Real Estate and Mortgages – Page 27

Some Practical Thoughts on Asset Allocation

Posted on 12 July 2009 by David Merkel

When I think about asset allocation, I typically begin with my model that chooses between BBB corporate bonds and common stocks.? The model still favors corporate bonds.? After that, I look at the bond market, and ask myself where I think risks have more than adequate compensation.? I look at the following factors:

Duration (Average Maturity is similar, sort of) — do we get fair compensation for lending long?
Convexity — does the bond benefit or get hurt by interest rate volatility?
Credit — are we getting decent compensation for credit risk?
Structure — Structured notes always trade cheap to rating, but how cheap?
Collateral/Sectors — Are there any collateral classes or sectors that are trading cheap to their fundamentals?
Illiquidity — are illiquid issues trading stupidly cheap?
Taxes — How are munis trading relative to tax rates and creditworthiness?
Inflation — is the CPI expected to accelerate?
Foreign currency — if nothing looks good on the above (or few things look good), perhaps it is time to buy non-dollar denominated notes.? My view is buy foreign currencies when nothing else looks good, because foreigners will do the same.

At present, I am not crazy about corporate credit relative to other bonds.? I would move up in quality.

We are getting decent compensation for duration risks, so I would buy some amount of long Treasuries.? I would also hold some cash, running a barbell.

On convexity, I would be market weight in conforming mortgages.? If I had an edge in analyzing non-conforming mortgages, I would buy highly rated tranches of seasoned deals (2005 and before).

I would do a lot of analysis, and buy seasoned CMBS (2005 and before) — there are real risks, but the seniors should not get killed.

Munis offer promise for taxable accounts — the difficulty is doing the credit analysis on long bonds.

On inflation — I am not a fan of TIPS right now.? I would rather buy foreign bonds.? The actions of foreign nations lend themselves to dollar depreciation.

So, where would I go with a portfolio that has an intermediate horizon, say, 5-10 years out?

30% global equities — half US, half foreign (emphasize value, but not financials)
15% long Treasuries
15% residential mortgages — seniors, conforming
10% CMBS seniors
15% cash
15% foreign bonds

Yeah, I know this seems conservative, but I am not a believer in the current rally in stocks or corporate debt.? This is a time to preserve capital, not hunt for yield.

Toward a New Concept of Asset Allocation

Posted on 10 July 2009 by David Merkel

To my readers: thanks for your responses to yesterday’s article.? I will do a follow up piece soon.? If you have more comments please make them — they will help me with the piece.? Main new concepts coming — need for a deliverable, speculators can’t trade with speculators, only hedgers.

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Longtime readers know that I am not a fan of modern portfolio theory.? It is a failure for many reasons:

It assumes there is one type of risk, the occurence of which is random.
It assumes that this risk can be approximated by volatility (variance of returns), rather than probability of loss, and the likely severity thereof.
Mean return estimates, volatility estimates, and correlation coefficient estimates aren’t stable.
In crises, correlations head to 1 or -1.? Assets divide into safe and “not safe.”
Problem: some assets always fall into the “not safe” bucket, but what falls into the safe bucket can vary.? Long Treasuries and commodities could be examples of assets that vary during a crisis, depending on the type of crisis.
It does not recognize multiple time horizons easily.? Bonds held to maturity have a different risk profile than a constantly rebalanced portfolio.
Risk is the same for all people, and their decision-making time horizons are the same as well.
And more…

I’m still playing around with the elements of what would make up a new asset allocation model, but a new model has to disaggregate risk into risks, and ask some basic questions:

Where am I getting paid to take risk?
Where am I getting paid to avoid risk?
What aspects of the financial landscape offer the potential for a change in behavior, even if it might take a while to get there?? What major imbalances exist?? Where are dumb people making money?
Where options are available, how is implied volatility relative to long-term averages?
What asset classes have momentum to their total returns?

