Category: Currencies

Ten Notes on Our Quasi-Government and the Financial System

Ten Notes on Our Quasi-Government and the Financial System

Posted on by David Merkel

Personal notes before I get started: I’ve been busy studying for the Series 7 (and also reviewing the compliance manual for my new firm — wow it is big). The two of them fit together, as I get to see how the regulations get applied. I’ve made through the study guide (what do you do when it is wrong — not that I found a lot of errors, maybe half a dozen?), and I am 20% through my first practice test. Went and got fingerprinted for the fourth time in my life yesterday. (The other three times were for adoptions.)

My links are back 🙂 but I had to give up my descriptive permalinks. 🙁 Maybe I’ll get them back when I upgrade the blog to WordPress 2.5.1. Beyond that, I am working on a book review for Gene Marcial’s forthcoming book, “7 Commandments of Stock Investing.”

Catching up on the markets:

Our Unorthodox Federal Reserve, GSEs and Government

1) Repo rates may not be negative now, but they were so recently. Fails (failures to deliver securities) become common, because of the lack of a penalty. Today we should see whether the TSLF has any impact on the scarcity of Treasuries. We should learn more about the direct landing program as well after the close today. It got off to a big start last week. Watch for the H.4.1 report after the close. Given all that is going on, it is becoming the critical weekly Fed document.

2) Now, because of all these actions on the asset side of the Fed’s balance sheet, some are calling the actions of the Fed, including the Bear Stearns bailout, revolutionary. Well, maybe. It’s certainly different than before, but there is a cost to doing business this way. Bit by bit the Fed loses flexibility as more and more of its highest quality assets become encumbered for a time.? The more that they do, also, the harder it will be to unwind, in my opinion.

3)? Greenspan…? If we turn off the spotlight, will he go away?? (Then again, he has enough money to buy his own spotlight.)? It is tough for anyone to defend a legacy, and I don’t blame him for trying, but the Fed became too integrated with the political establishment under his tenure, which made it too activist in avoiding short-term pain.? It made him look like a hero at the time, but now we are paying the price.? Overly loose monetary policy and financial supervision led to gluts of borrowing to finance assets that appreciated dramatically, until the ability to service the debt began to decrease.? I don’t think history will treat him kindly.? He said too much in the past that he is contradicting today.

4) Will the Fed buy agency MBS outright?? I think the answer to that one is yes, if the crisis persists. If housing prices drop enough further, like say 15%, the actions of the Treasury, Fed, FHLB, Fannie, Freddie, FHA, and whatever new lending monstrosity our imaginative Government comes up with will have to be closely coordinated.? At some level, if the Fed can’t trust the implicit guarantee of Fannie and Freddie, why should the rest of us?? That guarantee is as sound as a dollar! 😉

5)? It’s interesting to see the tide shift with respect to GSE involvement in the mortgage market:

6)? On a consolidated basis, our government, with its enterprises, are levering up.? This is a substitution of public debt for private, and more, just a lowering of capital standards for the GSEs.? (I wonder how comfortable the rating agencies are with this?)? This works while Treasury yields are low.? I wonder, though, how much impact this will have on the willingness of foreign buyers of Treasuries to continue their funding of our government?? One thing for sure, this will all get funded by the US taxpayers, together with those who lend to the US (dollar depreciation).

7) Now, it’s not as if the US is the only place in the world with central banking problems.? Consider the Eurozone, where there is still no lender of last resort.? How would they deal with a financial crisis?? I’m not sure; the ECB has quietly helped out some Spanish banks, but it is not really in their jurisdiction.? Under conditions of deflationary stress, it would not be impossible to see a nation whose financial system was in trouble either directly bail out the dud institutions, or even, exit the euro (last resort, but not impossible).

Or consider China, where inflation is getting a nice head of steam.? Their neomercantilism, with their crawling peg against the dollar is forcing them to import loose monetary policy from the US.? As the article cited points out, they need to significantly revalue their currency upward, which would would whack their exports, at least for a time.

8 )? For those that remember the files that I created for my piece, A Social View of the FOMC, it looks like I will have to update the file soon.? We have a successor to Bill Poole nominated, James Bullard.? When he is approved, I will update the file.? (I will miss Poole.? Though he was occasionally out of step with the rest of the FOMC, he always spoke his mind, which was usually more hawkish than the rest of the FOMC.)

9)? Now, Bullard is an Economics Ph. D.? (Surprise!) ? In my earlier piece, Jeff Miller took note of a few of the things that I said, and perhaps attributed to me an anti-Academic bias.? I don’t have a bias against academics, per se.? (Hey, can we put Steve Hanke on the Fed?!? One of my professors…)? I do have concerns about not having enough real debate.? If the neoclassical view of monetary policy is correct, then we don’t have problems, because everyone on the FOMC is either a neoclassical economist, or a monetarist.

Now, I do know the difference between politics and policy formation, and if I hadn’t been trying to keep the number of pages down, I might have had two columns.? (Getting it down to 15 pages was hard.)? But most of the FOMC members had either one or the other, but not both, so I left it as one column.? Next time I change the column heading.? That said, even if one is in a policymaking capacity in the executive branch, there is typically some political affiliation that helps get that person the job.? Those are relevant bits of experience, just as I noted everyone that had foreign experience, or military experience.? But what worries me is a lack of real diversity in views of how economics works.? (Perhaps we could get someone from the Santa Fe Institute?)

10) Finally, there will be a lot of pressure in the future to re-regulate our financial system.? Personally, I don’t think it is possible to create a regulatory scheme that eliminates crises.? The regulator shapes the type of crisis that will come, and when it will come, but it is impossible to wipe out the boom-bust cycle.? (We put off this bust for a long time, and now we are getting it with compound interest for time delay.)? If a regulatory regime is too tight, the financial companies complain because their ROEs are too low.? To the extent that it can, capital begins to exit the industry, or, the stock prices languish, and financials trade at low multiples on book, because they can’t earn much off their net worth.

Financial companies find the weak spots in any risk-based capital formula.? They also lobby the executive branch and Congress effectively.? Unless we slide into Great Depression II, I don’t think things will change remarkably from here.

I? agree that we need to re-regulate, but perhaps after this crisis is done, we can consider systemic reforms, and not the piecemeal stuff we have been dished up in the name of crisis management.? My re-regulation would be to reduce the Federal Government’s role in the credit markets, but then, I am walking out of step, and realize that is not what is going to happen.

One Dozen Notes on Our Crazy Credit Markets

One Dozen Notes on Our Crazy Credit Markets

Posted on 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?

