little mercy here in order to do well in the long run. Investment banks are powerful friends to have, and they remember who has helped them, and who has hurt them.

Tickers mentioned: BX

Musing About Fed Policy and Credit Crunches

Musing About Fed Policy and Credit Crunches

For the last six years, I’ve had a reasonably good call on Federal Reserve policy.? That partly stems from having been an institutional fixed income investor in one way shape or form for fifteen years.? This dates back to my days at Provident Mutual where the company at that point in time left hedging decisions in the hands of the line of business actuaries.? In 1994, I sold GICs (Guaranteed Investment Contracts) like mad after the first Fed tightening, and ran unhedged.? Smooth move at the time, but that was too much power to grant me.? In hindsight, I was a novice then, and it could have gone badly wrong.

But at the present time, my view on the FOMC is cloudy.? It’s cloudy for a few reasons:

  1. Bernanke is new, and we really don’t know his reaction function.
  2. He has granted more autonomy to the Board of Governors to speak their minds, unlike Greenspan.
  3. There are more inflation hawks with voting rights at present than over the past two years.
  4. Using the discount window adds another dimension to the puzzle.? Unless the gap between the discount window and Fed funds is narrowed further, I don’t see it becoming a major factor, unless they further liberalize collateral requirements, and who may use the window.

Now, Bernanke has committed to act to avoid damage to the economy from conditions in the credit markets.? To me, this is important, not because I think the Fed can help the dead and dying — they can’t.? They can help the walking wounded, and overstimulate the healthy.? In the former cases, credit spreads dominate, in the latter credit spreads are still low.? From my angle, the Fed will slowly be forced to recognize that problems developed from speculation in residential real estate, CDOs, overdone arbitrage strategies and private equity are either a) too big to solve through monetary policy, without causing a lot of inflation, or b) they will try to “solve” the problem anyway, and hope that inflation doesn’t rise too much.

There’s no panacea here, and personally, I am not expecting anything too great out of the US equity markets if the Fed starts loosening.? After all, during the tightening cycle, the market rallied, including financials.? That was weird.? Weird things come in bunches; “Don’t fight the Fed” didn’t work last time.? Will it work this time?? Many are assuming that Fed policy will make the markets go because it has done so in the past.? When too many think so, it may not work.

Now, a week ago, some could say that conditions were normalizing in the credit markets.? I didn’t think so, and still don’t think so.? As an example, consider what I wrote at RealMoney on Friday:


David Merkel
Systemic Risk Gives Way to Mortgage Hedging
9/7/2007 3:27 PM EDT

Treasury and Swap rates have fallen enough that we are finally getting mortgage refinancing/hedging activity. 10-year swap spreads are 12 basis points below where they peaked a month ago, and 10-year swap rates, which serve as a proxy for prime 30-year mortgage rates, are 35 basis points below their 18-month moving average. The 10-year swap rate has come down 90 bps since the peak three months ago. Remember the panic then over higher rates? I wish I had put on more then, but I didn’t panic, and my bond positions did well.At present the discount window action is doing little; I struggled to find any mention of it last night. But M2 is showing some life, and my M3 proxy as well… quietly, banks in the Federal Reserve System are expanding their balance sheets, making up for the loss of commercial paper (and mebbe absorbing some collapsing conduits…). But the monetary base is stuck in the mud, and Fed funds averages 5% since the crisis began. Lotsa talk, but not much action.

I would let the long bonds ride here, because mortgage hedging sometimes takes on a life of its own. That doesn’t mean that systemic risk has gone away, but some of it is being hidden by mortgage hedging; interest rate swaps have many uses. You can still see the systemic risk in the TED spread (over 160 bp), and other option implied volatility measures.

For more fun, look at the TIPS market, where inflation protected bonds are outrunning nominal bonds. The longest TIPS is up more than 2% today. Wow. Also, the carry trade currencies (yen/swiss franc) have been running as well.

So, fear is alive and well, and so are prime mortgage bonds. What a fascinating day to watch the bond market in action.

