Year: 2008

Curves and Corporate Credit

Curves and Corporate Credit

Posted on by David Merkel

Just a brief note on corporate bonds.? When I was a corporate bond manager 2001-2003, I learned a lot about inverted curves.? It was a tough time.? But what kind of inversion am I talking about?

Ordinarily, when there is little doubt over the creditworthiness of a company, the amount of incremental yield over Treasuries (spread) rises with the length of the security.? This is normal, leaving aside times when the yield curve is flat or inverted, because usually, the risk of default rises with time with even the best securities, because the future is less certain than the present.

The second stage is an inverted spread curve for a given company, which given a positively sloped Treasury yield curve, might leave the corporate yield curve positively sloped, but less so than Treasuries.? This indicates moderate worry over the credit risk of the company in question.? (Note: during a time of credit stress, the Treasury curve is almost always positively sloped, as the Fed tends to loosen during times of credit stress.)

Next is an inverted yield curve, where short term yields are moderately higher than long term yields.? This indicates significant worry over the credit risk of the company.

Finally, there is an inverted dollar (price) curve for the company.? This is where default is viewed as a likelihood.? The prices of the longest-dated bonds reflect current estimated recovery levels after default.? Short-dated bonds may trade near par. (Par: usually $100, also usually the amount of principal remaining to be received.)

This is a qualitative/quantitative way of thinking about the corporate bond market during a time of credit stress.? What percentage of the market falls into each bucket?

  • Not inverted
  • Inverted spread curve
  • Inverted yield curve
  • Inverted dollar price curve
  • In default

The more names in lower categories, the greater the degree of credit stress.? For companies with multiple issues of bonds, it is a simple way of characterizing the market, even in the absence of rating agencies.? (As a closing aside, equity implied volatility tends to rise as a company goes down the list.)

Wait, that’s not quite a close, and not an aside.? That is another way to lookat corporate bonds.? As the implied volatility of the equity gets higher, the more they migrate down the list.? Remember, leaving aside bank loans, usually only stable companies issue corporate debt.? As their prospects get less certain, implied volatility of the equity rises, and their debt moves down the list.

Fixing Securitization

Fixing Securitization

Posted on by David Merkel

After reading jck’s piece Securitization: Not Guilty, I said to myself, “well said.” He cited a study that showed that misaligned incentives were more to blame than secutritization itself.? (Academic paper here.)? And he cited this clever piece from the seemingly erstwhile blog Going Private.

Here’s my view.? I have lived through the first era of securitization, and I always thought that the equity/originator got off too easily.? They got their money out of the transaction too quickly, allowing themselves to profit if the deal survived for a while, and then died.? The equity of the deal should take the largest risks, rather than the subordinate certificates (most junior aside from equity).

Here’s my solution.? Require that the deal sponsor and originators retain the full equity piece, and that the size be regulated to make it significant.? Further require that the equity is a zero interest tranche, where the excess interest builds up to protect the subordinate securities.? They get paid last out of any residual cash flows of the deal.? The size of the equity piece might vary from 1% of principal on credit card, auto and stranded cost ABS, to 10% on CDOs.? Note that the equity pieces cannot be traded here, they must be owned by the sponsors or originators.

Now, if the equity only gets paid at the end, several things occur:

  • Sponsors/Originators have to be well capitalized.
  • They will be a lot more careful about credit selection, and not accept high-interest risky borrowers.
  • The subordinate certificates will get paid less interest, but with more certainty.

Does this change the nature of securitization?? Yes, and in a good way.? Securitization is useful, but in its initial phases, it suffered from the equity not having enough at risk.? My proposal solves that.? Put the equity at the back of the cash flow bus, such that the originator never makes a gain on sale, and that part of the financial system will be sound once again.

Debt and Sweat

Debt and Sweat

Posted on by David Merkel

Ordinarily, when I sit down top blog, I know what I want to write.? That’s not true now.? Yes, I could do a few book reviews.? I have six books read, and ready to go, but given the volatility of the markets, I feel I have to say something about the current activity.

I am a strong believer that there are few free lunches.? If there are simple policies that will easily produce prosperity, they would likely have been done by now.