LBSOX

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.

Berkshire Hathaway — The Anti-Volatility Fortress

Berkshire Hathaway — The Anti-Volatility Fortress

Posted on by David Merkel

I?ve commented on Buffett?s Shareholder letter now for the past five years.? Those who know me well know that I admire Buffett and Berky, but not uncritically.?? Also, I view Berky as primarily an insurance company, secondarily as an industrial conglomerate, and thirdly as an investment company.

Onto the letter:

From page 3:

You may recall a 2003 Silicon Valley bumper sticker that implored, ?Please, God, Just One More Bubble.? Unfortunately, this wish was promptly granted, as just about all Americans came to believe that house prices would forever rise. That conviction made a borrower?s income and cash equity seem unimportant to lenders, who shoveled out money, confident that HPA ? house price appreciation ? would cure all problems. Today, our country is experiencing widespread pain because of that erroneous belief. As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide goes out ? and what we are witnessing at some of our largest financial institutions is an ugly sight.

Buffett starts out with the cause behind most of our current problems in financial companies.?? There are too many houses chasing too few people, and inadequate underwriting of the financing, because of a misplaced trust in the rise of housing prices.

From page 4:

Though these tables may help you gain historical perspective and be useful in valuation, they are completely misleading in predicting future possibilities. Berkshire?s past record can?t be duplicated or even approached. Our base of assets and earnings is now far too large for us to make outsized gains in the future.? (emphasis his)

Buffett has been honest on this point for years.? As the business grows, it is unlikely to find opportunities as good in percentage terms as it did when it was smaller.? That?s normal, even for the best investors.

In our efforts, we will be aided enormously by the managers who have joined Berkshire. This is an unusual group in several ways. First, most of them have no financial need to work. Many sold us their businesses for large sums and run them because they love doing so, not because they need the money. Naturally they wish to be paid fairly, but money alone is not the reason they work hard and productively.

Buffett hits on what I think is one of the great secrets of good capitalism.? The best capitalists are not purely money-motivated, but are idealists, aiming for excellence as they serve others though their businesses.? In the best businesses that I have worked in, we did it because we loved what we did.? That?s a key for all good businesses, from the CEO down to the clerk.

From page 7:

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There?s no rule that you have to invest money where you?ve earned it. Indeed, it?s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can?t for any extended period reinvest a large portion of their earnings internally at high rates of return.

This is the core of Buffett the businessman.? He understands the need to redirect free cash flow to the opportunities that offer the best returns.? He knows that certain businesses will never be more than niches, and like a good farmer would, harvests his specialty crop each year, but doesn?t plant much more the next year.

He goes on for two pages on how he distinguishes between businesses, considering their long-term competitive advantage, return on investment, and capital intensiveness.??? It?s a good read, and very basic.? If it weren?t for the fact that many companies operate more for the good of management than shareholders, you might see this in operation more broadly.? (And you would see opportunities diminish for private equity as far as big deals go.? Private equity keeps public management teams on their toes, for the bigger deals.)

From pages 9-11, Buffett discusses his insurance businesses, and spends much less time on them than in prior years.? It is not as if there isn?t a good story to tell.? Are underwriting profits down?? Yes, but only by 10%.? The rest of the P&C insurance industry is struggling with the same problems, and is likely doing worse in aggregate.? I think that some major disasters will have to happen to re-energize earnings here.? Berky is an anti-volatility asset, and always does relatively better when the rest of the insurance industry is hurting.

On page 11, Buffett comments on his utility businesses.? Earnings are up in this line.? These are a natural fit for Berky, with their earnings yield considerably above Berky?s cost of float, and earnings that tend to do well when inflation is higher.? Expect Buffett to buy more here, but only during some significant pullback in utility stock prices.

From that page:

Somewhat incongruously, MidAmerican also owns the second largest real estate brokerage firm in the U.S., HomeServices of America. This company operates through 20 locally-branded firms with 18,800 agents. Last year was a slow year for residential sales, and 2008 will probably be slower. We will continue, however, to acquire quality brokerage operations when they are available at sensible prices.

From page 13:

Last year, Shaw, MiTek and Acme contracted for tuck-in acquisitions that will help future earnings. You can be sure they will be looking for more of these.

and

At Borsheims, sales increased 15.1%, helped by a 27% gain during Shareholder Weekend. Two years ago, Susan Jacques suggested that we remodel and expand the store. I was skeptical, but Susan was right.

?

From page 15:

Clayton, XTRA and CORT are all good businesses, very ably run by Kevin Clayton, Bill Franz and Paul Arnold. Each has made tuck-in acquisitions during Berkshire?s ownership. More will come.

Buffett understands that most good acquisitions are little ones that can be used to increase organic growth of the subsidiary. ?Same thing for intelligent capital spending, as at Borsheim?s.? He may keep a tight hold on free cash flow, but he listens to his subsidiary CEOs, and usually gives them enough to invest to improve the businesses.

Also look at the countercyclical nature of Buffett?s acquisitions.? He is willing to buy real estate sales franchises in this environment, if they come at the right price.? Much as I am a bear on housing, this is the right strategy, if you have a strong enough balance sheet behind it.

On pages 12 and 14, net operating income improved in Manufacturing, Service, and Retailing Operations, and fell in Finance and Finance Products.? He doesn?t discuss it, but there was a loss in life and annuity.? Berky mainly does life settlements there, a business I regard as somewhat malodorous because it undermines the life insurance industry, by weakening the concept of insurable interest.? Also, leasing didn?t do that well, as Buffett points out.

On page 15, I don?t have a strong opinion on his stock positions? they are a little more expensive than I like to buy, but he has to deploy a lot more money than I do, and has a longer time horizon.? His focus on long term competitive advantage is exactly right for his position in the market.

On page 16, Buffett discusses his derivative book:

Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories. First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

?

We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Our yearend liability for this exposure was recorded at $1.8 billion and is included in ?Derivative Contract Liabilities? on our balance sheet.

?

The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.

?

Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.

?

Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire?s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.

?

Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings ? even though they could easily amount to $1 billion or more in a quarter ? and we hope you won?t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.

?

Okay, so Buffett is long high yield credit, and seemingly receiving a pretty reward for it (the numbers seem too good, what is he doing?), and is long the US and other equity markets by writing long-dated European puts.? Sounds pretty good to me on both, though I?d love to see the details on the high yield, and on the equity index puts, Berky will be vulnerable in a depression scenario (it would be interesting to know the details there also).

?

