Real Estate and Mortgages – Page 19

Ten More Notes on the Current Market Scene

Posted on 24 August 2010 by David Merkel

11) I was surprised to read that there is not a perfect market in interest rate swaps.? They are so vanilla, but counterparty risk interferes.

12) There is always a skunk at the party, and who better than Baruch to dis bonds?? I half agree with him.? Half, because the momentum can’t be ignored entirely.? Half, because profit margins are wide.? But rates are low, and unless we are heading into the second great depression, stocks look cheap.? That’s the risk though.? Is this the second Great Depression? (Or the Not-so-great Depression that I have called it earlier.)

13) Housing is a mess.? The US government has been engaged in a delaying action on defaults, while calling it a rescue effort.? The sag in housing prices may lead to a recession.? The FHA is raising the costs of mortgages because their past loans have had too many losses.

14) Commercial Real Estate continues to do badly while some CMBS performs — no surprise that what is more secured does well.

15) The Fed gets whacked on its lack of transparency.? This could be a trend for the future.

16) In the current difficulties in the Eurozone, the ECB is beginning to suck in more bonds, presumably from peripheral Eurozone countries that are seeing their financing rates rise.? As central banks get creative, a simple question for currency holders becomes what backs the money?? It would seem to be governments, which will absorb losses if central banks generate them, and cover it with additional taxes or borrowing (some of which could eventually be monetized).? What a mess.

17) Bruce Krasting is almost always worth a read, and he digs up something that I had forgotten about how interest is credited on the Social Security Trust Funds.? It’s calculated this way:

The average market yield on marketable interest-bearing securities of the Federal government that are not due or callable until after 4 years from the last business day of the prior month (the day when the rate is determined). The average yield must then be rounded to the nearest eighth of 1 percent.

Krasting thinks that’s too high.? I think that is too low, given the true tradeoff that is going on here.? Think about it: when the government borrows from the SSTFs in a given year, a slice of the benefits incurred over that year don’t get “funded.”? The debt claim to back that should match the maturity profile of those future claims.? Medicare would have some short claims, Disability and Supplemental Security slightly longer, but Old Age Security develops most of the assets, and is a long claim.? Say the average person paying in is 40, and they will retire on average at 65.? That is a 25-year deferred claim that will last for maybe 20 years on average, with inflation adjustment.? The US offers no debt that is that long to back such a liability, so I would argue that the proper rate to use would be that of the longest noncallable debt offered by the Treasury.

But here would have been my second twist on this: they should have absorbed the longest marketable securities from the debt markets, and bought and held them.? That would have looked really ugly as the rates looked piddling against current interest costs.? But today, it would reflect the true costs of the borrowing from the SSTFs, and that cost would likely be greater than what was paid to the trust funds.? My guess is that the interest rate paid on the trust funds today would be higher than 5%, maybe higher than 6%, if a fair method had been used.

If there is enough interest, I could try to run the numbers, but the point is academic.? It would not change the total claims against the government plus SSTFs as a whole, but it might have changed the behavior of the government if it had tried to borrow on a long duration basis, competing for funds with private industry.? It would have revealed the true tradeoff earlier, and shown what a trouble we were heading for.

18) On retained asset accounts, this Bloomberg piece makes me say, “Yes, this is a big enough issue to deal with.”? For MetLife particularly, which has its own bank, it would be simple enough to set up a genuine bank account with all of the statutory protections involved.? If there are risks from forgery, that is big.? Even the risks of not being covered by the state guaranty funds is big enough.

My view is this: full cash payment should be the default, and a genuine bank account an option.? If you have one of these checkbooks now, and you want to minimize your risks, do this: write one check for the balance so that it is deposited in your bank account.? Simple enough.? You can protect yourself with ease here, even without legal change.

19) The yen will continue to rally until the Japanese economy screams.? Currency moves tend to last longer than we anticipate, and secular moves force needed economic changes on countries.

20) Consider what I wrote last week on long Treasuries:

I am not a Treasury bond bull, per se, but I am reluctant to short until I see real price weakness.? And some think that I am only a fundamentalist value investor.? With bonds, it is tough to catch the turning points, and tough to grasp the motivations of competitors.? Better to miss the first 10% of a move, than miss it altogether.

Now, I never expect to be right so fast, but with rates gapping lower on economic weakness — the 10-year below 2.5%, and the 30-year below 3.6%, I would simply say this: don’t fight it.? Let the momentum run.? Wait until you see a significant pullback in prices, and then short.? Don’t be a macho fool fighting forces much larger than yourself.? The markets can remain crazy for longer than you remain solvent.

