Category: Currencies

Fat Fed Profits Do Not Create a Healthy Economy

Fat Fed Profits Do Not Create a Healthy Economy

Posted on by David Merkel

1) Inflate the size of my balance sheet by 2.5x over last year, all through borrowing at really low rates.

2) Increase my interest spreads by ~50% over last year.

means:

3) I only increased my profits by ~50% over last year??!? :(? I would have thought that profits would have more than tripled.

Such is life for the Fed.? The crisis was a time that led me to write pieces like The Liquidity Monopoly, where the Fed, FDIC, and Treasury played favorites in the economy, and starved the portions of the economy not dominated by large firms, particularly with banks and autos.

My main point is that the Fed should have earned a lot more.? Where did it all go?? It will be interesting to see a detailed rendering of the Fed’s finances when this is done.? Did they realize losses on some of the assets that they bought?

My friend Peter Eavis of the Wall Street Journal agrees.? Or, read Felix, and then read the exchange between my two friends Alea and Kid Dynamite.? Alea knows more, but I like KD’s spirit.

The Fed has become more like the banks that it regulates.? They are taking on credit risk, duration risk, convexity risk, etc.? And being a government institution, they don’t have good incentives for knowing how to price risk.

So, when I see the Fed’s seniorage profits up only 50%, I am not impressed.? The Fed doesn’t mark to market, so we really don’t know the true performance.? Also, remember that seniorage profits are a hidden tax on savers, would earn a higher yield if the government provided less financing.

Part of why we end up in an economic funk is that we finance dud assets at favorable rates, so capital does not get redeployed to better uses.? Aside from that, cheap leverage creates a yield frenzy over healthy assets, so that they can become over-levered as well.? Examples are numerous:

To me it is no great achievement that the financial markets are doing well while the real economy is in the tank (Unemployment, Production).? That is the nature of what happens when credit is force-fed into an economy, even leaving aside the problems of cronyism.? There should be no optimism over the large profits realized by the Fed; it may defray our taxes, but on net, the policies have not helped create a healthier real economy.

Fourteen Comments on the Financial Economy

Fourteen Comments on the Financial Economy

Posted on by David Merkel

1) Yield-seeking — it is alive and well.? Check out this article on pay-in-kind bonds.? With PIKs, one can be concerned with the return on the money, and the return of the money at the same time.? The history of returns on PIK bonds are such that you are usually better off putting the money under a mattress.

2) More yield-seeking — spreads on mortgage bonds over Treasuries are at a 17-year low, and as I measure it, and all-time low.? Investors have gone maniac for GSE insured mortgage bonds.

3) I am as close to neutral on PIMCO as anyone I know.? I have written articles explaining how they make money, which is different from the public pronouncements of Gross and McCulley.? The current missive of Gross impresses me as fair, recognizing the limits of the Federal Government and the Fed.? PIMCO is taking less risk, selling US and UK debt, and buying German debt.? This is conservative; they are giving up yield.

4) Bruce Krasting notes that the Social Security system paid out more in 2009 than it took in.? That event was not supposed to happen until 2016 or so.? Aside from that, he notes the negative COLA adjustment.? As for me, I look at this and say, “Whether it comes slower or faster, it will come.? Medicare and Social Security will destroy the Federal budget eventually, or will be scaled back to where those that were taxed complain about it.

5) If you want to consider a technical reason for rates being so low, consider all of the mutual fund buyers.? They have favored bonds.? This is a contrary sign for interest rates — they are headed higher.

6) Bernanke blames bank regulation so that he can absolve monetary policy.? Typical.? Blame what you control less, to absolve what you control directly.? A better and brighter economist (in my opinion), John Taylor disagrees.? He views the mid-decade low rate policies as contributing to the lending frenzy.? Don’t get me wrong.? Bank regulation was lousy, but monetary policy was lousier, helping to create the boom that now gives us the bust that normalizes things.

7) How amazing was the junk bond market?? Better, how amazing was the distressed debt market?? Oh my, though junk bonds paced equities, distressed debt did far better.? Such is the case when a turn happens; this one was forced by the US Government.

8) If you want to understand how finance reform gets blocked, read this article.? Better than most, it explains the intricacies of why the Democrats have a hard time passing the legislation that the radicals would like.

9) I am not a Buffett-lover or hater.? When I read his opposition to Kraft raising its bid, I said to myself, “Of course.? Don’t overpay.? Most deals are best avoided.”? Which is true — M&A is in general a value destroyer.

10) Personal bankruptcies are rising in the US.? It is a messy time.

11) Let the Chicago School of Economics die.? I have already argued for their demise.

12) The CMBS market is experiencing delinquencies that have not been seen before.? This is just another example of the difficulties many commercial mortgage loans are in.

13) Strip malls have high vacancy rates.

14) I appreciate Tyler Cowen’s article, suggesting that things are pretty good.? We should be glad that other places in the world did well, even if we did not do so well.

