David Merkel – Page 272 – The Aleph Blog

Thinking About the Bear Stearns Bailout

Posted on 15 March 2008 by David Merkel

When I go to prayer meeting on Thursday evenings, I have recently begun requesting prayer for the economy and policymakers.? Ordinarily, I resist doing that, because it usually doesn’t sound right.? I remember one time two years ago explaining why we should pray about a given economic issue, and my dear wife said, “Let me get this straight.? We’re praying for the World Economy, that we don’t have a disaster?”? But when I was asked to explain my concern recently, I said, “Things are breaking in the financial system that no one a year ago would expect to break, and the costs could be high.? A second Great Depression is not impossible, and a repeat of something similar to the 70’s is more likely, minus the ugly clothes.”? That said, I am satisfied with praying for my daily bread, and the daily bread of others.

I didn’t expect to start the post this way, but that’s what’s on my heart.? Things are breaking that should not break, but what is happening is consistent with what I have been writing about here and at RealMoney for the past four years.? I am not a bear by nature, nor a bull.? I just try to analyze economic situations from a holistic perspective, and what I have seen over the past four years, was a massive increase in leverage that was not sustainable.? This affected the investment banks as well, and in this case, Bear Stearns in particular.

Confidence is tricky.? The investment banks are more highly levered than mortgage REITs, and we have seen the fallout there, even though real estate is more stable than the assets financed by most investment banks.

This is why in investing, I write about having a provision for adverse deviation, or in Ben Graham’s terms, “A margin of safety.”? With leverage, one should always calculate the maximum amount of? leverage consistent with prudence, and then take several steps back from there.? What is permissible in the boom phase has little relevance to the bust phase.

Now, I tell my children, “Don’t blame the Ump.”? In sports, if it is call of an umpire or referee that is the difference between victory and defeat, then you did not deserve to win.? You did not gain a commanding lead in the contest.? In this situation, Bear Stearns played close enough to the edge that rumors could begin to push at their short-term financing base, creating a crisis.? Investment banks must be like Caesar’s wife — there can’t be a hint of impropriety (with respect to financing).

Now, with a downgrade in credit ratings, Bear Stearns will have to find a buyer.? Why?? Major financial companies that lend have to have A-1/P-1 commercial paper ratings in order to make money.? The ability to borrow at cheap rates in the short run is important to profitability.

Naked Capitalism has some good points on this topic.? I would echo on the mortgage exposure.? More important is not being liked.? According to friends of mine, Lehman got rescued privately during the LTCM crisis because they convinced creditors to support them.? Bear walked out on the LTCM bailout, and it still leaves a bad taste in the mouth of Wall Street.? Wall Street does have honor, in a twisted way.? They remember who were their friends during tough times.? Bear was not one of them.

When there is a lot of worry around, it doesn’t take much to kick a marginal firm over the edge.? Bear had ample opportunity to move to lower level of leverage, and did not do it.? Now let’s talk about the rescuer.

The Omnipotent Federal Reserve

The Fed can’t run out of bullets, because it can always print money.? That comes with an inflation price tag attached, though.? In this case, they are providing funds freely to J. P. Morgan to the extent that they lend to Bear Stearns.? Now, I know why the Fed did this.? Bear Stearns my be small in a market capitalization sense, but is large when one considers all of the debts that they have, both in the cash and synthetic markets.? (As an aside, I was analyzing some muni bonds of a major issuer today, and it amazed me that Bear Stearns was their #2 counterparty.)

Now the Fed has Fed funds, the discount window, TAF, TSLF, and more.? I am not here to fault them for lack of creativity.? I am here to fault them for (like Bear Stearns) overtaxing their balance sheet.? There is only so much that the Fed can rescue before it chokes, because they (at that point) have no more safe assets to pledge.

I sold my capital markets exposure earlier this week, and I am glad that I did, late as that was.? The Fed is not big enough to rescue all of the investment banks, nor could they rescue the GSEs, without creating significant price inflation.? What a mess.? Avoid the depositary financials, and those that lend and intermediate aggressively.? This is not a time to be a hero in financials.

Book Review: Easy Money

Posted on 15 March 200815 March 2008 by David Merkel

For most of my readers, this book may prove to be too basic, but we all have friends that are not “money people.” They don’t know how to take care of their finances, and they constantly get into money troubles. This book could be of help to them.

Now, as you can see from the picture, you can see that she refers to herself as, “The Internet’s #1 Personal Finance Expert.” I can’t vouch for that. I like to think that I am aware of a wide number of trends in investing and money management, and this was the first time I heard of her.