Ten Notes on the Current Market Scene

Posted on 24 August 2010 by David Merkel

1) Start with the big one from yesterday.? On of my favorite monetary heretics, Raghuram Rajan, whose excellent book I reviewed, Fault Lines, pointed out how he had gotten it right prior to the crisis, versus many at the Fed who blew it badly.? Rajan suggests that Fed Funds should be at 2-2.25%, which to me would be a neutral level for Fed Funds.? That’s a reasonable level.? The economy needs to work its way out of this crisis, even if it mean failures of enterprises relying on a low short rate.? Entities that can’t survive low positive rates that give savers something to chew on should die.? Mercilessly.? Monetary policy at present is a glorified form of stealing from savers, who deserve more for their sacrifice.

2) Peter Eavis, an old friend, echoes my points on QE, in his piece Government Clouds Value of Investments.? When the government is actively trying to destroy the willingness to hold short-term assets, and engages in QE, it makes all rational calculations on investments a farce.

3) I agree with John Hussman in a limited way.? QE artificially lowers interest rates, which lowers the forward value of the US Dollar.? That doesn’t mean it will generate a collapse; I don’t think it could do that unless the Fed began to do astounding things, like monetize a large fraction of all debt claims.

4) The US Government is so dysfunctional that the baseline budget has increased 4.4 Trillion over the next 10 years.? This is the beginning of the end of the supercycle, and the reduction of America to the influence level of Brazil.? Earnings levels will converge as well, but more slowly.

5) While we are thinking soggy, think of Japan.? Years of fiscal and monetary stimulus have availed little.? Overly low interest rates have fostered an economy satisfied? with low ROEs.? Low interest rates coddle laziness, and encourage stagnation.

6) There are limits to stimulus, whether monetary or fiscal.? There is no magic way to produce prosperity by government fiat.? Stimulus, by its nature, will run into constraints of default or inflation, if taken far enough.? If not, why doesn’t the Fed buy up all debt?? (leaving aside laws) Isn’t QE a free lunch?

7) Deflation is tough; it weighs upon cities, states and other municipalities, who hide their true obligations.

8 ) Hoisington, the best unknown bond manager.? Where do they think long rates are going?? 2% or so on the 30-year.? Makes the current buyers of bond funds look like pikers.? That’s over a 35% gain from here.? If they are right, their fame will be legendary.? Now, that could explain the willingness to fund ultra-long duration debt, because the gains will be bigger still.? What a great confusing time to be a bond investor, until something fails.

9) Or consider the Norfolk Southern 100-year bond deal yesterday.? Quoting the WSJ:

In what bankers hope will be the first in a new round of 100-year bond sales, Norfolk Southern Corp. raised $250 million Monday by selling debt that it won’t have to repay until the next century.

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Investor interest was strong enough that the company increased the size of the new sale from $100 million. Market participants said investors had expressed an interest in buying at least $75 million of the debt before the company decided to announce the $100 million deal.

—

The interest rate on Norfolk Southern’s new debt is 6% for a yield of 5.95%, about 0.90 percentage points more than where the company’s outstanding 30 year debt was trading Monday. It was the lowest yield for 100-year debt bankers could recall, breaking through the 6% yield on the company’s 100-year issue in 2005.

—

“There is no question, obviously, that you are giving up a bit of liquidity, but you’re getting a pickup of 90 basis points to move out of the 30-year,” said Jeff Coil, senior portfolio manager at Legal & General Investment Management America. “But you’re getting good income on a stable cash credit in a sector where there are only a handful of rails left.”

Mr. Coil said the firm had a “sizeable” order in the deal. There were approximately 20 investors overall.

Moody’s Investors Service rated the new senior fixed-rate bonds Baa1, and both Standard & Poor’s and Fitch Ratings rated them BBB+.

Is 0.90%/year enough to compensate from going from 30 to 100 years?? I think so. The difference in interest rate sensitivity of a 30 versus a 100 are small at a yield of 5-6%, and if you have a liability structure that can handle it, as a life insurer might, it makes a lot of sense.? After all, a life insurer can’t economically invest in equities because of capital restrictions. You could compare it to investing in long dated preferred stock or junior debt, but then if there is a default, the losses are more severe than with a senior unsecured bond.

10) I’ve never found the yield curve model for recession/recovery compelling.? Limited data set, not covering the Great Depression, etc.

More to come.

Managing Illiquid Assets

Posted on 23 August 201023 August 2010 by David Merkel

Illiquidity is an underrated risk.? Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.? Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don’t trade often.

So where do we see failures due to illiquidity?

Banks — too numerous to mention, though FDIC insurance restrains it now.
Life insurers, particularly those that write a lot of deferred annuities.
AIG and the GSEs — abominations all.
Bear and Lehman — waiving the leverage limit was one of the stupidest regulatory decisions ever.
Hedge funds – LTCM was the granddaddy of failures, but many have choked because redemptions forced liquidation of assets at unfavorable prices.
No colleges, though those college that were too aggressive on illiquid assets got whupped in 2008.? Some were forced to raise liquidity in costly ways.? Same for many overly aggressive pension plans, many of whom came late to the game with Venture Capital, Hedge Funds, Timber, Commodities, etc.