As I have commented before, what we are seeing now is a shift in debt from the banks to the government.? Banks get capital, the government gets debt, and the money for the debt comes from three places: taxpayers, foreign lenders (central banks, probably) and perhaps at some point, the Federal Reserve could buy it (whether they monetize it or not is another question).? As jck noted yesterday, this has led to a selloff in Treasuries.? (Interesting that it happened on a day when the cash markets were closed, but the futures markets were open.? The reaction of cash bond market today is similar to that which the futures market exprerienced yesterday.)

Which brings me to my first point.? Today, when the rally in the fixed income markets gets reported (the markets again, were closed yesterday, you will likely hear that spreads rallied sharply.? But watch for the discussion of yields and prices (if there is any).? It’s quite possible that yields rise from Friday to the close of business today.

Second point, today $250 billion of the $700 billion got used on nine big/critical banks.? Now, this may have been somewhat coercive to some of the nine banks; as was said at Bloomberg:

None of banks getting government money was given a choice about it, said one of the people familiar with the plans. All of the banks involved will have to submit to compensation restrictions, said the person.

The government will also guarantee the banks’ newly issued senior unsecured debt, making it easier for them to refinance their liabilities, the person said.

Possibly the following message was delivered, “Be a good boy and get in line.? This is good for the nation, and we won’t be around for a decade.? You want to be a survivor, right?? You want friendly regulators when we review the levels at which you are marking your illiquid assets?? We thought so.? Sign here.”? (No surprise that Goldman then applies for a NY State, rather than Federal bank charter.? State regulation, particularly when you are a local champion, is much more flexible.? Just ask AIG. 😉 )

Though this leads to a short-term bounce in bank share prices, the long term effects are less clear, which brings me to my third point.? It’s one thing to bolster their balance sheets.? It is another to get them to lend, particularly in the bear phase of the credit cycle.? Also, as leverage comes down, and it will come down, so will profitability at the investment banks, and probably other banks as well.? Securitization will be less common, eliminating hidden leverage that allowed for less capital.

The same thing is going on in Europe, though they actually think about how they might pay for the bailouts.? In the UK, it pushes the national debt to GDP ratio to 100%.? As it gets closer to 150%, the international debt markets usually start to choke.? We have traded bank credit risk for national solvency risk at the margin.? Maybe that will be different here, if only government creditworthiness is perceived to be safe.? It is a “new era,” right? 🙁

I find it interesting that Barclays is refusing help.? Either the UK regulators aren’t so coercive as those in the US, or Barclays is not as levered as I thought.? Or, it could be hubris on the part of Barclays’ management team.

Even Japan is getting into the act, though these measures seem so weak that I wonder why they would bother.? The government and Bank of Japan stop selling bank shares, and allow companies to buy shares back more aggressively.? That may push share prices up in the short run, but it substitutes debt for equity, which shouldn’t have much of a long-term impact.

On the Central Banking Front

Now, with the seemingly limitless amount of US liquidity being to the short end of the US money markets, you would think that we would get a bigger move than we have gotten so far. This will take time, but watch the yield as well as the spread.? Also remember that LIBOR has become somewhat of a fiction at present.? There many quotes, but not so many loans to validate the quotes.

What is being done that is new?

  • TAF expanded to $900 billion.
  • New commerical paper program where the Fed backstops the A-1/P-1/F1 CP market, including ABCP.? Terms here.? FAQ here.? This is big, and it is much easier to start such a program than to end it.? It is difficult to end any program where credit is granted on less than commercial terms.? My guess is that it will be extended past its April 30th, 2009 planned expiry date.
  • Swap agreements allowing unlimited dollar liquidity to foreign entities through agreements with their central banks.
  • The Fed can now pay interest on reserve balances held at the Fed, which allows them to increase their balance sheet significantly.? In one sense, they become the Fed funds market.

What is not new is the idea that all we have to do is restore confidence, and everything will be fine.? No, we have to delever, and the US Gowernment is included in the list of those that need to delever.? There is no national reform going on here, but merely a shifting of obligations from private to public hands.

