Macroeconomics – Page 126

Alt-A Loan Performance Statistics Getting Worse

Posted on 30 May 200731 May 2007 by David Merkel

Look at this press release from Fitch. Though it is only dealing with one set of securitizations, Residential Accredit Loan, Inc., or RALI, it is interesting to see how many 2005 and 2006 deals are experiencing poor performance, and as a result, the lowest classes in those deals are being downgraded.

Just a reminder that the stress in lending is not limited to only subprime lending. All non-prime lending is affected. This is just a straw blowing in the wind… but I would lighten up on financial stocks with significant commitments to Alt-A lending relative to their overall book of business.

When Will the Goat Reach the End of the Snake?

Posted on 29 May 2007 by David Merkel

Speculation.? Rampant speculation.? This run in the market has to end soon, right?? Right?!

Look, I’m not so sure.? I have a lot to write on this topic, but not so much time.? Market trends have a nasty tendency to persist longer than fundamentally-based market observers would expect.? Let me give you the four things that could derail the markets, and tomorrow I can detail what I have seen in the markets concerning the four potential trouble spots (and more).

The recycling of US dollar claims from the trade deficit ends because the US dollar falls enough to make imports dear and US exports cheap.? US interest rates rise as a result, stopping the substitution of debt for equity, and in some cases, leading to the raising of new equity capital.? We have seen upward adjustments in many foreign currencies so far, but not enough to change the basic terms of trade.
Defaults in the bond and loan markets lead to a closing of the synthetic CDO market, which in turn leads to underperformance of many hedge fund-of-funds.??? Bond spread widen as risk returns to lending, and the substitution of debt for equity slows to a halt.
New supply comes to the equity market, overwhelming cash available.? This could come from private equity seeking to liquefy marginal asses at favorable prices.? Alternatively, this could come from private equity investments that are unable to pay their debt coupons.? It is less well known outside of fixed income investing that most insolvencies occur because companies can’t make a coupon payment, not that they can’t refinance a principal payment.
Rising inflation in countries providing capital to the US forces them to revalue their currencies higher, and not keep sucking in US dollar claims, which don’t provide any goods to their people who want to buy goods to support their lives.

Interest rates need to be around 1.5% higher to shut off the speculation with near-certainty (did not work in 1987… rates got much higher.).? Until then, the party can go on.? I have an article being developed on this topic, but I fear it is a “next week” item.

On Inflation

Posted on 19 May 2007 by David Merkel

Inflation is a vague concept, because the term stretches to do duty in multiple areas: wage inflation, consumer price inflation, asset inflation, and monetary inflation, to name a few.? I agree with what Milton Friedman said that inflation is always and everywhere a monetary phenomenon, but where I differ is that monetary inflation may express itself in terms of inflation in the prices of goods and services, or in asset inflation.? Where inflation chooses to manifest itself depends on the balance of savers vs. spenders in a country.? Monetary inflation plus saving equals asset price inflation.? Monetary inflation plus spending equals goods and services price inflation.

As for the last week, I have a few articles to bring to your attention on inflation:

Baby Boomers need to think about purchasing power risk in their old age.? This doesn’t mean overdosing on stocks, but it does mean considering investment classes that are correlated with inflation, like TIPS, floating rate bonds, selected commodities, and stocks of companies that produce them.
I’m on record that I don’t like the way that the US government calculates goods price inflation.? From the way that they deal with owners equivalent rent, to the substitution effect, to hedonics (correct in principle, but they don’t do it right), to plain mismeasurement of the proper basket of goods, and the concept of core inflation, they mess things up.
Barry Ritholtz and I agree on many things.? Inflation is one of them.? These two articles express much of what I think about what is wrong with the measurement of inflation.? Far better to use a median (Cleveland Fed) or trimmed mean (Dallas Fed) to eliminate volatility than to exclude food and energy.? Food and energy are crucial to our lives, and they have been running at higher rates of inflation.

Inflation is growing in many areas of the world, including those that finance our current account deficit.? Buying our bonds rather than letting their currencies rise, encourages inflation in their countries, while suppressing it in the US.? There will come a day when they float their currencies, and then inflation will return to the US with a vengeance.? When that happens, call Chuck Schumer to thank him for his vigilance on the Chinese exchange rate, not.

One Dozen More Compelling Articles Around the Web

Posted on 11 May 2007 by David Merkel

1)? Picking up where I left off last night, I have a trio of items from Random Roger.? Is M&A Bullish or Bearish?? Great question.? Here’s my answer: at the beginning of an M&A wave, M&A is unambiguously bullish as investors seize on cheap valuations that have gone unnoticed.? Typically they pay cash, because the investors are very certain about the value obtained.

