I like to think that I have a pretty strong stomach for risk.? I am used to losses.? I have my sell disciplines, and I act on them.? I also try to be forward-thinking about risk; not just reacting, but trying to anticipate what the markets are likely to deliver.? Every now and then, I get a surprise.? Here’s the surprise, which I got from The Big Picture (Barry’s blog).? Institutional Risk Analytics does some good work, and this article is representative of their work.? In it, they describe the two risks facing the large banks — risks from their assets, and risks from their derivative books.
The second link made me pause.? I know things are bad, and I can’t vouch for Institutional Risk Analytics’ risk based capital model for banks, but the level of notional derivatives exposure at many of the major banks to their tier 1 surplus made me pause.? There are two claims on surplus — losses from direct lending, and losses in the derivative books.
Those who have read me for a long while know that I think the derivative books at the investment banks are mismarked and possibly mishedged.? When accounting rules are not well-defined, and instruments are illiquid, even well-meaning managements tend to err in their favor in the short run.
This is significant in a number of ways, but the main one was pointed out in the first link, that with the continuing failure of small banks, how will the FDIC make depositors secure if a large-ish institution fails, when reserves are relatively low?? They need to raise their fees that they charge solvent banks to replenish their coffers.? They are also bringing back retirees with experience in dealing with insolvent banks.
So, are the banks in trouble?? Some of them are experiencing stress, and that is coming through higher credit spreads on their debt.? Given the higher costs entailed in funding for banks, it is all the more important in your investing to look for companies that don’t need much external finance.? After all, many banks may find it harder to lend.? Consider the difficulties in funding InBev’s purchase of Anheuser-Busch.? Large banks are straining at their limits.? They don’t have enough parties to sell loans off to, nor do they want to hold onto so much of the risk.
The bank loan and and bond markets are closely connected.? Troubles in one tend to spill over to the other.? Loans have a higher priority claim, so the yields are lower than for bonds.? As it is, investment grade corporate bonds, particularly financials, are facing higher yields.? The high yield market has slowed considerably.
So, what does this imply?? The banks are hunkering down.? They are scrutinizing all risk exposures.? They aren’t expanding lending, which is showing up in MZM, M2, and my M3 proxy.? Credit is getting tough/sluggish.
Money Supply
And the degree of leverage that banks are willing to use versus the Fed’s monetary base is dropping, and hard (the graph covers 28 years).
Bank Leverage
So, I’m not optimistic here. I believe in the value of “long only” money management as having better chances of risk control than hedged strategies, but this is making me queasy. What it makes me think, is that the FOMC’s next move is a loosen. It hurt to say that, particularly given my dislike of inflation, but the solvency of the financial system comes ahead of inflation in the Fed’s calculus, even though loosening won’t help much.
With that, I am looking to continued problems in banks, and perhaps for the economy as a whole.? Our next president will have a fun time with this…
A large-ish number of people have asked me to write this piece.? For those with access to RealMoney, I did an article called The Fundamentals of Market Tops.? For those without access, Barry Ritholtz put a large portion of it at his blog.? (I was honored .) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.
So, a number of people came to me and asked if I would write ?The Fundamentals of Market Bottoms.?? Believe me, I have wanted to do so, but some of my pieces at RealMoney were ?labor of love? pieces.? They took time to write, and my editor Gretchen would love them to death.? By the way, if I may say so publicly, the editors at RealMoney (particularly Gretchen) are some of their hidden treasures.? They really made my writing sing.? I like to think that I can write, but I am much better when I am edited.
Okay, before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different.? Tops and bottoms are different primarily because of debt and options investors.? At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.? Option investors get greedy on calls near tops, and give up on or short puts.? Implied volatility is low and stays low.? There is a sense of invincibility for the equity market, and the bond and option markets reflect that.
Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms.? They spike multiple times before the bottom arrives.? Investors similarly grab for puts multiple times before the bottom arrives.? Implied volatility is high and jumpy.
As a friend of mine once said, ?To make a stock go to zero, it has to have a significant slug of debt.?? That is what differentiates tops from bottoms.? At tops, no one cares about debt or balance sheets.? The only insolvencies that happen then are due to fraud.? But at bottoms, the only thing that investors care about is debt or balance sheets.? In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money warrant.