For investors:

For those that are investors, the biggest bounces tend to occur during depressionary conditions.? I would not get overly excited about the rally yesterday.? As John Authers at the FT points out, given the extreme changes being made, there should have been a bounce.? The question is whether it will persist.? I was a net seller into the rally toward the end of the day.? I think we have more troubles ahead.? Two things to watch:

  • LIBOR, CP yields and the TED spread. (The short end)
  • Overall yields of medium-to-long Treasuries and other long-dated debt.? (The long end.)

I expect yields to rise, even if some spread relationships fall.? The added financing needed by the US government is large.? Let us see where Treasury buyers have interest.

There are elements of this that remind me of my The US Dollar and the Five Stages of Grieving piece. This is for two reasons: first, we are asking foreign entities to hold more dollar claims at a time when they are stuffed full of them.? Second, this phase of the credit crisis reminds me of the “bargaining” phase of the five stages of grieving.? We are past a long denial phase, and the anger continues, but now we bargain that these proposals will allow us to escape the pain that comes from delevering.

I’m skeptical, but I hope that I am wrong, lest we get to the fourth stage “depression,” before we finally reach “acceptance.”? As it is, I am looking for companies with blaance sheets strong enough to survive the worst.? That is my task for the next few days.

Recession or Depression?

Recession or Depression?

Posted on by David Merkel

Back to the crisis.? I want to be a bull, really.? I read what Barry wrote on 10 bullish signals, and I think, yes that’s what history teaches us.? I have used that for profit in the past.? I even have a few more.

Here’s my knockoff of S&P’s proprietary oscillator:

That’s the lowest reading ever, with statistics going back to 1990.? For more, consider the discounts on closed-end funds — they are lower than ever.? Or, consider that the IPO market is closed.? Or consider that every implied volatility measure under the sun is through the roof in ways that we haven’t seen since 1987.? The yield curve of the US is wide.? Fed policy is accommodative; don’t fight the Fed.? Consider that well-respected value investors like Marty Whitman are finally excited about the market.? Credit spreads are at record highs in the money markets and in the corporate bond markets.? Finally, consider that the lack of insider transactions indicates a potentially bullish situation:

I have a hard time accepting the bullish thesis at this point because of troubles in most of the major banks, and the disappearance of all of the major investment banks.? I have a saying that when you have a major market malfunction, there tend to be many things going screwy at the same time.? I don’t like to say that it is different this time, but rather, we have to be careful whenever there is a significant hint of depressionary conditions.? If that is the case, we should see many abnormalities:

This is a global crisis, affecting most governments and firms.?? Our most severe crises, aside from the Great Depression, tended to be local, or limited to just a segment of the world.

Final notes: I warned about this disaster in advance, though I am not as prominent as a George Soros or Jeremy Grantham.?? I can dig up the references at RealMoney if necessary.? Last, as in the Great Depression, some moves by the government exacerbated the crisis, that may be true here as well.

With that, I conclude that we are back to the one key question: are we facing a recession or a depression?? If a recession, we should be buying with both hands, but if a depression, there will be better bargains later. At present, given the condition of the banks and the global scope of the problem, I lean toward the depression side of the argument, but I am not totally sold on the idea. There are bright people on both sides of the question. That said, I am not jumping to buy at present, even with many indicators that are favorable. The state of the financial system matters more.

IFRS: Incomparable Flexible Reporting Standards.

IFRS: Incomparable Flexible Reporting Standards.

Posted on by David Merkel

One housekeeping note before I start.? I made a small enhancement to the blog today.? I added a little link on the upper right, just below the banner that reads “Aleph Blog.”? If you click it, it brings you back to the home page.? I know that is how my banner is supposed to work, but I have not been able to get it to do that.

My first topic this evening is the SEC’s move to IFRS.? If you would like to protest this, the form is here.? Here is what I am submitting to the SEC:

=-=-==-=-=-=-=-=-=-=-=–=

Sirs,

I strongly oppose adopting IFRS in place of US GAAP.? I am not an accountant, but something more important, a user of financial statements.? I am a life actuary and a financial analyst.? I have been on both the preparation and use sides of accounting statements over the last 20+ years.