One good example of an approach like this is Jeremy Grantham at GMO.? Asset allocation begins by measuring likely cash flow yields on asset classes, together with the likelihood of obtaining those estimates.? With domestic bonds, the estimates are relatively easy.? Look at the current yield, with a haircut for defaults and optionality.? Still there is room to add value in bonds, looking at what sectors are cheap.

Are corporate spreads narrow or wide?
How are residential mortgage bonds priced relative to agency bonds, after adjusting for negative optionality?
How steep is the yield curve, and where is Fed policy?
What is the speculative feel of the market now?? Bold? Scared? Normal?
Related, how are illiquid issues doing?? Are they permafrost, or are molasses not in January?
If every risk factor in domestic bonds looks lousy, it is time to make a larger allocation to foreign bonds.
Cash is underrated, and it is safe.

Understanding bonds is an aid to understanding the rest of the market.? The risk factors in play in the bond market are more transparent than elsewhere, but the rest of the markets eventually adjust to them.

With stocks and commodities, the answer is tougher — we have to estimate future demand and supply for commodities.? Tough.? With stocks, we need to estimate future earnings, and apply a P/E multiple that is consistent with the future yield on BBB corporate bonds.? There is some degree of mean-reversion that can help our estimates, but I would not rely on that too heavily.

There is one more aspect to layer in here: illiquidity of equity investments.? With limited partnerships of any sort, whether they are hedge funds, venture capital, private equity, etc., one has to analyze a few factors:

Where is the sector in its speculative cycle?? Where are secondary interests being sold?
How much capacity do you have for such investments?? How much of your liability structure is near-permanent?? Is the same true of peer institutions?
Is the public equity market overvalued or undervalued?? Public and private tend to track each other.

Beyond that we get to the structure and goals of the entity neding the assets allocated.? Time horizon, skittishness, and understanding levels are key for making a reasonable allocation.

This is just my initial brain dump.? It was spurred by this article in the WSJ, on how asset allocation had failed.? Add in the article on immediate annuities, which are a great aid in personal retirement planning.? For those that think that immediate annuities reduce the inheritance to the children, I would simply say that it is longevity insurance.? If the annuitant lives a long time, he might run out of assets, and might rely on his children for help.? The immediate annuity would be there to kick in something.

Why did asset allocation fail in 2008?? All risk assets failed.? Stocks, corporate bonds, venture capital, private equity, CMBS, RMBS, ABS… nothing held up.? There were just varying degress of loss.? Oh, add in Real Estate, and REITs.? Destroyed.? Destroyed…

When the system as a whole has too much leverage, all risky asset classes get affected.? That’s what happened in 2008, as speculators got their heads handed to them, including many who did not realize that they were speculators.

Sorry, Doctor Shiller, not Everything can be Hedged

Posted on 9 July 20099 July 2009 by David Merkel

Many people don’t think through questions systematically.? That includes very bright people like Dr. Robert Shiller, who said in this article in Fortune, “We should be able to hedge everything from the rising costs of health care and education to national income risk and oil crises.”

Ugh.? And this from an esteemed professor at a significant university?? And one with which I have sometimes agreed?

I’ve written about this before in some of my market structure articles, where I tried to dig into the difference between natural, hedging, and gambling exposures.? I’ll use an ordinary example to illustrate this: the bankruptcy of IBM.

I use IBM as an example because it is so unlikely to go under.? But who would be directly affected if IBM went under?

Stockholders, both preferred and common
Bondholders
Banks that have loaned money
Trade creditors
Workers

Let’s talk about the bondholders.? They could buy protection via credit default swaps [CDS] to hedge their potential losses.? In order for that to happen a new class of risk-takers has to emerge that wants to take IBM credit risk, that don’t own the bonds already.? It’s not always true, depending on the specualtive nature of the market (and synthetic CDO activity), but one would suspect that those that want to take on the risk of a default of IBM would only do it at a concession to current market bond pricing, or else they would buy the bonds and pay fixed, receive floating on a swap.

But often the amount of CDS created exceeds the amount of debt covered.? I’m not suggesting that everyone owning bonds has hedged, either, but when the amount of CDS exceeds outstanding bonds, that means there is gambling going on, because it means that there are market players that are not long the bonds that are taking the side of the trade where they receive income in the short-run if the company survives, and pay if the company fails.

