Year: 2008

The Occasional Seemingly Free Lunch

The Occasional Seemingly Free Lunch

Posted on by David Merkel

hmf asks, “David – if possible, whenever you have a chance, could you please explain why there is any spread whatsoever between govt-guaranteed bank-issued debt (e.g., the GS TLGP bonds) and comparable treasuries.? It would seem they’re one and the same – thus no default risk.? Thank you very much!”

I left a comment on this on John Hempton’s blog, who also addressed this question.? The comment is still in moderation, so I will attempt to recreate my argument.

There are many US Government securities, some of which are “Full Faith and Credit” [FFC] that trade with a spread over on-the-run Treasury securities:

  • Off-the-run Treasuries trade at a discounted price (higher yield) due to illiquidity.? Note: On-the-run securities are the ones that have recently been issued.? They are often used by Wall Street for hedging purposes in other bond issuance, which adds to the liquidity (most of the time).
  • Title XI shipping bonds (full faith and credit) trade at a spread to a ladder of similar maturity Treasuries.? They are less liquid, but there is usually good demand for this paper.
  • Aid to Israel and TVA bonds are full faith and credit [FFC] and usually trade at a spread over Treasuries.
  • Overseas Private Investment Corp bonds (FFC) often trade at a spread over Treasuries.? I once bought some OPIC put bonds where the option adjusted spread was 2% over Treasuries.? I had to buy the whole issue, so, again, it was illiquid, because anyone you would try to sell it to you would have to educate them on the bond.? Not easy, why should the seller trust your explanation, particularly as you no longer want the bond?? (That’s what brokers are for…)
  • I used to manage a portfolio of Credit Tenant Leases.? Most of my leases were on buildings leased by agencies of the US Government, and the lease payments were not subject to appropriation, so I did not have to worry about the budgeting process of Congress.? These were not FFC, I had a cut-through claim to the lease payments; I had priority over the building owner in getting paid.? If the US were to fail to pay, I had recourse to the building owner (can’t squeeze blood from a stone, though), and failing that, I could take possession of the building.? So with a hard asset behind the loan, I was doing secured lending to the US Government, and getting 1.5-2.0% over Treasuries to boot.? Though the CTLs were fungible, they were definitely illiquid.? But when you think about the extra spread versus the possibility of loss — the property was high quality, the return was disproportionate to the risk.
  • Another [not FFC] piece of paper was a first mortgage note on a building that served a critical government purpose, where the government could not move because of old computers which they could not move due to fragility and security reasons.? We got roughly 3% over Treasuries in a small deal where I ended up buying 20% of the issue.
  • Are Fannie and Freddie guaranteed by the government?? They seem to be, but you can pick up an additional 100-140 bps if you lend to them.

So, it’s not unusual for FFC securities to trade at spreads over Treasuries.? And, it is normal for pseudo-government securities to so trade.? But it is weird for the 3+ year Goldman Sachs securities to be issued at 2.2% over the relevant Treasury security.? It’s not an illiquid issue — $5 billion is a big deal.? There is a little structural complexity, but it is in the nature of a financial guarantee from the government.

There is the matter as to whether the Government would ever selectively default on FFC guaranteed issues, but the courts would have something to say on that, unless Congress deleted their authority on the matter.? You can’t fight city hall; you certainly can’t fight the US Government, and it has been behaving erratically of late.

So, if I were managing insurance/bank assets, would I buy these issues with a FFC guarantee from the FDIC.? Yes, all day long unil I was full of them.? The reasons cited for not buying them don’t add up, and they seem really cheap.? I would use them as a substitute for Treasury and Agency securities.

PS — A note to the new administration: want to save money?? Easy.? Create a capital account for the budget, and borrow using Treasuries to buy the buildings that you use.? Don’t do CTLs anymore.

Here’s a bonus idea off of yesterday’s post.? Offer longer-dated floating-rate debt indexed to 3-month T-bills.? It would be a TIPS substitute, and cheaper.

Update: 10/27 10AM: Bond Newbie is correct. TVA securities are not FFC — I slipped on that one because of a project that I worked on long ago, and my knowledge was garbled. Here is an incomplete list of all FFC securities:

  • Farmers Home Administration Certificates of beneficial ownership
  • General Services Administration Participation certificates
  • U.S. Maritime Administration Guaranteed Title XI financing
  • Small Business Administration Guaranteed participation certificates and Guaranteed pool certificates
  • Government National Mortgage Association (GNMA) –? GNMA-guaranteed mortgage-backed securities, and GNMA-guaranteed participation certificates
  • U.S. Department of Housing & Urban Development Local authority bonds
  • Washington Metropolitan Area Transit Authority Guaranteed transit bonds

If anyone knows where there is a full list, I would be happy to post it.