My first critique is that there is nothing that is that big of an improvement over US GAAP in IFRS, and many areas that seem less accurate.? I will handle those later.? My point here is that in order to justify the costs of retraining accountants and financial analysts, what ever is put into place needs to be a large improvement over GAAP.? IFRS is not that.? It will impose big costs on US corporations to re-tool their accounting, and the small corporations will be disproportionately affected.? In the end, I don’t think we will have materially better financial statements.

Perhaps accounting consulting fees will rise in the short run from the conversion, but that it not a reason to put the rest of us through the wringer.? Just as laws are too important to be left to lawyers only, in the same way, accounting standards are too important to be left to accountants only.

Second, there have been a number of studies done that show that US GAAP confers an advantage of lower capital costs on companies that use it versus IFRS.? Why raise capital costs on US corporations?

Third, IFRS will not unify accounting standards around the world, because the national implementations of IFRS are significantly different.? Here’s an idea, though:? Call US GAAP an implementation of IFRS.? WHo knows, it might become the preferred IFRS because of its relative strictness.

Fourth, IFRS is more squishy than GAAP because it is “principles-based.”? We use rules-based systems in the US because they offer legal protection regarding fraud in securities laws.? I would argue that IFRS is actually rules-based also, but with a less-tested set of rules.? The rules of US GAAP are large because they have grown to meet the complexities of accounting in the modern economy.? More below.

Fifth, the additional squishiness/flexibility will make it more difficult to compare results across companies, making the job of securities analysts more difficult.

Sixth, US GAAP is more investor-focused than IFRS. That’s why it lowers capital costs.

Seventh, value investors will benefit from IFRS because the income statements and balance sheets will be less reliable, which will force more investors to the cash flow statement, which is harder to fuddle.? Average investors will have a harder time investing, to the extent that they look at financial statements.

Eighth, does Congress really want to give up its sovereignty over US accounting rules?? I think not; all it will take is one significant scandal, and Congress will move away from IFRS.? The pressure toward globalization is weaker than most think.

Ninth, IFRS is weaker when it comes to revenue recognition, joint ventures, and accounting for fixed assets and intangibles.? In general, the ability to revise asset valuations up should be limited or nonexistent.? The ability to be flexible in recognizing revenue should be similarly limited.

In the American context, where we have dispersed ownership, we need conservative accounting rules that are comparable across companies.? The proposed move from US GAAP to IFRS is a step backward.? Please do not sacrifice our relatively good accounting standards for something less accurate and applicable to the needs of our nation and its securities markets.

Sincerely,

David J. Merkel, CFA, FSA

Blame Game, Redux

Blame Game, Redux

Posted on by David Merkel

When I write, I don’t always know what will be popular, and what won’t.? Personally, I thought my article
Rethinking Insurable Interest was the more innovative of my two articles last night, but Blame Game made the splash.? Well, perhaps no surprise, the crisis has the attention of all of us.? I just have broader interests; I want to write about a wide number of things.

My readers took me up on my request, and gave me more targets to blame.? Let me expand on them:

21) The Rating Agencies — that was a popular choice.? Yes, the rating agencies messed up.? They always do.? Their job is an impossible one.? Should they be proactive or reactive?? Should they rate over the cycle, or be instantaneous?? Should they care about systemic risk issues?

Where they did err?? They competed for business, leading underwriting standards lower in structured finance.? They overrated the financial guarantors, who were their major clients.? Away from that, they made mistakes, but every firm offereing opinions makes mistakes.? I make mistakes regularly here.

22) Matt give me another party to blame, and I will let him speak for himself: I have one more to add – the Office of the Comptroller of the Currency. Not only did they fail to regulate the national banks, they also stone-walled State and local governments from bringing suit (claiming jurisdiction, but never following up on claims).

Add to that the divided regulatory structures that encouraged regulatory arbitrage.? That encouraged diminished underwriting standards.

23) Investment banks.? They asked the SEC to waive their leverage limts, and now none of the big guys are left as standalone publicly traded institutions.? They made a lot for a while, and then lost more.

24) Then there were the carry traders who have now gotten carried out on their shields. There were too many players trying to clip uncertain interest spreads, from hedge funds to Japanese housewives?