From the middle to the end of the M&A wave, the action is bullish in the short run, and bearish in the intermediate term.? The cash component of deals declines; investors want to do the deals, but increasingly don’t want to part with cash, because they don’t want to be so leveraged.

My advice: watch two things. One, the cash component of deals, and two, the reaction of the market as deals are announced.? Here’s a quick test: good deals increase the overall market cap of the acquirer and target as a whole.? Bad deals decrease that sum.? Generally, deal quality by that measure declines over the course of an M&A wave.

2) Ah, the virtues of moderation, given that market timing is so difficult. This is why I developed my eight rules, because they force risk control upon me, making me buy low and sell high, no matter how painful it seems.? It forces me to buy when things are down, and sell when things are running up.? Buy burned out industries.? Reshape to eliminate names tht are now overvalued.? These rules cut against the grain of investors, because we like to buy when comapnies are successful, and sell when the are failures.? There is more money to be made the other way, most of the time.

3) From Roger’s catch-all post, I would only want to note one lesser noticed aspect of exchange traded notes.? They carry the credit risk of the issuing institution.? As an example, my balanced mandates hold a note that pays off of the weighted average performance of four Asian currencies.? In the unlikely event that Citigroup goes under, my balanced mandates will stand in line with the other unsecured debtholders of Citigroup to receive payment.

4) Bespoke Investment Group notices a negative correlation between good economic reports and stock price performance.? This should not be a surprise.? Good economic news pushes up both earnings and bond yields, with the percentage effect usually greater on bond yields, making new commitments to bonds relatively more attractive, compared to stocks.

5) From a Dash of Insight, I want to offer my own take on Avoiding the Time Frame Mistake.? When I take on a position, I have to place the idea in one of three buckets: momentum (speculation), valuation, or secular theme.? What I am writing here is more general than my eight rules.? When I was a bond manager, I was more flexible with trading, but any position I brought on had to conform to one of the three buckets.? I would buy bonds of the brokers when I had excess cash, and I felt the speculative fervor was shifting bullish.? If it worked, I would ride them in the short run; if not, I would kick them out for a loss.

Then there were bonds that I owned because they were undervalued.? I would buy more if they went down, until I got to a maximum position.? If I still wanted more, I would do swaps to increase spread duration.? But when the valuations reached their targets, I would sell.

With bonds, secular themes don’t apply so well, unless you’re in the mid-80s, and you think that rates are going down over the next decade or two.? If so, you buy the longest noncallable bonds, add keep buying every dip, until rates reach your expected nadir.? Secular themes work better with equities, where the upside is not as limited.? My current favorite theme is buying the stock of companies that benefit from the development of the developing world.? That said, most of those names are too pricey for me now, so I wait for a pullback that may never come.

6) I’ve offered my own ideas of what Buffett might buy, but I think this article gets it wrong.? We should be thinking not of large public businesses, but large private businesses, like Cargill and Koch Industries.? Even if a public business were willing to sell itself cheap enough to Buffett, Buffett doesn’t want the bidding war that will erupt from others that want to buy it more dearly.? Private businesses can avoid that fracas.

7) And now, a trio on accounting.? First, complaints have arisen over the discussion draft that would allow companies to use IFRS in place of GAAP.? Good.? Let’s be men here; one standard or the other, but don’t allow choice.? We have enough work to do analyzing companies without having to work with two accounting standards.

8) SFAS 159?? You heard it at this blog first, but now others are noticing how much creative flexibility it offers managements in manipulating asset values to achieve their accounting goals.? My opinion, this financial accounting standard will be scrapped or severely modified before long.

9) Ah, SFAS 133. When I was an investment actuary, I marveled that hedges had to be virtually perfect to get hedge treatment.? Perfect?? Perfect hedges rarely exist, and if they do, they are more expensive than imperfect ones.? Well, no telling where this one will go, but FASB is reviewing the intensely complex SFAS 133 with an eye to simplifying it.? This could make SFAS 133 more useful to all involved… on the other hand, given their recent track record, they could allow more discretion a la SFAS 159, which would be worse for accounting statement users, unless disclosure was extensive. Even then, it might be a lot more work.

10) ECRI indicates better growth and lower inflation coming soon.? I’ll go for the first; I’m not so sure about the second, with inflation rising globally.