I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders.? In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times.? I described this in greater measure in Changes in Corporate Bonds, Part 1, and Changes in Corporate Bonds, Part 2.
Though this piece is about bottoms, not tops, I am going to use an old CC post of mine on tops to illustrate a point.
Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow?s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.
As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.
I?m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved. That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.
That?s why I think the hot coastal markets are bubblettes. My position hasn?t changed since I wrote my original piece.
Position: none
I had a shorter way of saying it: Bubbles pop when cash flow is insufficient to finance them.? But what of market bottoms?? What is financing like at market bottoms?
The Investor Base Becomes Fundamentally-Driven
1) Now, by fundamentally-driven, I don?t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to stay away from all stocks because of the negative macroeconomic environment, and, they will be shrill.
2) Fundamental investors are quiet, and valuation-oriented.? They start quietly buying shares when prices fall beneath their threshold levels, coming up to full positions at prices that they think are bargains for any environment.
3) But at the bottom, even long-term fundamental investors are questioning their sanity.? Investors with short time horizons have long since left the scene, and investor with intermediate time horizons are selling.? In one sense investors with short time horizons tend to predominate at tops, and investors with long time horizons dominate at bottoms.
4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.
5) Managers that ignored credit quality have gotten killed, or at least, their asset under management are much reduced.
6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then.? M&A volumes are small.
7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven?t morphed into permabears.
8 ) Value managers tend to outperform growth managers at bottoms, though in today?s context, where financials are doing so badly, I would expect growth managers to do better than value managers.
9) On CNBC, and other media outlets, you tend to hear from the ?adults? more often.? By adults, I mean those who say ?You should have seen this coming.? Our nation has been irresponsible, yada, yada, yada.?? When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom.? The ?chrome dome count? shows more older investors on the tube is another sign of a bottom.
10) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.
11) Value investors find no lack of promising ideas, only a lack of capital.
12) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.? They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.
13) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot ? e.g. money market funds, collectibles, gold, real estate ? they chase the next trend in search of easy money.
14) Short interest reaches high levels; interest in hedged strategies reaches manic levels.
Changes in Corporate Behavior
1) Primary IPOs don?t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.
2) Private equity holds onto their deals longer, because the IPO exit door is shut.? Raising new money is hard; returns are low.
3) There are more earnings disappointments, and guidance goes lower for the future.? The bottom is close when disappointments hit, and the stock barely reacts, as if the market were saying ?So what else is new??
4) Leverage reduces, and companies begin talking about how strong their balance sheets are.? Weaker companies talk about how they will make it, and that their banks are on board, committing credit, waiving covenants, etc.? The weakest die.? Default rates spike during a market bottom, and only when prescient investors note that the amount of companies with questionable credit has declined to an amount that no longer poses systemic risk, does the market as a whole start to rally.
5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.? As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.
6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.
7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.
8 ) High quality companies keep buying back stock, not aggresssively, but persistently.
Other Indicators
1) Implied volatility is high, as is actual volatility. Investors are pulling their hair, biting their tongues, and retreating from the market. The market gets scared easily, and it is not hard to make the market go up or down a lot.
2)The Fed adds liquidity to the system, and the response is sluggish at best.? By the time the bottom comes, the yield curve has a strong positive slope.
No Bottom Yet
There are some reasons for optimism in the present environment.? Shorts are feared.? Value investors are seeing more and more ideas that are intriguing.? Credit-sensitive names have been hurt.? The yield curve has a positive slope.? Short interest is pretty high.? But a bottom is not with us yet, for the following reasons:
Implied volatility is low.
Corporate defaults are not at crisis levels yet.
Housing prices still have further to fall.
Bear markets have duration, and this one has been pretty short so far.
Leverage hasn?t decreased much.? In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
The Fed is not adding liquidity to the system.
I don?t sense true panic among investors yet.? Not enough neophytes have left the game.
Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.
Some of my indicators are vague and require subjective judgment. But they?re better than nothing, and kept me in the game in 2001-2002. I hope that I ? and you ? can achieve the same with them as we near the next bottom.
For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.? Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.? This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).? There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.? In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company ? it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.
As for asset allocators, time to begin edging back into equities, but I would still be below target weight.
The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present.? That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question.? Long only investors must play defense here, and there will be a reward when the bottom comes.
12) Value investors find no lack of promising ideas, only a lack of capital.
13) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.? They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.
14) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot — e.g. money market funds, collectibles, gold, real estate — they chase the next trend in search of easy money.
15) Short interest reaches high levels; interest in hedged strategies reaches manic levels.
Changes in Corporate Behavior
1) Primary IPOs don’t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.
2) Private equity holds onto their deals longer, because the IPO exit door is shut.? Raising new money is hard; returns are low.
3) There are more earnings disappointments, and guidance goes lower for the future.? The bottom is close when disappointments hit, and the stock barely reacts, as if the market were saying “So what else is new?”
4) Leverage reduces, and companies begin talking about how strong their balance sheets are.? Weaker companies talk about how they will make it, and that their banks are on board, committing credit, waiving covenants, etc.? The weakest die.? Default rates spike during a market bottom, and only when prescient investors note that the amount of companies with questionable credit has declined to an amount that no longer poses systemic risk, does the market as a whole start to rally.
5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.? As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.
6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.
7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.
Other Indicators
1) Implied volatility is high, as is actual volatility. Investors are pulling their hair, biting their tongues, and retreating from the market. The market gets scared easily, and it is not hard to make the market go up or down a lot.
2)The Fed adds liquidity to the system, and the response is sluggish at best.? By the time the bottom comes, the yield curve has a strong positive slope.
No Bottom Yet
There are some reasons for optimism in the present environment.? Shorts are feared.? Value investors are seeing more and more ideas that are intriguing.? Credit-sensitive names have been hurt.? The yield curve has a positive slope.? Short interest is pretty high.? But a bottom is not with us yet, for the following reasons:
Implied volatility is low.
Corporate defaults are not at crisis levels yet.
Housing prices still have further to fall.
Bear markets have duration, and this one has been pretty short so far.
Leverage hasn’t decreased much.? In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
The Fed is not adding liquidity to the system.
I don’t sense true panic among investors yet.? Not enough neophytes have left the game.
Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.
Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and kept me in the game in 2001-2002. I hope that I — and you — can achieve the same with them as we near the next bottom.
For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.? Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.? This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).? There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.? In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company — it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.
As for asset allocators, time to begin edging back into equities, but I would still be below target weight.
The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present.? That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question.? Long only investors must play defense here, and there will be a reward when the bottom comes.
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That’s all for this post.? After comments are in, I will reformat the piece as one post and republish it.
Here’s a redacted version of the Fed’s statement today:
The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.
EconomicRecent information indicates that overall economic activity expanded in the second quarter,continues to expand, partly reflecting growthsome firming in consumerhousehold spending and exports.. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and elevatedthe rise in energy prices are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.
Inflation has been high, spurred by The Committee expects inflation to moderate later this year and next year.? However, in light of the earliercontinued increases in the prices of energy and some other commodities, and the elevated state of some indicators of inflation expectations have been elevated. The Committee expects inflation to moderate later this year and next year, but, uncertainty about the inflation outlook remains highly uncertain.high.
The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time. Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation are also of significant concern to the Committee.and inflation expectations have increased. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred an increase in the target for the federal funds rate at this meeting.
Quick Summary
Energy costs receding
Points at past easing indicating future stimulus (don’t expect more soon)
Highlights inflation risks
Many changes, but most of them are language tweaks and a little reorganization
Today’s FOMC meeting is largely a done deal.? No moves, but sound hawkish.? Personally, if I were in their shoes, I would move the Fed Funds target to 2.05%, just enough to weird the markets out, but not enough to do any real damage to those who rely on Fed Funds.? Creating uncertainty through breaking the convention on quarter percent moves would be good for the market, because market players have gained a false confidence over what the Fed can and can’t do.
The thing is, the Fed is boxed in, like many other central banks.? A combination of rising consumer prices, rising unemployment, and a weak financial sector will compel them to stay on the sidelines for now.
Now, as for Saturday’s post, I received a number of responses asking me to explain my views.? Here goes:
1) I’m not a gold bug; I have no investments in gold, or metals generally at present.? Any liking that I have for a gold standard is that it gets the government out of the business of manipulating the economy through manipulating the money supply.? Currency boards, pushed by my old professor, Dr. Steven Hanke, are another good idea.