Issuing Debt for as Long as Our Republic Will Last

Issuing Debt for as Long as Our Republic Will Last

Posted on by David Merkel

So Jimmy Rogers thinks the US dollar is going down?? He might be right.? There are few roads out of this crisis (more than one can be used):

  • High inflation (raise the nominal value of collateral behind loans, maybe?)
  • Internal Default (with depression)
  • External Default (including currency controls, and forced conversion to a new currency)
  • Large rise in taxation (leading to deep depression).
  • The Japan game, where the government attempts to force liquidity into the economy, leading to a low- or no-growth malaise.

At present, I think the government is pursuing the last of those, and avoiding inflation for now.? It is not in the DNA of the Fed to inflate, ever since the era of the ’70s.

Now, there is one idea floating around that I would like to suggest that we don’t do, or, if we do do it, let’s do it in limited amounts, like TIPS.? There is a proposal for Obama bonds — bonds issued by the Treasury in a currency other than dollars, such as the Japanese Yen.? It’s been done before; but I would urge against it because it gives up a key advantage that all of our debt is denominated in a currency that we think we control.? Why outsource that advantage to another central bank?

Anyway, I’ve discussed this earlier:


 David Merkel
A Modest Proposal for Balancing the US Budget in the Short-Run
1/9/2007 11:06 AM EST

This is not meant seriously, but an easy way to balance the US Budget in the short run is to issue Japanese Yen-denominated debt. Current interest costs would drop rapidly, and the budget would balance.

What’s that you say? What if the Yen appreciates versus the Dollar? The US has an ill-disclosed balance sheet, with many of its liabilities omitted, or merely disclosed as footnotes… Medicare, Social Security, the old Federal Employee defined benefit plan, etc., are all off the balance sheet. (And on the plus side, so is the value of most of the property of the government, as well as the present value of its taxation capabilities.)

Leaving aside other things that are off-budget (e.g., Iraq, Katrina relief), borrowing in foreign currencies is just another tool that the Federal government can use to put off today’s costs off to a future date. It’s something that our government does well.

Position: none, though I own TIPS, realizing that they are only second best to developed market foreign currency debt, and the US Labor department controls the CPI calculation…

My Idea

Lest I merely seem to be a critic, I have another idea that I think is more powerful: Issue 40-, 50-, 75-, and 100-year bonds.? Issue TIPS versions as well.? Hey, issue a perpetual — Consols!? As I have said earlier:


 David Merkel
Now Let’s Have a Treasury Century Bond!
8/3/2005 9:30 AM EDT

George, I’m really glad to see that the Treasury has finally gotten a lick of sense, and is re-issuing the 30-year, which they should be able to at yields lower then the current long bond maturing in 2031 (probably 10 basis points lower).

Timing is anyone’s guess, but I would suspect two auctions — in November 2005 and February 2006 — in order to give the new benchmark bond sufficient liquidity. Given the absence of long issuance, demand for this bond will be very strong in the hedging community.

Now, the Treasury won’t do this, but my guess is that there is even more demand for a 50-year, or even a century bond (100 years). It would help pension funds and structured settlement writers match their liabilities. Those bonds could sell at yields less than the 10-year. Won’t happen, but I can dream.

Final note, this removes one of my reasons for lower long rates, but I am still biased toward lower long rates. The other reasons still hold.

none mentioned, though I own Treasury Securities of various sorts, both directly and indirectly (don’t we all?)

There is a decent amount of demand for safe long-dated debt from pension plans, life insurance companies, and other long-term fixed income investors.? These bonds would likely have lower yields than the 30-year bond, because of buyers that like long fixed income because of its reliability in a crisis.? (And, for bond geeks — high positive convexity.)

Personally, I think the market would happily digest a lot of really long debt from a seemingly strong entity like the US Government.? What, are we going to let the Europeans have a monopoly on long sovereign debt here? ;)? US Treasury, be innovative — show the world how confident we are in the future of the US by issuing debt as long as we think this republic will last.? Surely that is longer than 30 years.

