Category: Real Estate and Mortgages

Ten Points on Commercial Real Estate Lending

Ten Points on Commercial Real Estate Lending

Posted on by David Merkel

Before I begin this evening, I would like to give a big praise to Calculated Risk.? CR and his readers do a great job of highlighting stories in economics and real estate; I get a lot of data from that blog.? Some articles cited this evening have sprung from links on a CR post; my non-citing of CR is not a lack of respect for what CR does.

1)? We are at the beginning of seeing large commercial properties slide into default where equity sponsors have concluded that there is no use throwing good money after bad.? Recourse typically does not exist on commercial loans, aside from the smallest loans.

The last article is interesting to me, in that the ability of the US Postal Service to walk away from leases is greater than I previously thought.? It is also interesting to contemplate the economics of a collapsing postal service.? Will the postal service charge a differential rate to serve rural areas?? It would align revenues with costs, but politically I can’t imagine it is feasible given the US Senate.

2)? Of course, those defaults have large negative implications for large and small banks, as well as CMBS and Commercial REITs.

The difficulty for banks is different because they do not hold their Commercial Real Estate [CRE] loans at fair value.? So long as the loan is performing, it can be held at par.? The accounting does not require anticipating failure, no matter how likely on average that failure would be.

The banks have writeoffs to take which the CMBS market is already anticipating.? Absent a larger rally in CMBS, there will be significant writeoffs at the banks eventually.

For a broader look at the troubles the banks face, look at this article: Q2 2009 Bank Stress Test Results: The Zombie Dance Party Rocks On.

3)? When the price of properties are down 36% from the peak, it implies that most recent lending, 2006 and beyond, is under water, and 2005 is iffy.

4) $165 Billion in Commercial Loans are Due in ?09.? Banks will extend the loans, whereas CMBS special servicers will foreclose on some and extend others — the balance sheet of a CMB Securitization is not as flexible as that of a bank.

5) “What evil lurks in the heart of Commercial Real Estate loans?? The Shadow Supply knows.”? Whether it is condos in Manhattan, or apartments in the same, the problem of underemployed real estate weighs on the market, waiting for a moment to sell, and making the recovery that much longer.

6)? Goldman Sachs is the key component of the oligarchy that controls the US Government and sucks the blood of the American taxpayer for profit. ;)? Now they are planning to repeat their clever pillage of residential housing in the commercial sector.

Look, GS is clever, and they will make money they can.? I never supported any of the bailouts, but if the government sets the rules inadequately, and GS finds holes to profit off of, where does the blame go, but to the government who set loose rules.

7)? Goldman also sees hard times ahead for Commercial REITs, as I do.? Prices are too high relative to NAVs.? There will be significant loan defaults.? Shall I mention that Deutsche Bank agrees?

8) At such a time, as is normal, underwriting standards rise, and loan volumes decline.? It adds insult to injury, but banks have to protect their balance sheets.

9) This is also affecting pension plans, which are large investors in commercial real estate, both equity and mortgages.

10)? And looking at the architectural billings index, any turn in commercial real estate will not be soon.

I will be considerably more bullish when these problems are half solved.? Until then, I am still a bear on financials.

Animal Spririts Eating Green Shoots

Animal Spririts Eating Green Shoots

Posted on by David Merkel

I have never liked Keynes concept of “animal spirits.” (I reread that piece, and though it is long, I think it is worth another read.? I try not to say that about my own stuff too often.)? Businessmen are generally rational, and take opportunities when they see them.? As for those that invest in the stock market, perhaps the opposite is true — panicking near bottoms, and buying near tops.

Most businessmen are risk-averse.? They do what they can to avoid insolvency.? But debt capital is cheap during the boom phase of an economic cycle, and businessmen load up on it then.? During the bear phase of the cycle, overly indebted businessmen pull in their horns and try to survive.? At bottoms, deals are too attractive for businessmen with spare cash to ignore — businessmen are rational, and seek deals that offer profitability with reasonable probability.

Unlike this article, I’m not convinced that the news does that much to affect behavior.? Movements in asset values are self-reinforcing not because of crowd opinion, but because of the accumulation and decumulation of debt and other financial claims.? As businessmen get closer to insolvency, they trim activity.? As their financial constraints get looser, they are willing to consider more investments with free cash.