2) Where am I on inflation/deflation?? We are experiencing goods and services price inflation, asset deflation, and a monetary system where the Fed is not increasing the monetary base, but the banks are expanding their liability structures over the last year, but that may have finally peaked.? Consider this graph:
There is a limit to how large the liabilities of the banking system can get relative to the Fed’s stock of high-powered money.? We reached that limit in the first four months of 2008, and now banks seem to be focusing on survival.
It is very hard to reflate bubbles — you can’t build an economy on sectors that are credit impaired, which makes me think that the housing stimulus ideas will likely fail.
3) The Fed is in a box.? They have no good policy options now.? They are stuck between rising (or at least high) inflation, rising unemployment, and the banks are not strong.? Fortunately the US Dollar has been showing a little more strength, but that’s probably anticipating the hawkish tone of today’s announcement.? If the statement is insufficiently hawkish, I would expect the US Dollar to weaken.
4) I expect goods inflation to persist in a moderate way over the intermediate-term, unless the main US Dollar pegs are broken (Gulf States, China).? Presently, we import a little of the inflation that the rest of the world is experiencing mainly through energy, and energy related commodities, like fertilizer.
5) Globalization does restrain wage growth on the low end.? On the high end, it is likely a benefit, and in the middle, probably neutral.? Those who benefit the most are those who are able to use relatively cheap labor for unskilled tasks.? But technological change also affects job prospects in different industries.? My view on steel is that the industry shrank mainly due to technological improvements at the lower cost mini-mills.
6) As for the GSEs, banks, and the investment banks, the Fed would be challenged to raise rates much.? At present, the positively sloped yield curve is allowing some banks to repair by borrowing short and lending long.? That is a good trade for now, but will be prone to trouble if the Fed ever concludes that it has to shift to fighting inflation, and not just put on a rhetorical show.
7) Finally, we have some degree of restiveness among the hawks on the FOMC.? I would expect two (or so) dissents favoring tightening today, but now with the current cast of ten (counting Elizabeth Duke, a banker), but if we get four, which is not impossible, I think it would unnerve the markets.? Mishkin is leaving at the end of August, and the custom is that he attends but does not vote at his last meeting.? (For more on FOMC dissents, I have this article.)
Well, let’s see what the FOMC has to say.? After all, at present, they are all talk.
In the midst of a loosening cycle, the Fed keeps the monetary base flat.? This is not normal.? Instead, they use their high-quality balance sheet to bail out the liquidity problems of banks, broker-dealers, and maybe others, all while not expanding high powered money.? This is not normal, either.? After all, the Fed wants to heal the providers of badly underwritten credit (and increased their efforts last week, also here, here, and here), but they don’t want any liquidity to spill over into the general economy, because it might spark a wage-price spiral.
Consider the efforts of the Treasury toward Fannie, Freddie, the banks, and the housing market generally.? Yes, they are trying to avoid systemic risk, and that’s important.? But where is the support from the Fed and Treasury over unemployment, which is beginning to grow currently.? I’m not just talking about more unemployment, but about less compensation growth for labor in total.? Their focus is away from that, and looking at stabilizing a financial structure.? That’s good for all of us, but a disproportionate amount of the benefits goes to enterprises that made bad loans.? My rules of bailouts say that you must make bailouts painful to management teams and shareholders, while protecting senior debt, and thus preventing systemics risk.? That is not what is going on here.
I’m no great fan of central banking; I believe it makes our economy more stable in the short run, but intensifies crises when they take place (In my opinion, we never would have had the Great Depression if we had not created the Federal Reserve).? Life under a true gold standard has real panics, but they are sharp and short.
At present, we are setting the stage for an increase in unionization.? I am no fan of unions, but who can blame workers from seeking more bargaining power when they have had it rough for a long while?
My summary is that the policies of the Bernanke Fed are too clever.? Restrain wage/price inflation while bailing out banks and broker-dealers, Fannie, Freddie, etc.? But goods inflation keeps running ahead, and the oversupply of houses keeps forcing prices lower.? The actions of the Fed and Treasury protect the financial system for now, but at what eventual cost?? It might have been better for the Bernanke Fed to have been more traditional, and have stimulated the general economy, while letting the Treasury protect individual financial institutions in trouble.
I don’t think this will end well, but perhaps a recession like 1973-74? will clear the decks.? The Fed has to see that its main roles are price inflation and unemployment, with systemic risk third.? Any other way of prioritizing Fed action will lead to greater controversy in the long run.
