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

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

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

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

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

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

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

That’s all for tonight, I’m beat.

Full disclosure: long DB

Blog Notes

Blog Notes

Personal news before I start for this evening. My new computer arrived today, I got set up for my Bloomberg trial (I feel smarter already; I can do wonders with a Bloomberg Terminal), and I got my first bona fide offer for advertising on my blog. My problem — what do I charge, and do I need to redesign my site to create more real estate on the screen? Programming isn’t my problem there per se; HTML isn’t rocket science, and I have hacked my way though probably two dozen programming languages in my years as an actuary.

The greater question is what I want my blog to look like for readers; getting a little cash flow is nice, but if it turns off the readers, that’s a minus. Any advice that you all can offer me is appreciated, particularly any counsel from bloggers accepting advertising at present.

Beyond that, I have plans to add a book review section, and I have a number of article ideas, many generously suggested by readers. I will begin writing more longer-dated stuff as the panic subsides, but I don’t see that happening for a few weeks at least.

The Longer View, Part 1

The Longer View, Part 1

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

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

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

A Baker’s Dozen on Current Issues in the Markets

A Baker’s Dozen on Current Issues in the Markets

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

  1. First a few macro pieces.? I usually don’t comment on Nouriel Roubini.? To me, he seeks too much publicity.? Is the present situation worse than LTCM?? Yes and no.? Yes, the entire housing market and housing finance areas are affected, as well as some levered areas in corporate credit — CDOs and loans to private equity.? No, at least not yet.? During LTCM, the solvency of at least one major investment bank (the rumor is Lehman) nearly went down.? That would have been worse than what we have at present by a fair margin.
  2. This piece from Paul Kasriel is interesting.? He brings up the correlation of seemingly unrelated asset classes, and hits the nail on the head by explaining that it id the owners of many risky classes of securities that are forced to sell due to margin calls that drives the rise in correlations.? Then he makes another hit on a favorite topic of mine, Chinese inflation.? That is the greatest threat to the value of the US Dollar and the end of Chinese stimulation of the US through the recycling of the current account deficit.? (At an ISI Group lunch late in 2006, I suggested that Chinese inflation was the greatest threat to the global economy.? Jason Trennert thought it was amusing.)
  3. I disagree a little with this otherwise useful piece from Investment Postcards.? In the middle of the graphic it reads “Subordinate bonds (junk-bond quality) on balance sheet.”? Usually not true.? Banks are typically more senior in the financing structure, unless they originated the loans themselves, and retain the equity residual.? In the first case, there is low probability of a large loss.? In the second case, a high probability of a more modest loss.
  4. Countrywide has certainly scared a number of people, including depositors.? First time I’ve seen anything resembling a bank (S&L) run in a while.? Here’s a quick summary on what went wrong.
  5. Now, US mortgage lenders are not the only ones having trouble, but also those in the UK.? Part of the issue there is that a larger part of their mortgage finance is adjustable rate, which makes rising short rates proportionately more painful there.? Maybe the Bank of England, which has been among the more aggressive inflation fighters, will have to loosen soon.
  6. One problem with securitization is that that legal documents are complex, and arguments over which party has what right become more common when deals go bad.? I’m no lawyer, but expect to see more situations like this one between CSFB and American Home.
  7. Okay, a rundown.? What markets have been hit so far?? Emerging markets, real estate and funds that invest in real estate,? merger arbitrage and LBOs, art, many hedge funds (an article on the demise of Sowood), high yield debt, and the stock market globally.? I’m sure I’ve missed some, but I can’t remember a time when so many implied volatilities went up so much at the same time.
  8. What’s not hurt as much?? Life insurance companies, though you sure can’t tell it from their stock prices.? I like Life the best of all my insurance sub-industries.? This area will come back sooner than most financials.
  9. What might have scared the FOMC most?? The move in T-bills.? It was the biggest rally over one or two days ever, as the Wall Street Journal concludes, that is panic.? Such an incredible bid for safety demonstrated a lack of confidence in the banking system, as well as other riskier elements of the markets.? It’s rare for T-bills and LIBOR to get so out of whack.
  10. But maybe things aren’t that bad, after all, US corporate earnings are rolling ahead at over a 10% rate.? I can live with that.
  11. Is Citadel a rescuer of Sentinel, or a rogue-ish clever firm that took advantage of panic at weakly managed Sentinel? Penson argues for the latter, but if there were multiple bids considered, it may be a difficult case for Penson to prove.? I would guess that Sentinel is toast, and that their clients will take most of the financial hits.
  12. Now, will the carry trade finally blow up?? After the move in the yen on Thursday, some thought so.? Some felt that it would plunge the world into a deflationary collapse.? I don’t think it will be that bad, but it will lead to inflation in the US, and an increase in the purchasing power of Asia and OPEC, at the expense of the US and a host of smaller countries (NZ, Iceland, etc.).? The parallels to LTCM are interesting; that’s the last time the carry trade got blown out.
  13. Finally, Hurricane Dean.? I wasn’t so bold two days ago, but I felt that damage to the US would be limited.? I’m more certain of that now.? (Someone tell the Louisiana Governor that there is no bullseye on her state.)? I’m an amateur meteorologist, but what I do in situations like this is measure the deviation of the track of the storm from the forecast.? In my experience, deviations tend to persist.? That told me that Dean was likely to miss Texas.? That’s more likely now; bad news for Mexico.? Pray for those in harm’s way.
A Moment of Minsky?

