Category: Bonds

Insurance Thoughts

Insurance Thoughts

Posted on by David Merkel

I am known for my views on insurance stocks, and I wrote about those views at RealMoney yesterday:


 David Merkel
Buy Insurance Stocks. Really.
1/18/2008 12:04 PM EST

Bouncing off Adam?s comments on the XLF, the insurers in the index are getting drubbed, and in my opinion, for little good reason. On an earnings basis, many of them are the cheapest I have seen maybe ever, and while some of their earnings prospects will be diminished by the fall in the market, and difficulties in the bond market, in general, the asset side of their balance sheets are in good shape. So, if you are looking for ideas, here are a few I am looking at: MetLife, Hartford, Travelers, Lincoln National, ACE, Chubb, Principal and XL. Hopefully this will do as well as my PartnerRe trade last August.

Position: Long LNC

I would add to that list SFG and DFG. After some thought, I acted:


 David Merkel
Bought Some Hartford, Added to Lincoln National
1/18/2008 12:45 PM EST

Lincoln National was a rebalancing buy, Hartford is a new position. Both are quality competitors with good balance sheets. The only possible drawback is in a protracted decline, earnings from variable products could suffer.

Position: long HIG LNC

Then, at the end of the day, I added:


 David Merkel
The Dike Has Sprung a Leak
1/18/2008 4:30 PM EST

Fitch downgrades Ambac to AA from AAA. Stock has a temporary rally. Is this a great country or what? Because of the social dynamic of the rating agencies, and the existence of one downgrade, the dike has been breached, and I would expect more downgrades.

Hey, maybe it?s time for the financing of last resort: Ambac could issue a convertible surplus note. Maybe even sell it privately to Buffett, who could own 30% of the company if things turn around. He won?t delta-hedge common against it. They might even be able to get away with a coupon below 15%. Package it with a reinsurance agreement, and the NY State commissioner smiles on it.

Okay, I went overboard there, but there was no reason for Ambac to have its short-lived rally. That?s probably why it didn?t stick.

Position: none

My last note was half-whimsical and half-serious. Buffett likes convertibles, particularly if they offer attractive optionality at the right price. The question is how big the problems are at Ambac relative to their small capital base.

Now, after the downgrade of Ambac, Fitch moved to downgrade Ambac-guaranteed bonds. This is serious stuff. Moody?s and S&P will also likely move on Ambac, and MBIA, FGIC, SCA, and more. Channel Re is toast, and PartnerRe and Ren Re have written off their stakes in them (what of MBIA?).? ACA Capital is dead, or nearly so, facing a midnight deadline for forebearance from their counterparties.

I should also add that there are reinsurance issues among the financial guarantee companies have reinsurance issues.? I mentioned Channel Re, which mainly provided insurance to MBIA.? MBIA and Ambac, from what I remember, mutually reinsure about 10% of each other’s liabilities.? Beyond that, you have poor RAM Re:?

RAM Re attempts to absorb a quote share of the liabilities of the primary financial guarantors.? I met their management team during their IPO.? They seemed to be good people, and talented managers.? But having a quota share of the seven soon-to-be-formerly-AAA guarantors is a ticket to not being AAA oneself.? They face risks of insolvency of primary writers, which could lead to their own insolvency.

What I am trying to convey here, is that stress at one guarantor could have ripple effects at other guarantors.? The least affected would be Assured Guaranty, FSA (a Dexia subsidiary), and Berky (of course).

As for the recent Barron’s article on MBIA, I would only say that it all depends on structured finance losses.? If losses on CDOs are severe, MBIA could be a sell even at these levels.

These are unusual times, and it pays for investors to avoid for the most part the financial guarantee space (mortgage and title too).? Other insurers (life, health, P&C) are likely better than other financials, and generally cheap; I own a bunch of them.

Full disclosure: long LNC HIG

Tickers mentioned: SCA RAMR AGO ACAH MBI ABK BRK/A BRK/B HIG LNC MET PFG DFG SFG CB TRV MET ACE XL

Why Financial Guarantee Insurance Failure is Less Harmful than it Seems to Municipal Bonds

Why Financial Guarantee Insurance Failure is Less Harmful than it Seems to Municipal Bonds

Posted on by David Merkel

Reader Question:

Hi David,? I really enjoy your blog very much.? Your recent post regarding AAA bonds brings up a question for me and I’ve seen several different answers in the press and on TV.