Position: none, my prior bond positions are with the firm that I no longer work for…

Not that I am calling for a recession in 2007, but when a hawk like William Poole says that the odds of a recession are rising, it tells me that the Fed is looking for a reason to cut rates.? With the jobs report on Friday (which I think is over-analyzed relative to its true value), the FOMC may have more reason to cut.? If nothing else, it gives them political cover to cut.

Now, there are bigger issues here, and it is possible to be too shortsighted about current policy.? Efforts to solve the immediate problem can complicate future problems.? Even the actions of the ECB, in doing nothing at their recent meeting, sends a signal that the credit markets are more important than inflation.

Financial crises will always happen, and if we use monetary policy and bank regulation to try to avoid them in entire, we only set ourselves up for larger crises in the future.? (Ask Japan how much it likes low interest rates — they are really stimulative.)? Financial crises eventually end when bad debts are liquidated, or when financing is adequate to make it through.? In this case, the Fed will have a hard time fighting the large increase in debt to GDP.? (Also here.)? Bad loans have been made.? Regulation can deal with future loans to some limited degree, but monetary policy is at best a crude tool to deal with past mistakes.

It is outside the Fed’s mandate from Congress to deal with asset bubbles unless they affect inflation or full employment of labor.? Yet the Fed gets criticism for that.? Maybe Congress should get the criticism.? As it is, most of the current problems are manifesting on the short end of the yield curve, and among non-regulated lenders.? There are some assets that Asset backed commercial paper conduits should never have financed, as the SEC is now probing.? No surprise, though; the BIS saw this coming, after a fashion, and much more clearly than US regulators.? In any case, the problems in short-term lending are difficult to deal with.? Clearly, credit losses need to be taken by lenders who made bad loans; I don’t think that Fed policy can do much about that.

The deeper problem is that financial systems that rely on short-term lending are inherently unstable.? From the end of Alan Abelson’s column this week:

But, Stephanie [Pomboy] sighs, the current credit bust is not confined to real-estate lending. In truth, there are interest rate “resets” galore across the entire economy. Borrowing short has become a raging epidemic. Floating-rate paper now accounts for 54% of total debt issuance, up from 26% as recently as 2002. That means a startling $540 billion in corporate bonds will need to be rolled over next year.

The serial abusers in this realm are — who else? — financial enterprises, who need to replace a tidy $428 billion in debt next year, a third more than this year. In 2008, too, some $160 billion worth of leverage loans mature.

To top off this orgy of borrowing short, there’s the $87 trillion interest-rate swaps market. Essentially, she explains, here’s where long-term fixed-rate obligations are converted into floating-rate short-term notes. Swaps, Stephanie reports, accounted for more than half the growth in the $145 trillion derivatives market in the past two years.

What she foresees is a kind of financial Armageddon as the credit crunch deepens and widens. “Scarcely will they finish putting the subprime situation under house arrest” before policymakers will be forced to address similar problems in “credit-card debt, commercial-real-estate loans, CLOs…and beyond.”

As the credit engine sputters, the repair crew will be forced to “print and spend.” That, she says, is what gold has figured out. And what equities, we might add, are only beginning to learn.

Now, ignore the derivatives to a degree, because for every long there is a short.? So long as the counterparty risk management of the investment banks works, there should be no reason to worry.? (I wonder about this, but know that the investment banks are trying to manage this.)? The increasing prevalence of floating rate finance should make the system more sensitive to Fed policy, but even more to LIBOR in the Eurodollar-markets, which the Fed can’t directly affect.? That doesn’t mean that they won’t try, though, and to me, it indicates that he Fed will cut rates significantly through 2008, assuming that inflation or a rapidly falling dollar doesn’t intervene.

We live in interesting times.? I think that there is an inflation bias here, and that investors should prepare for it.

Throwing the Switch on a New Blog Design

Throwing the Switch on a New Blog Design

I feel a lot better now.? It took more effort than I expected to do the redesign, but now it is done.? Comments are welcome, as well as suggestions.? Would a calendar be useful, etc?? I did not expect that I would have to learn some PHP and CSS, but it proved useful to do so.? Almost makes me want to tell stories about programming exploits in my early career, but I think I would bore most of you silly.