From 1995 to about 2004, I would imagine Federal Reserve Governors sitting around over dinner the night before the FOMC meeting, and because the mainstream view of monetarism hadn’t been discredited yet, and saying something to the effect of: “What would it take to create inflation? How fast could we move up the monetary aggregates and not get inflation?? We run a stimulative policy far more often than theory would demand, and we don’t get significant inflation.? We’re heroes! What a free lunch!”
(Note: the S&P 500 would look much more impressive if dividends were included.)? I’m not crazy about the way the CPI is calculated, for reasons listed in this article.? But there is a reason behind the lack of goods price inflation for that era.? The money wasn’t going into goods, it was going into assets, like stocks, bonds, venture capital, homes, etc.? There were too many dollars chasing too few assets.? Asset values inflated in the 80s and early 90s, leading to the “lost decade” 1998-2008, where the market went nowhere.
Part of that problem is that the ratio of savers to consumers was topping out 1998-2008, and the Baby Boomers as a whole were a lazy cohort with respect to saving money.
That’s the prologue, my real puzzle is similar to what I posited above.? Dick Cheney has reportedly said, “Reagan proved that deficits don’t matter.”? Well, Reagan had the luxury of running the largest peacetime deficits we have seen, but at least it eventually bore the fruit of the “peace dividend,” that Clinton got to harvest.
I can see some leading officials at the Treasury having dinner together, and they about the budget deficit, and they say this: “How much money can we borrow from abroad?? We keep running larger and larger deficits, and the foreigners keep taking the paper down even as the US Dollar falls. That is great for us politically, because export industries get stimulated, and no one cares about imports (buy American), except crude oil.? There don’t seem to be any limits here.? What a great boon it is to be the world’s reserve currency!”
Yes, it is good to be King.? But, kings topple when they cannot control the amount they extract from their subjects.? I wrote a piece for RealMoney on how central banks would diversify out of the Dollar.? My main point was that those with the least to lose would do so first, and those with the most to lose would do so last.? I commented that diversification out of the Dollar would be “Led by smaller central banks, such as Singapore, Russia, or India.”
Well, India revalued the Rupee up since then, and Russia has diversified away from Dollars.? Singapore?? Their Dollar has had a significant rally against the US Dollar.
But other revaluations have not occurred yet.? The Gulf states, except Kuwait, have maintained their Dollar peg.? China is running a dirty crawling peg, rather than revalue its currency upward by 20%.
As a result, there has been no discipline, no constraint to the level of borrowing by the US Government.? They will borrow even more in future years.? Is there a time where they will find a lack of willingness of lend in Dollars to the US Government and other Dollar-denominated debt and force US interest rates up?? I think so, and it will happen by the time the demographic wave crests around 2015, give or take a few years.? At that point, future dissaving will overwhelm asset markets, as they anticipate the cash needs of the Baby Boomers as they retire.
Inflation is returning to the US, and will return in greater measure when foreign central banks diversify away from the US Dollar.? Until then, they will import inflation from the US, as they send us goods, and we send them paper.
Our position is precarious, and makes us reliant on the kindness of strangers, who might for economic or political reasons decide that the Dollar is not worth investing in.? Like any writedown, they would admit the loss that they knew was there, and move on.
In the long run, that is why I think the path of the Dollar is down, even though I think it could rally in the short run.? We are absorbing too much of the world’s goods and providing too little in return.
Here’s a not-so-quick note on covered bonds.? What is a covered bond?? It is a form of secured lending, where a bank borrows money and offers a security as collateral.? That security remains on the bank’s books, but in a default the covered bondholder could claim the security in lieu of payment from the bank’s receiver.
It is not a passthrough, it is a bond.? The covered bond buyers do not receive the principal and interest from the security held by the bank, the bank receives it.? The covered bondholder (in absence of default) receives timely payment of interest at the stated rate, and principal at maturity.? Only in default does the value of the security for collateral matter.? If the collateral is insufficient to pay off principal and interest, the covered bondholders are general creditors for the difference.
Okay, so we’re talking about a type of secured lending, or secondary guarantee.? That exists in many places in different forms:
Credit Tenant Leases, which are secured first by the lease payments, and secondarily by the building.