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I have?about 35% of my portfolio in triple AAA muni bonds–most insured, but not all.? My intention with insured AAA bonds was to not have to worry about them.

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I’m now reading about the potential bankruptcies of the muni insurers–AMBAC, etc.? I heard on the tube today that “we will?see a muni bond crash” if the ratings on these insurers are lowered.? After the close I saw where one was lowered to a AA rating.? This is not what I like to hear and I suspect with further reading that the comment was overblown, possibly irresponsible.?

?

I hold my bonds to maturity with my principle concern of income generation. Is this something one should be worried about?? Anything specifically about the individual bonds that should raise read flags?? As I live in Arkansas, most are Ark. munis although I’ve got some from Puerto Rico.? Thanks for any insight on this.??And keep your great posts coming.

I don’t think you should be very worried.? Municipalities rarely default.? When they do default, it is typically for a little while, and then payment resumes.? So long as a municipal bond has an economic purpose behind it — a necessary city, county, state, or project, defaults are rare.

The financial guarantee is a way of making the bonds thought-proof.? Bond mangers don’t have to do credit analysis; the guarantee is enough.? The guarantors aren’t dumb (at least with respect to municipals), they know what doesn’t deserve a guarantee.

Without knowing exactly what you own, I can’t say it with certainty, but I can say it is likely that you will come out okay if all you hold are munis that have an economic purpose. ? (Be careful on the Puerto Rican issuers, I know little there.)? That said, the market value of your bonds have likely declined a little due to the possible loss of insurance protection.? If you are truly, buying and holding economically necessary issuers, you should end up fine.

Unstable Value Funds?

Unstable Value Funds?

Posted on by David Merkel

David Merkel
Things That Go “Bump” in the Night
1/17/2008 1:45 PM EST

One piece that I wrote three years ago for RealMoney has relevance today in a new way. Stable Value Funds often invest in AAA securities (some are solely invested in AAA securities), and some funds will have above-average exposure to securities credit-wrapped by the financial guarantors, and possibly, to some asset-backed securities that were rated AAA at issue, but don’t deserve that rating now. For those who have exposure to stable value funds through their defined contribution plans, it might be wise to check what exposures your funds have to the guarantors, and to AAA structured securities that are trading significantly below amortized cost. The summary statistic to ask for (not that they will give it to you) is the market-to-book ratio of the fund. If it gets lower than 97%-98%, I would avoid the fund.

Now for the good news: If a stable value fund breaks, the total loss is likely to be small, like that of a busted money market fund. The one exception would be if a stable value fund manager tried to meet withdrawals while facing a run on the fund, and ratio of the market value of the assets to the book value of the assets kept falling.

In such an event, better for the fund manager to stop withdrawals early and announce a new NAV that counts in the loss.

I don’t know of any stable value funds that are in trouble, so take this with a grain of salt. Most stable value funds are managed conservatively, so any testing will likely reveal that most of them are fine. There may be a few that aren’t fine, though, so a little testing is in order.

If you do find a need to move, money market and high quality bond funds are an excellent substitute for stable value funds. Be aware that you might have to leave funds in a non-competing fund option for 90 days to get there. In this market, the risks there could be as great as the losses on the stable value fund, so think out the full decision before making any change.

Position: none

That was my post at RealMoney today.? I wrote it with some degree of uncertainty, because stable value funds have a defense mechanism.? They can lower the crediting rate to amortize away the difference between book value and market value, and in a crisis, many will not argue with the credited rate reductions.? They are just happy to preserve capital.

Do I think this is a big problem?? No.? Do I think that no one is talking about this?? Yes.? The thing is, a lot of things can be hidden by the various wrap agreements that stable value funds employ.? If I were a stable value fund, I would not want to publish my market value to book value ratio.? If it’s above one, the fund will attract inflows, diluting existing investors.? If it’s below one, net outflows will increase, threatening a run on the fund.

Just be aware here, because if you can’t get a feel for the underlying economics of your stable value fund, you should probably seek another investment in the present environment.