Buffett is behaving like a long-tail P&C insurer, and he is willing to take on volatility if it offers better returns.? Berky is almost always willing to take on catastrophe risks, if they are more than adequately compensated.? If you are uncertain about this, ask the financial guarantors, they will tell you.

?

On page 17:

?

There?s been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot by foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here. Why should we complain when they choose stocks over bonds?

?

Indeed, what?s sauce for the goose is sauce for the gander.? Why should the rest of the world buy our depreciating bonds, when they can buy our companies, which in my opinion, often offer much better prospects?? As Buffett puts it later, we are force-feeding dollars to the rest of the world? the decline in value is to be expected.

?

Also on page 17:

?

At Berkshire we held only one direct currency position during 2007. That was in ? hold your breath ? the Brazilian real. Not long ago, swapping dollars for reals would have been unthinkable. After all, during the past century five versions of Brazilian currency have, in effect, turned into confetti. As has been true in many countries whose currencies have periodically withered and died, wealthy Brazilians sometimes stashed large sums in the U.S. to preserve their wealth.

?

Clever move, and emblematic of the shift happening in our world where resource- and cheap labor-driven nations grow rapidly, and build up trade surpluses against the developed world.? Their currencies have appreciated.

?

Also on page 17:

?

Our direct currency positions have yielded $2.3 billion of pre-tax profits over the past five years, and in addition we have profited by holding bonds of U.S. companies that are denominated in other currencies. For example, in 2001 and 2002 we purchased ?310 million Amazon.com, Inc. 6 7/8 of 2010 at 57% of par. At the time, Amazon bonds were priced as ?junk? credits, though they were anything but. (Yes, Virginia, you can occasionally find markets that are ridiculously inefficient ? or at least you can find them anywhere except at the finance departments of some leading business schools.)

?

The Euro denomination of the Amazon bonds was a further, and important, attraction for us. The Euro was at 95? when we bought in 2002. Therefore, our cost in dollars came to only $169 million. Now the bonds sell at 102% of par and the Euro is worth $1.47. In 2005 and 2006 some of our bonds were called and we received $253 million for them. Our remaining bonds were valued at $162 million at yearend. Of our $246 million of realized and unrealized gain, about $118 million is attributable to the fall in the dollar. Currencies do matter.

?

Though Buffett got scared out of many of his foreign currency positions over the last few years, intellectually he was right about the direction of the US dollar, and made decent money off it.? The Amazon position was a home run in bond terms.? Bill Miller benefited from that one as well.? (I also endorse the comment on occasional inefficient markets.)

?

On page 18:

?

At Berkshire, we will attempt to further increase our stream of direct and indirect foreign earnings. Even if we are successful, however, our assets and earnings will always be concentrated in the U.S. Despite our country?s many imperfections and unrelenting problems of one sort or another, America?s rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce ever-growing prosperity for its citizens.

?

This is one of America?s greatest sustainable competitive advantages.? We allow more flexibility and failure than anywhere else in the world.? We have a relatively open and free system of markets and government.? Woe betide us if we change this.

?

On pages 18-20, Buffett takes on employee stock option accounting and pension accounting.? He believes options should be expensed, and that companies should bring down their assumptions for investment earnings, because they are unrealistically high.? I agree on the latter, and on the former, I think full disclosure is good enough.? Accounting rules are important, but investors (like Buffett) look for long-term free cash flows, which are largely unaffected by accounting rules.

?

I don?t think the market is fooled in either case.? Companies with large stock option grants and high assumed earning on pension plans both tend to trade cheap.? Their earnings quality is light.

?

Finally, on page 20:

Whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers. Public pension promises are huge and, in many cases, funding is woefully inadequate. Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed. Promises involving very early retirement ? sometimes to those in their low 40s ? and generous cost-of-living adjustments are easy for these officials to make. In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep.

?

Ummm? say it again, Warren.? I?ve been saying this for years.? Hey, throw in multiple employer trusts as well.

?

With that, I would offer two observations about this letter from Warren.? First, it is shorter, and contains less data on the businesses, particularly the insurance businesses, but then, it was a quiet year.? Second, he had less in the way of ?soap box? issues this year.

?

In closing, Berky had a good year, and I have little to quibble with in this letter.? Another good job, Warren.

One Dozen Thoughts on Bonds, Financials and Financial Markets

One Dozen Thoughts on Bonds, Financials and Financial Markets

Posted on by David Merkel

1) The blog was out of commission most of Saturday and Sunday, for anyone who was wondering what happened. From my hosting provider:

We experienced a service interruption affecting the Netfirms corporate websites and some of our customer hosted websites and e-mail services.

During scheduled power maintenance at our Data Centre on Saturday Feb. 23 at approximately 10:30 AM ET, the building’s backup generator system unexpectedly failed, impacting network connectivity. This affected several Internet and Hosting Providers, including Netfirms.

Ouch. Reliability is down to two nines at best for 2008. What a freak mishap.

2) Thanks to Bill Rempel for his comments on my PEG ratio piece. I did not have access to backtesting software, but now I do. I didn’t realize how much was available for free out on the web. He comes up with an interesting result, worthy of further investigation. My main result was that PEG ratio hurdles are consistent with a DDM framework within certain moderate values of P/E and discount rates. Thanks also to Josh Stern for his comments.

3) I posted a set of questions on Technical Analysis over at RealMoney, and invited the technicians to comment.


 David Merkel
Professionals are Overrated on Fundamental Analysis
2/21/2008 5:19 PM EST

I’m not here to spit at technicians. I have used my own version of technical analysis in bond trading; it can work if done right. But the same thing is true of fundamental investors, including professionals. There are very few professional investors that are capable of delivering above average returns over a long period of time. Part of it is that there are a lot of clever people in the game, and that raises the bar.

But I have known many good amateur investors that do nothing but fundamental analysis, and beat the pros. Why? 1) They can take positions in companies that are too small for the big guys to consider. 2) They can buy and hold. There is no pressure to kick out a position that is temporarily underperforming. With so many quantitative investors managing money to short time horizons, it is a real advantage to be able to invest to longer horizons amid the short-term volatility. 3) They can buy shares in companies that have been trashed, without the “looks that colleagues give you” when you propose a name that is down over 50% in the past year, even though the fundamentals haven’t deteriorated that much. 4) Individual investors avoid the “groupthink” of many professionals. 5) Individual investors can incorporate momentum into their investing without “getting funny looks from colleagues.” (A bow in the direction of technical analysis.)