The More Things Change, The More They Remain The Same

The More Things Change, The More They Remain The Same

Posted on by David Merkel

I’ve been asked by a number of readers for my opinion on the economic team being put together by the incoming Obama administration.? I’m not that excited, but then Bush Junior’s economic team was pretty consistently disappointing.? What we have is a bunch of Clinton-era retreads in Summers, Orszag, and Geithner.? Bob Rubin may not be there, but those that learned from him are there.

And, this is change.? I have sixty cents sitting next to me.? That’s change also.? Moving from Paulson to Rubin’s students is exchanging one part of the intellectual framework of Goldman Sachs for its cousin.? As Ron Smith said to me off the air when I was recently on WBAL, the economic advisors of Bush and Obama are members of the same intellectual country club.? There is little real change there.

But, look at it on the bright side.? The best part of the Clinton administration was the Treasury Department and the affiliated entities.? Perhaps that will be true of the Obama administration as well — pragmatism ruling over dogmatism, and a fear of freaking out the bond market.? Could be worse.? Save us from misguided idealists (perhaps Bernanke — a pity he didn’t pick a different dissertation topic), who think they know how to fight economic depression, but really don’t, and waste a lot of time and money in the process.

As it is we get two new programs this morning that are more of the same😕 Keep expanding the Fed’s balance sheet; don’t think about the eventual unwind.? Create more protected lending programs that encourage lenders to flee unprotected areas of the market for protected areas.? Do anything to shift debt from private to public hands; but don’t do anything that truly reconciles bad debt.

I do have a beef with the selection of Geithner, though.? This Bloomberg piece gives a sympathetic rendering of his attempts to deal with derivatives.? He tried to achieve consensus of all parties.? My view is that the areas where he could achieve compromise were areas that were important but not critical.? He needed to take a bigger view and question the incredible amounts of leverage, both visible and hidden, that we were building up and focus on what regulatory structures could properly contain the increased leverage, lest the gears of finance grind to a halt, as they have done today.

We can be less sympathetic, though.? Chris Whalen’s (Institutional Risk Analytics) opinion of him is quite low, or, as he was quoted in this NYT article:

?We have only two things to say about Tim Geithner, who we do not know: A.I.G. and Lehman Brothers,? said Christopher Whalen of Institutional Risk Analytics. ?Throw in the Bear Stearns/Maiden Lane fiasco for good measure,? he said.

?All of these ?rescues? are a disaster for the taxpayer, for the financial markets and also for the Federal Reserve System as an organization. Geithner, in our view, deserves retirement, not promotion.?

Ouch.

?He was in the room at every turn of the crisis,? said another executive who participated in several such confidential meetings with Mr. Geithner. ?You can look at that both ways.?

This Wall Street Journal editorial is similarly bearish.? Geithner was in the room on every bad decision, and a few non-decisions.

Or, just consider some of the questions that should be put to Geithner.? They are significant.

My view is that he is a bright guy who is out of his league in trying to deal with the aftermath of the buildup in leverage, that has lead to the collapse in leverage that we all face.? Now, I can’t be that critical of him, because he has been cleaning up after the errors of many, a small fraction of which he bears some responsibility for.

No one is equal to solving this crisis.? It is bigger than our government, which made an intellectual mistake in thinking that it could promote prosperity through Greenspan-like monetary policies, which almost everyone lionized while they were going on, except a few worrywarts like me, James Grant, etc., who followed the buildup of leverage in the Brave New World.? Now we face its collapse; let’s just hope and pray? that it doesn’t lead to worse government than what we have now.

PS — If I were offered the opportunity to fix things, I would take it, and:

The last one I like the least, but I’m afraid it would have to be done.? Phase two would be:

  • Move to a currency that is gold-backed.
  • Replace the Fed with a currency board.
  • Create a new unified regulator of all depositary institutions.
  • Slowly raise bank capital requirements, and make them countercyclical.
  • Bring all agreements onto the balance sheet with full disclosure.
  • Enforce a strict separation between regulated and non-regulated financials.? No cross-ownership, no cross-lending, no derivative agreements between them.
  • Bar investment banks from being publicly traded, and if regulated, with strict leverage/risk-based capital limits.
  • Move back to balanced budgets, and prepare for the pensions/entitlements crisis.

On that last one, there are few good solutions there, but we would have to try anyway.? So it goes.