Score One Success for the Federal Reserve

Score One Success for the Federal Reserve

Posted on by David Merkel

I’ll give the Federal Reserve this, their TAF program has succeeded in bringing down US Dollar LIBOR rates relative to Treasuries and Fed funds.? I did not doubt that they could succeed at doing this; my main concern is what happens when they stop doing this.? Flooding the short end of the yield curve with liquidity has overwhelmed those seeking permanent liquidity cheaply, by offering large amounts of temporary liquidity cheaply, and saying that the program could become a regular part of the Fed’s policy tools.

So, the most recent auction priced out at 3.95%, well below the Fed Funds target of 4.25%, and below where Fed Funds have averaged recently, which is around 4.15%.? Why borrow at Fed funds if the TAF is available?? The TAF can accept a wider array of credit instruments as well.? Why even give a second thought to the discount window at 4.75%, if the same collateral can be financed by the TAF?? Granted, the rate was above the expected fed funds rate for the next month, but using that as a guideline is tantamount to surrendering control of the money supply to the Fed Funds futures market.

Looks like a win for the Fed, at least in the short run.? The long run could be a different story.? The old rule of Walter Bagehot was for the central bank to unlimitedly lend against secure assets at a penalty rate in a crisis.? In this case, it is lending against less than top-quality assets at what is a bargain rate.? In the long run, that is a recipe for monetary and price inflation.? Though longer-dated TIPS don’t reflect that future consumer price inflation, I expect that they eventually will.

Relying on the Kindness of Strangers as an Investment Strategy

Relying on the Kindness of Strangers as an Investment Strategy

Posted on by David Merkel

In 2002, when many credits were troubled, I would look at some of troubled positions that we held and do a recovery analysis, to see what we might get if the company filed for insolvency. Often in that process, I would find that investors elsewhere in the capital structure had different motivations than we did. The bank might prefer to liquidate the stinker, while the bondholders, in a more junior position, would prefer it kept as a going concern. Or, the equity investors that have control of the company might pursue a unprofitable strategy that encumbers the assets of the firm, leaving the bondholders with a less valuable entity for their debt claims. Or, the company could issue secured debt, effectively subordinating bondholders, while providing cash that could be used to buy back stock. Another case is when you have a valuable company with a liquidity problem. The banks will be willing to lend against that trapped value so that the company can repay bondholders, right? Right?! (Sigh.) In most of these situations, a bond investor finds that he is implicitly relying on the kindness of strangers. That is rarely a good place to be. 🙁

Now, a few judicious debt covenants could partially level the playing field, but with investment grade bonds those are rare. (Covenants work a lot better than fraudulent conveyance lawsuits, etc….) My main point here is that it pays to analyze situations in advance to understand when your bargaining power is weak. Risk control is best done on the front end, not the back end. Equity/Management will always hold the “capital structure” option to some degree, and unsecured lenders will always have a weak hand there.

So when I read this article about ladies in Baltimore losing their homes because they didn’t do enough scrutiny of the mortgage documents, partly because they were deceived by people who were seemingly experts, who said that they would be able to refinance the rate when the reset date hit, I thought about relying on the kindness of strangers again. It would be one thing if guaranteed refinance terms were offered at the initial refinancing, but absent that, credit conditions are fickle, and it can be a short interval between loose credit and tight credit. Relying on the ability to refinance a debt is always risky.

Today, consumer credit terms are tight. A year ago, they were moderately loose. Two years ago, terms were stupid loose. Who knows, later this year, terms could become stupid tight, where even good quality borrowers with adequate security can’t get credit.

Again, in investing, and even in personal finance, strive to understand your bargaining position. Do you hold the options? If it’s not you or those with you in your position, then others hold the options to control the assets. Usually those are held by the equityholders (or management, who sometimes act in their own interest, not that of the shareholders), and senior or secured debtholders. Those with weak positions, like preferred stockholders, unsecured and junior debtholders must be compensated for the weak position with extra yield or covenant protections.

The same analysis applies to structured securities, whether the credit enhancement comes from a guarantor or a senior-subordinate structure. In the good times, the equity controls the deal. In the really bad times, control often slides to those who are most senior in the capital structure.