Five Comments and Notes

Five Comments and Notes

Posted on by David Merkel

1) There is a new blog that I recommend: Macroeconomic Resilience.? I have commented there recently, and I think that he understands the complexity of markets in ways that most Ph. D. economists don’t.? Here is a recent post, and my comment.

http://www.macroresilience.com/2010/01/01/moral-hazard-a-wide-definition/comment-page-1/#comment-6

One job ago, at a hedge fund that was bearish on financials, we would talk about this all the time.? Regulators could have stopped the crisis in the early 2000s had they simply enforced lending standards.? The banks would have screamed and ROEs would have gone into the single digits, but the crisis could have been prevented.

But, regulators are to a degree subject to politicians.? Politicians, in the absence of any moral compass aside from re-election, are mainly beholden to those that fund their campaigns, when the electorate is without education, or a moral compass as well.? Thus, regulations were neutered.

After that, how many businessmen would watch out for the companies they served, instead of what would maximize their pay?? There were some bankers that did so and got shown the door.? There were other banks owned privately, were conservative, and missed the crisis.? It could be done, but the management team or owners had to deliberately sacrifice the short run in favor of missing an uncertain crisis.

Chuck Prince said something to the effect of “When the music is playing, you gotta get up and dance.” to justify doing business in the face of bad credit metrics.? Well, yes, in a place where no one cares for the long-run health of the firms, or of society as a whole.

Someone has to care for the long run.? Better it be free individuals rather than the government.? But if free individuals will not do it, eventually the government will.

2) I have been a fan of Michael Pettis for many years, from his publication of his book, The Volatility Machine.? Here is a comment that I posted at his blog, which I highly recommend:

http://mpettis.com/2010/01/china-new-year-and-one-more-vote-for-gdp-adjusted-bonds/

Michael, I ordinarily agree with you on almost everything economic, but I can?t agree on the trills. I believe in asset-liability matching, even at the government level. Try to match term risk and liquidity risk to what is being funded.

I have argued that the debt structure of the US government has been getting too short, and recommended that the US Treasury lengthen its funding policies ? I even said that to the Treasury officials that I met with in November.

http://alephblog.com/2008/11/25/issuing-debt-for-as-long-as-our-republic-will-last/
http://alephblog.com/2009/11/04/my-visit-to-the-us-treasury-part-2/ (2 of 7)

But trills have exceedingly long duration ? the remind me of some structured settlements that I have had to model, but these are perpetuities ? even longer for the coupon to grow. Duration looks like it would be north of 40 ? it depends on the assumptions used.

A perpetuity growing at GDP rates saddles our posterity with debts that they cannot bear. Cheap debt up front ? really costly on the back end.

http://alephblog.com/2009/12/27/not-so-cheap-trills/

But, thanks ever so much for your blogging. I learn so much from you. Keep it up.

3)? Insurance for those dropping out of school?? Sounds really dumb:

http://blogs.wsj.com/economics/2009/12/31/would-insurance-for-college-failure-keep-more-students-enrolled/

This sounds like a product that only dumb insurers would write. Never write insurance where the insured has better knowledge and more control than the insurance company.

4) Many are crying over auction rate preferred securities.? But most of the assets that were harmed were owned by corporations, who had investment professionals that chose auction rate preferred securities because they yielded significantly more than money market funds, but with seemingly little risk, and the system worked for around 20 years.

They took above average risks, and now they expect to be bailed out?? I have read through many ARPS prospectuses.? For those that read them, the risks were clearly disclosed.? I do not have a lot of sympathy for those that did not do their job.

5) From the “bitter taste” zone, we learn that foreign investors in US debt lost the most versus investing in the debt of other developed nations in 2009.? Should that surprise us when demands for loans accelerated dramatically in 2009?? I don’t think so, and most reasonable analysts would agree.

Nine Notes and Comments

Nine Notes and Comments

Posted on by David Merkel

As I roll through the day, i often make comments on the blogs and websites of others.? I suppose I could gang them up, and post them here only.? I don’t do that.? Other sites deserve good comments.? Today, though, I reprint them here, with a little more commentary.

1) First, I want to thank a commenter at my own blog, Ryan, who brought this article to my attention.? I’ve written about all of the issues he has, but he has integrated them better.? It is a long read at 74 pages, but in my opinion, if you have 90 minutes to burn, worth it.? I will be commenting on the ideas of this article in the future.

2) My commentary on Dr. Shiller’s idea on Trills drew positive attention, but the best part was being quoted at The Economist’s blog.

3) Tom Petruno at the LA Times Money & Company blog is underappreciated.? He writes well.? But when he wrote Fannie and Freddie shares soar, but for no good reason.? I wrote the following:

From my comments to my report on financials yesterday ?Federal Home Loan Mortgage Corp [FRE] and Federal National Mortgage Assn [FNM] Rise as U.S. Removes Caps on Assistance ? this gives the GSE stocks more time, and hence optionality. I still think they will be zeroes in the end, but there will be a lot of kicking and screaming to get there. The government is engaged in a failing strategy to reflate the housing bubble, and they aren?t dead yet.

I write a daily piece on financials for my company’s clients.? The stock of the GSEs rose because the odds of them digging out of the hole increased.? You can’t dig out of the hole if you are dead, so when you are near that boundary, even small changes in the distance from death can affect sensitive variables lke the stock price.? Plus, the odds rise that the US will do something really dumb, like convert theor preferred shares to common.