As for the current situation, I am less confident of the “green shoots.”? Yes, inventory decumulation has slowed down.? So has the increase in unemployment, maybe.? Yes, financing rates have fallen.? We still face a situation where China is force feeding loans for non-economic reasons into its economy, and where the financial sector of the US is still weak due to commercial real estate loans, bank loans to corporations, and weak financial entities propped up by the US government.? Even residential real estate is not done, because of the number of properties that are inverted, and the increase in unemployment, which I think is likely to get worse.

Applications: I think it is more likely than not that there will be another crisis with the banks, and another round of monetary rescue from the government.? I also think that many speculative names like AIG have overshot, and the advantage now rests with the shorts for a little while.? Real money selling is overcoming day traders.

Be cautious in this environment.? After I put out my nine-year equity management track record, the next project is to dig deeper in the risks in my own portfolio, and make some changes.

Nine Notes on Residential Real Estate

Nine Notes on Residential Real Estate

Posted on by David Merkel

I don’t really have one unified article type when I write here.? Sometimes I have a really strong conviction about something, and then it flows.? At other times, I gather data, do an analysis, and come up with a way of motivating it.? Then there are the Seven, Eight, Ten, Twelve, Fifteen, Twenty Points/Notes/Comments articles.? Tonight’s piece is one of those.

(An aside — the numbers stem from a comment from an editor of a Canadian business publication — he told me that certain numbers grab people’s attention more.? True?? Not sure.? I do know that one of my editors at RealMoney felt that some of my quirky titles lost readership.? Even today, my editor at SA freely revises my titles, sometimes making something an emphasis that I had not intended.? Whatever; she titles better than me.? What intrigues me is that other sites sometimes pick up her title, not mine, even when they link directly to my blog.)

I don’t do linkfests.? I don’t do them not because they are not valuable, but because others do them better then me, like Abnormal Returns.? So, I do something different.? As I troll the web each day, I tag articles for future comment.? I then wait until I have a critical mass of articles on a given topic, and then I publish one of the “XX Points” articles.? This enables a greater range of facets on a given issue.? I also allows me to give more of an integrated explanation of how I think it all fits together.? Now, the price is that some of the articles are dated.? I think they are fresh enough to highlight trends.

Enough explaining.? On to tonight’s topic, real estate and its effect on the real and financial economies.

1)? Principal forgiveness — it is what underwater homeowners want, and what they are unlikely to get.? Principal forgiveness means that a loss has to be taken by someone now.? Adjust the rate, adjust the term, adjust the amortization — it is all tinkering, even if it lowers the payment slightly, because the owner is still inverted on his mortgage.

Ideas like lowering the principal, but giving the bank a large chunk of the price appreciation at sale, or say 30 years out, would be cute, but still, the bank (or juniormost MBS certificate holder, who usually directs the servicer) would take a loss now.

So, I’m not surprised when I read articles like these:

Governments have power, but it is very difficult to fight the economics of the situation.? One further note, as is mentioned by a few of the above articles, is that the most profitable situation for the lenders/servicers, is that the property teeters on the edge of solvency, not only paying the mortgage slowly, but pays additional fees in the process.

2)? Will there be a second foreclosure wave?? Maybe.? First American CoreLogic argues that it will be the existing wave continuing.? I tend to agree with CoreLogic for the following reason: when you have enough of the mortgaged homes of the country underwater, it is difficult to slow the rate of foreclosure, because foreclosures happen to properties that underwater where one of the following occurs:

  • Death
  • Divorce
  • Unemployment
  • Disability
  • Disaster
  • Strategic default (buy a nicer home cheaper, and stop paying off this overpriced garbage)
  • Debt reset/recast

3)? The GSEs, despite the rally, are still in lousy shape.?? Fannie lost $14.8 Billion, and tapped the Treasury for liquidity.? Freddie earned less than $1 billion, but only because they revalued assets $5 billion higher.? Their regulator believes that they won’t be able to repay all aid that the US has granted them.? My verdict: the common of each company is an eventual zero.? Stay away.? Thrillseekers that like zero shorts, don’t do it; the odds are good for a zero, but the payoff is asymmetric.

4)? What percentage of homeowners are or will be upside-down or underwater?

I favor the estimates of First American CoreLogic.? First, they have great data.? Second, my view is that properties with greater than 90% LTVs are likely upside-down in a sale due to closing costs.? The inflection point in mortgagee behavior occurs between 90-100% LTVs, not at 100%+.

That’s why we are in such deep trouble.? With 32% of all mortgages inverted, there will be many more foreclosures, and prices should still head downward, even on the low end.

