Real Estate and Mortgages – Page 24

Dubai? Do Sell?

Posted on 27 November 2009 by David Merkel

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

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

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

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

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

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

Other selected articles on the mini-crisis:

Dubai Crisis Means ?Correction? to Mobius, Risk Aversion to Das
European Banks Face Potential Dubai World Losses
Time to Reread the History of Austria’s Creditanstalt in 1931… (h/t CR — banks failing can really drive a crisis)
Dubai Government Shock May Not Be Last
?The Sun Never Sets on Dubai World.? Really?
Barclays Capital ?change their view? on Dubai (Izabella Kaminska writes well, as do most of the writers at FT Alphaville.? In this case, Barclays had been quite bullish on Dubai World, and recent events have caused them to shift.)

Book Review: This Time Is Different

Posted on 25 November 200925 November 2009 by David Merkel

I love economic history books.? The book that I am reviewing tonight is different because unlike most economic history books, it is mainly empirical rather than mainly anecdotal.

Don’t get me wrong, one good anecdote can deliver more information than a carefully controlled study.? But more often, it is the careful studies that reveal more in their bloodless way.

This Time Is Different takes the reader through the last eight centuries of financial crises globally, subject to the prevalence of available data.? Data is more available recently, so the A.D. 21st, 20th, and 19th Centuries get more play than the more distant past.? Also, the developed West gets more coverage than the East.? This is to be expected.? It all depends on who writes down more.

Crises? have been far more common than the average economics textbook would suggest.? One of the first ideas to toss out of economics should? be that markets strongly tend toward equilibrium.? My own empirical research in the financial markets indicates that mean-reversion is there, but very weak.

The book has a wide number of disasters that it draws us through, namely inflation/debasement, currency crises, banking crises, and internal and external default.

Now, all of these crises tend to happen more frequently than the modern fat, dumb and happy Westerner would like.? Central banking has substituted fewer and larger crises for more and smaller ones.

Regardless, the chapters on sovereign defaults are worth the price of the book.? Will defaults be internal, external, or both?? A lot depends on how much debt will be compromised through default.? If a majority of debt is held externally, foreign creditors should be wary.

This book is needed now because many so-called scholars implicitly assume that the US Government could never default on its obligations.? Yes, it would be a horror, but leading nations in the world have defaulted before, and they will do so again.? It is the nature of mankind that it is so.? Promises happen in good times, and defaults happen in bad times.

Quibbles:

The book is listed as 496 pages, but for non-academics the true length is more like 292 pages.

Also, I would suggest to the authors, that there are predictive variables that they have not considered regarding crises.? Two variables are growth in debt, and yield spreads.? Debt grows like kudzu or topsy prior to crises, and yield spreads are very small prior to crises.? As the crisis nears, debt growth slows, and spreads widen a little.

Summary

This book is not for everyone.? If you tire looking at tables, and prefer more discursive arguments giving anecdotes rather than facts, this book is not for you.

Who could benefit: if you want intellectual confidence that sovereign defaults /currency failures can happen even in the US (note we have had two so far, in addition to many other financial crises), this will give you confidence that you are not a nut.? If you want to educate one of your friends who thinks that such disasters are impossible, this is the book for him.? Just make sure he is willing to endure a semi-academic book.

If you want to buy the book, you can buy it here: This Time is Different: Eight Centuries of Financial Folly.

Full disclosure: I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.? Those that want to support me can enter Amazon through my site and buy stuff there.? Don’t buy what you don’t need for my sake.? I am doing fine.? But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.? Win-win.

My Visit to the US Treasury, Part 7 (Final)

Posted on 10 November 2009 by David Merkel

Things have been busy for me, so this final part should be short.? What did I learn that I did not already know?? Not much, except:

The Treasury wants to convince? the public that it is doing its best, but that Congress is a slave to the Financial Services industries.
When asked about the latest bailout of GMAC, they said that didn’t qualify as a financial — the aid was to help the auto companies.? (If so, send it directly, and let GMAC expire.)
They said that they worried about the same things we did, though they had to maintain public confidence, and did not think it was as likely as we thought.
They did not bring up the GSEs.
They pointed at the financial markets as evidence of recovery, and did not speak of the real economy, which is weak.
There is no acknowledgment of what could go wrong in the long-run.? They are only playing for the next 3-7 years, at most.? Everything is done to goose the next year.
That the Treasury is trying to reduce its footprint in the economy is welcome news to me.
They said that they were trying to be wise stewards of the economy, but that Congress had questionable motives.