4) Kid Dynamite put up a good post on CDOs, I commented:

KD, maybe we should play chess sometime. Spotting a queen and rook is huge. I have beaten Experts, though not Masters on occasion (except in multiple exhibitions), and I can’t imagine losing to anyone who has spotted me a rook and queen.

All that said, I never gamble, and as an actuary, I know the odds of most games that I play.

Now, all of that said, I never cease to be amazed at all of the dross I receive in terms of ideas that look good initially, but are lousy after one digs deep.

Good post. Makes me wonder how I would have done in the same interview. Quants need to have a greater consideration of qualitative data. When I was younger, I didn’t get that.

5) Then again, Yves Smith comments on a similar issue at her blog.? My comment:

I?m sorry, but I think jck is right. The risk factors were clearly disclosed. Buyers should have known that they were taking the opposite side of the trade from Goldman.

As I sometimes say to my kids, ?You can win often if you get to choose your competition,? and, ?Winning in investing comes from avoiding mistakes, not making amazing wins.?

As a bond manager, I was offered all manner of amazing derivative instruments. I turned most of them down. Most people/managers don?t read the prospectus, but only the term sheet. Not reading the prospectus is not doing due diligence.

Since we are on the topic of Goldman Sachs, in 1994, an actuary from Goldman came to meet me at the mutual life insurer where I worked. I wanted to write floating rate GICs which were in hot demand, and all of my methods for doing it were too risky for me and the firm.

Goldman offered a derivative instrument that would allow me to not take too risky of an investment strategy, and credit an acceptable rate on the GIC. So, as I read through the terms at our meeting, a thought occurred to me, and so I asked, ?What happens to this if the yield curve inverts??

He answered forthrightly, ?It blows up. That?s the worst environment for these instruments.? Now, if you read the docs, it was there, and when asked, he told the truth. The information was not up front and volunteered orally.

But that?s true of almost all financial disclosures. You have to read the fine print.

As for the derivative instruments, in early 2005, many large financial institutions took billion dollar writedowns. All of my potential competitors in the floating rate GIC market left the market. I went back to buyers, and offered the idea that I could sell them the GICs at a lower spread, which would give them a decent return, but with adequate safety for my firm. All refused. They basically said that they would wait for the day when the willingness to take risk would return.

And it did, until the next blowup in 1998 around LTCM.

My lesson: the craze for yield drives many derivative trades. What cannot be achieved with normal leverage and credit risk gets attempted, and blows up during hard times.

Structure risks are significant; the give up in liquidity is significant. The big guys who play in these waters traded away liquidity too cheaply, and now they are paying for it.

=-=-=-=-=–=-==-=-Whoops, where I said 2005, I meant 1995. That loss I avoided for the firm was one of my best moves there, but we don?t get rewarded for avoiding losses.


6) Then we have CFO.com.? The editor there said they want to publish my comment in their next magazine.? Nice!? Here is the article.? Here is my comment:


Time Horizon is Critical
Yes, Wheeler did a good job, as did MetLife, including their bright Chief Investment Officer.

What I would like to add is the the insurance industry generally did a good job regarding the financial crisis, excluding AIG, the financial guarantors, and the mortgage insurers.

Why did the insurance industry do well? 1) They avoided complex investments with embedded credit leverage. They did not trust the concept that a securitized or guaranteed AAA was the same as a native AAA. Even a native AAA like GE Capital many insurers knew to avoid, because the materially higher spread indicated high risk.

2) They focused on the long term. The housing bubble was easy to see with long-term perception — where one does stress tests, and looks at the long term likelihood of loss, rather than risk measures that derive from short-term price changes. Actuarial risk analysis beats financial risk analysis in the long run.

3) The state insurance regulators did a better job than the Federal banking regulators — the state regulators did not get captured by those that they regulated, and were more natively risk averse, which is the way regulators should be.

4) Having long term funding, rather than short term funding is critical to surviving crises. The banks were only prepared to maximize ROE during fair weather.

I know of some banks that prepared for the crisis, but they were an extreme minority, and regarded by their peers as curmudgeonly. I write this to give credit to the insurance industry that I used to for, and still analyze. By and large, you all did a good job maneuvering through the crisis so far. Keep it up.

7) Then we have Evan Newmark, who is a real piece of work, and I mean that mostly positively.? His article😕 My comment:

Good job, Evan. I don?t do predictions, except at extremes, but what you have written seems likely to happen ? at least it fits with the recent past.

But S&P 1300? 15% up? Wow, hope it is not all due to inflation. 😉

8 ) Felix Salmon.? Bright guy.? Prolific.? His article on residential mortgage servicers.? My response:

Hi Felix, here?s my two cents:

I think the servicers are incompetent, not evil, though some of the actions of their employees are evil. Why?

RMBS servicing was designed to fail in an environment like this. They were paid a low percentage on the assets, adequate to service payments, but not payments and defaults above a 0.10% threshold.

Contrast CMBS servicing, in which the servicer kicks dud loans over to the special servicer who gets a much higher charge (over 1%/yr) on the loans that he works out. He can be directed by the junior certificateholder (usually one of the originators) on whether to modify or foreclose, but generally, these parties are expert at workouts, and tend to conserve value. The higher cost of this arrangement comes out of the interest paid to the junior certificateholder. Pretty equitable.