Commercial and Residential Real estate loans are secured by property, and the ability of the debtor to service the loan.? Same for auto loans.
Utilities do a certain amount of first mortgage bonds where they pledge valuable plant and equipment, and receive attractive financing terms.
Enhanced Equipment Trust Certificates are how airlines and railroads do secured borrowing, pledging airplanes and rolling stock as collateral if they don’t pay.
Insurance companies in certain large states can set up guaranteed separate accounts.? If the insurance company’s General Account is insolvent, the separate account policyholders are secured by the assets of the separate account.? The separate account is tested quarterly for sufficiency of assets over liabilities.? If there isn’t enough of a positive margin, more securities must be added.? If those assets prove insufficient in an insolvency, they stand in line for the difference with the general account claimants.
Here is what collateral is eligible for the as the pool of assets securing the bonds (stuff from the Treasury document in italics):
Under the current SPV Structure, the issuer?s primary assets must be a mortgage bond purchased from a depository institution. The mortgage bond must be secured at the depository institution by a dynamic pool of residential mortgages.
Under the Direct Issuance Structure, the issuing institution must designate a Cover Pool of residential mortgages as the collateral for the Covered Bond, which remains on the balance sheet of the depository institution.
In both structures, the Cover Pool must be owned by the depository institution. Issuers of Covered Bonds must provide a first priority claim on the assets in the Cover Pool to bond holders, and the assets in the Cover Pool must not be encumbered by any other lien. The issuer must clearly identify the Cover Pool?s assets, liabilities, and security pledge on its books and records.
Further collateral requirements:
Performing mortgages on one-to-four family residential properties
Mortgages shall be underwritten at the fully-indexed rate
Mortgages shall be underwritten with documented income
Mortgages must comply with existing supervisory guidance governing the underwriting of residential mortgages, including the Interagency Guidance on Non-Traditional Mortgage Products, October 5, 2006, and the Interagency Statement on Subprime Mortgage Lending, July 10, 2007, and such additional guidance applicable at the time of loan origination
Substitution collateral may include cash and Treasury and agency securities as necessary to prudently manage the Cover Pool
Mortgages must be current when they are added to the pool and any mortgages that become more than 60-days past due must be replaced
Mortgages must be first lien only
Mortgages must have a maximum loan-to-value (?LTV?) of 80% at the time of inclusion in the Cover Pool
A single Metro Statistical Area cannot make up more than 20% of the Cover Pool
Negative amortization mortgages are not eligible for the Cover Pool
Bondholders must have a perfected security interest in these mortgage loans.
Other major requirements (not exhaustive — stuff copied from the report in italics):
Overcollateralization of 5% must be maintained.? It must be measured each month.? If the test fails, there is one month to get the overcollateralization over 5%, else the trustee can terminate the covered bond program and return proincipal and accrued interest to bondholders.
For the purposes of calculating the minimum required overcollateralization in the Covered Bond, only the 80% portion of the updated LTV will be credited. If a mortgage in the Cover Pool has a LTV of 80% or less, the full outstanding principal value of the mortgage will be credited.? If a mortgage has a LTV over 80%, only the 80% LTV portion of each loan will be credited.
Currency mismatches between the collateral and the currency that the bond pays must be hedged.? Interest rate mismatches may be hedged.
Monthly reporting with a 30 day delay
If more than 10% of the Cover Pool is substituted within any month or if 20% of the Cover Pool is substituted within any one quarter, the issuer must provide updated Cover Pool
information to investors.
The depository institution and the SPV (if applicable) must disclose information regarding its financial profile and other relevant information that an investor would find material.
The results of this Asset Coverage Test and the results of any reviews by the Asset Monitor must be made available to investors.? The issuer must designate an independent Asset Monitor to periodically determine compliance with the Asset Coverage Test of the issuer.
The issuer must designate an independent Trustee for the Covered Bonds. Among other responsibilities, this Trustee must represent the interest of investors and must enforce the investors? rights in the collateral in the event of an issuer?s insolvency.
Issuers must receive consent to issue Covered Bonds from their primary federal regulator. Upon an issuer?s request, their primary federal regulator will make a determination based on that agencies policies and procedures whether to give consent to the issuer to establish a Covered Bond program. Only well-capitalized institutions should issue Covered Bonds.? As part of their ongoing supervisory efforts, primary federal regulators monitor an issuer?s controls and risk management processes.