There were five main things that appealed to me about this book. First, it’s not a long book (173 pages in the main body of text), and it is simply written, so an average person not good with finances could make his way through it. Second, even though small, it is pretty comprehensive for the finances of an average person or family. Third, I think she gets most issues right for average people who have relatively simple financial problems. Fourth, it provides advice on where to get more data, without marketing herself directly. Fifth, it summarizes action points for each area of personal finance.

I do write about personal finance a little, but you will never get the detailed advice on cash management, budgeting, personal credit, hiring advisors, and shopping smart from me that you will get from this book. My contribution is a more savvy view of investing and insurance. On the latter topic, insurance, I thought she covered the bases well. (As an aside, she shares my bias against variable annuities.)

Now, was there anything that I wasn’t crazy about? I know she wrote a book on the topic, but I think it would have been worthwhile to briefly explain why keeping a high credit rating in this age is so important, because of the effect that it has on insurance premiums, and even employment, leaving aside how much you will pay in interest, and how onerous lenders and creditors will be with you if you ever make a mistake.

Now on investing topics, the book is good but not great. For the average person that doesn’t matter. For those wanting to take a step up, I would recommend The Dick Davis Dividend. She focuses on saving enough (most people don’t save enough), and asset allocation through passive investments. She is a little too bullish on real estate for my tastes. Someone following her advice in these areas will do better than most, if they have the discipline to avoid panic and greed.

But, leaving those quibbles aside, this is a solid book, and those following its advice will benefit.

Full disclosure: If you buy through Amazon.com on any of the books that I review through links on my site, I get a very modest commission.

Personal Finance, Part 15 — How I Buy Cars

Posted on 14 March 2008 by David Merkel

When I buy a car, I analyze what car I would like to buy.? I look at reliability, repair costs, overall costs, and style.? I use Consumer Reports to help me analyze this.? Then I go to the website(s) of the manufacturer in question, and copy the data on all of the used models on offer at the dealerships within 30 miles of me.? With price as the dependent variable, I then run a regression with model year as dummy independent variables, and total miles as an independent variable.? After I run my regression, I look at the cars with the biggest price deviations, the predicted price is a lot higher than actual.? I then look at the features of the underpriced cars, and choose one where there are good features with a discounted price.

I go to that dealer, review the car, test drive it, and if it passes my tests, I haggle over the price, and buy it. ? In my experience, this cuts thousands off the price of the car.? What a great reason to have studied econometrics.

$6.25?!

Posted on 14 March 2008 by David Merkel

I will have a fuller post after I talk with Jim Gorman, CEO of National Atlantic.? If he thinks his company, which he owns around 13% of is only worth $6.25/share, that is a real surprise to me, and inconsistent with all of the other discussions that I have had with him over the last four years.? A few of you have asked me about appraisal rights.? Really, we should talk about this later if the deal gets approved; it’s too early to speculate there.? For those that remember my early posts at RealMoney on the Mony Group acquisition, remember that book value is sometimes illusory.? I don’t think that is the case here, but let me talk with Jim Gorman, and listen to the earnings call on Monday.? If they deliver another bomb, like last quarter, maybe $6.25 is generous.

Full disclosure: long NAHC

One Dozen Notes on Our Crazy Credit Markets

Posted on 13 March 200813 March 2008 by David Merkel

1) I typically don’t comment on whether we are in a recession or not, because I don’t think that it is relevant. I would rather look at industry performance separate from the performance of the US economy, because the world is more integrated than it used to be. Energy, Basic Materials, and Industrials are hot. Financials are in trouble, excluding life and P&C insurers. Retail and Consumer Discretionary are soft. What is levered to US demand is not doing so well, but what is demanded globally is doing well. Much of the developed world has over-leverage problems. Isn’t that a richer view than trying to analyze whether the US will have two consecutive quarters of negative real GDP growth?

2) So Moody’s is moving Munis to the same scale as corporates? Well, good, but don’t expect yields to change much. The muni market is dominated by buyers that knew that the muni ratings were overly tough, and they priced for it accordingly. The same is true of the structured product markets, where the ratings were too liberal… sophisticated investors knew about the liberality, which is why spreads were wider there than for corporates.