When I first came to RM 4.4 years ago, I asked a question of the technicians, and, I received no response. I do have two questions for the technicians on the site, not meant to provoke a fundy/technician argument, but just to get opinions on how they view technical analysis. If one of the technicians wants to take me up on this, I’ll post the questions — hey, maybe RM would want to do a 360 on them if we get enough participation. Let me know.

Position: none


 David Merkel
The Two Questions on Technical Analysis
2/22/2008 12:15 AM EST

I received some e-mails from readers asking me to post the questions that I mentioned in the CC after the close of business yesterday. Again, I’m not trying to start an argument between fundies and techies. I just want to hear the opinions of the technicians. Anyway, here goes: 1) Is there one overarching theory of technical analysis that all of the popular methods are applications of, or are there many differing forms of technical analysis that compete against each other for validity (and hopefully, profits)? If there is one overarching method, who has expressed it best? (What book do I buy to learn the theory?)

2) In quantitative investing circles, it is well known (and Eddy has written about it recently for us) that momentum works in the short run, and is often one of the most powerful return anomalies in the market. Is being a good technician just another way of trying to decide when to jump onto assets with positive price momentum for short periods of time? Can I equate technical analysis with buying momentum?

To any of you that answer, I thank you. If we get enough answers, maybe the editors will want to do a 360.

Position: none

I kinda thought this might happen, but I received zero public responses. I did receive one thoughtful private response, but I was asked to keep it private. Suffice it to say that some in TA think there is a difference between TA and chart-reading.

As for me, though I have sometimes been critical of TA, and sometimes less than cautious in my words, my guesses at the two questions are: 1) There is no common underlying theory to all TA, there are a variety of competing theories. 2) Most chart-readers are momentum players, as are most growth investors. Some TA practitioners do try to profit from turning points, but they seem to be a minority.

I’m not saying TA doesn’t work, because I have my own variations on it that I have applied mainly to bond investing. But I’m not sure how one would test if TA in general does or doesn’t work, because there may not be a commonly accepted definition of what TA would say on any specific situation.

4) One more note from RM today:


 David Merkel
Just in Case
2/25/2008 4:20 PM EST

Um, after reading this article at the Financial Times, I thought it would be a good idea for me to point readers to my article that explained the 2005 Correlation Crisis. Odds are getting higher that we get a repeat. What would trigger the crisis? A rapid decline in creditworthiness for a minority of companies whose debts are referenced in the relevant credit indexes, while the rest of the companies have little decline in creditworthiness. One or two surprise defaults would really be gruesome.

Just something to watch out for, as if we don’t have enough going wrong in our debt markets now. I bumped into some my old RM articles and CC comments from 2005, and the problems that I described then are happening now.

Position: none, and there are times when I would prefer not being right. This is one of them. Few win in a bust.

There are situations that are micro-stable and macro-unstable, and await some force to come along and give it a push, knocking it out of its zone of micro-stability, and into a new regime of instability. When you write about situations like that before the fact, it is quite possible that you can end up wrong for a long time. I wrote for several years as RM about overleveraging credit, mis-hedging, yield-seeking, over-investment in residential real estate (May 2005), subprime lending (November 2006), quantitative strategies gone awry, etc. The important thing is not to put a time on the prediction because it gives a false message to readers. One can see the bubble forming, but figuring out when cash flow will be insufficient to keep the bubble financed is desperately hard.

5) This brings up another point. It’s not enough to know that an investment will eventually yield a certain outcome, for example, that a distressed tranche of an ABS deal will eventually pay off at par. One also has to understand whether an investor can handle the financing risks before receiving the eventual payoff. Will your prime broker continue to finance you on favorable terms? Will your regulator force you to put up more capital against the position? Will your investors hang around for the eventual payoff, or will they desert you, and turn you into a forced seller? Can your performance survive an asset that might be a dud for some time?

This is why the price path to the eventual payoff matters. It shakes out the weak holders, and moves assets that should be financed by equity onto strong balance sheets. It’s also a reason to be careful with your own balance sheet during boom times, and in the beginning and middle of financial crises — don’t overextend your positions, because you can’t tell how long or deep the crisis might be.

6) I agree with Caroline Baum; I don’t think that the FOMC is pushing on a string. The monetary aggregates are moving up, and nominal GDP will as well… it just takes time. The yield curve has enough slope to benefit banks that don’t face a lot of credit problems… and the yield curve will steepen further from here, particularly if the expected nadir of Fed funds drops below 2%. Now, will real GDP begin to pick up steam? Not sure, the real question is how much inflation the Fed is willing to accept in the short run as they try to reflate.

7) Now, inflation seems to be rising globally. At this point in the cycle, the FOMC is ahead of almost all major central banks in loosening policy. I think that is baked into the US dollar at present, so unless the FOMC gets even more ahead, the US Dollar should tread water here. Eventually inflation elsewhere will get imported into the US. It’s just a matter of time. That’s why I like TIPS here; eventually the level of inflation passing through the CPI will be reflected in implied inflation rates.

8 ) Okay, MBIA will split in 5 years? That is probably enough time to strike deals with most everyone that they wrote coverage for structured products, assuming the losses are not so severe that the entire holding company is imperiled. If it’s five years away, splitting is a possibility, but then are the rating agencies willing to wait that long? S&P showed that they are willing to wait today. Moody’s will probably go along, but for how long?

9) I found it interesting that AQR Capital has not been doing well in 2008. When quant funds did badly in the latter half of 2007, I suffered along with them. At present, I am certainly not suffering, but it seems that the quants are. I wonder what is different now? I suspect that there is too much money chasing the anomalies that the quant funds target, and we reached the end of the positive self-reinforcing cycle around mid-year 2007; since then, we have been in a negative self-reinforcing cycle, with clients pulling money, and the ability to carry positions shrinking.

10) Now some graphs tell a story. Sometimes the story is distorted. This graph of the spread on Fannie Mae MBS is an example. Not all of the spread is due to the creditworthiness of Fannie Mae. Those spreads have widened 30 basis points or so over the past six months for Fannie’s on-the-run 5-year corporate bond, versus 50 basis points on the graph that I referenced. So what’s the difference? Increased market volatility makes residential MBS buyers more skittish, and they demand a higher yield for bearing the negative optionality inherent in RMBS. Fannie and Freddie are facing harder times from the guarantees that they have written, and the credit difficulties at the mortgage insurers, but it would be difficult to imagine the US Government allowing Fannie or Freddie to default on senior obligations.

That’s another reason why I like agency-backed RMBS here. You’re getting paid a decent spread to bear the risks involved.