Here?s my easy solution to the RMBS problem, then. Mimic the CMBS structure for special servicing. An RMBS special servicer would have to be paid a higher percentage on assets than a CMBS special servicer, because he would deal with a lot of small loans. The pain of an arrangement like this would get delivered where it deserves to go: to those who took too much risk, and bought the riskiest currently surviving portions of the RMBS deal.

The underfunded RMBS servicers may be doing the best they can. They certainly aren?t making a bundle off this. As a former mortgage bond manager, I always found the RMBS structures to be weaker than the CMBS structures, and wondered what would happen if a crisis ever hit. Now we know.

9) But then Felix again through the back door of Bronte Capital.? My comments:

I don?t short. Short selling is socially productive though. Here is how:

1) Sniffs out bad management teams.

2) Sniffs out bad accounting.

3) Adds liquidity.

4) Defrays the costs of the margin account for retail investors. Institutional longs get a rebate. Securities lending programs provide real money to long term investors, with additional fun because when you want to sell, you can move the securities to the cash account if the borrow is tight, have a short squeeze, and sell even higher.

5) Provides useful data for longs who don?t short. (High short interest ratio is a yellow flag in the long run, leaving aside short squeeze games.)

6) Allows for paired trades.

7) Useful in deal arbitrage for those who want to take and eliminate risk.

8) Other market neutral trading is enabled.

9) Lowers implied volatility on put options. (and call options)

10) And more, see:

http://alephblog.com/2008/09/19/governme nt-policy-created-too-hastily/Short selling is a good thing, and useful to society, as long as a hard locate is enforced.

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

That is what my commentary elsewhere is like.? I haven’t published it here in the past, and am not likely to do it in the future, but I write a lot.? Amid the chaos and economic destruction of the present, the actions are certainly amazing, but consistent with the greed that is ordinary to man.

On the Effects of Chinese Inflation

On the Effects of Chinese Inflation

Posted on by David Merkel

I have often thought that international macroeconomics boils down to looking at all of the big nations that have some degree of economic flexibility, and are willing to make non-economic decisions for political purposes.? They drive the excesses in the global economy through their actions. It is not as if their actions have no cost, […]

Handing Over Goods for Promises

Handing Over Goods for Promises

Posted on by David Merkel

Twenty years ago, I hit upon the idea that I should analyze entitlement programs by assuming that the dividing wall between the trust funds and the government did not exist.? That’s a useful idea, because OASDHI [Old Age, Survivors, Disability, Health Income] taxes and benefits are statutory in nature, and not guaranteed.? The “trust funds” are a legal fiction.? So, consider the entitlement programs as an extension of the federal budget, because that is what they are.

Time for a new blurring of distinctions.? The two parties in this case are the US Government and the Federal Reserve.? Let’s pretend they are one entity.? Why is this reasonable to pretend this?

  • Profits from the Federal Reserve go to the US Treasury.
  • The US Government appoints most of the critical members of the Fed’s governing board.
  • During the crisis, the Fed and Treasury worked hand in glove to achieve their ends.
  • The Fed takes actions that an ordinary Central Bank would not.? Why bail out Bear Stearns and AIG?? Why aid Fannie and Freddie?? Why buy mortgage-backed securities?? There is no reason for a central bank to own anything but the highest quality securities.

Much as Bernanke and others have protested about central bank independence, they have acted like an arm of the Treasury in most of 2008-2009.? So let’s stop the act, or let’s bring back men in the nature of Volcker, Martin and Eccles.? Tell Congress and the Executive that we are going to preserve sound money, and if they don’t like it, don’t reappoint us.

But suppose we continue on in the limp-wristed way that we have been going.? Maybe the US doesn’t have a Central Bank.? Maybe it has an additional financing arm.? Think of the Dollars you hold as o% 0-day commercial paper.? Think of the Fed encouraging banks to lend to them for the rate of less than 0.25%/year annualized on an overnight basis.? Consider their purchases of longer dated securities as similar to that of a hedge fund, admittedly a clumsy one, pasted onto our government.

So long as there is slack labor, slack capital, and slack resources, the cheap lending rates to the US government can persist.? But in the ’70s resources were not slack, and inflation occurred while there were recessionary conditions.? If the global economy is markedly stronger than the US economy, that could be our situation again — stagflation.

Central banks by their nature abhor two risks, credit risk, and lending long.? In the present environment, the Fed is doing both. Bagehot said to lend against impeccable capital at a penalty rate.? In the current crisis, the Fed, far from being independent, is absorbing credit risk, and lending long risk, and is doing so without abnormal compensation, indeed the compensation is sometimes subpar.

My sense is that when the Fed stops its purchases of mortgage bonds in the next few months, the longer-dated debt markets will cease to be so friendly, and rates will rise.? That is what should be happening.? It is risky to lend for long periods in US Dollar terms, and those that do so should be amply rewarded.

There are many who are arguing that the US should borrow more and spend with abandon.? They are fools; fools believe that the government can create prosperity through legislative or regulatory actions.? As it is, the creditworthiness of our government declines as we use its credit to bail out private interests.