On a personal level, a house is controlled by the owner if he can stay current on the payments (if any). Absent that, the bank controls the situation, subject to the rights of other claimants (the taxman, home equity lenders, mortgage insurers, etc.)

If strangers are kind to you, that is a good thing. Be grateful for a society that encourages that kindness. But don’t rely on it in investing or personal finance.

PS — sometimes even a good analysis of your rights and options can go awry. The KMart bankruptcy was a good example of that, where KMart had assets worth more than their liabilities, and could have gotten financing to continue. But a bankruptcy judge allowed their petition, and they were able to give creditors and lessors the short end of the stick. Those that controlled KMart post-bankruptcy made out handsomely. It would be difficult to repeat that aspect of the success.

Thus, you might look at this good article on Sears Holdings (successor name for KMart) in a slightly different light. The financial engineering gains can’t be repeated. It now must make its money as a retailer. As the article gently points out, being a good investor and a good retailer don’t naturally go together.

Bringing this back to topic, does management of Sears act in the best interests of shareholders? Management has the incentives to do so, but sometimes the intellectual gratification of the CEO can get in the way of making good business decisions. Management has control, the outside passive minority investors do not. Their only options are to ride on the Sears bus, or get off. If an investor doesn’t think the management of Sears is doing it right, he would be foolish to trust them with his money.

How to Manage a Portfolio

How to Manage a Portfolio

Posted on by David Merkel

Given the title above, I feel embarrassed to write, because the topic is too basic. I write because too few managers think clearly on the topic. The following analysis applies to long only funds and hedge funds; it also applies to equity and bond funds. The impetus to write this note arrived because the Fidelity Magellan Fund is reopening because cash inflows will make the life of the portfolio manager easier… not that he will get many inflows for now.

My view is that it should not be hard to manage a shrinking portfolio. It is much harder to manage a rapidly growing portfolio. (I have experienced that, and that is a topic for another day.) Here is the key concept: the portfolio manager must rank his portfolio by expected returns, adjusted for risk. This applies to both the longs and shorts. If there are cash inflows to a portfolio, assets should be allocated to the highest returning assets. If cash outflows, assets should be liquidated from the situations with the lowest expected returns. It is that simple, and I did that when I was a corporate bond manager. It worked well.

The reason why it will not be implemented at many asset management shops is that it takes work to do it, and we all avoid work if we can. But maintaining lists of long and short ideas ranked by likely risk-adjusted returns will yield better decision making, if one will do it.

The Fed, Financial Guarantors, and Housing

The Fed, Financial Guarantors, and Housing

Posted on by David Merkel

This post will be a little more disjointed than others. One housekeeping note before I start: I’m behind on my e-mail. I will catch up on it next week, DV.

Fed and Federal Government Policy

I don’t know; it seems like there are rumblings that the Fed will imminently take action, and that does not resonate with me. You can also read the stuff from Doug Kass at RealMoney, or consider the rebirth of the Plunge Protection Team. We are not so far from the next Fed meeting that waiting would make that much of a difference, particularly since the Fed tipped its hand when Bernanke spoke recently. There is a decent-sized cut coming, and the Treasury yield curve reflects it.

Now, I have my doubts as to the long-term efficacy of unusual measures from the Fed or the Treasury. You can’t get something by government fiat. Even a Fed Governor thinks we expect too much from the Fed, a sentiment with which I heartily agree, even though the Fed is partially responsible for creating that illusion. If the Fed took more of a “we do our best, but our powers are not that large in the long run” approach, market players might not give them so much credence.

Now, I’m not going so far as Anna Schwartz, who thinks the current Fed isn’t up to the task. That may or may not be true; what is hard to dispute is that Alan Greenspan dealt the existing FOMC a bad hand from a prior monetary policy that too easily responded to minor crises, rather than letting the economy take some pain. Moderate recessions are good for the economy; save the heroics for depression-like conditions.

Financial Guarantors

I may fail at it, but I try to be honest and self-critical here at my blog. For example, I did not suggest that Warren Buffett would buy Ambac, but I was misinterpreted as saying so. Now that Ajit Jain says that Berky might buy into one of the financial guarantors, I am not going to say that I predicted that, because I didn’t. It would be amusing if Buffett announced his new entry into the financial guaranty space to drive their prices down so he could buy a stake cheaper, but that is not his style. He values his reputation. That said, the NY regulator may not have thought enough steps ahead in pushing for Berky to set up a new guarantor. Good for new issues; perhaps not as good for old ones at legacy carriers.