11) I would be cautious about using prics from CMBX, ABX, etc., to make judgments about the cash bonds that they reference. It is relatively difficult to borrow and short small ABS and CMBS tranches. It is comparatively easy to buy protection on the indexes, the only question is what level does it take to induce another market participant to sell protection to you. When there is a lot of pressure to short, prices overshoot on the downside, and stay well below where the cash bonds would trade.

12) One last point, this one coming via one of our dedicated readers passing on this blurb from David Rosenberg at Merrill Lynch:

A client sent this to us last week

It was a New York Times article by Louis Uchitelle in December 1990 on the housing and credit crunch. In the article, there is a quote that goes like this ? ?This is different from the experience of the Great Depression, but something related to the 1930?s is beginning to happen?. Guess who it was that said that (answer is at the bottom of the Tidbits).

Answer to question above

?Ben Bernanke, a Princeton University Economist? (and future Fed chairman, but who knew that then?).

My take: it is a very unusual time to have a man as Fed Chairman who is a wonk about the Great Depression. That makes him far more likely to ease. The real question is what the FOMC will do if economic weakness persists, and inflation continues to creep up. I know that they want to save the day, and then remove all policy accomodation, but that’s a pretty difficult trick to achieve. In this scenario, I don’t think the gambit will work; we will likely end up with a higher rate of price inflation.

One Year At The Aleph Blog!

One Year At The Aleph Blog!

Posted on by David Merkel

It has been one year since I started The Aleph Blog. During that time, we have seen a lot of changes:

  • The panic in China in late February 2007.
  • The troubles in subprime, home equity, and residential real estate generally. (Commercial real estate is a work in progress.)
  • Increased realized volatility in the markets.
  • Increased price inflation.
  • The accelerated decline in the US Dollar.
  • Blowout of private equity lending.
  • Trouble as the rating agencies and the financial guarantors.
  • Trouble in the money markets from SIVs and ABCP.
  • Troubles in the municipal bond markets, mainly from overspeculation, but also from troubles at the guarantors.
  • The FOMC shifts from being an inflation fighter to a weak economy and lending fighter.
  • I left my previous employer (good guys generally), and have become employed elsewhere (a much better match for my abilities and desires).
  • My broad market portfolio has adjusted to changing market conditions, and continues to outperform the S&P 500, as it has for the last 7.5 years.

Pretty amazing, I think. My blog is an expression of my character in the economics/finance/investment world. I have a lot of interests, so my blog is diversified in what I write about. There is almost always someone more experienced than me writing about a given issue. I think of myself as a good number 2 (3? 5? 10?) on many issues. Because of that, my job is to look for the interactions — the second-order effects in other markets that may give us a clue as to future happenings.

If you want to see a sampling of what I felt my best articles have been, you can look here. If you have other nominations for this category, I am all ears.

Why did I start the blog? Rejection from those that I wrote for and worked with. I was frustrated, and needed an outlet for self-expression. Learning from what I wrote at RealMoney, from the first day, I followed the same ethics code, to protect those that I worked for.

What of the future? I plan on some meaty articles on inflation, the PEG ratio, some book reviews, and perhaps a series on long-term investing for children. (In addition to what I mentioned in Post 500.)

Now, I did not expect the level of acceptance that I received in my first year, and so I thank my readers. I have been quoted in a wide number of places that I would not have expected when I started this. I only ask that if you like what I write, please refer my blog to your friends, as it seems best to you.

To all of my readers, here’s to a profitable year number two. Thanks for being with me over the past year. For those that have commented here, a special thank you. To my family and church, thank you. Finally, thanks be to Jesus Christ. Woo-hoo! What a great year! 😀

Ten Fed Notes, Plus One

Ten Fed Notes, Plus One

Posted on by David Merkel

I like variety at my blog.? I like to think about a lot of issues, and the interconnections within the markets.? Sometimes that makes me feel like a lightweight compared to others on critical issues.? But what I am is a stock and bond investor who analyzes the economy to make better investment decisions, primarily at the sector level, and secondarily at the asset class level.

At present, analyzing the FOMC is a little confusing.? Why?

  • We have Fed Governors speaking their minds, because Bernanke doesn’t maintain the control that Greenspan did.? Thus we hear a variety of views.
  • The economy is neither strong nor weak, but is muddling along.
  • The Dollar is weak, but doesn’t seem to be getting weaker; it seems that a pretty accommodative forecast of FOMC policy has been baked in.
  • MZM and my M3 proxy are running ahead at double-digit rates, while M2 trots at around 6%, and the monetary base lags at a 2% rate.? We are now more than nine months since our last permanent injection of liquidity.? I asked the Federal Reserve in an e-mail to tell me what the longest time was previously between permanent open market operations one month ago, but they did not respond to me.? (They did respond to me when I suggested my M3 proxy, total bank liabilities.)
  • The Treasury yield curve still has a 2% Fed funds rate in 2008, but the recent curve widening should begin to inject some doubt into the degree of easing that the Fed can do.? Once yield curves get near maximum steep levels, something bad happens, and the loosening stops.? At a 2% Fed funds rate, we will be near maximum steep.
  • The steepening of the curve has raised mortgage rates.? So much for helping housing.
  • The TAF auctions have reduced the TED spread to almost reasonable levels, but it almost seems that the Fed can’t discontinue the auctions, because the banks have found a cheap source of financing for collateral that can’t be accepted under Fed funds.
  • At present, I see a 50 basis point cut coming at the 3/18 meeting.? That’s what fits the yield curve, Fed funds futures, and the total chatter.? For the loosening trend to change, we will need something severe to happen, such as a inflation scare or a dollar panic.
  • Now the equity markets are not near their peak, but the debt markets are showing more fear, and that is what is motivating the Fed.? Capital levels at banks?? Credit spreads on bonds?? Ability to get financing?? The Fed cares about these things.
  • In some ways, Bernanke cares the most.? Of all the people to have in the Fed Chairman seat at this time, we get a man who is a scholar on the Great Depression, and determined to not let it happen again, supposing that it was insufficient liquidity from the Federal Reserve that led to the Depression.? That might not have been the true cause, but it does indicate a Fed biased toward easing, until price inflation smacks them hard.

One last note.? Though I haven’t read through the 2001 transcripts of the FOMC, I have scanned the 1999 and 2000 transcripts.? The FOMC is flexible in the way that they view policy, and willing to consider things that aren’t perfectly orthodox, such as the stock market, even if it is hidden in the rubric of the wealth effect.