5)? But maybe things aren’t so bad, at least on the low end.

6)? All that said, the high end isn’t seeing much action, and prices continue to sag.? There aren’t many move-up buyers.

7)? What characterizes the underwater borrower?? Cash-out refinancing, and home equity loans.? The home as an ATM always relied on the “greater fool” theory implicitly — that there would always be a greater fool willing to buy out the home at a greater price than the new amount of leverage.? On the home equity loans — banks are doing all that they can to avoid recognizing losses.? With home equity loans, losses are usually total.? The only thing that surprises me here is that it has taken this long to get to realizing the losses.

8 ) So you want appraisers to be honest, but not yet?? Appraisers, auditors, etc. — third party evaluators are conflicted — he who pays the piper calls the tune, and no one is willing to have the buyer pay for the appraisal.? So now the appraisers try to be honest and business can’t get done?!? Those who hire appraisers, make up your minds; do you want a few short term deals, or do you want reliable long term business?

9)? On the dark side, many option ARMs will default before the payments recast.? That means the recast wave will be more gradual, but it won’t be any less troublesom in aggregate.

That’s all for this evening.? Absent something else pressing, I will write about commercial real estate on Monday night.

Ten Unsolved Problems in the Global Economy

Ten Unsolved Problems in the Global Economy

Posted on by David Merkel

There are many celebrating the recovery as if it were already here.? This is a brief post to outline my main remaining concerns for recovery of the global economy.

1)? China is overstimulating its economy, and forcing its banks to make bad loans.? This pushes up commodity prices, and makes it look like China is growing, but little of the investments made are truly needed by the rest of the global economy.

2)? Western European banks have lent too much to Eastern European nations in Euros.? The Eastern Europeans can’t afford it, and widespread defaults are a possibility.

3)? The average maturity of bonds held by foreign investors in US Treasuries is falling.? Runs on currencies happen when countries can no longer roll over their debts easily, which is facilitated by having a lot of debt to refinance at once.

4)? On a mark-to-market basis, market values for commercial real estate have fallen dramatically.? Neither REIT stocks nor carrying values for loans on the books of banks reflect this yet.? Many banks are insolvent at market-clearing prices for commercial real estate.

5)? We still have yet to feel the effects from pay-option ARMs resetting and recasting.? Most of the pain in residential housing is done, but on the high end, there is still more pain to come, and the pay-option ARMs will reinforce that.

6)? The rally in corporate debt and loans was too early and fast.? Conditions are not back to normal for creditworthiness.? There should be a pullback in corporate credit.

7)? We had global overbuilding is cyclical sectors 2002-2007.? We overshot the demand for large boats as an example.? We overdeveloped energy supplies (that will be short-lived), metals, and other commodities.? It will take a while to grow into the extra capacity.

8 )? The US consumer is still over-levered.? It will be a while before he can resume his profligate ways, assuming a new frugality does not overcome the US.? (Not likely by historical standards.)

9)? The Federal Reserve will have a hard time removing their nonstandard policy accommodation.

10)? We still have the pensions/retiree healthcare crisis in front of us globally.

That’s all.? To my readers, if you can think of large unsolved problems in the global economy, forward them on to me here in the comments.? If I agree, I will incorporate them in future articles.

Twenty Notes on Current Risks in the Markets

Twenty Notes on Current Risks in the Markets

Posted on by David Merkel

1)? A modest proposal: The government announces that they will refinance all debtors.? Not only that, but they will buy out existing debt at par, and allow people and firms to finance all obligations at the same rate that the government does for whatever term is necessary to assure profitability or the ability to make all payments.? The US Treasury/Fed will become “The Bank.”? No need for the lesser institutions, The Bank will eat them up and dissolve their losses, taking over and refinancing their obligations.? Hey, if we want a single-payer plan in healthcare, why not in finance?? Being healthy is no good if you can’t make your payments. 😉

This scenario extends the US Government’s behavior to its logical absurd.? The US Government would never be large enough to achieve this, but what they can’t do on the whole, they do in part for political favorites.? They should never have bailed out anyone, because of the favoritism/unfairness of it.? Better to have a crash and rebuild on firmer ground, than to muddle through in a Japan-style malaise.? That is where we are heading at present.? (That’s the optimistic scenario.)