We might not be as bad off as Greece, but what assurance do creditors of the US have that they will be repaid in purchasing power similar to that which they lent?? I don’t see the assurance.? Better to invest in the debt of non-PIIGS euro-debt. [PIIGS — Portugal, Ireland, Italy, Greece and Spain]

There is a lot of stress in the global economy as it attempts to reconcile economies that must export, no matter what, with those that must run deficits, no matter what.? The exporters take in debt from the nations that borrow in order to make books balance.? I don’t know when that system will break, but it will break, delivering losses to the exporters, much as that happened in the era of mercantilism.

That said, when the exporters lose, so will the countries that relied on the cheap financing, including the US.? Interest rates will be higher, and the US economy will be that much weaker, aside from exporters benefiting from a weaker dollar.? This may not take place for years, but it will eventually happen.

In other words, the cheap finance that the US has will eventually fail.? I don’t know when that will be, but eventually the world will tire of handing over goods for promises.

On Sovereign and Quasi-Sovereign Risks

On Sovereign and Quasi-Sovereign Risks

Posted on by David Merkel

I like investing internationally, because of the diversification it offers, both in stocks and bonds.? Or, think of it as a hedge.? Will the American Experiment continue to prosper?? We have come a long way from the Founding Fathers, and more than half of it is not good.

But there are some place in our world that I will not invest in.? I have two requirements.

  • Contract law must be close to that in the US, or better.
  • Accounting practices must be close to the quality of the US, or better.

Sounds simple, but foreign tales are beguiling.? There is an exclusiveness about them, and a sense of greater knowledge for the one who has bothered to learn a trifle.? My acid test is watching over a long period and seeing how they treat foreign shareholders.? That is a good measure of the morality of management.? If they cheat foreign shareholders, they will eventually cheat domestic shareholders as well.

So, what don’t I invest in?

  • Russia
  • China
  • Most of the Middle East.
  • Venezuela
  • And other places that do not protect foreign shareholders on a level that is at least close to that of citizens.

The idea is to avoid situations where your rights as a shareholder might be ignored.? It does not matter how cheap an asset is; if the ability of the asset to be liquidated is low, so should the valuation of the asset be low.? Don’t buy pigs in pokes.

This has application today with Dubai.? The Dubai government is telling creditors that it will not stand behind Dubai World, and nor will the UAE, but Abu Dhabi will stand behind UAE banks.? This is tough on foreign creditors because foreign creditor rights in Dubai have not been tested until now.? Even domestic rights are unclear.

A Note on Debt Risks

Much Islamic debt, because of the prohibition on interest, acts like an extremely volatile hybrid bond during times of stress.? This incident will prove instructive on how these bonds keep or lose value in a reorganization.? What happens here will probably have an impact on how much money will be willing to flow into these vehicles in the future.? Personally, I never found them compelling, and probably won’t in the future.? There is something compelling about straight senior unsecured debt that pays interest.? I think the guarantees involved, together with straightforward reorganization processes, create a fair game where it is easier to decide whether lending or borrowing makes sense.

Complexity in bonds is usually a loser for the lender — whether complexity of the borrower’s finances, complexity of holding company structures, complexity of the governing laws, or even enforcing a complex contract where the lender duped the less-knowledgeable borrower.

What applies to corporate debt — long term buy and hold investors do okay with investment grade debt, but less well with junk debt, and worse the junkier it gets.? Layer on top of that the difficulty of being able to psychologically buy and hold during a crisis.? Even if you personally have the fortitude to do so, there may be others that influence you that don’t.? (E.g., the rating agencies come along near the trough of the crisis, and tell the CEO that they will downgrade you if you don’t sell bonds with the risk du jour.? Or, your clients look at their statements, and see the unrealized losses and beg you to sell — it doesn’t matter, the screaming is always the loudest at the bottom (in hindsight).

A Final Note on Sovereign Risks

Sovereign and quasi-sovereign risks like Dubai World may play a larger role in overall credit risk as the broader crisis plays out.? When I was younger, I thought the great risk of the Euro was that it would be too weak.? Bite my tongue.? The risk is that it could be too strong, and marginal European countries (Greece, Iceland, Ireland, Spain, Portugal, and many Eastern European countries) that have too much Euro-denominated debt relative to their ability to tax and pay will find themselves pinched — and they can’t inflate their way out.

When I first came to bond investing (early 90s), sovereign risks were viewed? skeptically, excluding the large Western nations — bond managers had been taught by the greyheads who had seen sovereign defaults, and the difficult of recovering money in default, still had a bias against sovereign and quasi-sovereign risks.? That bias is largely gone today, after a period of few sovereign losses.? Yes, Mexico, Russia and Argentina have given their share of heartburn, but the significant growth in the emerging markets has made bondholders forgiving.? Add in the long term structural deficits of the US and Japan, and it makes for a really interesting investment picture.

Be aware.? If you hold sovereign debts, look at the ability of the government to tax and pay over the long haul.? On quasi-sovereigns, analyze the explicit guarantees, if any, and the governing law — as you can see with Dubai World, in a crisis, only the guarantees matter, and only to the degree that they are enforceable under law.? With Dubai World, it will be judged in Dubai courts by a judge appointed by the ruling family of the emirate, which owns the equity of Dubai World.? Not a strong bargaining position in my opinion.? The only thing worse than relying on the kindness of strangers, is relying on the kindness of adversaries.