What Might the Shape of the Treasury Yield Curve Tell Us?

What Might the Shape of the Treasury Yield Curve Tell Us?

Posted on by David Merkel

There are many things that are unusual about the current Treasury yield curve. I’ve built a moderately-sized model to analyze the shape of the curve, and what it might tell us about the state of the economy, and perhaps, future movements of the yield curve. My model uses the smoothed data from the Federal Reserve H15 series, which dates as far back as 1962, though some series, like the 30-year, date back to 1977, and have an interruption from 2002-2005, after the 30-year ceased to be issued for a time.

So, what’s unusual about the current yield curve?

  1. The slope of six months to three months (19 bp) is very inverted — a first percentile phenomenon.
  2. The slope of two years to three months (38 bp) is very inverted — a third percentile phenomenon.
  3. The slope of seven years to ten years is steep (57 bp – 5 bp away from the record wide) — a 100th percentile phenomenon.
  4. The slope of five years to thirty years is steep (186 bp – 30 bp away from the record wide) — a 100th percentile phenomenon.
  5. The slope of two years to thirty years is steep (274 bp – 97 bp away from the record wide) — a 97th percentile phenomenon.
  6. The slope of ten years to thirty years is steep (82 bp – 29 bp away from the record wide) — a 98th percentile phenomenon.
  7. The butterfly of three months to two years to thirty years is at the record wide (312 bp). (Sum of #5 and #2. Buy 3 months and 30-years, and double sell 2-years? Lots of positive carry, but the 30-year yield could steepen further versus the rest of the curve, and its price volatility is much higher than the shorter bonds.)

What prior yield curves is the current yield curve shaped like?

  • 9/7/1993 — after the end of the 1990-1992 easing cycle to rescue the banks from their commercial real estate loans.
  • 2/15/1996 — after the end of a minor easing cycle, recovering from the 1994 “annus horribilis” for bonds.
  • 9/14/2001 — 60% through the massive easing cycle where Greenspan overshot Fed policy in an effort to reliquefy the economy, particularly industrial companies that were in trouble. Also days after 9/11, when the Fed promised whatever liquidity the market might need to stave off the crisis.

Okay, I’ve set the stage. What conclusions might we draw from the current shape of the yield curve?

  1. The curve is forecasting a 2% Fed funds rate in 2008.
  2. Fed policy is adequate at present to reliquefy the economy; the Fed doesn’t need to ease more, but it will anyway. Political pressure will make that inevitable. (If we really want an independent central bank, let’s eliminate the pressure oversight that Congress has over the Fed. Better, let’s go back to a gold standard; a truly private monetary policy. Oh, wait. I’m behind the times. We don’t want an independent central bank. Dos that mean we can now blame Congress for monetary policy errors?)
  3. We could see a record slope for the yield curve (in the post Bretton Woods era) if the Fed persists in its easing policies.
  4. One can sell sevens and buy tens, dollar-duration-weighted and have positive carry. Assuming one can hold onto the position, it would be hard to lose at these levels, if the last thirty years of history is an adequate guide to the full range of possibilities.
  5. The Fed is planting the seeds of its next tightening cycle now. Every cut from here will make the tightening cycle that much more intense.
  6. The curve can get steeper from here, but it is getting close to the boundaries where strange things begin to happen. The Fed is not omnipotent, and the steepening curve is evidence of that.
  7. As I have said before, recently, the US Dollar is no longer a “sell” for now. The anticipation of Fed funds cuts is already factored in, and even if we get down to 2%, I suspect that we can’t go much lower because of negative real interest rates and rising inflation.

That’s where I stand for now. The Fed is trying to rescue the economy from asset deflation, much like 1990-1992, but will run into the buzzsaw of price inflation, and tighten a la 1994. Conditions in the real economy are not as weak today as they were in 2001, but the banks are in worse shape. That will drive further loosening by the Fed, until inflation is intolerable. Continue reading “What Might the Shape of the Treasury Yield Curve Tell Us?”

Eight Thought on Our Fragile Debt Markets

Eight Thought on Our Fragile Debt Markets

Posted on by David Merkel

It’s early morning now, after two days on the road.? It is good to be home, and it will be good to get back to “regular work” once the workday begins.? A few thoughts:

1) Here are two Fortune articles where Colin Barr quotes me regarding Buffett’s offer to reinsure the muni liabilities of the financial guarantors.? He correctly quotes my ambivalent view.? I am not willing to take Ackman’s side here, nor that of the guarantors and rating agencies.? This is one of those situations where I don’t think anyone truly knows the whole picture.? My thoughts are limited to Buffett’s offer.? He’ a bright guy, and he is hoping that one of the guarantors is desperate enough to take him up on his offer.

2) Personally, I found this note from the WSJ economics blog worrisome.? Ben Bernanke is probably a lot smarter than me, but I can’t see amelioration in the residential real estate markets in 2008.? We still have increases in delinquency and defaults at present.? Vacancy is increasing. Inventory is increasing.? The market is not close to clearing yet.

3) I like the “quants.”? Are they a big force in the stock market?? Yes.? But they are an aspect of Ben Graham’s dictum that in the short run the stock market is a voting machine, but in the long run it is a weighing machine.? “Dark pools” sound worrisome, but to long-term investors they are a modest worry at best.? Traders should be concerned, but that is part of the perpetual war between traders and market makers/specialists.

4) There are two aspects to the concept of the rise in housing prices.? One is the scarcity of desirable land near where people want to live.? The second is that financing terms got too loose.? Marginal Revolution says there is/was no housing bubble.? They are focusing on the first issue, and downplaying the second issue.? My view is that there are legitimate reasons for housing prices to rise, but we built more homes than were needed, and offered financing terms to buyers that were way too generous.? To me, that is a bubble, and we are still working through it.

5) Auction-rate securities have always seemed to me to be micro-stable, but subject to macro-instability.? What do I mean?? Small fluctuations get absorbed by the investment banks, but large ones don’t.? As an old boss of mine used to say, “liquidity is a ‘fraidy cat.”? It’s around for minor jolts, but disappears in a crisis.

6) Muni bond insurance is thought insurance.? Most municipal bonds are small.? What credit analyst wants waste time analyzing a small municipality?? With a AAA guaranty, the bonds get bought in a flash, and they are liquid (so long as the guarantor continues to be viewed positively).? So, I still view municipal guarantees as having value.? Not everyone else does.

7)? Intuitively, I can feel the dispute regarding the recycling of the current account deficit.? The two sides boil down to:

  • When are they going to stop buying depreciating assets?
  • What choice do they have?? They have to do something with all the dollars that they hold.