2)? I have exited junk bonds, and even low investment-grade corporates.? Consider what Loomis Sayles is doing with junk.? Yield = Poison, to me right now, which echoes a very early post in this blog.? There are times when every avenue in bonds is overpriced — that is not quite now, because of senior CMBS, carefully chosen.? All the same, it makes me bearish on the US Dollar, and bullish on foreign bonds.? This is a time for capital preservation.

3) High real yields are driving the sales of US Government debt.? Is that a positive or a negative?? I can’t tell, but there is always a tradeoff for indebted governments, because they can usually reduce interest expense by financing short.? When their average debt maturity gets too short, they have a crisis rolling over the debt.? We are not there yet, but we are proceeding on that road.

4)? I have a bias in favor of buyside analysts, after all I was one.? But this research makes me question my bias.? Perhaps sellside analysts are less constrained than buyside analysts?

5) Debtor-in-possession lending is diminishing, reflecting the likelihood of loss.? In some cases that may mean more insolvencies go into liquidation.? Interesting to be seeing this in the midst of a junk bond rally.

6)? Short-selling isn’t dead yet.? Would that they would take my view that a “hard locate” is needed; one can’t short unless there is a hard commitment of shares to borrow.

7) Should we let managers compete free of the constraints imposed by manager consultants?? You bet, it would demonstrate the ability to add value clearly.? I face that? problem myself, in that I limit myself to anything traded on US equity exchanges.? As such, I have beaten most US equity managers (and the indexes) over the last nine years, but no one wants to consider me because I don’t fit the paradigms of most manager consultants.

8 )? Is there a fallacy in the “fallacy of composition?”? I think so.? Yes, if everyone does the same thing same time, the system will be unstable.? But if society adopts a new baseline for saving/spending, the system will adjust after a number of years, and there will be a new normal to work from.? That new normal might be higher savings and investment, in this case, leading to a better place eventually than the old normal.

9)? Anyway, as I have said before, stability of a capitalist system is not normal.? Instability is normal, and is one of the beauties of a capitalist system, because it adjusts to conditions better than anything else.

10)? Corporate treasurers are increasingly engaged in a negative arbitrage where they borrow long and hold cash so that the company will be secure.? How will this work out?? Will this turn into buybacks when things are safe?? Or will it just be a drag on earnings, waiting for an eventual debt buyback?

11)? Does debt doom the recovery?? Maybe.? I depends on where the debt is held, and how is affects consumption spending.? Personally, I think that consumers and small businesses are under a lot of stress now, and it won’t lift easily.

12)? So things are looking better with junk bond defaults.? Perhaps it was an overestimate, or that it would not all come in 2009.? We will see.

13)? Junk bonds do well; junk stocks do better.? In a junk rally, everything flies.? All the more to hope that this isn’t a bear market rally; if so, the correction will be vicious.

14)? Eddy, pal.? Guys who criticize data-mining are near and dear to me.? Now the paper in question has a funny definition of exact.? I don’t know how to describe it, except that it seems to mean progressively more accurate.? I didn’t think the paper was serious at first, but given the relaxed meaning of “exact,” it data-mines for demographic influences on the stock market.? Hint: if you have lots of friends when you are nine, ask for stock as a birthday present.

15)? I’m increaisngly skeptical about China, and this doesn’t help.? I sense that the global recession is intesifying, amid the current positive signs in the US.

16)? Do firms with female board members do worse than companies with only male board members?? No, but they get lower valuations, according to this study.? I started a study on female CEOs in the US, and I got the same result, but it is imcomplete at present — perhaps new data will invalidate my earlier findings.? Why does this happen, if true?? Men seem to be better at managing single investments, while women are better at managing portfolios.

17)? Do we have more pain coming from the banks?? I think so.? Residential real estate problems have not reconciled, and Commercial real estate problems are just beginning.? If we mark loans to market, many large banks are insolvent, and this is not an issue that will easily be healed with time.

18)? As a nation, I like Japan, and would like to visit it someday.? What I don’t want is for the US to imitate its economic stagnation, but maybe that could be the best of all possible worlds for the US.

19)? I am de-risking my equity and bond portfolios at present.? I do not think that the present market levels fairly reflect the risks involved.? I am reducing risk in bonds, and looking for strong sustainable equity yields in equities.

20)? Echoing point 17, we face real problems on bank balance sheets from commercial real estate lending.? There is more pain to come.? The time to de-risk is now.

Ten Notes on the Current Markets

Ten Notes on the Current Markets

Posted on by David Merkel

1)? Great minds think alike.? Fools seldom differ.? Remember my post on AIG’s subsidiaries?? Well, now in the New York Times, much of the same.