Over the next few weeks, I will be adding some subdued advertising, and setting up an Amazon Store, with (initially) short reviews of investment books from which I have benefited.? If you want to buy the books, I appreciate it, but my service here will be to give you enough knowledge of what the book is about, that you can figure out whether it would really be of value to you or not.

On a different note, much of next week will be devoted to finishing my slides/talk that I will be giving to the Investment Section of the Society of Actuaries at the Annual Meeting on October 15th.? I’ll post the slides here when I’m done, and you all can have a look at them.? My talk is on the Global Macroeconomy.? Small topic, huh?? I offered others, but that was the one that they most wanted, and would be the most challenging for me.? Good thing that the markets have gotten so interesting — when they asked me to speak back in April, things were much quieter.

Again, I thank you for reading my blog, and particularly for those who register and comment.? You make the blog and my life richer.

Blog Notes

Blog Notes

No post tonight, because I spent a lot of time today working on my site redesign.? I’m afraid most of the time went for naught.? I am getting pretty close to completion, though, and when the new design goes live, I would like feedback on it.? I will miss some design elements of the current site, and I am still working with the new design to make it look better.? It is more functional than the present site, but it is not as pretty, and I’m afraid I’ll have to sacrifice there.? (On the other hand, maybe I need to get a book on PHP programming…)

One more note: Remember when I wrote about Timothy Sykes forthcoming book?? No?? Oh well, it’s for sale now, and there is a link at the bottom of this post.

Oh, wait, one more off-topic comment: be sure and check out this new feature at Google Maps.? Suppose I wanted to go from Baltimore to Milwaukee, but I wanted to go through Indianapolis.? I can type in “21042 to 53005” to generate a map, but then I can drag the path to Indianapolis, and it calculates the optimal path.? Other applications: you are looking at your work commute, and find that the optimal path goes through a construction zone.? You can drag the path to avoid the zone, and it calculates a new optimal path.? Pretty neat.

Stressing Credit Stress

Stressing Credit Stress

How bad will the credit crunch be?? Will it last into 2008?? Will it be worse than LTCM?? Is this the end of structured finance as we know it?? My quick answers: Yes, maybe, and no.? Structured finance is too useful of a concept to regulate too heavily.? Ratings are also difficult to do without from a regulatory standpoint.? The concept of “buyer beware” must apply to fixed income managers inside regulated financial institutions.? Ratings are ratings and not guarantees; they supply useful summary data, but are no substitute for due diligence.

Now, the ratings agencies’ stocks have been pinched by the crisis.? I think that they will bounce back, and on more weakness, I could be a buyer.? That said, it is interesting to see them edge away from their aggressive ratings on CPDOs [constant proportion debt obligations], particularly as the prices sink.

There may be some upward drivers for the ratings agencies.? After all, investment grade bonds are being issued like mad.? (Another reason to favor high quality companies at present.)? The head of Deutsche Bank sees the market normalizing.? (And maybe if you borrow in euros, it is.)? On the other hand, high yield spreads are at a new record for the past few years, and distressed debt is finally arriving in size.? (Maybe enough to choke all the vultures?)? Risk is real for junk grade companies, and residential real estate related assets.? The willingness to take financial risk has normalized; now it is time for the market to go beyond normal to petrified.? Now, who can help us more with petrified than Jeremy Grantham?? He sounds the alarm on real estate related assets, junk obligations, and the equity markets.

Finally, I should have included this in my last post, but the short term debt markets are rough in the UK as well.? UK LIBOR hit a 10-year high recently.? When many of the various LIBORs of the world are showing signs of fear, it is possible that a larger trouble is at hand.? Until recently, all of the major central banks of the world were tightening, all at once.? With the exception of Japan, I expect them all to begin loosening soon, and begin accepting higher rates of inflation.? Perhaps I have my next investing theme?

Full Disclosure: long DB

Theme: Overlay by Kaira