25) House flippers — whenever investors get to be more than 10% of a real estate market, beware.? Sad, but I heard an ad on the radio for buying residential real estate in order to rent it out.? It is not time for that yet.

26) The quants — they enabled models that gave a false sense of security.? They did not take into account decreased lending standards, and assumed that housing prices would continue to go up, albeit slowly.

They also assumed that various classes of risky business would be less correlated, but when hedge funds and fund-of-funds take many risks, returns become correlated because of investoors enter ing and exiting sectors.

27) The tax havens and hedge funds.? Hedge funds are weak holding structures for assets.? In a crisis they can be sellers, because they want to lower leverage.

28) Mainstream financial media — CNBC, etc.? They were relentless cheerleaders for the bull markets in stock and housing.? This isn’t a compliment, but financial radio makes CNBC sound cautious.? FInancial radio seems to be a home for hucksters.

And, that’s all for now.? If you have more parties to blame, feel free to respond.? One final note on my point 16, diversification, from the prior post: many quants did us wrong by focusing on correlations stemming from only boom periods.? There are many problems with correlation statistics in finance, but the big problem is that correlations are not stable even during boom times, much less between booms and busts.? In a bust, all risky assets become highly correlated with each other, invalidating ideas of risk control through diversification.

My view of diversification is holding safe assets and risky assets.? High quality short-term debt does wonders to reduce the volatility of results.? Other hedges are less certain.? Nothing beats cash, even when money market funds are open to question.

Blame Game

Blame Game

Posted on by David Merkel

Some people don’t like the concept of blame.? They view it as useless because it wastes time in looking for a solution.? I will tell you differently.? Blame is useful because it identifies offenders, which is the first step in eliminating the problem.? The trouble is that few have the stomach to get rid of the offenders.

So, as I traveled home from prayer meeting with my children last night, we listened to a radio show discussing the current credit crisis.? This was a good discussion, unlike many that I hear.? But the discussion (on NPR) eventually focused on “who should we blame?”? Okay, here is my incomplete version of who we should blame:

1) The Federal Reserve, especially Alan Greenspan.? For the past 20 years, we couldn’t let the economy have a severe, much less a moderate recession.? Rates were reduced before significant pain was felt by those who had borrowed too much.? The 1% Fed funds rate in 2003 was the pinnacle of that effort.? It created the ultimate bubble; there is nothing left to reflate in 2008 from easy monetary policy.

2) Congress and the Presidency — they encouraged undue leverage in a variety of ways:

a) Fannie, Freddie, the FHLB, and more: Everyone has gotta live in a single family home.? Gotta do that.? Thomas Jefferson’s ideal was that we should encumber future generations so that marginal buyers could live in houses beyond their means.? They compromised lending standards more and more, along with private lenders as the boom went on.

b) The SEC: in a fiat currency world, controlling the currency means controlling leverage of financial institutions.? The SEC waived leverage restrictions on the investment banks in 2004, leading to a boom, and a bust. Big bust.? Ginormous bust — how many large standalone investment banks are left?

c) Particularly the Democrats in Congress defended the GSEs as their own pet project.? I am not bashing the CRA here; I am bashing the goal of having everyone live in a house beyond their means.

d) We offered a tax deduction on mortgage interest, and a limited exemption on capital gains from selling a home.? There is no good reason for these measures.

e) And, the Republicans in Congress who favored deregulation in areas for which it was foolish to deregulate.? Much as I favor deregulation, you can’t do it if you have fiat money (unbacked paper money).? In that case you must restrain the growth of credit.

f) The Bush Jr. Administration — they did not enforce regulations over financial institutions the way that the law would demand on a fair reading.? Again, I’m not crazy about regulation, but unless you have a gold standard, or something like it, you have to regulate the issuance of credit.

g) Their unfunded programs with promises to the future; the states and Federal Government always promise today, and don’t fund it.? Hucksters.

3) Lenders steered borrowers to bad loans.? There was often implicit fraud, and in some cases, fraud.? The lenders paid their staff to do it.

4) Borrowers were lazy and greedy.? What? You’re going to enter into a transaction many times your income or net worth, and you haven’t engaged helpers or friends to advise you?? Regardless of the housing price mania, you should have gone slower, and done more homework.? Caveat emptor — you neglected that.