2)? Fed Independence! (spit, spit)? Come on, Bernanke, you argue against the Fed being audited because it might compromise Fed independence, and yet you regularly have lunch with leaders of the Executive branch.? You compromise the independence of the Fed more than any audit could by acting cooperatively with the Treasury.? If you were really independent, you would do what is best for your explicit mandate — fighting inflation and unemployment, rather than tinkering with non-bank credit markets, and rescuing companies.

3) Manus manum lavat. One hand washes the other.? Banks that have been bailed out are buying more Treasuries.? Some of that is lower spreads — lack of lending opportunities.? The rest is implicitly paying back the government.

4) The government may be increasing its sales of TIPS.?? I’ve been less bullish on TIPS of late, and this does not encourage me to change.? Further, farmland values may be falling.? Given growth in demand for food in the world, that should not be so, but maybe that is wrong.? Maybe depressionary conditions are that strong.? I also offer up the piece from UBS, via FT Alphaville, that suggests that deflation is more likely to minimize the total cost of debt to the US government.

All of this depends on the current length of US government debt.? If all of it were nominal (not inflation-indexed) 30-year debt, the US Government would gladly inflate.? Their financing is locked in.? But if it were all short-dated, the US government would have to manage the powder keg.? After all that was Mexico in 1994 — the government was financed in the short-term interest rate markets.

Thus, governments that have not been prudent, and have financed short-term can face a run on the currency.? The US government finances to an average of 4-5 years, so it is not apparent whether they could face a run or not.

The more TIPS that are issued as a fraction of the total debt, the less valuable the inflation guarantee becomes.? If China, or any other creditor thinks that TIPS are the solution to loss of value on US debt claims, let them realize this:

  • Yes, if the US inflates its currency, there will be protection.
  • No, if the US defaults on its obligations, you won’t be materially better off.
  • If the US decided to selectively default on foreigners, paying them back in a different US dollar than the domestic one, TIPS won’t help you much.

5)? Bye, bye, Fannie and Freddie?? Sending them into runoff was my proposed solution when the crisis hit.? Now that the reality of the humongous losses from mortgage lending and guarantees has become apparent, the government faces reality, and may wind them down.? As it is now, we know that F&F are unlikely to pay back their aid from the government in full.? In my opinion, better that the government would have let the companies go into Chapter 11 without interference. Instead, the taxpayers bail out much of the capital structure that did not deserve a bailout.

6)? Should Ben Bernanke be reappointed as Fed Chairman?? It doesn’t matter.? There is no significant variation in ideas among likely candidates that would make a significant difference in how the Fed behaves.? I don’t think Ben should be reappointed, but I don’t see any worthy replacements.? Ron Paul is out of the question, sadly.

These articles argue that Ben Bernanke should not be reappointed, and they make some good arguments:

All that said, what is the option?? Is there someone stunningly good standing in the wings, with a materially different view of monetary policy from Bernanke, who would be acceptable to the activist Obama administration?? I don’t see one available, so perhaps the devil you know is better than the devil you don’t.

7)? The corporate bond market has been on fire of late, with higher prices, tightening spreads and greater issuance.? We had several episodes like that in 2002, before facing reversals.? The first time is not the charm, and I would expect more of a backup in prices because corporate loss rates have not peaked yet.

8)? Let me just point out that “cash for clunkers” is another version of the “broken window fallacy.”

9)? As for AIG, I don’t expect the government to be paid back in full.? Sales of AIG subsidiaries have gone at cheap prices, and only the simple subsidiaries have been able to be sold.? Investment banks will make money on the deal, though.

10)? Even if GDP shrinkage is slowing due to government spending, that still means that the private sector is weak.? GDP ex-government growth will be a statistic to watch in the future.

Book Review: Mr. Market Miscalculates

Book Review: Mr. Market Miscalculates

Posted on by David Merkel

Since the first time I read him, I have been a fan of James Grant.? He helped to sharpen my focus on how money and credit work in the long run, and how they affect the economy as a whole.? Reading one of his early books, Minding Mr. Market: Ten Years on Wall Street With Grant’s Interest Rate Observer, I gained perspective on the increasingly complex financial world that we were moving into.