May I go back to my original questions:

Haven?t low interest rates boosted speculation and not the real economy?
We are looking at big deficits for the next seven years, but what happens when the flows from Social Security begin to reverse seven years out?? What is your long-term plan for the solvency of the United States?
We talk about a strong dollar policy, but we flood the rest of the world with dollar claims.? How can we have a strong dollar?
None of your policies has moved to reduce the culture of leverage.? How will you reduce total leverage in the US?
Why did you sacrifice public trust that the Treasury would be equitable, in order to bail out private entities at the holding company [level]?? People now believe that in a crisis, the government takes from the prudent to reward the foolish.? Why should the prudent back such a government?
If we had to do bailouts, why did we bail out financial holding companies, which are not systemically important, instead of their systemically critical subsidiaries?
We are discussing giving tools to regulators for the tighter management of the solvency of financials.? There were tools for managing solvency in the past that went unused.? Why should we believe the new ?stronger? tools will be used when the older tools weren?t used to their full capacity?? (The banks push back hard.)

I’ve answered 1 and 2.? The rest are unanswered.? Here are the brief answers.

3) No, there is no strong dollar policy.? Wait for the day when we are net exporters (and our relative wages will be lower then.)

4) They are doing nothing to? reduce total leverage in the US.? My own guess is that it is increasing.

5) And there is the question, aside from fairness, were the bailouts Constitutional?? A narrow reading of the Constitution says no, but our government does many, many things that violate a narrow reading of the Constitution.? The fairness question was not raised either, the bloggers there were attacking effectiveness, not fairness.

6) This is my guess — we bailed out holding companies because it was the simplest way to do it.? More thought would have led to a cheaper solution, but thought is rare during a panic.

7) I have no answer to point 7.? There is no good reason to hand over stronger tools to a culture that has not used weaker tools.

Aside from all that, we could have spent more time on international issues.? There was the joke at the beginning of the session that one fellow tasked with raising money was “fluent in Mandarin.”?? From the chuckles, I gauged it to be a joke.

But that might prove to be the most significant point economically.? The Treasury is putting pressure on the Dollar through high debt issuance, and the Fed through the creation of short-term credit to heal various debt markets.? The benefits are going to debtors, not creditors.? What value should the creditors assign to the Dollar?? The simple answer should be less than previously.? Yet, nations follow many noneconomic goals, many of which benefit the US as the reserve currency in the short-run.

The ultimate answers are complex, because they rely on how other nations will act.

Final Note

I have found interesting the commenters that automatically assume that being willing to go to the Treasury and eat one cookie equals compromise.? There are a lot of scared and frustrated people in the US, and they see their prosperity ebbing, and are looking for someone to blame.

Let me try this — as the world has gone capitalist, the edge of the US has been eroded.? Now we face a world where doing certain jobe should pay the same, regardless of where they are located.? Wages in the US will converge with those from the rest of the world, adjusted for capital investments.

Throughout human history, “middle classes” have been abnormal.? The current adjustment in the US may be showing the once large middle class that it is not a normal thing, and is hard to maintain.

There is no conspiracy.? The US Government is up against economic forces larger than it can combat.? The rest of the world is out-competing the US, and the US? has a shrinking portion of the pie as a result.

My Visit to the US Treasury, Part 6

Posted on 7 November 20098 November 2009 by David Merkel

Now, none of us knew when we came that only bloggers were invited.? Personally, I expected it to be a broader press briefing that some bloggers could come to as well.? “Deep background” is well understood to the press, but new to bloggers.? My blogging friends at the meeting can correct me, but all of us were surprised that it was only bloggers at the meeting.