I call this a gambling market, because there are parties where the transaction takes place where neither has a relationship to the underlying assets.? There is no risk transfer, but only a bet.? My view is such gambling should be illegal, but I am in a minority on such points.

Now think about another asset: my house.? Aside from being somewhat dumpy, beaten-up by my eight kids, the house has a virtue — I live in it free and clear, with no debts to anyone, so long as I pay my property taxes.? So what is there to hedge here?? I’m not sure, maybe future property taxes?

Aside from the county, and my insurance company, I’m not sure who has a real interest in my house.? If I knew that there were many people betting on the value of my house, I might become concerned.? What actions might people take against me in bad or good times?

But maybe no one would have interest in my house.? It’s just one house, after all.? Who would have a concentrated enough interest in it to wager on it?

Now, some would say, we don’t have an interest in your house specifically, but we do have an interest in houses on average? in your area.? That’s fine, but there is no one with a natural exposure to all of the houses in my area, aside from the county itself.

This is why I think that most real estate derivatives involve gambling.? There is no significant natural exposure hedged.? It is only a betting market.

And such it would be for most real assets.? Few would want to create markets where the owner know more than they do, or, where there a few options for gaining control if things go bad.

At the end of the day, all of the assets of our world are owned 100%.? Everything else is a side-bet.? Personally, I would argue that the side bets should be prosecuted and eliminated, which would bring greater stability to the economic system.? No tail chasing the dog.? Let derivative transactions go on where here is real hedging taking place; away from that, such transactions are gambling, and should be illegal.

To Dr. Shiller, many markets are thin.? The concept that everything can be hedged assumes deep markets everywhere, which is not the case.? Time for you to step outside the university bubble and taste the real world.? It’s not as hedgeable as you might imagine.

Seven Notes, Primarily on the Financial Sector

Posted on 7 July 2009 by David Merkel

1)? I have been arguing for a while that commercial mortgages are an unresolved issue with most banks, who still hold their loans at par.? Contrast that with the pricing on Commercial Mortgage Backed Securities [CMBS] or REIT stock prices, which show commercial real estate pricing in the dumps.? Look at these articles: (one, two, three).? How many commercial properties are inverted?? Who knows, but when properties sell for significantly less than replacement costs, it is not a good scene.

Regarding CMBS, as the loss estimates ratchet up, the credit ratings ratchet down.? Securities sold in 2005 and after will suffer, as well as marginal CMBS from earlier vintages.

2)? Outside of conforming mortgages, losses in residential mortgages are considerable.? Consider how S&P is raising its loss assumptions on alt-A loans.? Or consider how being underwater, or close to underwater affects the willingness of people to default.

3)? That last article helps point out a truth that is neglected.? Defaults predominantly happen when borrowers are underwater, or nearly so.? Changing? the mortgage interest rate is cheaper in the short run, but does not cure? the situation as well as reducing the principal (forgiving part of the loan).? Why less loan forgiveness?? Two reasons: Accounting would require a bigger short-term loss, and the government prefers subidizing a piece at a time, so it prefers smaller annual subsidies, rather than a once-and-for-all cure.? They would rather pay over time, and overcommit future budgets, than pay the full freight now, even if it is cheaper in the long run to do so.

4)? But many defaults are strategic.? The owners know which side their bread is buttered on, and they default when their properties are too far underwater (one, two).

5)? The states can’t print money like the Federal government can.? Excluding California, of course, which has its new currency, the IOU.? (We are still waiting for a secondary market to arise.? Perhaps some enterprising bank? will offer to buy IOUs at a discount.? As it is, banks either honor in full or refuse to honor the IOUs.)? The states represent the current troubles better than the Federal government does, because they must meet the challenge through expense cuts and tax increases, both of which are painful.

All that said, next year may be more painful, because of greater unemployment, and lower taxes from real property.