Face it.? Most alternative asset classes involve additional illiquidity.? That is an additional risk, and when evaluating those investments, the expected rate of return must be greater than that for liquid investments.

As an aside, there is another factor to be considered with alternative investments.? That factor is strategy capacity.? Alternative investments do best when they are new.? Here is my version of the phases that they go through:

New — few know about it except some business-minded investors.? Only the best deals get done.
Growing — a modest number know about it, and a tiny number of consultants.? Only very good deals get done.
Comes of age — many know about it, and most consultants pitch it to their clients as the way to go.? Good deals get done.
Maturity — almost everyone knows about it, and it is a standard aspect of asset allocation for consultants, who have their means of differentiating between different providers, based on metrics that will later be revealed to be useless.? All reasonable deals get done.
Post-maturity — Late bloomers make it to the party, and beg to get in, thinking that past is prologue, and do not realize that deal quality has eroded severely.
Failure, which brings maturity — deals fail, leading the market to scrutinize all investments, leading to true risk-based pricing.? Later adopters abandon the market, and take losses.? Earlier adopters sharpen practices, and prepare for a more normal asset class.

So, when looking at illiquid assets, how do you determine how much to invest?? First determine how much of your funding base will never leave over the next 10 years.? When I was a corporate bond manager, that was 25% of the assets that I was managing, because of structured settlements and immediate annuities.

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.? Invest that much in short to intermediate bond investments.? You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

But after that, there is an additional way of controlling illiquidity risk — time once again for the fusion solution! Money market funds run a ladder of maturities.? Stable value funds run a longer ladder, as should commodity ETFs, rather than floating at spot.? Then there are clever advisers who run municipal and other bond ladders for wealthy and semi-wealthy clients.? Running a ladder of maturities is one of the most robust management techniques as far as interest rate risk is concerned.? There is always money coming out and in every year, which slowly leads the portfolio yield in the direction of average rates.

Now, if these bonds are less liquid muni bonds, but the credit risk is low, you don’t care as much about the illiquidity, because the ladder produces its own liquidity as bonds mature.? The key question is sizing the length of the ladder, which comes down to a question of analyzing the liquidity/income needs of the client, combined with a forecast on the secular direction of rates.? The forecast is the least important item, because it is the toughest to get right.? (An aside: who has been right on bond yields consistently for the last 20+ years?? Hoisington, my favorite deflationists.? Wish I had listened more closely.)

The same principle applies to pension funds, endowments, life insurers with a few twists.? Divide your liabilities in two.? What obligations do you know cannot be changed, except at your discretion?? That group of liabilities can have illiquid assets to fund them.? Try to match the payout streams, but if not, try to match them in broad with a ladder, keeping in mind what mismatches you will likely face over the next 1-2 years in order to properly size your cash position.

The rest of the liabilities need more intensive modeling, analyzing what could make them change.? You can try to buy assets that change along with the liabilities, but in practice that is hard to do.? (That said, there are no end of clever derivative instruments available to solve the problem in theory.? Caveat emptor.)? The assets have to be liquid for this portfolio.? Other aspects of portfolio choice will depend on valuation parameters, credit spreads, yield curve shape, market volatilities, as well as macroeconomic factors.

Three Closing Notes

1) Now, all that said, just because you can take on illiquidity doesn’t mean that you should.? A good manager has a feel from history for what the proper liquidity give up is in valuations for stocks and other risk assets, and credit spreads for fixed income assets of all sorts.

Was it worth moving from the:

Relatively liquid AAA tranche to the illiquid AA, A or BBB tranche for 0.10%, 0.20%, 0.40%/year respectively?? As a bond manager at much larger insurance company said back in 2000 — “It’s free money.”? (That is almost always a dangerous phrase.) My view was there was more illiquidity and credit risk than we could consider.
Relatively liquid large-issue BBB bank bond to the relatively illiquid small-issue BBB bank bond for 1% more in yield?? Hard to say.? There are a lot of factors involved here, and your credit analyst will have to be at the top of his game.? It also depends on where you are in the speculation cycle.
Liquid public equities to private equity or hedge funds with lockups?? Tough question.? Try to figure out what the unlevered returns are for comparative purposes.? Analyze long-term competitive advantage.? Look at current deal quality and valuation metrics.? For hedge funds, look at how credit spreads moved over their performance horizon.? Anyone can make money when spreads are tightening, but who makes money when spreads are blowing out?? Analyze them over a full credit cycle.

2) Institutions that did not previously do more liquidity analysis because we had been in near-boom conditions for decades need to at least do scenario testing to assure that they aren’t overplaying their hands, such that they might be forced to make bad decisions if liquidity gets tight.? Safety first.? (This applies to governments and industrial corporations too, as we will experience over the next three years.)