3) Back to the voting machine versus the weighing machine a la Ben Graham. It is much easier to short credit via CDS, than to borrow bonds and sell them. There is a cost, though. The CDS often trade at considerably wider spreads than the cash bonds. It’s not as if the cash bond owners are dumb; they are probably a better reflection of the true expectation of default losses, because they cannot be traded as easily. Once the notional amount of CDS trading versus cash bonds gets up to a certain multiple, the technicals of the CDS trading decouple from the underlying economics of the bond, whether the bond stays current or defaults. In a default, often the need to buy a bond to deliver pushes the price of a defaulted bond above its intrinsic value. Since so many purchased insurance versus the true need for insurance, this is no surprise.. it’s not much different than overcapacity in the insurance industry.

4) If you want a quick summary of the troubles in the residential mortgage market, look no further than the The Lehman Brothers Short Swaption Volatility Index. The panic level for short term options on swaps is above where it was for LTCM, and the credit troubles of 2002. What a take-off in seven months, huh?

5) Found a bunch of neat charts on the mortgage mess over at the WSJ website.

6) I have always disliked the concept of core inflation. Now that food and fuel are the main drivers of inflation, can we quietly bury the concept? As I have pointed out before, it doesn’t do well at predicting the unadjusted CPI. Oh, and here’s a fresh post from Naked Capitalism on the topic of understating inflation. Makes my article at RealMoney on understating inflation look positively tame.

7) The rating agencies play games, but so do the companies that are rated. MBIA doesn’t want to be downgraded by Fitch, so they ask that their rating be withdrawn. Well, tough. Fitch won’t give up that easily. Personally, I like it when the rating agencies fight back.

8 ) Jim Cramer asks if Bank of America will abandon Countrywide, and concludes that they will abandon the bid. Personally, I think it would be wise to abandon the bid, but large companies like Bank of America sometimes don’t move rapidly enough. At this point, it would be cheaper to buy another smaller mortgage company, and then grow it rapidly when the housing market bounces back in 2010.

9) Writing for RealMoney 2004-2006, I wasted a certain amount of space talking about home equity loans, and how they would be another big problem for the banking system. Well, we are there now. No surprise; shouldn’t we have expected second liens to have come under stress, when first liens are so stressed?

10) In crises, hedge funds and mortgage REITs financed by short-term repo financing are unstable. No surprise that we are seeing an uptick in failures.

11) As I have stated before, I am not surprised that there is more talk of abandoning currency pegs to the US dollar. That said, it is a getting dragged kicking and screaming type of phenomenon. Countries get used to pegs, because it makes life easy for policymakers. But when inflation or deflation gets to be odious, eventually they make the move. Much of the world pegged to the US dollar is importing our inflationary monetary policy.

12) Finally, something that leaves me a little sad, people using their 401(k)s to stay current on their mortgages. You can see that they love their homes, as they are giving up an asset that is protected in bankruptcy, to fund an asset that is not protected (in most states). Personally, I would give up the home, and go rent, and save my pension money, but to each his own here.

Brief Note on the Fed Actions

Posted on 12 March 2008 by David Merkel

I’ve been puzzling about the recent Fed actions, and I think there is less there than meets the eye.? Don’t get me wrong, the Fed has acted.? It is changing the composition of its balance sheet in the short run, absorbing MBS, and pushing out Treasuries.? But it is not expanding its balance sheet.? After several novel policy initiatives, it should be painfully obvious to Fed-watchers that the lack of increase in the monetary base is intentional.

The Fed is trying to influence financing in the residential mortgage market versus Treasuries, in the short run.? It is not trying to stimulate the economy through expanding the monetary base.

The short-run aspect of the program hobbles it to some degree.? The Fed can say that they will continue to finance in the short term indefinitely, but nothing says that louder than expanding the terms from 28 days to two years.? If it’s in the agreement, the expanded length of financing will get a much bigger result than a rolling four week window.? Think of it this way: the Fed might want to continue the short-term financing indefinitely, but there have been times in the past where the Fed has felt forced to abandon a plan because of global macroeconomic events (think 1986-7, when the dollar fell, then the bond market fell, then the stock market fell…).? Promises are one thing, contractual terms are another.

I’m not a fan of central banking, but if we are going to have central banking, this is a time when the monetary base should be expanding, at least modestly.? I think the Fed in this case is being “too clever” and needs to do a permanent injection of liquidity.? If they don’t want to do that, well, let’s move back to the gold standard, and privatize monetary policy.