A Final Aside

I knew about how dodgy the investments were that Dubai and its corporations were undertaking, so I was always a skeptic, though I never wrote about Dubai, because it is so far afield for me.? What I did not know was the near slavery of foreign workers tricked to go to Dubai, and then forced to work with little to no rights.? Read the story, it is not pretty, but reinforces a belief of mine that governments and corporations willing to cheat one group of people, will cheat other groups of people as well.? Character is important in any credit decision, and the government of Dubai does not have good character in my book.

Dubai? Do Sell?

Dubai? Do Sell?

Posted on by David Merkel

There are always areas of excess in every market boom phase.? Dubai is an example of that.? Why can they build the tallest building, and construct islands in the Persian Gulf?? Cheap capital, riding on the oil boom, sent Dubai to incredible heights.? In an economic game of crack-the whip, Dubai is at the end of the line — they don’t have much energy production, but they have grandiose ideas that benefit if those with oil wealth decide to spend money nearby for fun, rather than abroad.

Now the Dubai government’s champion development corporation, Dubai World, faces bankruptcy.? Given the debt guarantees of the Dubai government, what happens?? Dubai is not big, and as part of the United Arab Emirates, is reliant on help from the other Emirates, particularly Abu Dhabi.? The worries are that there could be “contagion”-type effects that could affect the creditworthiness of related entities, particularly those that have lent to Dubai World.? Most of those are either UAE-related or European banks.? This isn’t a US issue, unless it becomes a big European issue — unlikely, but remember that European banks are more levered than US banks.? The US Dollar has been gaining on this news.

Secondary aftershocks would be entities similar to Dubai — other places in the world that have borrowed a lot in an attempt to grow rapidly.? Thus many emerging markets are getting hit in this mini-crisis.? What investors should remember is that in ordinary circumstances (peace, absence of famine, plague, or rampant socialism), the economy tends to grow at about 2%/year.? One can try to increase that by borrowing, and at the right opportunity that can be a winner.? But most of the time, huge increases in debt levels are eventually associated with default.? In a highly leveraged financial system where lenders are themselves indebted, defaults can cascade.? Also, as mentioned above suspicions get raised with similar entities for a different type of cascade.? A third aspect can involve a reduction in general willingness to take risk on the part of most investors.

Often at such a time, various government ministers/bureaucrats come forth and say, “There is nothing fundamentally wrong here.? All we need is to restore confidence.? This is not a solvency issue, it is a liquidity issue!”? Uh, maybe, but keep your hand on your wallet.? One has to examine how separable the various economic issues are.? Where contagion exists, it is like a massive arrangement of dominoes.? The more leverage on any entity, the taller that domino is.? The more leverage in the system, the more tightly the dominoes are spaced.? That arrangement can be stable for a time.? Stable, that is, until someone knocks over a key domino.

Now, most analysts are saying that this situation is contained, and after falling hard for the two prior days, European markets are rallying today, including financials.? Values for debts closely related to Dubai World have fallen hard, and S&P and Moody’s have downgraded them, and may declare the payment delay to be a default. (Also, with credit to Moody’s — they did downgrade many Dubai-related entities earlier this month.? Remember, with rating agencies, smart investors ignore the ratings, and look at what the analyst says.? The Moody’s analyst highlighted the lack of any explicit guarantees from Dubai.)

I would simply say be careful.? The total debts of Dubai-related entities are not clearly known, and the degree of willingness of friends and lenders to support them is unknown.? In the credit business, relying on the kindness of strangers is not a wise strategy.? The challenge is to see that in advance and avoid debt situations where informal reliance on third parties is a large part of the case for creditworthiness.? I would add that investors in junior debt issues, including Islamic pseudo-debt issues have to be cognizant of the lack of guarantees involved.? Study the prospectuses with care in such situations, and avoid risks that are less clear, particularly during bull markets, where the rewards for being correct are small.

Other selected articles on the mini-crisis:

My Visit to the US Treasury, Part 5

My Visit to the US Treasury, Part 5

Posted on by David Merkel

One other blogger took his nameplate with him — I’m not sure who; the rest left theirs.? But this is what was in front of each one of us as we sat down to discuss matters at the US Treasury.? Treasury officials had similar nameplates.? It dictated where we would sit as well.? From the front of the room on the left, for bloggers it was Financial Armageddon, (Megan McArdle — not there), Accrued Interest, and Across the Curve.? On the right, Naked Capitalism, Kid Dynamite, Interfluidity, Me, and Marginal Revolution.? Aside from putting the two bloggers with the most traffic at the front, there did not seem to be any rhyme or reason to the seating.

The Treasury officials presenting generally sat in front, a few sat to the side and behind us.? It made for an interesting dynamic during the portion of the meeting where some bloggers disagreed over whether derivatives should be exchange traded or not.? The folks from the Treasury grinned.? See?? These aren’t easy questions to answer!? For me, with a middle view (bring interest rate swaps to exchanges first and see how they work, then try other instruments that are less liquid), I found the exchange to be a waste of precious time, but it was revealing of the attitudes of those in the Treasury.? I knew what the bloggers thought already.