But not all have shared the opinion of Mr. Grant’s wisdom.? When I worked for Provident Mutual, the Chief Portfolio Manager (at that time new to me, but eventually a dear colleague) said to me, “feel free to borrow any of the publications we receive.”? For a guy who likes to read, and learn about investments, I was jazzed. But, when I came back and asked whether we subscribed to Grant’s Interest Rate Observer, I got the look that said, “You poor fool; what next, conspiracy theories?” while she said, “Uh, noooo. We don’t have any interest in that.”

Now the next two firms I worked for did subscribe, and I enjoyed reading it from 1998 to 2007. But now the question: why buy a book that repeats articles written over the last fifteen years?

I once reviewed the book Just What I Said: Bloomberg Economics Columnist Takes on Bonds, Banks, Budgets, and Bubbles, by another acquaintance of mine, the equally bright (compared to James Grant) Caroline Baum.? This book followed the same format, reprinting the best of old columns, with modest commentary.? In my review, I cited Grant’s earlier book as a comparison, Minding Mr. Market.

As an investor, why read books that will not give an immediate idea of where to invest now?? Isn’t that a waste of time? That depends.? Are we looking to become discoverers of investment/economic ideas, or recipients of those ideas?? Books like those of Grant and Baum will help you learn to think, which is more valuable than a hot tip.

Here are topics that the book will help one to understand:

  • How does monetary policy affect the financial economy?
  • Why throwing liquidity at every financial crisis eventually creates a bigger crisis.
  • Why do value (and other) investors need to be extra careful when investing in leveraged firms?
  • What is risk?? Variation of total return or likelihood of loss and its severity?
  • Why financial systems eventually fail at compounding returns at rates of growth significantly above the growth rate of GDP.
  • Why great technologies may make lousy investments.
  • Why does neoclassical economics fail us when trying to understand the financial economy?
  • How does one recognize a speculative mania?
  • And more…

The largest criticism that can be leveled at James Grant was that he saw that he would happen in this crisis far sooner than most others.? Being too early means you eventually get disregarded.? The error that the “earlies” made, and I knew quite a few of them, was not recognizing how much debt could be crammed into the financial economy in order to juice returns on fixed income assets with yields lower than likely default losses.? That’s a mouthful, but the financial economy had not enough good loans to make relative to the amount of loans needed to maintain the earnings growth expectations of the shareholders of financial companies. Thus, the credit bubble, facilitated by the Fed and the banking regulators.? You can read all about it in its many facets in James Grant’s book.

You can buy the book here: Mr. Market Miscalculates: The Bubble Years and Beyond.

Who would benefit from the book?

  • Those that have assumed that neoclassical economics adequately explains the way our economy works.
  • Those that want to understand how monetary policy really works, or doesn’t.
  • Those that want to learn about equity or fixed income value investing from a quirky but accurate viewpoint.
  • Those that want to be entertained by intelligent commentary that proved right in the past.

As with other James Grant books, this does not so much deal with current problems, as much as educate us on how to view the problems that face us, through the prism of how past problems developed.

Full disclosure: If you buy anything through the links to Amazon at my blog, I get a small commission,? but your costs don’t go up.?? Also, thanks to Axios Press for the free review copy.? I read the whole thing, and enjoyed it all.

Seven Notes on the Current Market Mess

Seven Notes on the Current Market Mess

Posted on by David Merkel

1)? Avoid short-cycle data.? When writing at RealMoney, I encouraged people to ignore short-term media, and trust those that gave long-term advice.? After all, it is better to learn how to invest rather than get a few hot stock picks.

In general, I read writers in proportion to their long-term perspective.? I don’t have a TV.? I rarely listen to radio, but when I do listen to financial radio, I usually feel sick.

I do read a lot, and learn from longer-cycle commentary.? There is less of that around in this short-term environment.

When I hear of carping from the mainstream media regarding blogging, I shake my head.? Why?

  • Most bloggers are not anonymous, like me.
  • Many of us are experts in our? specialty areas.
  • Having been practical investors, we know far more about the markets than almost all journalists, who generally don’t invest, or, are passive investors.

Don’t get me wrong, I see a partnership between bloggers and journalists, producing a better product together.? They are better writers, and we need to get technical messages out in non-technical terms.

We need more long-term thinking in the markets.? The print media is better at that than television or radio — bloggers can go either way.? For example, I write pieces that have permanent validity, and others that just react to the crisis “du jour.” Investors, if you are focusing on the current news flow, I will tell you that you are losing, becuase you are behind the news flow.? It is better to consider longer-term trends, and use those to shape decisions.? There are too many trying to arb the short run.? The short run is crowded, very crowded.