Book Review: A History of Interest Rates

Book Review: A History of Interest Rates

Posted on by David Merkel

This book is big, very big at ~700 pages. It is a testimony to the idea that history doesn’t repeat itself, but it often rhymes.

The book is arranged chronologically, and geographically within each time period.? Time is spent on each are roughly in proportion to the amount of unique data that we have from each era.? Thus, the recent past gets more pages per year.? Roughly one-quarter of the book goes from ancient times to 1800, and one quarter to the 19th century.? Half of the book is 1900-2005.

There are several things that the book points out, common to each time and area investigated.

1) It is very difficult to eliminate interest.? Even when governments or religions try to restrict interest, either in rate charged or in entire, systems arise to create promises to pay more in the future that than full payment today.

2) The more technologically advanced economies get, the lower interest rates tend to get.

3) Boom/bust cycles are impossible to avoid.

4) Governments introduce currencies and often cheat on them (debasement, or inflation of a fiat currency).

5) Governments do sometimes fail, whether due to a lost war, civil war, or default, taking their currencies and debt promises with them.

6) The economic cycle across the world is usually more correlated than most people believe at any given point in time, even in ancient times.? (How much more today… decoupling indeed…)

7) Cultures that allowed for a moderate amount of debt financing prospered the most, in general.

Those are my summary points after reading the book.? Homer and Sylla drew some but not all of those conclusions.? It’s an ambitious book and and ambitious read.? Sidney Homer did a lot of significant work researching from the past to the middle of the 20th century, and Richard Sylla did an admirable job giving the grand sweep of the increasing complexity of the bond markets as the 20th century progressed until 2005, which was an interesting point at which to end the fourth edition.? The fifth edition, should there be one, will prove even more interesting as it surveys the end of the housing and credit bubbles, and the shape of the financial system in their aftermath.

This book is a must for those that like economic history.? I really enjoyed it.? For those without such an interest, it’s a big, somewhat-expensive, show-off book that will be occasionally useful as a reference.

If you want, you can find it here: A History of Interest Rates, Fourth Edition (Wiley Finance)

PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? I’m not out to sell things to you, so much as provide a service.? Not all books are good, and not every book is right for everyone, and I try to make that clear, rather than only giving positive book reviews on new books.? I review old books that have dropped of the radar as well, like this one, because they are often more valuable than what you can find on the shelves at your local bookstore.

The Citi was Asleep, is Asleep, and I Hope They Don’t Cause Us to Sleep

The Citi was Asleep, is Asleep, and I Hope They Don’t Cause Us to Sleep

Posted on by David Merkel

Time moves fast in a crisis.? It surprises me that it was only seven weeks ago that I wrote, What A Fine Mess You Have Gotten Us Into, where I commented:

  • What the FDIC did with WaMu affects other banks like Wachovia.? Bidders will let the holding company fail, and bid for the operating bank subsidiary assets.? Holders of holding company securities get hit, as their likelihood of getting reasonable recoveries disappears.
  • We are putting a lot of faith in the health of Citigroup, Bank of America, and JP Morgan.? If one of them fails, the game is over.? Given their complexity, and the recent takeovers, the odds of there being a significant mistake are high.? Consider further that they are counterparties for more than 50% of all derivative transactions, so the synthetic leverage is high as well.

What I meant by “the game is over” is that the idea that you can keep laying off risk on increasingly large and complex banks would be over as a strategy.? Also, the ability of the US Government to continue to bail out every decrepit entity would be tested, and possibly found wanting.

Or, as I noted on Friday, in my piece Broken?:

There are still more oddities to the current bond market, most of which involve parties that can?t take certain risks any more.? We can expand that to banks, and toss in Citi.? Citi is trading like it is going out of business.? Now, Citi is one of the ?too big to fail? [TBTF] banks, along with JP Morgan, Bank of America, and Wells Fargo.? If they are in trouble, I?m not sure who can buy them; they would probably be too much for even a coalition of the other TBTF banks to handle.? Is there a foreign bank that wants them?? I doubt it.? This would be another area where a new TBTF chapter of the bankruptcy code would be useful.

So now we have a bailout of Citi by the US Treasury and FDIC.? At present the rescue of Citi is a plus to the markets, because it takes a short-term problem off the table, leaving behind a more ill-defined long-term problem: how much can the US Government borrow/guarantee?? Also, what of their derivative exposures, and the state of the other TBTF banks?? It’s difficult to get that big in a credit boom without absorbing the seeds of the credit bust.