A Moment of Minsky?

Sometimes I think that the Keynesian and Austrian Schools of economic thought can be merged into a consistent synthesis that would disagree about the goals of policy, but largely agree on how economies work.? One of the men that would help promote such an idea would be Hyman Minsky.

One of the beauties of capitalist economies is that they are dynamically unstable.? Businessmen as a whole for a variety of reasons tend to over- and underestimate the desirability of doing business as a group.? There at least two reasons for this.? First, there is trend-following, because success by one businessman causes others to try it, until it is overdone, then a large number of businessmen drop out, setting the stage for the next cycle.? Second there are shocks correlated across the system, whether it is monetary policy (too high/low for too long), tariffs, tax changes, wars, technological shifts, etc.

This instability is actually a plus for the system, because each period of failure creates the seeds for the next round of success, as vulture investors pick over the assets of failed firms and redeploy them to longer lasting practical uses.? The decks have to be cleared of bad ideas every now and then, or else the marginal efficiency of capital declines, along with overall interest rates.

But central banks prolong cycles by bailing out marginal ideas and not letting them purge, also creating a culture where risk is not respected, because the central bank will ride to the rescue.? Today, we are at such a “Minsky Moment,” where we rescue the marginal, and overleverage some currently healthy segments of the economy, while housing-related and high-yield related items die a lingering death.? We will likely set up the seeds of the next bubble in the next year, while we reconcile only the most egregious of business ideas.? (Amazing how many real estate agents and mortgage loan brokers there are, huh?? Same for investment bankers… time to redirect these bright people to solving operational business problems, and away from financing issues.)

Now, maybe this time we run into the brick wall, where inflation rises amid weak business conditions, as it did in the 70s.? At that point, the economy will take the pain.? Bernanke will keep the economy from a 30s experience, but possibly at the price of a 70s experience.? After all, which would you rather have, depression or stagflation??? Both are unpopular words, and I hate dragging them out, but if the price of avoid Depression is Stagflation, the present FOMC will take that cost.

The FOMC as a Social Institution, Part 2

The FOMC as a Social Institution, Part 2

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

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

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

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

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

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

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

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

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

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

One Dozen Items That Characterize The Market Now

One Dozen Items That Characterize The Market Now

I’m going to write this post backwards tonight, partly because going from specific to general may make more money for my readers tomorrow. Let’s go:

  1. Did you know that there has been panic in closed-end loan participation funds? No? Well look here. Or look at this Excel file. Here’s the skinny: the average loan fund has only lost 0.47% of its net asset value since 8/10, but the average price has fallen by 6.30%. You can pick up a little less than 6% here, with modest risk, or a little more, if you are clever. Remember that the grand majority of loans here are senior and secured.
  2. The Title insurers have gotten crushed. Here’s to the activists who bought a ton of LandAmerica in the 90s, something I advised against. Title volumes will slow. Wait for the home inventories to crest, and decline a little, then buy a basket of the Title companies.
  3. I have a decent amount of exposure to Latin America in the portfolio. That Brazil and Mexico have been whacked has cost me, even though my companies are conservative.
  4. The winds are blowing. Hurricane Dean is in the Gulf, and may do damage to Yucatan, and after that, oil infrastructure and Texas. Given the late start of the season, I would not begin to suggest that this will be a heavy loss year. Damages from Dean are still uncertain as well.
  5. From the excellent Aaron Pressman, I offer you his insights off of Nicholas Taleb’s book The Black Swan: The Impact of the Highly Improbable. What I would point out here is that when times are unusual, a lot of things tend to be unusual. Credit events tend to be correlated, so when things go bad as in 2000-2002, many seemingly unrelated things go wrong at the same time, often due to correlations in the portfolios of the holders, particularly leveraged ones.
  6. Having seen a decent amount in prime brokerage relationships at a medium-sized firm, I can only say that they are needed but overrated, and the conflicts of interest are significant.
  7. I wish i were managing structured securities again. Buying AAA CMBS at LIBOR + 0.60%. That’s the best since LTCM! Pile it on! Hey, maybe we can lever it?! 😉
  8. Onto credit issues. Fed funds futures are rising in price (down in yield) over the current credit woes. Canadian ABCP participants may have a good solution to their troubles. Convert the claims to longer dated floating rate paper, which can still be held by money market funds. Countrywide cut to BBB+, which effectively boots them from the CP market. Rescap goes to junk, but it should have been there already. If Countrywide survives you can make a lot of money in their unsecured debt. I’ll pass, thank you. I’d rather hold the equity. Anworth is also getting smashed in this environment.
  9. Have you seen the credit summary in the Wall Street Journal?
  10. I had argued at RealMoney that home equity loans would eventually get hit. A non-consensus opinion. Well, now they are getting hit.
  11. DealBreaker.com has chutzpah, particularly on this list of hedge funds that might have blown up.
  12. You can look at it on the serious side or the funny side. Either way, losing money for clients stinks. That’s why I focus on risk control.
Triage

Triage

I’m still working through my portfolio, but I have categorized some stocks:

The Dead — Companies with bad balance sheets, but have been whacked so bad that it is still worth playing

  • Jones Apparel
  • Deerfield Capital
  • YRC Worldwide

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

  • Lafarge
  • Industrias Bachoco

Seemingly healthy that might have financing problems — Sold

  • Lithia Automotive
  • Group 1 Automotive

Uncertain as of yet

Barclays plc

Safe New Names Bought

  • PartnerRe
  • Microcap yet to be named when I have my full position on.

More tomorrow. As you can tell, I am positioning my broad market fund more conservatively. I am not optimistic on how we work through the amalgam of debts that might not get paid.

Full disclosure: long PRE IBA DFR JNY YRCW BCS LR

Afternoon Actions

Afternoon Actions

I sold Lithia Automotive in the late morning for the same reason as Group 1 Automotive.? Mid-afternoon, I replaced the position with PartnerRe.? As I commented at RealMoney:


David Merkel
Bought Some PartnerRe
8/16/2007 3:35 PM EDT
  • Trades well below adjusted book.
  • Reserves are conservative even prior to the fact that they don’t discount their reserves.
  • Reasonable P/E multiple
  • Quality balance sheet
  • Quality management team.
  • Conservative asset policy
  • Not overexposed to southeastern property risks.
  • Position: long PRE

    What I didn’t mention was how much not discounting their reserves is worth after-tax: nearly $20/share.? Take out a few other items, and you get an adjusted book value of around $85 on a very strong and diversified reinsurer.? I can live with that.

    Full disclosure: long PRE

    Morning Actions

    Morning Actions

    Bought a little Lafarge and Industrias Bachoco in to the morning’s decline. Eliminated Group 1 Automotive, and began the acquisition of a little microcap trading below book value with no debt. The integrating theme here is holding onto businesses that don’t need external financing, and selling businesses that require external financing, starting with companies that haven’t been hit that badly yet.

    Could the existing financing troubles spill over into auto financing and auto floorplan financing? That’s possible, though I don’t see the transmission mechanism now. The potential trouble with Group 1 (aside from a balance sheet with high intangibles), is that changes in financing terms could dent their earnings stream. Now, I know that the automakers are highly motivated to move the metal, and will aid the financing process, but I don’t think they can be relied on in entire, unless they only selling for Honda and Toyota, which have superior balance sheets.

    The moves so far this morning are cash neutral. We will see how that changes as the day progresses.

    Full disclosure: long LR IBA

    Theme: Overlay by Kaira