3) Finally, if you decide to make a large illiquid purchase like Mr. Buffett did last year, make triple-sure of your logic and your liquidity positioning.? Nothing lives forever, but you can prolong the life of the institutions you serve by careful reasoning and planning, particularly regarding liquidity.? Get financing when you can, not when you need it. It takes humility to do so, but it yields the quiet reward of continued existence at a modest price.

Queasing over Quantitative Easing, Redux

Posted on 21 August 201021 August 2010 by David Merkel

People are good about making binary comparisons for the most part, leaving aside come of the more complex choices highlighted in the book, “Priceless.”? Would you like coffee or tea?? Do you prefer this room painted blue or white?

Where things get complex is when there are a zillion choices, and your quest is to pick the best one, particularly when there are multiple attributes to each possible choice.? Consider the problems of trying to choose the one best stock for the next ten days, months, or years.? The best solution is to redefine the problem and try to choose an excellent bunch of stocks for each period.? Give up on the impossible game to play the possible game.

I follow this logic when I make stock trades.? It is not possible to get the best companies consistently, but it is possible to look at the companies that you are buying, and the companies that you are selling, and conclude that the new portfolio is superior to the old portfolio.? Three or four times a year, it pays to freshen the portfolio, selling the companies with the weakest potential, and buying those with more potential.

Now, binary comparisons underlie many aspects of financial accounting and management.? Think of doing a net present value [NPV] calculation.? We do them frequently, but how often do we ask what they really mean?? The NPV calculation compares the after-tax cash flows of a project to a hypothetical investment, which is to shrink the asset base of the company by buying back stock and retiring debt.

As a young actuary, I was fascinated by how much a small change in interest rates could change the present value of a policy.? I worked with two companies in the structured settlement business, both of which had the same philosophy on asset management — write short policies and long policies, and invest to the middle of them.? Though, with the second one, I took the opportunity to buy ultra-long bonds when they were attractive.

In an interest-spread management business like life insurance, the binary comparisons were in many ways more obvious, as I would swap bonds relatively worse for those relatively better.

Wait, how does this relate to quantitative easing?

The Fed can create liquidity in two ways — it can send the liquidity out to the general economy, raising prices.? Or, it can use the liquidity to buy assets, in most cases, government or high quality bonds, which lowers interest rates in that area, raising the prices of assets so bought.

Quantitative easing has a direct impact and an indirect impact.? The direct impact is that those that issue the bonds that have? been bought face lower yields and are inclined to issue more.? More Agency MBS, more Treasury issuance.? It is an obscure and indirect means of monetizing government debt and Agency MBS.? The government likes nothing better than to have a captive, non-economic buyer of its securities, particularly in a period of extreme deficit spending.

The indirect impact is that as Treasury yields fall, the yields on other debts fall to a lesser degree.? There are many investors out there who need yield, and as safe yields fall, they take more risk in order to achieve their desired income.? The conundrum of QE is that people get torn between income and losing capital by taking too much risk.

This helps to explain why stock valuations are low relative to high-quality bond yields.? The high-quality bond yields, affected by QE are not indicative of the true risks faced in the high quality lending.? Stocks and lower quality bonds are affected to a lesser extent — as it is harder get yield out of quality instruments, most will dip to lower quality instruments.

I learned as a corporate bond manager that every now and then I had to fly the “Jolly Roger,” but for different reasons.? When yield lust consumed the market, I would do painful up-in-credit lose-not-much-yield trades.? When there was panic, I would wave in yieldy bonds that were more than adequately protected.? In one sense, I was doing the market a favor, even though I was trying to make gains for my client.? I was always on the other side? of the money that was panicking.

So, what does QE do?? It lowers the cost of government debt (for now), and drags lower the cost of high quality debt, because there isn’t as much government debt available to buy because of QE.? As for high-yield bonds, and stocks, the effect is weak.

So, will QE improve economic prospects?? In my opinion, no.? Unless QE begins buying high yield debt and stocks (please don’t ever do this), it will not a have any impact on real businesses.? Government should be neutral, and beyond bias — buying the securities of a non-government enterprise should be forbidden — there should be no favorites to the government.? (What’s that you say, we have already had favorites via the rescues of 2008-2009?? Sad but true, but no reason to repeat the error!)

QE leaves investors in an awkward spot.? There are no safe places to place money with any yield.? So, you can earn zero, or take risks that seem uneconomic to gain yield.? Almost makes me want to be a trader, because there is little logic to where I invest. There is no obvious place for me to invest.

If the government thinks that QE will force investors to invest, I have news for them — yes, some will take more risks, but they will lose through their investing. Risky assets are only good at a fair or fear price, not at one where yields or risk margins are dragged low by QE.? Trying to tweak our psyche as a whole is ridiculous, and deserves only scorn by voters and investors.