My only clue that they might have treated us nicer than some other gatherings, was that some staffers not at the meeting came in after the meeting to raid some cookies.? Now, maybe that is normal regardless there.? I’ve seen the same things in corporate settings.? The e-mail announcement, “Open season in room 406!”? That said, the chocolate chip cookies were all gone. :(? I had one, as did Tyler, I think.? Maybe the Treasury officials had the rest.

Personally, I am comfortable with the restrictions on reporting from the meeting.? The Treasury’s high-level staff sound the same tune.? It doesn’t matter if we identify them or not, they reflect the policies of the Obama Treasury.? With restrictions on not identifying who said what, to me it does not matter, because they were senior Treasury officials.? We can quote, or approximately quote.? We can’t tie it to a single person.? That doesn’t affect us much.? We know what they think, and we can write about it.? We just can’t say exactly who said it, or whether they were there.

Making Money or Not

Few areas of the US government are designed to make money.? One of the main points that Treasury made to us was that the TARP would cost little, or might make money.? TARP is a piece of a larger puzzle.? My question is this, counting in all of the bailouts, including all stimulus programs, what is the cost to the taxpayer?? Now, I ask my readers what they know here. E-mail me with any comprehensive pieces that you have seen, or put it in the comments, so that all can see.

When I look at the bailouts, AIG, Fannie, and Freddie have sucked up /are sucking up resources.? With respect to the GSEs, I appreciate the view that the Administration views Fannie and Freddie as a hole in the system that they can use to funnel money to housing without asking Congress for approval.? Certainly their financial result show it.? Fannie lost a lot of money last quarter and is begging for help.? Freddie lost less, but is not asking for money now, but they likely will in the future.? As for the Treasury, they have opted to not maximize the value of Fannie by allowing her to sell of tax credits to others, notably Goldman and Berky.? They are not interested in maximizing the value of the GSEs, only of using them for their policy goals.

One slide the Treasury showed us was that they thought they were making money across all of the TARP bailouts that they did.? Also, that their guarantee programs had made money as well.

True, so far the guarantee programs have made money.? That does not mean that the government should be in that business, as it may encourage greater risk taking later, because they think the government will rescue them in times of trouble.? In England, at least some think it is a bad precedent.

TARP may be doing okay, but the same moral hazard argument applies.? Also, bailouts may come after shareholders have lost a lot, but management teams may (and seem to be now) benefit disproportionately from the bailout.? Away from that, the losses from the GSEs, Auto companies, and AIG swamp other gains.? That’s what it seems to me.? Does anyone else know better?? Please put it in the comments, for all to see.

Away from that, consider how the FDIC is basically broke, and that the FHA is not far behind.? This crisis is not over.

A Place of Agreement

One place where I can agree with the Treasury is that there should be only one regulator of depositary institutions.? The insurance industry can choose among states, but for the most part there are states for big companies,and states for small companies.? The states willing to regulate the big insurance companies have done a great job relative to the banking regulators.? There are few failures.? AIG died for non-insurance reasons.? Penn Treaty was a basket case long before the crisis.? Who else died?

Having one regulator for banks will remove the ability of the banks to choose the weak regulator.? It raises the risk that the one regulator will be corrupted.? That’s a lesser risk, because with many regulators, the odds that one will be corrupt are high, and corrupt institutions will go to them to be regulated.? With one regulator, politicians can more easily watch the troubles, and can more easily assign blame.

I have no objection to one national insurance regulator either.? That said, many states will object, because they have differing standards.? But does Congress really want to do insurance law?? It takes up a lot of time and is complex.

The Final Note for Now

Things always look best for a borrower immediately after his most recent loan.? So it is for most programs in our economy that favor giving loans in this crisis to stimulate demand.? So it was in the 70s and 80s with lesser developed countries.? The finances looked great after the loans, but after they had spent it away on consumption, things looked much, much, worse.

So it is with government programs that interfere with the free market through offering cheap lending terms.? They give a temporary lift that leads to greater problems once the subsidy is spent away.? So it is now with government subsidies and loans.