Redirection of Liquidity, Not Creation of Liquidity

Posted on 11 March 2008 by David Merkel

These short-term financing arrangements (TAF & TSLF) are an attempt of the Fed to redirect liquidity from ordinary channels (fed funds and the like), to the short-term funding of banks and dealers with acceptable collateral. Acceptable collateral varies, with differing haircuts depending on the collateral and the financing program. At this point, Agency MBS and AAA whole loans (not on review for downgrade — presumably that means no negative outlooks from any ratings agency) are encouraged.What I find most interesting in all of this how little true liquidity the FOMC has injected in this cycle. The monetary base is flat. What this looks like is an attempt to selectively reflate the economy — help the banks and dealers, but keep total liquidity close to fixed.

And, in the face of this, total bank liabilities keep expanding at a 10%+ clip. It almost feels like any source of liquidity is good liquidity to the banks. Of course, they get a lot of it from the FHLB, which has been the big unconstrained lender in this cycle. Fannie and Freddie may now be able to make larger loans, which loosens up hosing finance a bit, but only the FHLB has the balance sheet to do so in this cycle, and they have done it. Call them the “shadow Fed.” But even their balance sheet is finite, and they are only implicitly backed by the US Government, like Fannie and Freddie.

So where does this leave us? Muddling along. Even the redirection of liquidity will not get the banks and dealers too jazzed, because they are only short term measures, with uncertain long-term funding availability and cost. More attractive than the “free” market for now, but that’s about it.

The Fed is trying some clever ideas. I have just two concerns — what happens when you unwind them, and are they perhaps too clever?? There may be unintended consequences…

The Fed is Short-Term Rational, But Not Long-Term Rational

Posted on 11 March 2008 by David Merkel

Keynes said, “In the long run, we are all dead.”? Now, those of of us who believe in Jesus Christ would object, but that’s not my purpose for writing here.? At present, the FOMC is pursuing a short-term strategy to reliquefy the short-term markets through the TAF and other means, leaving the long-term inflationary results to play out as they will.? As they do this, they listen to the strains from banks and other lenders and ignore the price signals from food and energy, which are in greater demand globally.

Long-term rationality would have the Fed stop about now, because the present yield curve is adequate to stimulate the economy. I argued that at RealMoney, when the Fed started raising rates above 3%.? Overshooting would lead to bad results.? The same is true here on the flip-side. Lowering rates by too much will create its own troubles,

The Fed likes to talk about its “independence,” but really it has little, unless it is willing to make some politically unpopular moves, and not lower rates much further.

I’ll tell you what I expect: the FOMC will lower the Fed funds rate by 50-75 basis points at the meeting on 3/18.? They follow the market; they don’t lead it.? Even though loosening does little good for dodgy financial companies, they loosen in hope that they might end the leverage crisis.

The Value of a Balance Sheet

Posted on 11 March 2008 by David Merkel

Monday, at about 10AM, I sold my holdings in Deerfield, Deutsche Bank, and Royal Bank of Scotland.? I did it bloodlessly, realizing that Deerfield is the largest loss I have ever taken.? With the proceeds, I bought two placeholder assets that I will hold until the next reshaping (coming in a month), the Industrial (XLI) and Technology (XLK) Spiders.? By doing that, I cut the majority of the links that I had to the leveraged lending economy, which is collapsing at present.? When I saw that haircuts on repo for prime agency collateral had been raised for the second time, I threw in the towel, because too many things have broken that even I did not expect would break. (Even the haircuts on Treasuries have risen.)

With Deerfield, I made the error that if the collateral was very high quality, it could survive, even at high levels of leverage.? In a true panic, that does not matter.? All that matters is whether your leverage is low enough to allow you to survive the credit bust, and that you can do that over your financing horizon.

Financing horizon?? By that I mean how often your solvency gets measured.? For many mortgage REITs, that is a daily, weekly, or monthly phenomenon.? The longer the period, the better the odds of survival.? Short repo financing is by its nature is a weak financing method in a crisis.? The day you cross the line (margin inadequate) the brokers move to liquidate.? Given that some other managers may have been more aggressive, your excess capital can disappear, as more aggressive mangers miss margin calls, and the pressure of their liquidations, forces your more conservative positions down, and you have to liquidate also.

Now, think of a life insurance company, a long-tailed casualty insurer or a defined benefit pension plan.? If they buy AAA whole loans, or prime mortgage collateral, they can hold that position for 3+ years without worry.? Their liabilities aren’t going anywhere.? They know what they will be able to hold the investment through the panic period.? There are still questions over what the best time to buy is, but with many large companies or plans, the optimal thing to do is to suck in a little bit each day, quietly, when the bonds are cheap.? You won’t get the exact bottom; no one does, but you will do well.? My own example is buying floating rate trust preferreds back in late 2002.? Bought a 2% position over two months for my life insurance client without disturbing the markets.? My client cleared a minimum of 10% on those investment grade bonds within a year as the panic lifted.