Go, take your QE with you and destroy the economies of other nations.? Let interest rates rise here, and allow savings to grow, that will be deployed into the businesses of the future, not QE, that invests to protect the past.? We don’t need more homes, autos, and banks.? We don’t need AIG or the GSEs.? Just leave our economy alone, we can live with the booms and the busts, unamplified by central banks and federal governments.

Eight Notes on 8/19

Posted on 19 August 2010 by David Merkel

1) I am not a Treasury bond bull, per se, but I am reluctant to short until I see real price weakness.? And some think that I am only a fundamentalist value investor.? With bonds, it is tough to catch the turning points, and tough to grasp the motivations of competitors.? Better to miss the first 10% of a move, than miss it altogether.? And consider this teardown of the past bear case here.? Or look at the bull case here.? Or, look at Japan supporting us as China sells.

But are there enough buyers out there for Treasury notes on the current path of deficits? At present interest rates, the answer is likely “no,” after some time.? The US is going to have to change its behavior, and shrink deficits, especially expenses from defense and entitlements.

2) To Narayana Kocherlakota: Yo, man, time to grow up.? Markets are what they are.? They react to what you say, not what you mean.? But beware the the day that you say what you mean, lest the market go bonkers.? What, you say that is unfair? Feh, sir, welcome to the markets.? We understood what you meant.? There is no document so analyzed as the FOMC statement.? If it is misanalyzed in your view, it is your fault for sloppy language.

3) Hitting a 10 out of 10 on the “Hooey scale,” this piece at Martin Wolf’s forum rings the bell. Quantitative easing has lowered rates in Japan, but has not helped employment to any degree.? The same will be true for the US.? Hint: lowering discount rates raises the value of existing enterprises, but does little for new enterprises because new enterprises need equity finance.? There is no evidence that lower interest rates, of themselves, will lower unemployment.

4) If someone had said to me that I would say something nice about Basel III soon, I would have growled.? But I was wrong, Basel III limits short-term leverage.? Very nice, would that Dodd-Frank had been equally useful.? (I wrote about this many times.) The thing that still gores me about the Basel standards is that it is wrong to rely on companies for credit analysis.

5) When the debt reacts bad on a merger, so do I.? So it is for American General Finance.? Fortress may want to buy it, but do they really get the lending to AIG?? The bad experience on subprime lending, etc.

6) We have already had one lost decade, the question that we have is whether we will have two decades. We may have recognized some losses faster than Japan, but the policies that we are pursuing of stimulus, running deficits, and forcing high quality interest rates lower is the same strategy that failed in Japan.? The government needs to stop hogging the liquidity through QE, and let private markets allocate liquidity.

7) Corporations act to protect their interests, regardless of those who follow them.? Google aside, few CFOs want to take risk with their excess short term assets. Flexibility is a real asset in volatile times, so good CFOs keep their powder dry rather than stretch for yield.

8 ) Saw this cute piece on residential real estate prices in the US.? There is still room for prices to fall.? A house is a place to live; under ordinary circumstances it is not an investment.? That said, though low rates aren’t stimulating a lot of buying, they are leading to a decent amount of refinancing.

That’s all for now.? Gotta go help my oldest daughter move out.

One Dozen Comments on the Current Market Situation

Posted on 18 August 2010 by David Merkel

Here are my thoughts on the markets, in no particular order:

1) Momentum draws investors.? Long treasuries have run hard, and people like them now.? My view is, if you want to short them, wait until they rise 0.1% more in yield, then short.? There are a lot of weak longs to shake out.

2) That said, long rates are generally falling in the developed world.? Gives a real feel of global debt deflation.

3) Not that the yen sees any problem here for now.? This makes me more bullish on the yen; few nations are willing to allow their currency to appreciate.

4) Arguments over residential mortgages. Geithner sees room for a federal role. Gross want the Feds to make mortgages full-faith-and credit obligations of the US Government.? A shameful statement from a man who built his wealth through free markets, and now looks to protect it through Socialism. John Carney is far better, though he flounders over what to do.? To me it is obvious — take Fannie and Freddie through Chapter 11 after their debt guarantees are gone, and let the market buy up the pieces.? Fannie and Freddie have lost money for the US over their existence; they have served no useful function, any more than some misbegotten tax incentive might have done.? And, as Kid Dynamite has put it, “The problem is that home prices are too high.? We need more deflation, and more debt reduction.

5) Physics is the wrong analogy for economics.? Ecology is the right analogy.? Like ecologies, economies resist prediction and control.? People adapt, inanimate objects don’t.? So you might enjoy these articles from FT Alphaville and Bookstaber.