Other Posts

Two more posts on the meeting, one from a blogger who was there:

A Sit Down With Senior Treasury Officials – Part II

and one who was not, somewhat critical, but constructively so:

Treasury and the?Blogs

As for me, I’m glad I went.? I have a better zeitgeist of the US Treasury.? I am not more impressed, nor less impressed with them.? I do want the Federal Reserve to consider inviting us to meet with them.? They are far less accountable than the Treasury, and many of us would like to counsel them on their behavior that seemed smart at the time, but will likely prove destructive to the republic.? Dare you invite us, Ben, or do you have less courage than the Treasury?

My Visit to the US Treasury, Part 4

Posted on 6 November 2009 by David Merkel

So, who did I recommend for the next meeting at the Treasury? (I think there will be one.)

Economists View http://economistsview.typepad.com/
Cafe Americain http://jessescrossroadscafe.blogspot.com/
Market-Ticker http://market-ticker.denninger.net/
Econbrowser http://www.econbrowser.com/
Greg Mankiw?s Blog http://gregmankiw.blogspot.com/
Carpe Diem http://mjperry.blogspot.com/
Credit Writedowns http://www.creditwritedowns.com/
Gregor Macdonald http://gregor.us/
Jeff Miller http://oldprof.typepad.com/
Floyd Norris — NYT http://norris.blogs.nytimes.com/
Market Beat — WSJ and their real time economics blog, deals, and real estate blog… http://blogs.wsj.com/marketbeat/
FT Alphaville — http://ftalphaville.ft.com/
James Pethokoukis — Reuters http://blogs.reuters.com/james-pethokoukis/ (also Matt Goldstein and Rolfe Winkler at Reuters)
Curious Capitalist — Time http://curiouscapitalist.blogs.time.com/
Matt Taibbi — http://trueslant.com/matttaibbi/ (And others at the same site)
Trader Mark http://www.fundmymutualfund.com/
Dealbreaker http://www.dealbreaker.com/
The Epicurean Dealmaker http://epicureandealmaker.blogspot.com/
Ultimi Barbarorum http://ultimibarbarorum.com/
Zero Hedge http://www.zerohedge.com/ (ask for Tyler Durden or Marla Singer)
The Reformed Broker http://thereformedbroker.com/
Crossing Wall Street http://www.crossingwallstreet.com/index.html
Cody Willard http://cody.blogs.foxbusiness.com/

Add to that good ideas from my readers:

Warren Mosler
Bill Cara

Now, Treasury responded to me, thanking me for the list, but said that the mainstream media bloggers already have access.? Fine with me — I was just gauging talent and reach.

The Nature of a Liquidity Trap

Go back in history over the last 25 years.? How did the Fed manufacture recoveries?? They lowered interest rates enough so that borrowers would be willing to borrow and refinance assets that had cash flow streams that were not financable in the higher interest rate environment, but financable in the lower interest rate environment.

With each successive rescue, interest rates at the trough were lower than before, inviting borrowers that were increasingly marginal to buy assets, borrowing money at cheap rates to pay them off over time.? We thought we saw the bottom, 2002-2004, but no.? The Fed Funds rate can go to zero, and what’s more the Fed can buy longer dated Treasuries, Agencies, and Mortgage Bonds, lowering interest rates on the longer end of the yield curve.? This allows even more marginal borrowers to buy assets. If they face some hiccup in their cash flow, they will default, and quickly.? If you doubt this, consider the high currently expected rate of default on FHA loans originated over the last two years.

Yes, low rates can get them to buy, but it cannot get them to hold on.? But wait, these are criticisms of the Fed, not the Treasury.? Mostly so, but what of the expensive housing tax credit? and cash for clunkers.? Those belog to the Treasury.? They are not economic programs — the costs far outweigh the benefits.? But wait.? Those shouldn’t be pinned on the Treasury; Congress, bought and paid for, are pushing these programs on behalf of their lobbyists.

If so, where is the administration to shame Congress over such behavior?? Where is the President who should press for a line-item veto?? (I like Wisconsin’s version. 😀 )? Let the Treasury, backed by Obama, ascend to the bully pulpit, and say that such programs are a waste of taxpayer dollars.

The Fed and Treasury have been able to touch of a speculative rally in financial assets, which benefits financials, but with weakness in? end-user demand, the lower rates do nothing to stimulate investment in plant and equipment.