So, I am selling a little into the euphoria.? We will see where all of this leads, but my guess is that it is just one more step on the road to credit failure for the US Government.

Book Review: How to Be the Family CFO

Book Review: How to Be the Family CFO

Posted on by David Merkel

This review will be short, because my view of How to be the Family CFO, is mixed.? Let me start by saying that I preferred the book Easy Money, by Liz Pulliam Weston, because it had more concrete? advice than did Family CFO, by Kim Snider.

Also, I did not feel that I was being “marketed to” in Easy Money, but I did in Family CFO, particularly toward the end of the book, where the dividend-oriented Snider Investment Method (R), is discussed.? What put me off was the promotional nature of the writing, and the lack of detail, particularly any information on capital gains and losses from the strategy.? Definitely not Global Investment Performance Standards-compliant.? Also, the strategy would be undiversified, in my opinion, by being overexposed to income factors.

Now, there is one major positive to the book, a place in which it is superior to Easy Money.? It motivates the “why” of getting your financial life in order, while Easy Money is better with the “how.”? What I admire about the author is that after failure, she grew up, and learned to be a serious adult about planning for the future, and using money wisely.

Most of my readers I expect are good at handling their money, but perhaps you have family or friends with self-inflicted money troubles.? If they lack motivation, you could get them a copy of Family CFO (with my caveats).? If they have motivation but lack knowledge, you could give them Easy Money.

Both are available from Amazon:

How to Be the Family CFO

Easy Money: How to Simplify Your Finances and Get What You Want out of Life (Liz Pulliam Weston)

PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? If you wanted to get it anyway, it is good for both of us…

Book Review: The Only Guide to Alternative Investments You’ll Ever Need

Book Review: The Only Guide to Alternative Investments You’ll Ever Need

Posted on by David Merkel

I’m taking a brief break from “all crisis, all the time” writing.? I’m backlogged on book reviews, and it is time to write some.

When I get a book on asset allocation, I suck in my gut and say, “Oh no, not another book that falls into the common traps of only relying on past history, and doesn’t consider structural factors….”? I was surprised this time, and I have a book on asset allocation that I can wholeheartedly endorse.

Messrs. Swedroe and Kizer have distinguished between asset classes in sophisticated ways.? With annuities they classify immediate annuities as good, variable annuities as bad, and equity indexed annuities as ugly.? I could not have said it better.

They identify real traps for the retail investor: avoiding the structured product that Wall Street tries to feed retail investors.? They always find new ways to cheat you, encouraging you to sell options that seem cheap, but are quite valuable.

They also describe areas of the asset markets that are less correlated with domestic stocks and bonds — Real Estate, TIPS, Stable Value (I would note the over a long period stable value and bonds do equally well), Commodities, International Stocks, and Immediate Annuities.

Assets that are hybrid between equity and debt tend not to offer much diversification to a balanced core portfolio, so junk bonds, convertible bonds, and preferred stock do not offer much of a diversification advantage.? Similarly, Private Equity is highly correlated with public equity returns over a intermediate-to-long time horizon.? (I would note that any of those assets classes may present relative valuation advantages at certain points in time, and that expert managers can add value, if you can find them.? As for now, high yield is attractive, and there is value in busted convertibles trading for their fixed income value only.)

Hedge funds are difficult to consider as an asset class.? Their is much variability across hedge fund types, and within each type of hedge fund.? There are a lot of difficulties with survivorship bias in analyzing the effectiveness of hedge funds as a group.

The book has several strengths:

  • How do the costs of an asset class affect performance? (e.g. Variable Annuities)
  • How do taxes affect performance? (e.g. covered calls)
  • How does complexity affect performance? (e.g. Structured products)
  • How do personal factors like age and risk averseness affect what products might work well?
  • How does inflation affect performance?

Now, this is only indirectly a book on asset allocation.? It is not going to give you a set of procedures to tell you how to analyze your personal situation, the relative attractiveness of various classes at present, and the macroeconomic environment, and calculate a reasonable asset allocation for yourself, your DB plan, or endowment.? But it will give you the necessary building blocks to see how each alternative asset class fits into an overall asset allocation.