5) Appraisers were slaves of the lenders who wanted to originate and sell.

6) Those that originated MBS did not check the creditworthiness adequately.? They just sold it away.? Investment banks did not care where a profit was coming from in the short run.

7) Servicers did not demand a high price for their services, making it hard for them to service anything but solvent borrowers.

8) Realtors steered people into buying more than they could rationally afford; I’m not saying they did that on purpose, but their nature was to sell to get the highest commissions.

9) Mortgage insurers and financial guarantee insurers — because of the laxness of accounting rules, they were able to offer guarantees significantly in excess of what they could pay in the deepest crisis.

10) Hedge funds, investment banks and their investors — they demanded returns that were higher than what was sustainable.? They entered into businesses that would not survive difficult times.

11) Regulators let themselves be compromised by those following the profit motive.? Many hoped to make money after joining private industry later.

12) America.? We let ourselves become short-term as a culture, encouraging short-term prosperity, regardless of the cost.

13) Neomercantilists — they lent us money, because they wanted they export sectors to grow for political reasons.? This made our interest rates too low, encouraging overinvestment and overconsumption.

14) Average people who voted in Congress, and demanded perpetual prosperity — face it, we elect those that govern us, and there is the tendency in America to love the representative that brings home the pork, while hating Congress as a whole.? Also, we need to bear with recessions, and let them do their work, and not force our government to deal with them.

15) Auditors that did a cursory job auditing financial entities.? As the boom went on, standards got lower.

16) Academics who encouraged a naive view of diversification, and their followers who believe in uncorrelated returns.? In a bad economy, everything is correlated, and your statistics from a good economy don’t matter.

17) Pension and other funds that believed the academics.? It is amazing what institutional investors will fund, given the mistaken idea that correlation coefficients are stable.? Capitalistic economies are unstable by nature!? Why should we expect certain strategies to workallo the time?

18) Governmental entities that happily expanded government programs as the boom went on.? Now they are talking about increased taxes, rather than eliminating programs that are of marginal value to society.? Governments should not rely on increased taxes from capital gains, or real estate tax assessments.

19) Those that twitted “doom-and-gloomers,” and investors who only cared if markets went up.? It is hard to write about what could go wrong in the markets.? Many call you a wet blanket, spoiling their fun, and alleging that you are a short, or some sort of misanthrope.? The system is biased in favor of happy talk.? Just watch CNBC.

20) Me, and others who warned about the current crisis. Perhaps we weren’t clear enough.? Maybe our financial interests made us look like we were talking our books.? I know that I spent a lot of time on these issues, but in the short run, I was still an investor, trying to make money in the markets, hoping that what I feared would not occur.? Now I am getting my just desserts.

This is an incomplete list.? I invite you to add others to the list in your comments.

Rethinking Insurable Interest

Rethinking Insurable Interest

Posted on by David Merkel

Let’s take a short break from “all credit crisis, all the time.”? I want to talk about an issue that troubles us in a number of ways.? The legal doctrine of “insurable interest” [II] is critical to the life insurance industry.? II states that only those with a direct economic or (sometimes) sentimental interest can seek to buy life insurance on another person.? The sentimental interest is limited to close family, and sometimes friends, if approved by the insured.

This protection exists for several reasons:

  • Insurance exists to reduce risk, not promote gambling.
  • The tax-favored nature of life insurance relies on the idea that it is helping people who would be harmed by the death of the insured.? Absent that, the IRS will eliminate those favors.
  • We don’t want to raise the risk of murder by allowing anyone to take out insurance on another person.? Even though murder by the policyholder would invalidate the claim, that can be hard to catch.

Now, those who know me as a life actuary know where I am going next.? I’m going to complain about stranger-owned life insurance, viatical settlements, premium financing and the like.? Good guess; I’ve written about those before.? I’ve turned down job offers in that area for ethical reasons.? You only get one reputation in the business, so you better guard it carefully.

But, that’s not what I am going to write about, much as I think that many of those practices should be outlawed.? I’m going to write about credit default swaps.

Wait.? What do credit default swaps have to do with insurable interest?? Legally, nothing at present.? This article will suggest that there should be a link.