11) What nation has more per capita housing debt then the US?? Britain. (And its almost all floating rate…)? With economics, it is hard to amaze me, but this Wall Street Journal article managed to do so.? Though lending institutions bear some blame for sloppy underwriting, it amazes me that marginal borrowers that are less than responsible can think that they can own a home, or that people who have been less than provident in saving, think that they can rescue their retirement position by borrowing a lot of money to buy a number of properties in order to rent them out.? In desperate times, desperate people do desperate things, but most fail; few succeed.? We have more of that to see on this side of the Atlantic.

12) I am not a fan of what I view as naive comparisons to other markets and time periods.? There has to be some significant similarity in the underlying economics to make me buy the analogy.? Thus, I’m not crazy about this comparison of the current US market to the Nikkei in the late 80s.? Japan was a much more closed economy, and monetary policy was far more loose than ours is today.? I can even argue that the US is presently relatively conservative in its monetary policy versus the rest of the developed world.? So it goes.

Four Interesting Things I Have Seen Around the Web

Posted on 10 May 200710 May 2007 by David Merkel

1) In Grad School, one of my Ph. D. fields was econometrics. In general, I agree with this piece by Jeff Miller on the payroll survey, but I have a few things to add. My main problem with the birth-death model is that they use an ARIMA model. We only use ARIMA models when we don’t have sufficient cofactors to try to explain something structurally. At best, an ARIMA model is the reduced form solution to the broader structural model for which we do not have data. Second, I would simply add that the true error bonds on the month-to-month change are large, and I would advise everyone to look at year-over-year changes to get a better sense of the trend in the economy. As Morganstern showed over fifty years ago, economic data has so much noise that noise swamps signal until you look at year-to-year changes.
2) From the ever excellent Daniel Gross at the NYT, comes his piece questioning how important the US is the US to the global economy at present. I have written about the same thing over at RealMoney. With the US accounting for a shrinking fraction of global trade, it is hard to see how the role of the US is not diminishing here. We need to get used to the idea that we are “first among equals,” and make our policy requests as a part of coalition building among the nations that trade.
3) In general, I like John Hussman; I have learned a lot from him. We even live in the same city. That said, his commentary on share buybacks needs some clarification. Once a buyback is completed, the economics of the buyback are reflected in the diluted EPS. One should not count it as a dividend; the increment to book value reflects the change in value. But after the announcement, but prior to the buyback itself, investors analyze whether a management team is credible on the announcement. Does management follow though? Can the balance sheet handle it? Credible management teams can make the stock price rise with the mere mention of a buyback.

4) Calling John Henry and his modern counterparts: can traders be replaced by computer algorithms? Average traders, yes. The best traders, no. Good trading relies on a variety of factors that are difficult to turn into math. I learned that as a corporate bond manager/trader. Sensing when the speculative nature of the market is turning is touchy. There are many aspects of that that I think would be difficult to teach to a machine. It’s one thing for a computer to beat us at chess, which is a relatively simple game, but when will one beat us consistently at poker?

I have more, but I will publish now, and bring the rest back tonight.

A Half-Dozen Comments on the Current Market Environment

Posted on 5 May 20076 May 2007 by David Merkel

Here’s my take on a large part of what is going on it the markets now.

Bond market implied volatility is low. Tony Crescenzi comments about that on the Treasury market, but it is also true of the agency and swap markets. Less true of corporates, because rumored LBOs are making market players jumpy, but spreads are still pretty tight. People are too complacent…
What did well in the first four quarters of this year? Borrowing from Merrill Lynch, in terms of sectors, it would be utilities and materials, follow by healthcare and energy. In terms of quality, low quality continues to win, which is a function of tight credit spreads. Growth strategies are working — low PEG ratios, small caps, and high ROE are doing well so far in 2007.
China may take the global economy over the edge. Between tightening interest rates and raising deposit requirements, they are moving to slow their economy. One thing that fights against them is the currency; much stimulus comes from keeping the yuan low.
One factor that helps to keep oil prices high is the inefficiency of the average state-owned oil company. Venezuela, Iran, and Indonesia are great examples of the damage that can be done by negligent government-sponsored companies tha don’t reinvest enough in their businesses.
Fascinating to see copper and gold up, Baltic freight up and timber prices down. US housing is damaging timber, but demand outside of the US is driving the rest at the margin.
Even more amazing is the foreign buying of Treasuries, which proceeds unabated to recycle the shrinking current account deficit.

I have more, but I am tired, and will post more on Monday.