If you want to, you can buy it here: The Only Guide to Alternative Investments You’ll Ever Need: The Good, the Flawed, the Bad, and the Ugly

PS — Remember, I don’t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don’t pay anything extra.? Such a deal if you wanted to get it anyway…

Broken…

Broken…

Posted on by David Merkel

Things have been bad in the bond market of late, but many amazing things happened in the bond market yesterday.? I printed out a number of screens from my Bloomberg terminal near 4PM yesterday:

htt

And this blast from the past:

It is hard to convey the depth of the panic gripping the bond market of late, but when t-bills are priced at less than 10 bp of yield, and the 30-year bond rallies almost 9 bucks (46 bp) in one day, that says a lot.? The last graphic above is from Black Monday, when the stock market crashed in 1987.? The move in T-bonds was even greater than that day in spread terms, which is pretty astounding, because ther was a lot more spread to grab in 1987.? In dollar terms, that was a $3+ move, so the move today was unprecedented.

Also consider that 30-year TIPS fell at the same time as the large move up in nominal bonds.? Inflation protection is being given away for free in some cases (zero for 10 years), at very nominal fees in other cases (0.7% for 30 years), and being paid in other cases (-0.5% for 5 years).? The forward inflation curve looks pretty bizarre.? If I can find time, perhaps I can put up a graph.

Away from that, 30-year swap spreads closed near -60 basis points.? Swap rates are supposed to be similar? to where AA banks borrow/lend, so something is broken here.? My suspicion is that long duration managers (pension plans, life insurers) have for some reason felt forced to buy fixed-rate? promises through the swap market, rather than buying zero coupon bonds, the longest of which yield more than 3.5%, considerably more than swap rates.? Anyone holding a position to receive 30-yr fixed, pay floating saw it appreciate by 9-10%, which is pretty amazing.

Many of the rates on the Treasury curve are record low yields as far as I can tell. This contrasts against all of the other bond markets, including agencies, where rates are significantly above Treasuries.? Investment grade and high yield bond spreads are at record levels.? My view is that they should be bought selectively, realizing that purchasing power in this market is supreme, and not give it up easily.

Read Across the Curve for how investment grade corporate spreads are moving out.? CMBS spreads have gotten destroyed.? If I were running life insurance money, and my client felt his liabilities could not run, I would be buying AAA CMBS hand over fist, carefully selecting older deals with better credit quality.? That said, you can see the effects of the carnage in the shares of life insurers, which are the biggest providers of long-term credit.? (ouch with tears)

There are still more oddities to the current bond market, most of which involve parties that can’t take certain risks any more.? We can expand that to banks, and toss in Citi.? Citi is trading like it is going out of business.? Now, Citi is one of the “too big to fail” [TBTF] banks, along with JP Morgan, Bank of America, and Wells Fargo.? If they are in trouble, I’m not sure who can buy them; they would probably be too much for even a coalition of the other TBTF banks to handle.? Is there a foreign bank that wants them?? I doubt it.? This would be another area where a new TBTF chapter of the bankruptcy code would be useful.

I’ll have a more detailed response to my piece, It’s Called a Depression later.? I would say that I found the commentary interesting, particularly the places where some suggested that:

  • I focused too much on financials.
  • Negativity itself is the problem.
  • Why don’t you focus on what’s going right?

Aside from the Great Depression, every other recession since that time, the banks, insurers, etc., may have had a large subset under stress, but not to this degree.? Our economy is credit-based, and the amount of credit is a record multiple of GDP.? That credit in the past greased the gears of non-financial companies.? The troubles in financials is affecting the whole economy.? There will be a sustained decline in demand, because much of the prior demand relied on the ability to borrow.

I have long felt that this is no “crisis of confidence” as many in the government will say.? Rather, it is a realization that when one marks many positions to their market clearing levels (at a lower degree of leverage for the financial system as a whole), that many financial institutions are insolvent.? The government can try to reflate the bubble but it is too small to do so.? Reflating bubbles is not generally achievable, anyway, because the negative dynamics around the old deflating bubble preclude it.? Typically we blow a new bubble instead.

Now, I try not to be controversial.? I don’t like trotting out words like Depression or Stagflation for their shock value.? I bring them out when I think they can be useful in clarifying the situation at hand.? I am not a doom-and-gloomer? by nature.? I would much rather be running my “long only” equity portfolio during a bull market.? Relative performance, at which I have done well, is nice, but nothing beats absolute performance.

Ask yourself, though.? If you were at the start of a new depression, what would it look like?? My list yesterday is an example of what I think it would look like.? Given the freeze-up in lending where the government has not intervened, such as A2/P2 commercial paper and corporate bonds, this is a situation where problems in financials are spilling over to nonfinancials.