6) As I commented today on Twitter: “Get ready for the bookstore massacre http://bit.ly/cywtPT $BKS fiddles with its capital structure, while it gets outcompeted by $AMZN.”? I mean it.? The problems of Barnes & Noble are organic problems of competing against Amazon and losing.? Who controls B&N is less important than what strategy they take from here.? It is a lousy time for B&N to be consumed with a noneconomic issue, when they are getting killed.? And forget BGP… they are dead too.

7) Matthew Lynn hits the nail on the head.? Additional debt does not promote recovery.? If true in Europe, then true here as well.

8 ) The Dallas Fed questions whether we can stimulate our way to prosperity.? My answer: the more we place the decision in the hands of individuals the better the decisions will be.? We know what we need better than the government does.

9) Did we misunderstand the Fed’s recent FOMC non-action?? I don’t think we did , but Federal Reserve Bank of Minneapolis President Narayana Kocherlakota thinks that we did.? I think he has to understand the markets better — we work off of changes in expectations.? We expected the Fed to do nothing again.? Now that you are buying in more Treasuries, we know that the economy is weak, and we buy long fixed income as protection.? At least we are front-running you.

10) Hey, another blogger summit at the Treasury, and this one has three of the originals there (but not me).? Comments from Marginal Revolution as well.? One participant told me it wasn’t worth it to be there and the Treasury was not prepared to answer questions, but who can tell?? I have an idea: let the Treasury webcast the meeting.? I know from the first meeting that neither the Treasury nor the bloggers would have been dominant.? At least it would be transparent; isn’t transparency what the Obama Administration is about? 😉

11) Cramer has ten reasons that the market won’t blow up.? Good.? I am 80% invested.? All I will say is that the rules are different when debts are being deflated.? Things don’t behave the same way as when debts are growing.

12) TIPS are in an awkward spot here.? Negative yields on the short end imply that buyers are looking for more inflation.? I might think that in the long run, but would be reluctant to bet on that over the next five years.

Odds and Ends Stemming from a Question from a Friend

Posted on 17 August 201017 August 2010 by David Merkel

“How can I beat the Lehman Aggregate?” a bond manager friend recently asked me.? Tough question in this environment; I’m still musing about it.? It’s a tough market.

Start with Treasuries — they are the bedrock of the market.

Here is the Treasury yield curve at 4 polar moments in the last two years.? Two times where no one doubted that the economy was bouncing back: 6/10/2009 and 4/5/2010. One time where everyone thought the end was near: 12/18/2008.? Then there is now; the front five years of the curve is like the panic.? 7-20 years is like 75% of the panic.? 30 years is half of the panic, relative to the last two years.

So what to make of it?? Despite the Fed’s willingness to buy twos through tens, I think the thirties look attractive versus twenties and tens.? The curve typically peaks near 20 years, and that’s not true now.

Are things as bad as at the panic point in December 2008?? No, but the front-end thinks so.? I would be inclined to try a barbell where thirties and bills are overweighted, and twos through twenties are underweighted.? How big to make the bet?? That is up to your risk appetite.

Now remember, this is a trade, not a long-term investment.? Sometimes I think that government policy tends to turn us into speculators and traders… the first intentionally, the second by accident.

Now all of this is amid China lightening the boat on Treasuries.? That did not stop the rally.? As the article said:

For one thing, Japanese investors have steadily bought more U.S. debt as China has shrunk its portfolio. Japanese holdings rose to $803.6 billion in June and have increased by $82.7 billion since last July.

Domestic buyers have also helped fill the gap. U.S. household ownership of Treasurys in the first quarter was $795.7 billion, the highest in a decade, according to the latest Federal Reserve data available. Private pension funds, life-insurance companies and commercial banks have also raised their holdings to record or multiyear highs.

China favoring the Euro at this point is an interesting move, contrarian from an investment standpoint, but seeking European favor from a political standpoint.? Politics and economics go together in China, given the crude top-down planning they impose on the economy.

But what kind of market is it when both long Treasury bonds and gold rally at the same time?? It is a fear market that does not know what to fear.? “We fear ‘flation!!!”? Which kind of ‘flation, they are not sure, but things look bad.? Makes me want to short them both, but let the momentum die first…

Agency mortgages are problematic because of the weakness in home prices leading many mortgages to be not refinancable.? Thus the bonds trade at low interest rates, but high spreads to Treasuries.? Personally, I don’t think a mega-refinance is possible legally, but that makes the bonds a little cheap to Treasuries.? This would be an area to analyze collateral, and buy selectively.

One thing that is different from the panic in December 2008 is that corporate spreads are tighter now.? BBB bonds still look attractive, but with junk, you have to be selective.? I would focus on highest quality, and BBBs, and underweight the rest.? Consider buying the bonds of Moody’s.? Quite a spread at 3%, and unless something weird happens, it is still quite a franchise.