Covered Bonds may account for no more than four percent of an issuers? liabilities after issuance.
Issuers must enter into a deposit agreement, e.g., guaranteed investment contract, or other arrangement whereby the proceeds of Cover Pool assets are invested (any such arrangement, a ?Specified Investment?) at the time of issuance with or by one or more financially sound counterparties. Following a payment default by the issuer or repudiation by the FDIC as conservator or receiver, the Specified Investment should pay ongoing scheduled interest and principal payments so long as the Specified Investment provider receives proceeds of the Cover Pool assets at least equal to the par value of the Covered Bonds.? The purpose of the Specified Investment is to prevent an
acceleration of the Covered Bond due to the insolvency of the issuer.
Not more than 10% of the collateral may be composed of AAA-rated mortgage bonds.
My Stab at Analysis
The four percent limitation takes a lot of wind out of the sails of this for now.? The regulators are taking this slow.? They want to see how this works before they let it become a large part of the financing structure of the banks.
So long as this remains small, there shouldn’t be any large effects on the yields for unsecured bank bonds, both of which are structurally subordinated by the new covered bonds.? In other words, if some more assets are off limits in an insolvency, particularly more of the better-quality assets, that means that much less is there to recover.? Now, discount window borrowing and FHLB advances are secured already, so this just makes the issue of what is left in an insolvency to the unsecured lenders tougher.? That doesn’t affect depositors under the FDIC limits, but if you have deposits or CDs exceeding the limits, you might want to watch this issue.
Acceptable collateral is generally high quality, which means the bank has to pledge some of its better mortgages, and accept a 5% minimum haircut on the amount received back.? This should provide some support to the jumbo loan market; I didn’t see any size limits.? It looks like it would be impossible to issue subprime loans because of the 80% LTV, income verification, no neg am, first lien, underwriting must be done at the fully indexed rate.? Maybe some Alt-A could be done, but I’m not sure.? With the requirement that you have to replace collateral if a loan goes 60-days delinquent, I’m not sure a bank would want to put in collateral with a high probability of replacement.
For underwriting, an LTV of 80% or better is acceptable.? Other underwriting guidelines are left implicit to guidance given in the past on lending practices.? It’s possible that appraised values could be stretched to meet the 80% hurdle.? It’s happened before.
AAA-rated mortgage bonds are an interesting twist here as well.? I assume that it has to be AAA at every agency rating the bonds, first lien collateral, Prime or Jumbo collateral in order to be consistent with the intent of the document, but that is not explicitly defined.? Could a bank contribute a AAA home equity loan to the pool?? I doubt it, but…
Securitization is still getting done through Fannie and Freddie, but so long as the private mortgage securitization market is closed, this could be an attractive option for some banks to finance their mortgage loans.? When the securitization market comes back, covered bonds should reduce considerably as a financing source.? Overcollaterization for a securitization is less than the 5%+ that is necessary here, and it gets the loans off of your books, reducing capital requirements.? If I were a bank entering into a covered bond program, I would only borrow for the amount of time that I would expect the securitization market to be closed.? That could be years, but at some point, it will likely be cheaper to securitize, and the bank won’t want the mortgages trapped in the covered bond program then.
Beyond that, the bank would analyze whether it has better terms in securitized borrowing from the FHLB, or the newly non-stigmatized discount window of the Fed.? Even funding the loans through an ordinary deposit/MMMF/CD base would be most attractive under normal conditions, if the bank has the capital to support the loans.
Other collateral was proposed for use in covered bonds, but the regulators are taking it slow there as well.? They are starting with higher quality collateral; it might get expanded later.? The banks would probably like that.
Two final notes, and a tentative conclusion: this is a relatively complex solution for giving a new financing method to banks.? Only medium-to-large banks could be able to use it.? I’m not sure who a logical buyer of small transactions might be…. Hmm… maybe it could be a substitute for CD investors. 😉
Second, the inclusion of of a Specified Investment is interesting.? It further constrains what can be done with the proceeds of the bonds, which could be a big negative.? Are banks going to buy GICs from insurers?? BICs from other banks?? I don’t know.? Maybe I am misundstanding that part.
My conclusion, after all that, is that I don’t think this is going to be that big of a help to banks in the short run.? Why?