The Biggest Financial Problem

I’ve written a number of pieces on why debt matters. (Or, where is the breaking point?)? I am in the process of reviewing This Time is Different: Eight Centuries of Financial Folly — a book that deals with the reality of sovereign defaults over the last 800 years.

Surprise! Over-indebted countries do default on their debt more often than less-indebted countries.? During the current crisis, we have two mechanisms running to blunt the troubles.? The government is running a large deficit, and the central bank is sucking in longer-dated bonds to lower interest rates.? I talked about why lower interest rates are not necessarily a blessing yesterday.? Today’s thoughts are on deficits.

After the meeting, I said to one Treasury staffer, “One of the quiet casualties of this crisis is that you lost your last bit of slack from the entitlement systems.”

“What do you mean?”

“Just this, prior to the crisis, Social Security and Medicare would produce cash flow surpluses for the Government until 2018.? Now the estimates are 2016, and my guess is more like 2014.? The existing higher deficit takes us out to the point where the entitlement systems go into permanent negative cash flow.? This means that the US budget is in a structural deficit for as far as the eye can see, fifty years or more, absent changes to entitlements.”

He looked at me and commented that it would be the job of a later administration.? No way to handle that now.? To me, the answer reminded me of what I say to myself when I go on a scary ride at Six Flags with my kids.? There is nothing we can do to change matters.? The only thing to adjust is attitude.? So, ignore the fact that you are afraid of heights, and enjoy the torture, okay?

Would that I could do that with the present situation.? The long term problems are too numerous, and the present crisis saps attention from what is arguably a larger problem.? Medicare, Social Security, unfunded Federal pensions and retiree healthcare, underfunded state pensions and unfunded retiree healthcare, and underfunded corporate pensions (flowing to the PBGC) are the crisis of the future.? We are talking underfunding and debts equivalent to 4x GDP in total.

The deficits may be helping out areas of our economy for which there is already too much capacity — autos, banks, housing, but isn’t aiding the parts of the economy that don’t have excess capacity.? The one advantage to Americans is that a decent amount of the debt is absorbed by the neomercantilists, who will get paid? back in cheaper dollars (if at all) than the goods that they provided originally.

This all feels like the Japan scenario.? Low interest rates, low growth if any in non-protected sectors, soggy debt-laden protected sectors, excess capacity in areas not salable to the rest of the world, high government debt, and a demographic crisis.? Also speculation using cheap leverage for carry trades.

I’ll try to tie this up in another post or two.? Sorry if this is verbose.

On Bond Investing, ETFs, Indexes, and the Current Market Environment

On Bond Investing, ETFs, Indexes, and the Current Market Environment

Posted on by David Merkel

Bond indexes are what they are.? They represent the average dollar invested in the bond markets.? Those that say that the indexes are flawed miss the point.? Indexes represent the average return of an asset class, with all of its warts and wrinkles.? That is the nature of an index; it earns what the asset class as a whole earns.

So what if big issuers dominate the index?? The average dollar in bonds reflects that.? Do you want to take a bet against the average?? You probably do, and I do as well.? But it is not the purpose of an index to make that bet, so much as to facilitate that bet for active managers.

I appreciated the book The Fundamental Index ? Arnott did us a favor by writing it.? The book shows how to do enhanced indexing off of fundamental factors.? (A pity that the book went public at the point where most of those factors were overpriced.)

The trouble with enhanced indexing is scalability.? Suppose Arnott?s fund and those like it grew large relative to the market as a whole.? The components of his strategy that are smallest relative to their total market size will get bid up disproportionately.? Eventually they will not be a favored investment of the strategy, and as they move to sell, they will find that they are large holders of something the market is not so ready to buy.? As the price goes down, perhaps it becomes attractive again. Perhaps an equilibrium will be reached.

One thing is certain, though.? The non-enhanced index can be held be everyone.? The enhanced index will run into size limits.

What then for bond ETFs?? Are they chained to inferior indexes? ?No.? By their nature, bond indexes are almost impossible to replicate perfectly because of liquidity constraints. Many institutional bond investors buy and hold, particularly for unique issues.? That?s why indexes are constructed out of liquid issues which will have adequate tradability.? Who issues those bonds?? The big issuers.? It is not possible to create a scalable bond index in any other way, and even then, there will always be some bonds in the index that are impossible to find, and/or, because they are index bonds, they trade artificially rich to similar bonds that are not in the index.

Almost all bond indexers are enhanced indexers, because they don?t have enough liquidity to exactly replicate the index.? Instead, bond indexers try to replicate the factors that drive the index, with better performance if they can manage it.? That?s where choosing non-index bonds that are similar in characteristics, but have better yields comes in.? That is the value of active bond management; it does not mean that the indexes are flawed, but that there are ways for clever investors to systematically do better, that is, until there are too many clever investors.

Pricing Issues

Morningstar prepared this piece on pricing difficulties with bond ETFs and open-ended bond funds.? Yes, it is true that many bonds don?t trade regularly, and that matrix pricing gives estimates for prices on bonds that have not traded near the close, where an asset value must be calculated.