Accounting vs. Financing

Now, there’s a lot of talk about fair value accounting standards, and how they are adding to the volatility at present.? They are adding to the volatility, but they have less effect than the way things get financed.? Unless the fair value accounting leads a company to violate a debt covenant, typically it does not have that much effect, because it does not change the pattern of cash flows that the company will generate.? Short term financing, where the portfolio’s “market value” gets measured on a daily basis has a much bigger impact, because as prices fall, liquidation of assets can feed a collapse of prices.? Or consider this article from Going Private, which cites an article from Financial Crookery, which highlights an attempt by Merrill Lynch to avoid having to pay out cash on a putable bond.? In order to do that, they make the bond more valuable, so that it won’t be put.? But this isn’t an accounting issue.? It is a financing issue.? Merrill doesn’t want to part with cash now, so it makes its future financing schedule more difficult.? It is a complex way of selling off a bit of the future in order to bail out the present.

Now, I disagree with The Economist article that spawned those posts as well.? There is a better way.? In place of the four common financial statements (Income Statement, Balance Sheet, Cash Flow Statement, and Shareholders Equity), have six.? The two additional statements would come from having a amortized cost income statement, and a fair value statement, and then, the same for the balance sheet.? It would not be a lot of extra work, because all of that data has to be gathered now already.? It would just create two different ways of looking at a financial entity.? One views it as a buy-and-hold investor (amortized cost), and the other as a trader (fair value).? The interpreter of those statements could decide which is more relevant.

I proposed this to an IASB commissioner 2-3 years ago, and she was horrified at the idea.? Two income statements?? Two balance sheets?? What confusion.? I pointed out to her that every financial statement is designed to answer one question.? Bond investors have to rearrange the data to do their analyses; we could create an EBITDA statement to make life easier for them, but we don’t.? The two statements types define two different ways of looking at a firm.? Each is more valid in different situations.

Now, for utility and industrial firms, these distinctions usually don’t matter much, but they do matter for financial firms.? There could be a seventh statement added there, which life insurance companies calculate for their regulators.? All financial companies should have cash flow testing done over the greater of the life of their assets and liabilities, over a wide number of interest rate and credit scenarios, calculating the present value of distributable earnings, to show where they are vulnerable.? They should publish the assumptions and results, and then let the market stew over them.

Now, for my actuarial friends, this would be the “Actuarial Full Employment Act.” Life Insurers control risk not by looking at short term movements in market prices, but through long-term stress testing.? It is no surprise that the insurers are doing much better than the banks in this environment.

Negative Real Interest Rates and Asset Deflation

Posted on 8 March 20089 March 2008 by David Merkel

I always try to separate my views of what I think the FOMC will do, versus what the FOMC should do. It’s hard for me now, because I think the FOMC is pursuing the wrong strategies. The yield curve is steep enough now, that further easing will not yield much incremental benefit. Further, a loose monetary policy only stimulates healthy areas of the economy that can absorb more borrowing, not areas with impaired balance sheets.

But what will the Fed do? Loosen. Aggressively. Don Quixote would be proud. They will make the TAF permanent and big, and the discount window will be a relic of a simpler age.

Let’s think of the short run versus the long run. In the short run, the FOMC wants to get the economy moving again, and is willing to tolerate negative real interest rates in order to do so. The Fed funds target is already 1%+ below the CPI, and the argument is over whether the next move will be to loosen 50 or 75 basis points. Negative real interest rates promote goods and services price inflation. (I don’t know about everyone else, but when filling up my gas tank nears $100 I begin to worry. Eight kids — 15-seat van, 10 cylinders…) In the long run, the FOMC will have to deal with price inflation. Even with the current yield curve, I can tell you that goods price inflation will worsen, leading to monetary tightening that will be painful, or no tightening, and inflation that rivals the 70s.

The Fed could target lending to the weak areas of the economy, while leaving monetary policy alone. That would invite charges of favoritism, which is why it won’t happen.

So, in my opinion, asset deflation will persist, and goods price inflation will increase. As for me, I will likely sell my positions in Deerfield Capital, Royal Bank of Scotland, and Deutsche Bank on Monday, replacing the exposure with an index for now. I have agonized over the seemingly cheap capital markets names for some time now, and I have been the loser there. I will return, but for now, it is safer to have no investment banking or mortgage exposure. The asset deflation is hitting them hard, and lending is contracting.

Full disclosure: long DB RBS DFR