So look to value investing, and lengthen your holding period.? Don’t trade so much, and let Ben Graham’s weighing machine work for you, ignoring the votes that go on day-to-day.

2)? Mark-to-Market accounting could not be suppressed for long in an are where asset and liability values are more volatile.? Give FASB some credit — they are bringing the issue back.? My view is when financial statement entities are as volatile as equities, they should be valued as equities in the accounting.

3)? Very, very, weird.? I cannot think of a man that I am more likely to disagree with than Barney Frank.? But I agree with the direction of his proposal on CDS.? My view is this: hedging is legitimate, and speculation is valid to the degree that it facilitates hedging.? Thus, hedgers can initiate transactions, wtih speculators able to bid to cover the hedge.? What is not legitimate is speculators trading with speculators — we have a word for that — gambling, and that should be prohibited in the US.? Every legitimate derivative trade has a hedger leading the transaction.

4)? I should have put this higher in my piece, but this post by Brad Setser illustrates a point that I have made before.? It is not only the level of debt that matters, but how quickly the debt reprices.? Financing with short-term dbet is almost always more risky than financing with short-term debt.

Over the last six years, I have called attention to the way that the US government has been shortening the maturity structure of its debt.? The shorter the maturity structure, the more likely a currency panic.

5)? Look, I can’t name names here for business reasons, but it is foolish to take more risk in defined benefit pension plans now in order to try to make up? the shortfall of liabilities over assets.? This is a time for playing it safe, and looking for options that will do well as asset values deflate.

6)? Junk bonds have rallied to a high degree; at this point I say, underweight them — the default losses are coming, and the yields on the indexes don’t reflect that.

7) Peak Finance — cute term, one reflecting a bubble in lending/investing.? Simon Johnson distinguishes between three types of bubbles — I’m less certain there.? Also, I would call his third type of bubble a “cultural bubble,” rather than a “political bubble,” because the really big bubbles involve all aspects of society, not just the political process.? It can work both ways — the broader culture can draw the political process into the bubble, or vice-versa.

The political process can set up the contours for the bubble.? The many ways that the US Government force-fed residential housing into the US economy — The GSEs, the mortgage interest deduction, loose regulation of banks, loose monetary policy, etc., created conditions for the wider bubble — subprime, Alt-A, pay-option ARMs, investor activity, flipping, overbuilding, etc.? In the process, the the federal government becomes co-dependent on the tax revenues provided.

I still stand by the idea that bubbles are predominantly phenomena of financing.? Without debt, it is hard to get a big bubble going.? Without cheap short-term financing, it is difficult to get a stupendous boom/bust, such as we are having.? That’s just the worry behind my point 4 above.? The US as a nation may be “Too Big To Fail,” to the rest of the world, but if the composition of external financing for the US is becoming more-and-more short-term, that may be a sign that the endgame is coming.

And, on that bright note, enjoy this busy week in the markets.?? Last week was a tough one for me personally; let’s see if this week goes better.

Seven Miscellaneous Notes

Seven Miscellaneous Notes

Posted on by David Merkel

1) I am proud of my two middle children, Peter and Jonathan (#4 and 5 out of my 8 ) who have started an “odd jobs” business in this environment, doing yard work, pet sitting, etc.? As other neighbors in our area have seen their good work, all of a sudden, they are gaining a lot of new business.? They are both workers, and hard work pays off.

2)? I appreciate this article in Barron’s where the thoughts of Doug Kass are featured.? I have very high respect for Mr. Kass, because he marries two qualities: he has a keen sense of market timing, and yet a sense of relative value also.? I agree with him the intermediate-term returns should be blah, because it is more difficult to lever up at present.

3)? The states are in more trouble than the US Government, because they have to run balanced budgets, and can’t print money.? California can send out IOUs, which aren’t a currency (yet).? Philadelphia can stiff vendors for now, but what of the future?? California may come to some sort of short -term agreement that postpones real troubles until next year.? Same for Philadelphia.? And, true for many municipalities that are finding cash to be short, because capital gains, sales, and real estate taxes are flagging.

Unlike Gregor (bright man that he is), I do not think that the US Government will bail out California.? Why?

  • Every state will ask for a bailout.
  • States have no bankruptcy code, so those pressing them for money have few options.? (That said, say goodbye to the municipal bond market.)
  • The US Government has enough problems as it is — if you want help, take a number and get in line.