6)? Beware junior debt.? I know that at other times I have used trust preferred securities offensively to make money as the credit cycle turned in 2002, but that is a very hard game to play, and we aren’t there yet for this cycle.

7) I’ve had many people writing me for investment advice, and in the near term, I will try to write a piece that summarizes my views of what to do now.? In broad, I lean toward reducing risk exposure, and sitting on high quality short term debt.? For those that hedge, quality will be rewarded, and structure penalized over the next? 6-12 months.? And, avoid financials, aside from exchanges and insurers with clean assets.

It Takes Two to Tango

Posted on 4 July 2009 by David Merkel

For every buyer there is a seller.? For every debit, there is a credit.

People often accept naive views of how the market works, perhaps considering how their own life seems to work, and not considering? the other side of the trade.? As an example, aside from laziness, why do market observers report a day where the market goes down on no significant news as “profit taking,” or grab at some lame smaller story which couldn’t explain the decline?? For every seller, there is a buyer.? No money went into or out of the market unless there was a new IPO, rights offering, company sale for cash, buyback, cash dividend, etc.? People don’t run away from or run to the market; only the terms of the tradew change at the margin.

The same applies to current account deficits.? They have to get funded from somewhere, and on unfavorable terms to the lender if the borrower happens to be the world’s reserve currency.

Thus, when I consider arguments over whether America is to blame for its profligate ways, or whether those that funded the deficits are to blame, I simply say that the books have to balance.? Neither is to blame; both are to blame.

It is not as if China has free capital markets.? Given their neomercantilism (uneconomic export promotion), they had to find places where their exports would be accepted.? The answer was the US.? After that, what do their banks do with excess dollars?? They buy fixed income dollar assets, which they foolishly think will preserve value until they need to liquidate the assets for goods or services of some sort.

That recycling of the current account deficit forced rates lower in the US while the Fed was tightening.? For the Fed to have fought that influence, they should have tightened more rapidly, compared to the plodding 1/4% each FOMC meeting.? How often have mortgage interest rates fallen while the Fed is tightening?? Not often, which is why the Fed was impotent during the last tightening cycle.? It is also why the blows hitting the global economy have fallen more lightly on the US.? To the extent that foreigners buy our bonds denominated in dollars, that transfers a part of the pain to them.? Thanks, but you could have avoided our pain had you opened your markets to our goods and services.

There are many efforts in play to try to replace the dollar.? Most if not all will fail.? At present, the US is politically secure in ways the other large currencies are not, and many invest in the US not to preserve full value, but to preserve most of the value, whatever that may be.

As with many things in life — it takes two to tango.? Blame is infrequently singular.? Both the US and China should own up to their shares of the current problems.? Then, maybe, solutions could be found.

A Redacted Copy of the June FOMC Statement

Posted on 24 June 200924 June 2009 by David Merkel

April 2009	June 2009	Comments
Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract, though the pace of contraction appears to be somewhat slower.	Information received since the Federal Open Market Committee met in April suggests that the pace of economic contraction is slowing. Conditions in financial markets have generally improved in recent months.	The FOMC is following trends in the financial markets. The stock market is higher, and credit spreads are tighter, but what of tomorrow?
Household spending has shown signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit.	Household spending has shown further signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit.	The FOMC sees further signs of stabilization of household spending.
Weak sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories, fixed investment, and staffing.	Businesses are cutting back on fixed investment and staffing but appear to be making progress in bringing inventory stocks into better alignment with sales.	They view much of the weakness as being an inventory correction that will end soon.
Although the economic outlook has improved modestly since the March meeting, partly reflecting some easing of financial market conditions, economic activity is likely to remain weak for a time.	Although economic activity is likely to remain weak for a time,	They are more certain that economic conditions have improved.
Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.	the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.	Materially the same.
In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.	The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.	They trust that slack capacity will keep inflation low, despite rising commodity prices. They are less worried bout deflation. Stagflation is not a word in their vocabulary.
In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.	In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.	Identical
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	They are trying to lengthen the view of the market on how long the FOMC is able to maintain a low fed funds rate.
As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year.	As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year.	Identical.
In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn.	In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn.	Identical.
The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.	The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.	Identical.
The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs. The Committee will continue to carefully monitor the size and composition of the Federal Reserve’s balance sheet in light of financial and economic developments.	The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.	Much language change; not much substantive change.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.	Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.	Identical.