It’s a struggle.? In the short run, supporting the US Dollar makes a lot of sense, but the build-up of continual imbalances is tough.? Why should we buy into a depreciating currency in order to support our exporters?

8 ) Privatize your gains, socialize your losses.? It’s a dishonest way to live, but many press their advantage in such an area. Personally, I think that losses need to be realized by aggressive institutions.? They took the risk, let them realize the (negative) reward.

That’s all for the morning.? Trade well, and be wary of things that work in the short run, but are long run unstable.

Ten Odds & Ends

Ten Odds & Ends

Posted on by David Merkel

I’ve wanted to post on a bunch of little things for a while, and while it won’t make for organized reading, maybe we can have some fun with it?? Here goes.

1) If Prudential drops much further, I am buying some.? With an estimated 2009 PE below 8, it would be hard to go wrong on such a high quality company.? I am also hoping that Assurant drops below $53, where I will buy more. ? The industry fundamentals are generally favorable.? Honestly, I could get juiced about Stancorp below $50, Principal, Protective, Lincoln National, Delphi Financial, Metlife…? There are quality companies going on sale, and my only limit is how much I am willing to overweight the industry.? Going into the energy wave in 2002, I was quadruple-weight energy.? Insurance stocks are 16% of my portfolio now, which is quadruple-weight or so.? This is a defensive group, with reasonable upside.? I’ll keep you apprised as I make moves here.

2) Reader Steve brought this to my attention: Mark Gilbert at Bloomberg brought attention to a monetary policy game at the San Francisco Fed’s website.? So did the estimable Marketbeat blog at the WSJ.? The game used to be found at this link.? Alas, no more.? Maybe all of the attention crashed the site, after all, the SF Fed can’t afford a heavy-duty website like mine.? Okay, sorry, they get 10x the traffic that I do, more like The Kirk Report.

Perhaps the game was removed over the embarrassment from Gilbert playing the game and applying the current Fed strategy to the game, and finding inflation going through the roof.? Now, for those that want to play a monetary policy game, my current favorite is this one from the Bank of Finland.? In a true American version of the game, we would replace the manic announcer with clips of who else, Jim Cramer.? Nobody does it better.? Oh and for true junkies looking for monetary policy games, here is a list of some of them.

3) Dig the falling long bond.? Worst day since 2004.? Echoing what I said yesterday, there’s a lot of fear in that part of the market, and a lot of foreign interest.? Well, at the 30-year auction, foreign interest was light at the lowest yield since regular auctions began in 1977.? A few strong economic numbers can make fear temporarily dissipate.

4) Here’s what I posted at RealMoney today:


 David Merkel
Moody’s Downgrades XL Capital Assurance
2/7/2008 3:34 PM EST

When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade). Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)

Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.

Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: none

Now after the close, MBIA offered stock at a 14% haircut to the closing price. ? Let’s see where the price closes tomorrow… it almost boils down to the number of buyers saying, “At a 14% haircut, there’s no way that it will close below that level.? We can buy and flip for an easy profit.”? In this case, though, there are 60%+ more shares after this issuance.? That’s some level of dilution.? MBIA may keep its AAA, but that says little for the value of holding company common stock.

5) One reader wrote me, “mr. merkel — would you care at all to expound on point 2? it’s been the assertion of some that what makes the monoline threat a non-issue is specifically that there IS a harmony of interests in seeing ambac, mbia et al at least get to a point where they can run off their obligations. however, i must admit, i’ve not seen the case made with specificity — that is, what are the interests of the interested parties, and how do they conflict or coincide?”

Point 2 was the idea that a bailout would be tough to achieve, because of differing interests on the part of those being sought to bail out the guarantors. ? Here’s my rationale: different investment banks have differing levels and types of exposure to the credit risks covered by the guarantors.? Coming up with an equitable allocation of concessions would be tough, but not impossible.? Beyond that, you have all of the ways that the guarantors reinsured each other, which further tangles the web of promises.? A bailout could be done, given enough time, and enough angelic third-party experts to divide the pie perfectly.? Time is short here, and I suspect the rating agencies will lose patience, given their need to protect their franchises.

6) At present, the yield curve indicates a 2% Fed funds rate by mid-to-late 2008.? Uh, that’s not what I would do, but it seems pretty likely for now.? What kind of price inflation would get the attention of the Fed here?? Beats me; the slope of the yield curve today is adequate to allow banks to make money; if the Fed waits at these levels, the economy should recover over the next two years.

7) I liked the idea of this post at the American Prospect, but for a different reason.? Since I called the housing bubble very clearly over at RealMoney, and even subprime too, does that mean that I can criticize the Fed with impunity?? Constructively, of course.

8) From another reader, Bamboo: I have not seen much discussion of the statutory capital requirements of the financial guaranty insurers.? It seems that Article 69 of the New York Insurance Law is the critical statute.

Although the rating agencies do not consider mark to market losses in their evaulations of capital adequacy, do they affect statutory capital?

Is there a possibility that the financial guarantors will have to take a premium deficiency reserve for their structured finance business?

I would like to get a copy of article 69, but I can’t find one.? In general statutory regulations are less market-oriented than rating agencies and GAAP.? The problems usually show up faster on GAAP than Stat, leaving aside high growth situations.

9) Another reader, Bill Luby of VIX and More, writes: Hi David,

Once again, kudos for keeping up a consistently high quality of posting here.? Your thinking often sets my brain in motion — in a very good way.

If you don’t mind, I’d be interested to get your take on the current status of the bond insurer problem and how you think it might play out.? In addition to what happens to MBI and ABK, I am also interested in whether you think others with a stronger financial position (AGO?) might make significant gains in this space.

Cheers,

-Bill

Yes, AGO, Dexia (FSA), and Berky all do well from the turmoil.? Strong balance sheets benefit from increased volatility, even as weak balance sheets are harmed.

10) Finally, from Reader Scott, regarding Medicare and entitlements, “David, wondering your thoughts on how the situation gets addressed.? There is no question at all that the equation doesn’t solve, presently.? My current thoughts are that (1) taxes go higher – not even up for serious discussion; and (2) so do trade barriers.? we trade some protectionism, a la Europe, and reduced overall welfare, for a feel-good “leveling” of some of society’s current inequties.? our nation’s most influential demographic, old folks, who vote, are appeased. add to that, perhaps, some guest worker immigration policies.? second class citizens earning second-tier wages.? on balance, we begin looking a lot more like Europe, reversing the cherished myth of American exceptionalism, and staving off acceptance of the twenty-first being the China Century.? Care to comment?”