Now, I admire Marty Whitman and Aldo Zucaro, but so far, their forays into the mortgage guaranty space have not worked out. I’m not counting them out, but it still may be early for that trade. Maybe we should wait for one of the companies to fail. The remaining companies should do well, once capacity drops out.

As for MBIA, they cut their dividend, which to me indicates a lower future level of profitability. Then they raise $1 Billion through surplus notes at their operating subsidiary, and pay 14% to do that. That has to be a record spread for a new-issue nominally AA-rated bond. Personally, I think I would pass on the notes, except for a flip. I would rather hold the common. Scenarios that would kill the common would most likely also kill the surplus notes. The common has more upside potential.

Residential Real Estate

I am fascinated by the willingness of some of the courts to insist on strict standards before they allow lenders to foreclose. Examples:

In general, I think there are legitimate flaws in the documentation that got ignored before the number of attempted foreclosures became so large. This is pointing out some stresses in the system. When this is done, securitization will not vanish; it will just be better managed.

Now as a final note, it is somewhat shameful that banks can’t follow FAS 114. The calculations aren’t hard; they just don’t want to recognize losses that they should recognize. That’s the real issue, so FASB and Congress should not give in here.

Fifteen Points on Credit Where Credit Ain’t Due

Fifteen Points on Credit Where Credit Ain’t Due

Posted on by David Merkel

I’ve wanted to do a post on credit for a while, but I’ve just had too many things to think about. Well, here goes:

1) From the “We Keep Him in a Bubble” file there is James Glassman with his prediction that Spring 2008 would bring the end of the housing troubles. Why does this guy still get air time? Why wasn’t Dow 36,000 enough? There are too many vacant homes to reconcile, there is no way for Spring 2008 to be it….

2) For an excellent summary of where we are in housing, Calculated Risk has this review piece.

3) Not all defaults are subprime. They are happening with Option ARMs, and even prime loans where they had to get Private Mortgage Insurance.

4) Is the subprime mortgage bust bigger or smaller, or similar to the size of the the S&L crisis? I’ll go with bigger. I don’t buy DeKaser’s smaller argument because securitization has provided more credit to small and medium sized businesses. I do think Portfolio.com is on the right track by looking at the amount of the housing price rise that has happened.

5) Personally, I find it delicious that the banks get stuck footing the bill in particularly bad foreclosure situations. So much for structural complexity in lending.

6) Americans are the most overhoused people in the world. No one else gets as much space, or stores as much stuff, broadly speaking. This book review of “House Lust,” will take you through the whole matter, in probably too much detail. (And yes, my house is large also, but I have ten people here… Americans can be unusual in other ways too; as a culture, we are more optimistic about children.)
7) From Calculated Risk, a tale of why lenders tend to forbear with marginal borrowers that are having difficulties with their current loans. One thing they don’t mention, the Residential MBS market does not have special servicers like the Commercial MBS does. When a loan gets into trouble, the CMBS special servicer gets paid adequately, but the ordinary RMBS servicer does not, particularly when lots of loans are in trouble. It is a weakness in the RMBS system.

8 ) As the TED spread declines, market players begin to relax about liquidity. But what of solvency? As losses are realized by banks, some will have to shore up their capital positions, and to do that, they will have to ratchet back lending.

9) How similar is the US today to Japan back in the early ’90s? There are some similarities, given the property bubbles in both places, and the interest rates that get lower and lower, but there are differences — a healthier banking system in the US, and a more market-oriented economy here as well. A depression is possible in the US, but I would not assume it at present.

10) Is the US consumer spent-up? Could be. Consider this article on auto loans as well. Personally, I am surprised at the degree to which lenders will make consumer loans with inadequate security, but that is just a normal aspect of American life today. For now.

11) What of corporate bonds? It certainly seems like junk bonds will be seeing more defaults in 2008. (Here also.) This shouldn’t surprise us, because the credit quality was low and the volume of high yield bond issues was high 2004-2006. It takes a little while for bad debt to season, and we should see the results in 2008.