Insurable interest exists to protect the insured, a natural person, against increased risk of death from policyholders seeking to do him harm.? Corporations are corporate persons under the legal code.? Should they not get the same protection?

Credit default swaps pay off when a corporation “dies.”? I know there are additional complexities here, but play along with me for now.? There are parties that get hurt when a corporation dies:

  • Suppliers
  • Employees
  • Sponsored pension funds
  • Debt/loan holders
  • Stockholders
  • And maybe more…

They have an insurable interest in the continued well-being of the corporation.? They should be allowed to issue credit default swaps to the degree that it allows them to hedge their exposure, and no more.? Any excess exposure is gambling, not insurance, and should be forbidden by law.

Yes, like Charlie Munger, I believe that gambling should not be legal on public policy grounds.? Credit default swaps are not insurance as the regulators define today, but they should be regulated as insurance, and only financial guarantee insurers should be allowed to insure it, and those seeking insurance should prove insurable interest, or the contract is null and void.

Now, if you see my logic, forward this article to your Senators and Congressmen.? Let’s change the dynamic that has introduced so much speculation into the bond markets, where there is more credit default swaps than there are bonds available.

At a time like this, when many things are coming unhinged, this is just one more thing to set right, so that we can have a more stable financial system.

A Note on the Greenspan Legacy

A Note on the Greenspan Legacy

Posted on by David Merkel

Check out this article from the New York Times on the Greenspan legacy.? In my time at RealMoney, I took some heat for being a critic of Greenspan.? I won’t list all of it, but I will echo this one post:


 Aaron Task
Speaking of Permabears…
7/26/2006 1:27 PM EDT

Thanks for the response, Rev.

Meanwhile, Merrill’s Rich Bernstein has an interesting note out arguing that the Fed’s 450 basis points of tightening “has not yet severely impacted the U.S. economy” because the expanded use of credit derivatives has created an alternative source of liquidity.

“Whereas the majority of Wall Street is focused on the traditional growth/inflation trade-off, we hope Mr. Bernanke is also considering this new and expanding form of credit creation,” Bernstein writes. “Our belief is that he is indeed quite concerned, and that despite current dovish jawboning, he will ultimately tighten more than investors currently expect.”

Position: Awaiting the Beige Book.


 David Merkel
By Default, No Credit Where It Is Not Due
7/26/2006 2:23 PM EDT

Aaron, I read the Rich Bernstein piece. I usually agree with what he writes, but not this time. The amount of yield compression created by credit default swaps is 50 basis points at best, which doesn’t even come close to the 450 basis points that the FOMC tightened. Now, if someone makes the argument that the rates on corporate bonds 10 years and longer haven’t increased significantly over the past 27 months, I would agree with that, but that has little to do with credit default swaps, which are a short maturity phenomenon for the most part.

I thought of writing a note on the article cited in Bernstein’s piece, but ran out of time yesterday. It is a horrendously optimistic article, and too short-sighted. Credit derivatives, as I have noted before, have induced two anomalies into the credit markets. First, they make spreads artificially tight on the short end. Second, they create demand for bonds after they default.

Both of these are “tail wagging the dog” phenomena. When the market for making side bets gets bigger than the main business of financing corporate credit, something weird is going on. The real test will come when we get the next spike in investment grade defaults. When we had the last spike, the credit default swap market had notional amounts smaller than the corporate bond market. Now the credit default swap market is more than four times the size of the corporate bond market in nominal terms. When it happens, all of the negative effect of too much insurance chasing too few bonds to be insured will be revealed.

One more aside, the idea that the low default rates since 2003 is unusual is wrong. We had a longer period in the mid-90s. The effect of credit default swaps and collateralized debt obligations on default in the short run is modest at best (even the article says CDOs lower borrowing costs by 3-5 basis points).

In the long run, it may make the default problem worse. Whenever you lend a debtor money, he immediately looks more creditworthy because of the liquidity. When the liquidity goes away, as it always does for some minority of corporate borrowers, the debt problem is worse not better.

Position: none, but my bet is that Buffett is right on credit derivatives, and Greenspan wrong (why does that seem like an easy bet?)