Americans are exceptional, and that is not always a good thing.? We have fewer presuppositions than most of the world, and that leads to innovative solutions, a certain amount of unnecessary chaos, and occasional hubris.? We are probably heading for an era of leveling, but that is not certain.? Historically, it is likely.? Trade may be another matter; we may be getting close to a point where the rest of the world sees the value of freer trade, even if the US goes the other way.? Organized efforts against free trade are weak compared to protectionist eras.

As for old folks that vote, yes, that’s what makes this problem tough.? I’m not into doom and gloom, but I can see a negative self-reinforcing cycle coming.? If Bush, Jr., got smacked over his all-too-cautious attempt at Social Security reform (it would have done almost nothing, but listen to the squeals), can you imagine what true reform of a much bigger problem might entail?? We would need a full blown panic in the debt markets to get focus there, and as for now, foreigners are still very willing to roll over US debt denominated in US dollars.

Full disclosure: long AIZ, LNC

The Boom-Bust Cycle, Applied to Many Markets

The Boom-Bust Cycle, Applied to Many Markets

Posted on by David Merkel

Every now and then, valuation metrics in a market will get changed by the entrance of an aggressive new buyer or seller with a different agenda than existing buyers or sellers in the marketplace.? Or conversely, the exit of an aggressive buyer or seller.

Think of the residential mortgage marketplace over the last several years.? With an “originate and securitize” model where no one enforced credit standards at all, credit spreads got really aggressive, and volumes ballooned. Many marginal mortgage lenders entered the market, because it was strictly a volume business.? Now with falling housing prices, there are high levels of delinquency and default, and mortgage volumes have shrunk, leading to the failures/closures of many of those marginal lenders.? Underwriting standards rise, as capacity drops out.? Even prime borrowers face tougher standards.? In two short years, fire has given way to ice.

If you’ll indulge another story of mine, I worked for an insurer who had a well-run commercial mortgage arm.? Very conservative.? They did small-ish loans on what I would call “economically necessary real estate.”? See that ugly strip mall with the grocery anchor?? Everyone in the area shops there; that’s a good property.

Well, in 1992, the head of the Commercial Mortgage area had a problem.? The company had only three lines of business, and two lines representing 60% and 20% of the assets of the firm were full up on mortgages.? What was worse, was they didn’t want to even replace maturing loans, because the ratings agencies had told the company that commercial mortgage loans were a negative rating factor.? Never mind the fact that the default loss rate was 40% of the industry average.

He stared down the possibility that he would have to close down his division.? He had one last chance.? He called the actuary that ran the division that I was in (my boss), and pitched him on doing some commercial mortgages.? The conversation went something like this:

Mortgage Guy: I know you haven’t liked commercial mortgages in the past, but my back is against the wall, and if you don’t take my originations, I’ll have to shut down.? You’ve heard that the other two divisions won’t take any more mortgages at all.?

Boss: Yeah, I heard.? But the reason we never took commercial mortgages was that we didn’t like the credit spread compared to the risks involved.? 150 basis points over Treasuries just doesn’t make it for us.

M: Well, because many companies have reduced originations, the spreads are 300 basis points now.

B: 300?! But what about the quality of the loans?

M: Only the best quality loans are getting done now.? I can insist on additional equity, in some cases recourse, and faster amortization.? My loan-to-values are the lowest I’ve seen in years.? Coverage ratios are similarly good.

B: Well, well.? Perhaps I’ve been right in the past, but I’m not pigheaded.? Look, we could take our percentage of assets in mortgages from 0% to 20%, but no more.? At your current origination rate, that would allow you to survive for two years.? We will take them all, subject to you keeping high credit quality standards.? Okay?

M: Thank you.? We’ll do our best for you.

And they did.? For the next two years, our line of business and the mortgage division had a symbiotic relationship, after which, spreads tightened significantly as confidence came back to the market.? We had 20% of our assets in mortgages, and the other two lines of business now felt comfortable enough with commercial mortgages to begin taking them again — at much lower spreads (and quality) than we received.

It’s important to try to look through the windshield, and not the rear-view mirror in investing.? Analyze the motives of current participants, new entrants, and their likely staying power to understand the competitive dynamics.? I’ll give one more example: the life insurance industry was a lousy place to invest for years.? Why?? A bunch of fat, dumb, and happy mutual companies were willing to write life insurance business earning a minimal return on capital.? As another boss of mine once said, “It doesn’t take mere incompetence to kill a mutual life insurer; it takes malice.”? Well, malice, or at least its cousin, killed a number of insurers, and crippled others in the late 80s to mid 90s.? Investment policies that relied on a rising commercial real estate market failed.

But that was the point to begin investing in life insurers.? They began pricing capital economically, and the industry began insisting on higher returns as a group.? Many mutuals demutualized, and the remaining large mutuals behaved indistinguishably from their stock company cousins.? The default cycle of 2001-2003 reinforced that; it is one of the reasons that the life insurance industry has had only modest exposure to the current difficulties afflicting most financials.? After years of being outperformed by the banks, the life insurers look pretty good in comparison today.

I could go on, and talk about the CDO and CLO markets, and how they changed the high yield bond and loan markets, or how credit default swaps have changed fixed income.? Instead, I want to close with an observation about a very different market.? Who likes Treasury bonds at these low yields?

Well, I don’t.? At these yield levels the odds are pretty good that you will lose purchasing power over a 2-3 year period.? Then again, I’m a bit of a fuddy-duddy.? So who does like Treasury yields at these levels?

  • Players who are scared.
  • Players who have no choice.

There is a “fear factor” in Treasury yields now.? Beyond that, there is the recycling of the current account deficit, which is still large relative to the issuance of Treasuries.? The current account deficit is large, but shrinking, since the US dollar at these low levels is boosting net exports.? As the current account deficit shrinks, Treasury yields should rise, because foreign demand has been a large part of the buyers of Treasuries.? The Fed can hold the short end of the curve where it wants to, but the long end will rise as the current account deficit shrinks.

I think the current account deficit does shrink from here, because the cost of buying US debts, and not buying US goods is getting prohibitive.? Also, fewer retail buyers will take negative real yields.

That’s my thought for the evening.? Analyze the motives of other players in your markets, and don’t assume that the current state of the market is an equilibrium.? Equilibria in economics are phantoms.? They exist in theory, but not reality.? Better to ask where new entrants or exits will come from.

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