12) When I did my “Fed model” I used BBB corporate yields as my comparison to earnings yields on equities. Given the backup in credit spreads, my Fed model is not nearly as favorable as those using Treasuries. But those looking only at credit spreads get the wrong result also. With Treasury yields so low, most high quality bonds are not attractive now.

13) On the bleak side, I tend to agree with Naked Capitalism and the FT that there is a transfer of power going on in the world, away from the US, and toward China and the Middle East. Power follows capital flows, and they are funding the US at present. They will own more and more of US businesses over time. They increasingly won’t be satisfied by owning our debts.

14) I found this piece from Credit Slips to be educational. There are certain types of income that can’t be garnished; nonetheless, garnishing happens. The only way to protect yourself is to fight back, and that article highlights how it is done.

15) Finally, credit at its most basic level. Credit is trust; trust that repayment plus interest will occur. Who do you trust? Personally, I found the discussion following Barry’s post to be depressing, because so many commenters were cynical. here was my comment:

Capitalism is based on trust. Without trust, capitalism will slowly cease to exist. Yes, there will be barter-type transactions, but any complex long-term transaction or relationship is based on trust. Any multi-party transaction requires trust, because multiple parties can gang up on the weak one.

Even representative government requires trust. Now, that trust is often abused, but who wants to get rid of representative government?

There is a lot more trust within our society than most of us imagine. Woe betide us if trust drops to a minimum level.

Estragon (thank you) agreed with me at the end, but it is fascinating to consider the implications of a society where trust is declining. Ultimately, it means that credit will be declining.

Looking Beyond the Three Percent Horizon

Looking Beyond the Three Percent Horizon

Posted on by David Merkel

Give the Fed some credit. Not literally, of course. Isn’t it their job to give us credit?

I haven’t talked a lot about Fed policy in a while, so I thought it was time to do an update. Five months have passed since my 3% sometime in 2008 call was made, and now it is becoming the received orthodoxy. That’s why I have to ask what is wrong with it, or better, what is the next phase beyond it?

Truly, I don’t know for sure, but I will offer out my thinking process. We are seeing rising unemployment and inflation at the same time. The bond market is rallying, anticipating falling Fed funds rates, but not forecasting rising inflation rates. (Buy TIPs!) In the spirit of watch what they do not what they say, let’s review the relevant Fed data.

We are in a period of asset deflation and consumer price inflation, so this is a difficult period to negotiate through. You can listen to facile comments from PIMCO; everyone is focused on economic weakness, and few are focused on rising inflation.

I think we get to a 3% Fed funds rate, but we don’t get much below it, because by that time, a 3% Fed funds rate will imply a negative real interest rate on the short end. Congress will have an implied inflationary bias, because the complaints will come more from asset deflation. They will kick nudge the Fed that way to the extent that they can.

The TED spread is not as wide as it once was, but it is still in a historically high range. Anything above 60 basis points implies stress. To reduce this the Fed has set up an auction facility, called the TAF. The TAF has been expanded, which allows for a greater variety of securities to be lent against. That’s the real novelty of the TAF. Not new liquidity but new collateral. That said, even the discount window is getting greater use. As a result, the Commercial Paper market is showing some life, even for asset backed commercial paper.

So, liquidity is increasing on the short end, to the point where a 1/4% cut in Fed funds has for practical purposes already happened. A formal 1/4% cut at the next FOMC meeting would do little except ratify what has already been done. Now there is weakness in the job market, and the PMI is signaling some weakness as well. The yield curve has moved down, particularly on the short end, to reflect expectations of more cuts from the Fed.

But TIPS yields are quiet, at least for now, and viewing the Fed as quasi-politicians, whose main goal in life is to avoid political pain, the path of least resistance is to loosen policy further. Fed funds futures and options are indicating the most likely outcome in on January 30th is a 50 basis point loosening. Ordinarily, because of the “gradualist” culture that has built up inside the Fed, I am reluctant to argue for loosenings other than 25 basis points. I think at this point, I have to argue for 50 basis points, but with the usual squishy language that pays heed to all potential threats, effectively saying, “But no more after this! Conditions are balanced!” We know better, though. The only real question is when rising consumer price inflation or a deteriorating Dollar (think of 1986) will be a sufficient counterweight to economic weakness.