All that said, there are three things that could go wrong here:

Contrary to the expectations of the Fed, inflation could rise, and cause the Fed to tighten.
All of the excess dollar claims could lead to greater depreciation of the dollar.
Defaults could cause credit spreads to widen.

Those have not gone wrong yet, but they are all threats.? More tomorrow, when I discuss difficulties with entitlement programs.

My Visit to the US Treasury, Part 3

Posted on 5 November 2009 by David Merkel

Going back to bank stress-testing for a moment, one interesting thing that a Treasury official said at the meeting was that unemployment did not have a big effect on foreclosures.? Unemployment has a big effect on credit card defaults, but not foreclosures.? I disagree.

As a multi-purpose quant, I have learned over the years that it is impossible to estimate an option curve/function when the variable in question has only been “in the money” or “out of the money.”? (As an example, one can’t estimate the withdrawal function on deferred annuities because haven’t had a large sustained rise in interest rates since the product was created.)? With mortgage debt, over the last 70 years, real estate values? have never fallen enough to make default a reasonable choice until now. Thus in the past, when unemployment hit, one could sell, rather than default.? As I have said before, foreclosure typically occurs when someone is inverted on their mortgage, and a life event happens: death, divorce, disability, disaster, disemployment, change in financing terms, or deciding that it is worthless (and doing a strategic default).

But now residential real estate values have fallen.? When someone loses their job, the option to default becomes real.? Do a short sale, and give the bank a hit.

With stress-testing, the devil is in the details.? How do you turn unemployment, housing prices, etc., into losses tailored for each individual company?? Different underwriting standards can make quite a difference in the results.? I would have been more than happy to dig through detailed stress testing models.? That was my job once.

When the Treasury announced the stress-testing results, it was at? a time when the gloom was thick.? It was a positive to the market that the government would not require huge amounts of extra capital, and in most cases, no extra capital.? Thus the market rallied.

With many simple asset classes that were under stress, the Fed and Treasury offered guarantees that would enable them to easily survive the panic.? Absent the guarantees, most short assets would have been “money good,” but there would have been significant doubt for a brief time.

As I commented to a Treasury staffer after the meeting, with financing rates so cheap to buy financial debts, regardless of what kind, it is no surprise that corporate bond spreads have tightened, while there is still little lending to finance growth in the real economy.? That is why there is such a gap between Wall Street and Main Street.

Main Street sees unemployment and low capacity utilization.? Wall Street looks at bond spreads and P/Es.? Those are not the same things.? The current stimulus has emphasized healing the financial sector in an effort to avoid contagion and depression.? It does not directly address slack in the real economy.? The real economy funds the bailout of financials, but does not directly benefit.? Thus the disconnect between Main Street and Wall Street.

Many financial? measures and companies have rebounded, but little expansion has occurred in the real economy.? Even with companies that have done bond offerings, they have often used the proceeds to bolster the balance sheet, rather than expand capacity.? Safety first is the watchword.

Perhaps a change happens when companies with a lot of cash appear as takeover targets in a sluggish market.? Easier to grow market share through acquisition rather than organically, and what’s better, their cash helps pay for the deal.

Housing Initiatives

It seems that the low end of the housing market has bottomed.? Government programs have something to do with it.? The tax credit has made a difference in the short run, as has the efforts of the Fed to support the mortgage markets through the purchase of RMBS.

Mortgage modifications are advertised by the Treasury, but the results are small.? Away from that, I will say that successful modifications occur more likely when there is some degree of principal forgiveness.

Tonight, I will pick up on the risks of low interest rates in part 4.

Who was Invited?

I’ve been in touch with staffers at the Treasury.? One of them gave me a list of the invitees.? Here is the list of those invited that did not come:
Abnormal Returns
Alea
Barry Ritholtz
Clusterstock
Free Exchange at The Economist
Paul Kedrosky
Andrew Leonard
Calculated Risk
Yglesias
Megan McArdle
Mike Konczal
Baseline Scenario
Mish
The Audit at Columbia Journalism Review
Credit Slips
Prudent Investor
Brad Delong
Felix Salmon

If you were in the Treasury’s shoes, who else would you have invited?? E-mail me, or put it in the comments.? Tomorrow I will mention who I thought would have been good additional guests.