Beyond that there are always issue-specific bonds that seem to be undervalued.? Those are worth tossing in, and adusting the rest of the portfolio to adjust duration and credit quality.

Some closing notes:

Why is Google issuing commercial paper?? Please, tell me.? They have no lack of short-term liquidity.? Are they aiming for financial profits like a hedge fund would?? In some ways they are already– take note that they are doing securities lending to pick up additional yield (see my comment after the article). If this becomes a large part of Google, the P/E multiple on Google should come down, because financial entities arbing credit spreads do not deserve high multiples.? Better Google should pay out the excess cash to policyholders as a special dividend in 2010.
As an aside, I would add that the financialization of profits in general brings down the P/E multiples of industrial companies.? It looks so easy at the beginning.? Just finance the purchases of your own products through a captive subsidiary, and the extra profits roll in, with a small drop in the P/E.? That’s fine as far as it goes, but it usually doesn’t stop there; the division head of the finance sub seeks new vistas — if he can lend successfully in one area, he can do it in others.? We’ve got the infrastructure; why not use it?? The result at best is a GE or a Textron — two stocks that have gone nowhere over the last 14-15 years.
Many people in the US are selfish and want to decrease spending on others, but not themselves.? We see that through both of our clueless parties arguing over priorities, and people who want to see the deficit cut, but not in their prized areas.? The logic of shared pain has not yet arrived.? Things haven’t gotten bad enough to drive real spending or tax reform yet.
Last note: this is a period where people are demanding certain yield, thus bidding up bond prices versus stocks.? It reveals a lack of certainty about the future.? It makes some stocks look attractive — in many cases corporate bond yields are below stock earnings or cash flow yields, and even below dividend yields in some cases.? This article is an example of this phenomenon.? The key question is how long profit margins can remain elevated.? With labor plentiful relative to work, that could be a while, leaving aside risks in the financial system.

So, what should I tell my friend?? Maybe this:

Duration: emphasize short and long.
Credit: emphasize highest quality and some BBBs
Underweight financials with weak liability structures (I.e., the too big to fail banks) for now.
Mortgages: play carefully, but play.
If you don’t get a big yield premium for illiquidity, don’t play in illiquid bonds.
Can you do a little foreign? If so, diversify a little into the developed world fringe currencies outside of the US Dollar, Euro, UK Pound and Yen.

These are tentative conclusions that I would have to work out further — I don’t have my thoughts together on CMBS, Munis, etc.? That’s all for now.

Redacted Version of the August 2010 FOMC Statement

Posted on 10 August 201010 August 2010 by David Merkel

Comments

Adds new paragraph for quantitative easing, round 2.? Will invest maturing Treasuries, Agencies and Agency MBS in longer term Treasuries.
Four months ago I wrote: The FOMC is overly optimistic on employment and housing issues.
Now the weakness is evident.? Hope has given way to modest pessimism, as they have shaded virtually all of their views of economic strength down.
Two months ago I wrote, ?Implicitly blaming the Eurozone is cheap, we have enough issues on our own for the weakness ? residential housing, commercial real estate, and over-indebted consumers.?
Now they have given up that evasion, and continue to shade down their views.
Hoenig still dissents; hasn?t gotten bored with it yet.? Fight on, Tom.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.

Queasing over Quantitative Easing

Posted on 10 August 2010 by David Merkel

The world’s largest hedge fund, the Federal Reserve, is trying to decide whether it should expand its operations.? Unlike most hedge funds, the Federal Reserve has a big advantage in that it can fund itself cheaply, and for the most part, at its own discretion.

Unlike most hedge funds, it issues 0-day 0% Commercial Paper, which is accepted almost everywhere as a means of completing transactions.
Banks affiliated with them must place reserves with the Fed, on which they earn interest of around 0.25%
The affiliated banks, not finding as many opportunities as they would like to lend privately on a risk-adjusted basis, leave more money than they have to at the Fed, again earning about 0.25%.

What a cheap funding base.? They can buy almost any asset and make money, so long as equity/credit risk is limited, and so long as the yield curve doesn’t hit new records for steepness.? Given that the Fed does not have to mark most of its positions to market, and does not have to worry about margin calls in the conventional sense of the term, they make money year after year, and hand most of the profits over to the US Treasury, which keeps accounts for the Fed’s main owner, the US Congress.

Life is tough when you have to serve multiple conflicting interests.

They demand that you create conditions for full employment, something beyond your control.
They ask that you restrain inflation, which is possible.
They ask that you lend, because the banks affiliated with you are not lending, and an increase in lending is always a good thing, right?

So, like Keynes, the fools that think that a lower rate of interest is always better urge that the Federal Reserve should expand its balance sheet and buy up more Treasuries, Agencies and Agency MBS, forcing rates lower.? What good can come from forcing high-quality long rates lower?