Small size of the program.
High overcollateralization.
Mostly (90%+) high quality mortgages can be pledged.
Capital requirements don’t change because the loans stay on the books.
Need for the Specified Investment.
Marginally increases the yields on unsecured debt.
But the benefit they get is a cheap-ish borrowing rate.? Would this get a AAA yield and rating?? Probably.? Is that enough to overcome the negatives?? Well, let’s watch and see, but I would expect it to have less impact than many expect.
What a week.? I got whupped the last two days of the week, and am behind the S&P 500 by less than a percent for the month to date.? The moves of my portfolio relative to the S&P 500 have been unpredictably large compared to past experience.? I am down a little year to date.
My one brief note for the night is to say that there are libertarians, even in financial crises.? I am one.? To the degree that I recommend bailouts, they are painful, and meant to end the current government subsidy of the institutions.
After that, I will mention my acquaintance Caroline Baum, who favorably cites Jim Bunning.? He is one of the few, along with Ron Paul, who will uncover the follies of our monetary policies. Then I will mention George Schultz, who says we should avoid intervention in the GSEs (Fannie and Freddie).? He advocates that our government should be concerned with what it does not do — this is very out of step with the American psyche — action is always preferred to inaction, as opposed to the Hippocritean “First do no harm.”
Finally, I will mention Roger Lowenstein.? He is right; failure is a necessary part of capitalism.? Fascists (Crony Capitalists) and Socialists will protect favored industries, but failure gives important signals to all economic actors — what to avoid.
In one sense this is an essay on the short run versus the long run.? Our current economic policy is short-term laser-focused.? The “right” decisions to promote short-term prosperity reduce the prospects of long-term proserity.? A certain amount of fear of failure promotes long-term carefulness and prosperity.
We learned the wrong lessons from the Great Depression.? Yes, there will be instability in capitalist economies, and it can be severe.? But government action exacerbates that instability more often than not.? It is better to live with the occasional small crisis, than to have huge crises come because the monetary and fiscal authorities were too lenient.
I haven’t written about the Fed much recently, largely because little has changed.? The Fed is frozen in its position.? Can’t raise rates because the banking system is on edge (and now the Fed informally cares for the systemic risk created by the investment banks).? Can’t raise rates because labor unemployment is rising.? Can’t lower rates because inflation is moving up.? Can’t lower rates because the dollar will dive.? What a pickle!
This is my monetary aggregates graph over the last year.? Growth of the monetary base is anemic, but that is intentional.? Rather than let the monetary base grow through the purchase of Treasuries, the Fed is using its balance sheet to add liquidity to certain money markets.? When was the last time the Fed did a purchase of Treasuries?? 5/3/07.? I think this is the longest period in the Fed’s history without a purchase of Treasuries, and I have written the Fed to ask, but alas, no answer.? For comparison purposes, there is a tool at the NY Fed website that allow you to look at permanent open market operations after August 25, 2005.? How many purchases of Treasuries during the tightening/flat period from 8/25/05 to 5/3/07?? Fifty-nine.? Fifty-nine during a predominantly tightening period, and not one during a loosening period?
I point this out because the Fed is behaving very differently under Bernanke than any Fed Chair since the Great Depression.? Part of it is the situation in the capital markets.? Leverage got too high among a number of big capital markets players, and the SEC didn’t do diddly.
But under this new arrangement, liquidity goes out to the capital markets through the Fed’s new programs, but not out (at least not directly) to the commercial banking system and the general economy.? The balance sheets of some financial entities get relief, but not much stimulus makes it into the general economy.? What liquidity that is created gets extinguished by the Fed, because they sell/lend Treasuries to fund their lending programs.
It’s an inflationary world, and one of the reasons that the US is not feeling it as bad is that we are the world’s reserve currency.? So long as China and OPEC keep buying US debts, the game can go on, but woe betide us if the music stops.
At present, Fed funds futures indicate a Fed that is frozen.? No more moves in 2008.? Using my “pain model” for the Fed (the Fed acts to minimize its political pain), I would concur.? When you don’t know what will work, doing nothing seems like a great plan.
A great plan for now, that is.? My guess is that the Fed can’t be out of step with the rest of the world for too long, and in 2009, they will begin tightening, even if the economy and the banks are weak.
.) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.