As it is California is a basket case, with dysfunctional politics from the referendum process.? Let California get its own house in order, and reform its government, including the initiiative process.? If it still has problems once it is in as good a shape as other states, fine, let it petition the Federal Government.? It won’t get there anytime soon.

4) Regarding the Fed, I’m not the only one suggesting that there be more regulation.? You can listen to Allan Meltzer, or William Greider.?? I give Dr. Meltzer more weight here, but one thing is clear — the Fed is an undemocratic institution with few avenues for accountability.

5)? Will we have robust growth soon?? Former Federal Reserve Governor Laurence Meyer, thinks we won’t see full employment until 2015.? Truth is, with aging demographics, we may not see full employment for a longer time, as baby boomers that can’t afford to retire continue to work.

6)? Aside from regulatory sloppiness, why does Goldman Sachs get a free pass on their VAR calculation (and also here)?? What is VAR for, except to constrain risk?? No one should get exemptions.

7)? My view is that derivative and cash positions should be treated the same in a regulatory sense.? But derivatives were unregulated compared to cash positions.? Investment decisions with the same economic result should be equally regulated.? Much as I am not crazy about government regualtion, with regulated institutions, derivatives should be decomposed into their cash equivalents, and regulated the same way.

China, the Wild Card — Seven Notes

China, the Wild Card — Seven Notes

Posted on by David Merkel

1) Is China really growing or not?? Wait, is that a stupid question, or what?? Of course China is growing, and pulling the global economy out of the ditch as well.? Read this report from Time.? Uh, maybe not.? What if it is all a lending bubble?

What seems to be happening is that the powers that be in China are encouraging banks to lend aggressively.? Firms in China aren’t finding a lot of opportunities in export markets, so they build up inventories “that they know they will need eventually.”? Financial counterparties and individuals speculate on financial assets like real estate and stocks as they find cheap financing available.? (Example)

That’s my view of China at present.? I think those that are arguing for a resurgence in China at present are missing the similarities to the late 1980s with Japan where large amounts of productive capacity were built up with no markets large enough to sell the incremental production to.

I could be wrong, but this is leading me to lighten up on cyclicals.? Maybe some utilities…

2) With all of the noise of those looking for a replacement for the US Dollar as the world’s global reserve currency, I have two questions:

  • Are the surplus nations looking to reduce their surpluses, and thus suck in fewer foreign assets?
  • Is there a new deficit nation that is politically stable, militarily strong, etc., that is capable of running current account deficits for some time?? Surplus nations need a safe place to invest.

3) In the meantime, the US tries to assure trading partners that their purchasing power is safe.? We remember the laughable assertion of Tim Geithner trying to assure the Chinese that they did not have to worry about devaluation of the dollar.? Well, now he is saying the same things to the Saudis.? At least with the Saudis, we are doing their bidding in the Middle East, by bottling up Iran,? so perhaps he does not have to worry so much there.

4) Back to point 2.? Are the current account surplus nations willing to consume from the rest of the world and flip around to deficit conditions, letting their currencies appreciate, and killing their politically powerful export industries?? That’s what it will take to replace the US Dollar.? I don’t care who is arguing against the US as a reserve currency.? The reserve currency must by nature offer high quality securities on net to the surplus nations to invest in.? It must run current account deficits on average.

That’s why China can’t be the world’s reserve currency.? China isn’t willing to stop export promotion, or encourage domestic consumption.? India and Russia may kvetch as much as they like, but both are in the same boat as China, but to a lesser degree.

Oddly, the best policy for most of the complainers would be to allow/encourage imports, and stop export promotion.? Freed from these distortions, the global economy would start to normalize.? Cross-border capital flows would decline because exports would not need to be balanced out.

5) The US has no interest in selling Yuan-denominated debt yet.? China eagerly buys Treasuries today.

6)? Does the one child policy fuel excess savings in China?? Maybe, but I doubt it is a big factor.? Dowries are unlikely to eclipse the actions of the central bank and government.

7) A final note from Andy Xie — there is a lot of momentum in China, but little underlying change in the fundamentals.

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My summary is this:? To the degree that the recent upturn is driven by expectations that China pull the global economy out of the ditch, the move is mistaken.? As my friend Cody Willard asked me three years ago, what happens if Chinese growth proves to be a sham?? Can you trust their statistics?

My answer was that I wasn’t certain, but that things would get more clear if that were the case — and I think things are clearer now.? My policy implication is to move assets out of export-driven sectors, and those driven by China demand.? Utilities, here I come. 😉

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