Quick Hits:

The FOMC is following trends in the financial markets. The stock market is higher, and credit spreads are tighter, but what of tomorrow?
They view much of the weakness as being an inventory correction that will end soon.
They trust that slack capacity will keep inflation low, despite rising commodity prices. They are less worried bout deflation. Stagflation is not a word in their vocabulary.
They are trying to lengthen the view of the market on how long the FOMC is able to maintain a low fed funds rate.
They are projecting calm to all who will listen, but will inflation and the dollar cooperate?? Will economic weakness not deepen from here?? The jury is out.

Problems with Constant Compound Interest (3)

Posted on 16 June 2009 by David Merkel

This post should end the series, at least for now.? Tonight I want to talk about the limits to compounding growth.? Drawing from an old article of mine freely available at TSCM, I quote? the following regarding talking to management teams:

What single constraint on the profitable growth of your enterprise would you eliminate if you could?

Companies tend to grow very rapidly until they run into something that constrains their growth. Common constraints are:

insufficient demand at current prices
insufficient talent for some critical labor resource at current prices
insufficient supply from some critical resource supplier at current prices (the “commodity” in question could be iron ore, unionized labor contracts, etc.)
insufficient fixed capital (e.g., “We would refine more oil if we could, but our refineries are already running at 102% of rated capacity. We would build another refinery if we could, but we’re just not sure we could get the permits. Even if we could get the permits, we wonder if long-term pricing would make it profitable.”)
insufficient financial capital (e.g., “We’re opening new stores as fast as we can, but we don’t feel that it is prudent to borrow more at present, and raising equity would dilute current shareholders.”)

There are more, but you get the idea.

Again, the intelligent analyst has a reasonable idea of the answer before he asks the question. Part of the exercise is testing how businesslike management is, with the opportunity to learn something new in terms of the difficulties that a management team faces in raising profits.

As with biological processes, when there are unlimited resources, and no predators, growth of populations is exponential.? But there are limits to business and investment profits because of competition for customers or suppliers, and good untried ideas are scarce.? Once a company has saturated its markets, it needs a new highly successful product to keep the growth up. Perhaps international expansion will work, or maybe not?? Are there new marketing channels, alternative uses, etc?

Trying to maintain a consistently high return on equity [ROE] over a long period of time is a fools bargain and I’ll use an anecdote from a company I know well, AIG.? I was pricing a new annuity product for AIG, and I noticed the pattern for the ROE of the product was not linear — it fell through the surrender charge period, and then jumped to a high level after the surrender charge period was over.

I scratched my head, and said “How can I make a decision off of that?”? I decided to create a new measure called constant return on equity [CROE], where I adjusted for capital employed, and calculated the internal rate of return of the free cash flows.? I.e., what were we earning on capital, on average over the life of the product.

I took it to my higher-ups, hoping they would be pleased, and one said, “You don’t get it!? You don’t argue with Moses!? The commandment around here is a 15% return on average equity after-tax!? I don’t care about your new measure!? Does it give us a 15% return on average equity or not?!”

This person did not care for nuances, but I tried to explain the ROE pattern, and how this measure averaged it out.? It did not fly.? As many have commented, AIG was not a place that prized actuaries, particularly ones with principles.

As it was AIG found ways to keep its ROE high:

Exotic markets.
Be in every country.
Be in every market in the US.
Play sharp with reinsurers.
Increase leverage
Press the accounting hard, including finite reinsurance and other distortions of accounting.
Treat credit default swap premiums as “found money.”
Take on additional credit risk, like subprime lending inside the life companies through securities lending.

In the end, it was a mess, and destroyed what could have been a really good company.? Now, it won’t pay back the government in full, much less provide anything to its shareholders, common and preferred.