You Can Buy, But You Can’t Sell, And Vice-Versa

Posted on 2 May 2007 by David Merkel

Be sure and check out this article from the Wall Street Journal.? Derivatives being private contracts between two parties, they can’t easily be traded.? To eliminate a position prior to maturity, one can do three things:

Sell it back to the party you bought it from.
Sell an equivalent contract to a third party.
Sell your interest in the contract to a third party.

In situation 1, the exposure goes away, but the negotiation can be tough because they know they are the only ones that can eliminate the exposure in entire.? In situation 2, the exposure goes away, but one still has counterparty risk, in that they have bought and sold the same item to two different parties.? If one party defaults while owing money, the other obligation does not go away.

In situation 3, the exposure goes away if it can be done.? Sometimes the derivatives prohibit such a trade, because they don’t want the possibility of diminished creditworthiness.

So, as the WSJ points out: derivatives, even crdit and equity derivatives can’t be traded like stocks.

A Modest Proposal to Raise Taxes on Mr. Buffett (and me)

Posted on 2 May 2007 by David Merkel

I doubt that it will go anywhere, but there is a proposal on Capitol Hill to tax private equity funds more.? As usual with Congress, we can criticize this from two angles.? The first is that they are creating a discriminatory rule that will create more clever structuring, but not result in significantly more taxes.? Private equity funds might float stubs of their holdings on the public equity markets in order to avoid taxation.? There are other ways they could deal with it as well.

The other criticism is that the proposal is not broad enough.? We need to tax everyone on the appreciation of their assets every year, whether they have sold them or not. Granted, this modest proposal would require a substantially larger IRS, but as for real estate, the Feds could piggyback off of what is done at the state level, with suitable massaging to create comparability.

This would whack the life insurance industry, certain tax-efficient mutual funds, etc.? It would lead to many abandoning their holdings on which they wanted to avoid taking the tax hit.

With the money raised here, the AMT could be easily eliminated.? What’s more, we could lower the top marginal tax rates, still bring in excess revenue.? We could have a flat tax, and the rich would pay a lot more than today.? No more shelters; everyone pays on the increase of their beneficial income, whether they have received it in cash or not.? This would create greater liquidity and volatility in the markets as stock that was locked away comes out for sale to create liquidity for tax payments.

Do I want this system?? If it is part of radical simplification and flattening of the tax code, yes.? Those who benefit from the system would pay their fair share, rich and poor alike.? I might end up paying more, but it would be more equitable.

PS — private businesses would still be difficult to apply this to, but I would tax them on their EBITDA.

The Global Monetary/Currency Conundrum

Posted on 2 May 20072 May 2007 by David Merkel

Here are the facts to be reconciled:

M3 (or its equivalent) is growing smartly in most major nations around the world year-over-year at present.
Most major central banks are tightening or on hold; few if any are loosening.
The US current account deficit persists, and nations that trade with us continue to buy our bonds.
The US dollar continues to sag slowly against most major currencies.

Here’s the way that I reconcile them. Many of the central banks are not very independent, and so they are under pressure not to let their currencies appreciate versus the dollar. So, they take excess dollar liquidity and buy US bonds, forestalling the problem, because bonds will pay them more dollars in the future. This gives some lift to the dollar, but not enough, because not all central banks are willing to do this, so the US dollar sags slowly.

Because of the excess liquidity, M3 rises, and in response, the foreign central bank tightens monetary policy, but then they undo a large part of it by buying US bonds as a part of their monetary base. It will take many interest rate rises to cool off these economies, or an unwillingness to buy US bonds with their US dollar liquidity.

The Business Week article that I linked to talked about how interest rates rose 1.5% in less than two months when foreigners ceased to lend to the US in early 1987. (This followed a fall in the US dollar in late 1986.) This could happen again, but it will take a large central bank that acknowledges that they have embedded losses on their US bond portfolio not reflected in current prices, and then works to limit their losses by eliminating dollar reserve.
My advice: be aware, and don’t keep all of your bonds in US currency-denominated issues.

Twelve Unusual Items Affecting the Markets Now

Posted on 30 April 20071 May 2007 by David Merkel

1) The TED [Treasury-Eurodollar] spread, which is a measure of market confidence, is up dramatically over the past two months, from 18 basis points to 52 at present. That indicates decreased confidence in the banking system, though swap spreads have not widened to confirm that judgment.