Remember the scandal over mutual fund front-running?? In that case, stale pricing off of last trades enabled clever connected ?investors? to place late trades where the calculated NAV was far away from the theoretically correct NAV (if assets traded continuously).? In order to calculate the theoretically correct NAV (which the late traders did in order to make money), the mutual funds had to engage in a form of matrix pricing, adjusting the last trades to reflect changes in the market since each last trade until the close.? Far from being inaccurate, matrix pricing is far superior to using the last trade.

I will take the opposite side of the trade from the Morningstar piece.? Markets are not rational, especially bond ETF investors.? I trust the NAV more than the current price; matrix pricing is complex, but it is pretty accurate.? Yes, for some really illiquid, unique issues, it will get prices wrong, but that is a tiny fraction of the bond universe.? We can ignore that.

Rationality comes to bond ETFs when sophisticated investors do the arbitrage, and create new ETF units when there is a premium to the NAV, or melt ETF units into their constituent parts when there is a discount to NAV.? That pressure places bounds on how large premiums and discounts can become.

The more specific the bonds must be to create a new unit, the harder it is to do the arbitrage, and the higher the level of premium can become before an arbitrage can occur.? If a less specific group of bonds can be delivered to create a new unit, i.e., the bonds must satisfy certain constraints on issuer percentages, issue sizes, duration [interest rate sensitivity], convexity [sensitivity to interest rate sensitivity], sector percentages, option-adjusted spread/yield, etc., then arbitrage can proceed more rapidly, and premiums over NAV should be smaller.

So, when there are large premiums to NAV, it is better to sell.? Large discounts, better to buy.? Of course, take into account that short bond funds should never get large premiums or discounts.? If they do, something weird is going on.? Long bond funds can get larger premiums and discounts because their prices vary more.? It takes a wider price gap versus NAV before arbitrage can occur.

As for cash creations, those that run the ETF could publish a shadow ETF price, which would represent the price that they could create new units themselves, taking into account how they would like to change the ETF?s positions in order to better outperform while matching the underlying characteristics of the index.? That shadow ETF price could not be a fixed percentage of the existing NAV.? It would have to vary based on the cost of sourcing the needed bonds.? This would run in reverse for cash-based redemptions, which would only likely be asked for when the ETF was at a discount.? Better for the fund to do some modified ?in-kind? distribution, agreed to in advance by the sophisticated unit liquidator.

Derivative Issues

Well, if there?s not enough liquidity in the bond market to accommodate our desired investment, why not create it synthetically through credit default swaps?? That might work, but if the bonds are illiquid, often the derivatives are as well, or, the derivatives trade rich to where an identical bond would trade in the cash market.? There is also credit risk from the party buying protection on the default swap; if he goes broke, your extra yield goes away, at least in part.

I don?t see derivatives as being a solution here, though they might be helpful in the short-run while waiting to source a bond that can?t be found.? Derivatives aren?t magic; liquidity comes at a cost, and some of those costs aren?t obvious until a market event hits.

Also, I would argue that the rating agencies are better judges of creditworthiness on average than the prices of credit default swaps.? Though rating agencies should be examined for their conduct in structured securities, their record with corporates is pretty good.? The rating agencies do fundamental research; yields do reflect riskiness, but markets sometimes wander away from their fundamental moorings.? Derivatives can trade rich or cheap to the cash market for their own unique reasons.? Same for bond spreads ? just because one bond has a higher spread than another similar bond, it does not mean that that bond is necessarily more risky.

When I was a corporate bond manager, I would occasionally find bonds that yielded considerably more than others of a given class.? My job, and the job of my analyst was to find out why. ?Often the bond was not well known, or was a better quality name in a bad industry.? On average, spreads reflect riskiness, but in individual situations, I would rather trust the judgments of fundamental analysts, including the rating agencies, though private analysts are better still.

So what should I do in the Current Environment?

I don?t think we are being paid to take credit risk at present, so stay conservative in bonds for now.? Specifically:

  • Underweight credit risk.
  • With equities, stress high-quality balance sheets, and stable industries.
  • Underweight financials, particularly banks and names that are related to commercial real estate.
  • GSE-related residential mortgages look okay.
  • TIPS don?t look good on the short end, but look okay on the long end.
  • Be wary of paying premiums on bond ETFs? and maybe look at some closed-end funds that trade at discounts.
  • The yield curve is steep, but that is ahead of a lot of long supply coming from the US Treasury.? Stick to short-to-intermediate debt, and wait for supply to be digested.? After that, maybe some long maturity positions can be taken as rentals, so long as inflation does not take off.
  • Diversify into foreign bonds, but don?t go crazy here. ?The Dollar has run down hard, and opportunities are fewer.? (I will have a deeper piece on this in time, I hope.)

This is a time to preserve capital, not reach for gains.? Don?t grasp for yields that cannot be maintained.

PS — Thanks to the guys at Index Universe and Morningstar for the articles; they stimulated my thinking.? I like both sites a lot, and recommend them to my readers.? The articles that I cited had many good things in them, I just wanted to take issue with some of their points.

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