Now, as for what is going right, I invite readers to offer their ideas.? Please comment.? I will offer four:

  • Residential mortgage rates are declining a little (though rates are above the levels when Bernanke and Paulson introduced their “scare tactics.”)
  • The dollar is performing well.
  • The US government can borrow at amazing rates. (That no one else can touch, unless you are a long term swap counterparty…)
  • Commodity prices are falling, hard.

These are all consistent with a depression scenario.? Demand for safety, and lack of global demand for the basics.? That said, it is a lot more pleasant filling up my tank.

In closing, as some of my older friends who have passed on once said to me, “If the locusts eat your crop, at least you don’t have to harvest.”? This is true, but cold comfort.? I would be happier with the economy that I argued was unsustainable for so long.

PS — As an aside, the government, by protecting some sectors of lending, has intensified the crisis in theareas it did not protect.? The rally in nominal Treasuries is a grab for safety at any price.? The crash in corporate bonds is the opposite.? Money runs (so to speak) from unprotected to protected sectors in a crisis, and so, the government helps create crises, and diminishes liquidity by protecting some favored sectors of fixed income.

It’s Called a Depression

It’s Called a Depression

Posted on by David Merkel

I’m going out on a limb here, and I’m going to suggest that we have already entered a depression.? The concept of a depression is even less objective than that of a recession,? but some suggest that a decline in real GDP of 10% or more is the criterion, which we have not attained yet.

I don’t think a 10% decline in GDP is the right threshold.? Depressions are different because of their widespread nature, often coming through financial systems that are in danger.

As it is now, many things are happening that are depression-like.? Here we go:

  • Record high levels of total debt to GDP
  • Many go hat in hand to the government.
  • The spreads of the bond market are at record levels since the last depression, and maybe comparable.
  • There is policy paralysis and confusion.? No one knows what to do (or leave alone), they act blindly or cower in fear.
  • Ultrasafe investments have record low yields.
  • Banks don’t trust each other.
  • GDP is shrinking, and unemployment is increasing at a rapid rate.
  • Financial businesses are failing and shrinking at high rates.
  • The government comes in to “help” the markets, and ends up replacing the markets.
  • The security of banks and other financial entities is open to question.

Will we get a 10% decline in real GDP?? I think so, but I am nowhere near certain on that.? What I am certain of is that the gears of finance are jammed.? The bond market is a shadow of its former self, and few are willing to take seemingly prudent risks.? I’m not sure the government can do much to affect this; it will work out over time, as debts are paid off and forgiven, as the last depression did.

I won’t be your host through this depression, should I live so long.? But knowing what things will be like if we are in a depression is a real advantage for those who invest or run businesses.? Be careful.

Who Has A Balance Sheet?!

Who Has A Balance Sheet?!

Posted on by David Merkel

From 2003 to 2007, we went through a period where the balance sheets of financial entities went through a systemic downgrade.? They became:

  • More leveraged
  • Less transparent via derivatives
  • More reliant of floating rate finance
  • Reliant on debt structures with shorter maturities
  • More sensitive to calls on cash via ratings-sensitive collateral agreements

That is what has set us up for the problems that we have today.? In the bond markets, those conditions have led to the failures of many large market makers, straining the remaining system.? The remaining market makers in bonds are offering little liquidity amid the panic.? It doesn’t matter what sub-segment of the bond market I point at, every part faces a lack of risk-bearing capacity as parties hoard cash.

Part of this is the fault of the Treasury and Fed, as they proffered their TARP and pulled it back.? The greater the uncertainty from large parties, the more that small parties run and hide.

Away from that, many parties with capital have decided (seemingly) as a group to seek safety all at once, leading to a general malaise in all things risky.? Part of that could be related to the original TARP, as many parties decided to wait on selling until the TARP came along.? With no TARP (as originally conceived), those inclined to sell made offers, and the markets balked.

What can I say? Compared to 2002, there are fewer entities willing to bear credit risk during the crisis, even for short amounts of time.? This allows for arbitrage situations that don’t immediately get resolved, because no one has the balance sheet necessary to do it.

Eventually we will get to a point where those with unencumbered cash will make an effort to close those arbitrage gaps, and lend to worthy businesses at exorbitant rates, but it may take some time.? Until then, the market will flounder in the volatile way that it does.

Theme: Overlay by Kaira.