Continuing Coverage

Here is a list of posts to date on the meeting:

Friday in Vegas (Kid Dynamite):
“A Sit Down With Senior Treasury Officials – Part I”

Naked Capitalism:
“Curious Meeting at Treasury Department”

The Aleph Blog:
“My Visit to the US Treasury, Part 1”
“My Visit to the US Treasury, Part 2”

Across the Curve:
“Bond Market Open November 04 2009”

Accrued Interest:
“Financial Regulation: How Would You Have It Work?”

Michael Panzner
Treasury Officials Meet With Financial Bloggers

A Few Observations of My Own

Interfluidity
Sympathy for the Treasury

That’s all for now.? Until this evening and part 4.

My Visit to the US Treasury, Part 2

Posted on 4 November 20094 November 2009 by David Merkel

Before I start this evening, to all my fellow bloggers out there, if you were invited to the gathering at the US Treasury and did not come, I have a request and a question:

If you were invited, send me an e-mail.
Tell me why you decided not to come, if you would.

If present trends continue, I can tell you that bloggers are not pushovers for the US Treasury, but neither are they deaf or heartless.? Since my last post, here are the responses to the gathering:

As all bloggers there will note, those from the Treasury were kind, intelligent, funny… they were real people, unlike the common tendency to demonize those in DC.? As for me, I live near DC, and I am an economic libertarian, but I have many friends at many levels inside our bloated government.

They have to do their jobs.? If there is a conspiracy, it is well-hidden.? There are simpler ways to understand the mess that comes out of national politics.? We get the result that is least offensive to the most, and pleasing to few.

We had a good discussion, but I am not the one to put myself forward.? I made some comments, but did not get to ask my questions.? My personality was not the dominant one.

What I propose to do in this series of articles is go through the main arguments of the US Treasury from the handouts that they gave us (sorry, I can’t scan them and put them out for view), and try to give a fair rendering of what they have done.? My audience is dual: I am addressing those who read me in the blogosphere, and those at the Treasury.

-=-=-=-=-==–=-==–==-=–=-==-=-=-=-=-=-

Treasury officials said that they were trying to reduce the footprint of the rescues/bailouts as much as possible, doing it at a rate that would not jeopardize the recovery.? Their goal is to put in place? regulations that will prevent future disasters once the current disaster is past.

David: Well, yeah, that’s what to do if you can.? The question is what will happen to the markets when you start to remove significant stimulus from critical areas, as I said to my pal Cody a year ago.? Much of that is not in the domain of the Treasury, but the Fed.

The Treasury understands that the troubles of 2008 came from poor credit regulation and tight coupling in the financial system.

David: we over-encouraged single family housing as a goal for Americans.? When debt was too high for cash flows from average American households to afford residential housing, the prices of housing began to fall, and the foreclosure process began, as foreclosures happen once someone is inverted on their mortgage.? Residential real estate prices overshot by a lot.? We should be surprised that there are problems now?

I would not only eliminate the tax credit for new buyers, but I would phase out the interest deduction for mortgage interest.? Get people financing with equity, not debt, even if it means the economy is sluggish for a few years.? It will bring a longer-lasting self-sustaining recovery.? Debt-based systems are inherently fragile because fixed commitments remove flexibility from the system.

To the Treasury I would say, “Markets are inherently unstable, and that is a good thing.”? They often have to adjust to severe changes in the human condition, and governmental attempts to tame markets may result in calm for a time, and a tsunami thereafter.

Those that understand chaos theory (nonlinear dynamics) were less surprised by the difficult markets that we have faced.? We saw it coming, but could not predict exactly when the system would face crisis.? Bears are often right, but with significant delays.

The government is not the majority player in the system, but is the biggest player.? At critical points their willingness to offer support helped lead to a market rebound.

Now in the actions of the government, there is some “making virtue out of necessity.”? In supporting Fannie & Freddie in February 2009, they did not have much choice, unless they were to let them fail, which might have been a good thing.? As it is, F&F seem to be black holes where the government is unlikely to recoup their investments.