I’ve always been a skeptic on the macro-level of derivatives, because they don’t change anything for the system as a whole, unless the losing party is undercapitalized.? The seeming calm that derivatives helped to induce merely shifted volatility to parties that could not bear losses under significant stress.? Talking about a “Great Moderation” during a bull market is hooey.? It’s a Great Moderation if lending terms are stable in a bear market.

Greenspan is a bright guy, but like many bright guys who become beholden to the DC establishment, they circumscribe their reasoning to the politics that they live in.? Few of us have the stomach to speak truth to power; I wonder what I would do under the same cirumstances, though my constitution says I would be a short-lived creature in DC, which does not want to hear the truth.

My guess is that Greenspan will fare badly in history books one century from now.? The inflation that he induced, and the false confidence he engendered will be villified.

Industry Ranks for the Reshaping

Industry Ranks for the Reshaping

Posted on by David Merkel

There has been only one other time in my life where I felt so skittish about my methods: June-September 2002.? I got whacked hard by the market then, harder than at present, but I bounced back October 2002 – January 2004, making it up and then some.

I don’t count on that now, but I will give you may industry ranks as of this week:

Running my usual screens, I get a bunch of new tickers to consider:

ABD ??? ABG ??? ACE??? ACGL??? ADCT??? AEG??? AEL??? AFG??? AFSI??? AGII??? AHL AIG??? ?AIZ??? ALL??? ALU??? AMPH??? AMSF??? AN??? ANEN??? ARRS??? ASI??? AWH??? AXA??? AXS??? AZ??? CB??? CBG??? CHEUY??? CIEN??? CINF??? CMVT??? CNA??? ?CNO CPHL??? CPII??? CRMT??? CRNT??? CTV??? DFG??? DSITY??? EBF??? EIHI??? EJ??? ENH??? ENTG??? FFG??? FMR??? FNSR??? FSR??? GBE??? GCOM??? GILT??? GLRE??? GLW??? GNW??? GPI??? GSIG??? HALL??? HCC??? HIG??? HMC??? HMN??? HYSNY IHC INDM ING IPCR IRS JDSU JLL KGFHY L LGGNY LNC LTXC MET MHLD MIG MIGP MRH MRVC MXGL NDVLY NSANY NVTL OB OPLK OPXT PAG PEUGY PFG PL PMACA PNX PRE PRU PTP PUK PWAV RE RFMD RGA/A RNR RTEC RUSHA RUSHB SAFT SAH SAIA SEAB SUR SWCEY SYMM TER THG TLAB TM TMK TRH TRV TTM UAM UFCS UNM UTR VOD VR VTIV WRB XL YRCW ZFSVY

Some of these are on the last list, and some of them I own.? Personally, my “green zone” methods are making me queasy at present because in a credit crisis, trends tend to persist a lot longer, so I will be more likely to look at names that are stalwarts in this crisis.? My investment methods are not purely quantitative.? I use quantitative methods to assist my qualitative reasoning.

As such, I have a few more tickers to toss into the hopper, many of which are safe names, or, names in the red zone that seem cheap:

AA??? ABX??? ALL??? ALOG??? BGP??? BHI??? BKS??? BRNC??? CAG??? CNI??? CP??? DD??? DLX??? DOW??? DPS??? EOG??? FCX??? HAR??? HCC??? HOLX??? HPQ??? IBM??? ITW??? ITW??? MCF??? MET??? MMM??? MSFT??? NBR??? NYX??? ORCL??? PBR??? PFG??? POT??? PRU??? RDC??? REXI??? RTI??? SII??? TAP??? TEL??? TIE??? TM??? VEIC??? WMT??? XTO

Together with my last post, these are the tickers that I will compare against my existing portfolio to choose new names for my portfolio.? As for where I got the batch of tickers for my last post on this topic, my method is to take every idea that I hear over a quarter that I think is interesting, and I note it down, or print it out.? It is eclectic in that sense, but when I analyze the ideas at the end of the quarter, I try to forget where I got the ideas, so that I can analyze them fresh.? I am the main analyst here, and I try to avoid believing the arguments of others when I do my final analysis.

Theme: Overlay by Kaira.