The US Dollar is weak here, and that reflects the judgment of many actors as to the value of what they get paid back will be. My guess is that foreign investors sense that inflation is higher in the US than is stated in the Government’s statistics. Too many dollar claims (internal and external) chasing too few goods that they want to buy. What will dollar-denominated bonds be worth at maturity? (Judging by current yields, quite valuable for now.) And will the US Government allow significant US companies to be owned by the Chinese, or by Arabs? How free market is the US really? Will foreign governments stop policies that disfavor the purchase of US goods? Perhaps once they import enough inflation, they will.

With gold, crude oil, and a host of agricultural prices high, and with structural reasons for them to remain high, the FOMC won’t feel too happy as they cut rates. But cut they will, and then we get to see where the excess liquidity flows. Some will bail out banks, which will invest in safe instruments in areas of the economy not under threat. Loans in or near default will not be affected. Well, more on that later. Tonight’s post will be on credit issues.

In closing, a return to the problem that I posed at the beginning: So what’s wrong with the 3% Fed funds forecast, or better, what is the next phase beyond it? It could go several ways:

  1. Rising price inflation and a deteriorating dollar lead to an end to the cycle, and the Fed funds rate either stops falling, or has to rise to squeeze out inflation.
  2. Continuing asset deflation, and declining but still positive economic growth (as the government measures it) leads the Fed to continue to loosen, or stand pat in the face of rising consumer price inflation.
  3. Liquidity difficulties in the banking system morph into solvency difficulties, leading pseudo-M3 and credit to contract (after all the banks are doing the heavy lifting here, not the Fed) and the Fed starts to loosen aggressively.
  4. We get a “bolt for the blue” leading to something not currently predictable, but which leaves policymakers in a bind.
  5. We muddle along, get to something near a 3% Fed funds rate, and continue to muddle (think of 1992-1993).


Personally, I favor scenario 2. And, for those that like to invest, TIPS are reasonably priced. Insurance against scenario 2 is inexpensive, and relatively high quality. But be wary, because particularly in a Presidential election year, there could be significant surprises (part of scenario 4).

Long VIPSX

Two Final Notes in 2007

Two Final Notes in 2007

Posted on by David Merkel
  1. When I was seven years old, my parents gave me a colorful wind-up alarm clock. I thought it was beautiful. They taught me how to wind it up each evening so that I would wake up to go off to first grade. Being a boy, after a while, I wondered how tight I could wind it, but there seemed to be a limit to that. One night, I found I could wind it one “click” tighter than usual. A week or so later, another “click” tighter. After some time, I wound it one click to many, and I heard a snap, after which the clock rapidly moved in reverse for about 30 seconds, and then moved no more. I was heartbroken, because I really liked the clock. Perhaps its “death” was not in vain, because it is a great analogy for a full swing of the credit cycle. The spread tightening in the bull phase of the cycle is initially relatively rapid, and gives way to smaller bits of incremental tightening, until it is too much, or an exogenous force acts on it. Eventually, when cash flow proves insufficient for debt service, the credit cycle turns, and the move to spread widening is rapid. Once spreads get really wide, the cycle can resume when those with strong balance sheets can tuck bonds away and realize a modest return in the worst scenario, if they just buy-and-hold. Though it did not happen for me, it would be the equivalent of buying the little kid a new clock. Then the cycle begins again.
  2. Economically, Japan has had a lost decade. It is beginning to verge on two decades. During this time, interest rates have been low, and growth has not been forthcoming. The main reason why low rates did little to stimulate the economy is that the banks were impaired, and could not lend. The secondary reason was demographic; equity markets tend to do well when there are more savers versus spenders. For Japan, that peaked in the early 90s. For the US, that will peak in the early teens. Now, it is possible that the more market-oriented culture of the US has reacted to this factor faster than Japan would, thus the relatively stagnant equity market in the 2000s in the US. This is also a cautionary note to those that thing that lower short-term rates will benefit the US markets; after all, what good have they done for Japan?

Thanks to all my readers, and especially my commenters. You make the blog worthwhile to me. I hope to better for all of you in 2008. Happy New Year to all of my readers, whether here, or at other sites that use my posts. May God bless you richly in 2008.

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