As for the bank stress-testing, one can look at it two ways: 1) the way I looked at it at the time — short on details, many generalities, not trusting the results.? (Remember, I have done many such analyses myself for insurers.) or, 2) something that gave confidence to the markets when they were in an oversold state.? Duh, but I was dumb — the oversold market rallied when it learned that the Treasury had its back.

I’m tired, and that’s enough for the evening.? I’ll pick this up tomorrow.

My Visit to the US Treasury, Part 1

Posted on 3 November 2009 by David Merkel

This will have to be brief, because I am tired.? I have had to deal with family and work issues today, and only now have time to blog.

You might have seen my fanciful post, Fallowhaven, Part 1.? I wrote that because I thought I could reveal almost nothing of my visit to the US Treasury today.? As it is, I can talk about it, but not quote any officials there, nor say who was there from the Treasury.

My surprise was that only bloggers were there.? I expected reporters from major papers, but that was not the target audience.? The closest to mainstream media would have been Megan McArdle, who presumably said she would be there (there was a placard for her), but did not show.? The rest of us were independents:

As I write now, only John Jansen has commented on the meeting, and only briefly.? I have a lot to say about the meeting, but I can’t get it into one post.? I will spread it out over several posts, and try to explain the? views of the Treasury, are where they make sense, or not.

I appreciated being able to meet my fellow bloggers.? Putting faces to the names is special.? Would that I could bring all of the major investment/finance/economics bloggers together for a gathering.? There would be many disagreements, but it would sharpen us all.

More tomorrow –? I want to talk about the successes and failures of the current rescue, and how the Treasury views them.

Fannie + Goldman + US Treasury + Tax Credits = Complex Mess

Posted on 2 November 2009 by David Merkel

In a prior job, I spent a decent amount of time on Affordable Housing tax credits.? The idea was to reduce my life insurance company client’s taxable income to the point where they would be close to but not subject to the corporate alternative minimum tax.? Occasionally my work would take me on trips to industry conferences on Affordable Housing.? When I would go to these meetings, there would be a panoply of players there — Banks, Insurers, Utilities, perhaps a health insurer or two, and a few other odd tax-focused companies would attend.? In? addition to tax benefits, often banks could get some amount of Community Reinvestment Act [CRA] credits for financing affordable housing.

Oh, there were Fannie and Freddie, also.? They each represented 1/3rd of the investment base, leaving 1/3rd to everyone else.? So at the conferences, there would be a lot of them around.? Throw a rock, hit someone from a GSE.

The tax credits made a lot of sense for Fannie and Freddie back when they were profitable.? The credits/deductions minimized their taxes.? (They had numerous tax reduction schemes, but this was a big one.)? But now Fannie and Freddie are unprofitable, and it is less than certain as to when they will ever be profitable again. It would make a lot of sense for Fannie and Freddie to sell their Affordable Housing deals to some profitable entity that can use the reduction in taxes.

I have gone through a deal like this for a former client back in 2000.? It’s complex but not impossible to do.? The problem for Fannie Mae in this case is that they are now controlled by the US Treasury, and the prospective purchaser is Goldman Sachs.? Very bad optics.? The US Treasury does not want to look like it is favoring Goldman by approving the deal, and it is conflicted in its decision, because allowing the transaction will cause the Treasury to take in less taxes, though it might increase the value of Fannie.

This is what you get for having the Government take stakes in businesses that they regulate, rather than doing a simple liquidation of a very large failed enterprise.? (Stories from NYT, WSJ)? Both business and politics end up worse off when they are not kept as separate as possible, so that the ordinary conflicts between the two stay at the level of business pushing back over regulations and the government attempting to correct business abuses.

I don’t know where this one goes.? Goldman buying the tax credits should have been a moderately complex deal, but the complex interests of the US Treasury make the matter much more difficult.? My intuition says this won’t be the last time we see a conflicted situation like this in the near term.

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

Posted on 29 October 2009 by David Merkel

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

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

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

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

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

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

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

Pricing Issues

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

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

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

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

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

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

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

Derivative Issues

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

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

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

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

So what should I do in the Current Environment?

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

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

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

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