My answer is, not much.? Existing debts if non-callable, will be worth more.? If debtors are solvent, and can refinance, they? can lower their debt service costs, though that is a minority of borrowers.? Beyond that, it will lead the favored debtors to borrow more — Treasury, Fannie, Freddie, etc.? We need more borrowing, right?

But a greater effect can be the speculative frenzy engendered by dropping the rate that savers earn to such a low level, leading them to invest more aggressively to meet their income targets.? As with any other sort of speculation, the game is over when people rely on the occurence of capital gains.

I think quantitative easing is a mistake; I also think it does not help matters much.? It transfers resources from creditors to debtors in a funky way.? That is not the right way to go if you want a country to grow.? (Which, contrary to the received wisdom, would mean that raising short term rates would be better for the US and Japanese economies than engaging in quantitative easing.? There would be short-term pain, but there will be pain regardless of how this policy is conducted.)

If the Fed makes a bow in the direction of quantitative easing on Tuesday, such as reinvesting the proceeds of MBS in more MBS, the markets will rally, but I would fade it, because it will have no long-term beneficial? impact on the economy.

There is no free lunch.? Any action that seems to cost nothing on the part of the Fed or the Federal Government will have no long-term effect on the economy.? Quantitative easing is one of those comforting fairy tales that is a fraud, whether intentionally so, or not.

Book Review: Complicit

Posted on 15 July 201010 December 2010 by David Merkel

I am not sure how many current economic crisis books I have reviewed.? I think I am getting close to a dozen and I am currently reading “Fault Lines.”? I’m not sure I want to do many more crisis book reviews.? Tonight’s review is Complicit, by Mark Gilbert of Bloomberg.

Bloomberg columnists are typically good writers, with detailed knowledge of their subject areas, and a no-nonsense approach to writing.? This book from Mark Gilbert is no different.? As Joe Friday often said, “All we want are the facts, ma’am.”

And for the most part, that’s what you get in Complicit.? It is not a long book at 173 pages, but it comprehensively chronicles the growth in leverage, and how it spread to many areas of the investment markets.

When bubbles grow, everyone is a friend.? Underwriting becomes lax, limits are stretchable, FICO scores are pessimistic approximations, etc.? Risk is transitory; we originate to sell.? Regulators don’t want to stand in the way of seeming prosperity.? Nor do politicians.

Leverage gets higher in explicit and implicit ways.? Credit spreads get tight as a drum.? It is a virtuous cycle… until it become a vicious cycle.

In the bust, credit spreads rise, cutting off the possibility of refinancing.? Then asset defaults come, and GSE and bank insolvencies.

Central banks did not view inflation broadly enough, focusing on goods price inflation, and ignoring the asset inflation that was distorting the economy.? They disclaimed an ability to see, much less deal with bubbles.

The high yield market became a frenzy for yield, with CDO equity bidding for lousy bonds and default protection on lousy corporations.? Debt spreads tightened to levels that indicated perfection had arrived.

Investors chased risk, seeking returns.? There were too many parties willing to make fixed commitments, because they needed to earn a lot.? Balance sheets were ignored, and income statements were everything.? History being bunk, was thrown out the window, because it was different this time, we were in a new era.

The crash in Shanghai was the first warning in February 2007, followed by the equity quant crisis in August 2007, and the breakdown in the money markets.? All of the clever ways parties used to lever up short-term credit blew up, forcing banks to take credit back onto their balance sheets.? At that point, everyone should have dumped the banks, but few did; leverage was too high, and asset prices were falling.

The critical decision was bailing out Bear Stearns.? I agree with Gilbert; either both Lehman and Bear should have been bailed out or neither.? I think not bailing Bear and Lehman out would have led to the best outcome.? After Bear failed, other banks would have moved to straighten themselves out.? We might not have had as much failure had as we eventually did. The inconsistency of regulation, as well as the unwillingness or regulators to be tough added to the crisis.

The book covers the September 2008 climax well, but takes us past that, offering possible solutions.? I particularly liked the ideas of limiting the number of academics in important regulatory posts, and having more regulators with practical experience.? I also liked central bankers being proactive on bubbles, and the asset/liability matching inherent in paying those that make long term decisions with financial instruments that last for the term of the decision, and are contingent on the credit quality of that decision.? An example would be paying securitization originators with pieces of the subordinated tranches.

I liked the book; for those with limited time, the book is particularly suitable, because it is brief.

Quibbles

Gilbert’s style is hard-hitting; though many financial companies took advantage of government largesse, few practically considered the possibility of bailouts while the boom was going on; they were pursuing profit with little thought of systemic risk. There was a lot of greed, but in my opinion, few expected bailouts, but took them when they were offered.

Who would benefit from this book?

Most people would benefit from this book on the crisis.? The book is available here: Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable (Bloomberg)

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