2) The Indian Rupee has rallied almost 10% against the dollar over the past two months, because of the need to recycle the US current account deficit, and restrain inflation at home, tighter monetary policy is needed in India, and many other developing nations. That means upward pressure on their local currencies, which will hurt their exporters. India is letting that process happen at present, other developing countries are allowing dollar liquidity to further inflate their economies.

My view is that the next major blow-up will happen as a result of a neophyte developing large country central bank overshooting on their tightening of monetary policy. China is my lead candidate, but India could do it as well.

3) Ordinarily I like what Jack Ciesielski has to say. He is far beyond me in terms of understanding the nuances of accounting standards, and I recommend his work to all professionals. I think his recent Barron’s article misses a nuance of SFAS 159, though. If SFAS 159 were mandatory, Fannie and Freddie might have some difficulties. But SFAS 159 can be ignored by any company that wants to ignore it, and used to the degree that any company wants to use it, so long as they disclose where they are using it and where they aren’t using it. So, I’m not sure the SFAS 159 has much relevance to Fannie and Freddie over the short run. Over the long run, it might be different if SFAS 159 becomes mandatory, or if the US adopts International Financial Reporting Standards.

4) I have posted at RealMoney on numerous occasions regarding overvaluation of many risky asset classes versus safe asset classes. I appreciated the piece at TheStreet.com regarding Jeremy Grantham, and the piece over at The Big Picture discussing it. I think he is right, but early. We haven’t run out of liquidity yet, and perhaps we get an exponential rise in risky assets that signifies the end. On the other hand, tightening global central banks in aggregate could be the end. For the cycle to change, we need a fall in profit margins, and a rise in discount rates. I think both are on the way, but they don’t come like clockwork.

As an aside, if managed timber is still cheap to Mr. Grantham, that could be a good place to hide. Decent return, and some inflation protection.

5) Dig this article from Businessweek. Know what it reminds me of? Manufactured housing back in 2000-2003. Lenders bent over backwards to keep loans current, at a price of future credit quality, and only gave up when their companies were facing death. Most died; a couple survived and much of the remaining corpus is part of Berky now.

The banks will keep marginal lending alive until it becomes a serious threat to their well-being; after that they will act to protect the banks. The severity of loan defaults thereafter will be very high.

6) How much international goodwill has the US lost through unilateralism? Part of that cost is measured by the fall in the dollar. The current account deficit presumes on the good graces of the rest of the world, but at the edges, if our policies aren’t well-liked, the deficit will get cleared at lower exchange rates for the dollar. Just another reason that I am long foreign currencies.

7) Central bank tightenings? Look at Japan and China. I have a little more belief that China will continue to tighten; they have been doing so for the last year. The acid test is how much they are willing to let their currency appreciate, and I think China will let that happen.

I am more skeptical about Japan. Their central bank is not very independent, and regardless of the article I cited, there isn’t a lot of reason for the Bank of Japan to act rapidly. Central Banks are political creatures that avoid pain; they are not entrepreneurs, particularly not in Japan.

8) What’s better in accounting, rules or principles? The current mood in accounting leads toward principles. The idea is that principles allow for a more accurate description of the corporate economics than the application of rules that though consistent, may not fit all companies well.

I split the difference on this issue. We need rules and principles. Rules for consistency and comparability, and principles for accuracy to individual situations. That is why I would have two income statements and two balance sheets. One off of amortized cost that would be consistent and comparable across all firms, and one off of fair market value, that would give management’s view of the economics of their firm.

9) I had been critical of the FOMC over at RealMoney because they had not been injecting enough reserves into the banking system in order to keep the Fed funds rate at 5.25%. Over the last week they have amended their ways. They have bought bonds and sold cash, and now Fed funds resides more comfortably near 5.25%. (I would post a link, but as I write the Fed website is not responding.

10) A harbinger of things to come: Fitch downgrades some 2006 subprime deals.

11) The Wall Street Journal was “dead on” this morning about talking about the degree of leverage being applied to the markets. I’ve been writing about this at RealMoney for some time, and I would advise everyone to look closely at their asset portfolios, and ask what assets would be at the most risk if financing were interrupted. For equity investors, I would encourage you to be long stocks with high ROAs, not high ROEs.

Do derivatives make a mockery of margin requirements? You bet they do, and we can start with furures and options, before moving on to private agreements.

12) Leave it to Caroline Baum to catch the mood of the government, and apologists for the current economy. Ex-housing, we are doing fine. Another way to say it is housing is doing lousy, and export-oriented sectors have not made up the difference.

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That’s what I am seeing now. Are you seeing thing I am missing, or do you disagree with what I have said? Post here, and let’s discuss it.