Even a company that is clever about acquisitions, like Assurant, where they do little tuck-in acquisitions and grow them organically, will eventually fall prey to the limits of their own growth.? That won’t happen for a while there, but for any company, it is something to watch.? Consistently high growth requires consistently increasing innovation, and that is really hard to do as the assets grow.

If True of Companies, More True of Governments

This is not only true of companies, but even nations.? After a long boom period, state and federal governments stopped treating growth in asset values as a birthright, granting them a seemingly unlimited stream of taxes from capital gains, property, and transfer taxes.? They took it a step further, borrowing in the present because they knew they would have more taxes later.? The states, most of which had to run a balanced budget, cheated in a different way — they didn’t lay aside enough cash for their pension and retiree healthcare promises.? The Federal government did both — borrowing and underfunding, because tomorrow will always be better than today.

Over a long enough period of time, things will be better in the future, absent plague, famine, rampant socialism, or war on your home soil.? But when a government makes long-dated promises, the future has to be better by a certain amount, and if not, there will be trouble. That’s why an economic downturn is so costly now, the dogs are behind the rabbit already, running backwards while the rabbit moves forwards makes it that much harder to catch up.

I’ve often said that observed economic relationships stop working when people start relying on them, or, start borrowing against them.? The system shifts in order to eliminate the “free lunch” that many thought was available.

A Final Note

Hedge funds and other aggressive investment vehicles should take note.? Just as it is impossible for corporations to compound their high profits for many decades, it is impossible to do the same as an investor.? Size catches up with you.? It’s a lot easier to manage a smaller amount — there are only so many opportunities and inefficiencies, and even fewer when you have to do so in size, like Mr. Buffett has to do.

“No tree grows to the sky.”? Wise words worth taking to heart.? Investment, Corporate, and Economic systems have limits in the intermediate-term.? Wise investors respect those limits, and look for growth in medium-sized and smaller institutions, not the growth heroes of the past, which are behemoths now.

As for governments, be skeptical of the ability of governments to “do it all,” being a savior for every problem.? Their resources are more limited than most would think. Also, look at the retreat in housing prices, because the retreat there is a display of what is happening? to tax revenues… the dearth will last as long.

Full disclosure: long AIZ

Ten Points — Mainly About the Debt Markets

Posted on 12 June 2009 by David Merkel

1) Why have long interest rates been rising?

Increased supply.
Mortgage bond/supply hedging. (also one, two)
Belief in a strengthening economy.
Long-term inflation expectations have been rising.
Some foreign investors are selling.
Flight to trash.

Number 1 is incontrovertible.? Number 2 is close.? Number three is true, though the economy is not strengthening that much in inflation adjusted terms.? As for 4, yes, TIPS inflation breakevens have been steadily rising, both short- and long-term.

The last one is the most interesting.? It is the analogue to the equity investors that are buying financials.? Since the financials have been hot, equity managers lagging in performance have encouraged the purchase of hot financials.? Same for junk bonds among broad mandate bond managers.? Many managers are buying long financial corporates for speculative gains, while selling long Treasuries to fund the purchases.

With a few exceptions, it has paid recently for bond managers to play on the riskier areas of their mandates, with the exception of high quality long duration bonds, which were the big winners last year, and the big losers this year so far.

So when you look at the rise in high-quality long rates (prices down), and the rally in junk (prices up), etc., realize that these are part of a larger phenomenon.?? There is not one simple reason for the recent moves, there are many, and they are loosely related.

2)? That’s not to say that the Fed publicly understands this (one, two, three) .? When they announced their plan to buy long Treasuries, Agencies, and Mortgage bonds, there was some hope that they could keep mortgage rates down and stimulate the economy by making cheaper to finance homes.? That dream is in tatters now (one, two, three, four, contrary opinion from Paul Kasriel, who I generally respect).? The six forces listed above are bigger than the Fed’s ability to control.

3)? Will the Fed start tightening rates in 2009?? Yes or no?? When you phrase the question that way, most thoughtful observers will answer no, saying that the Fed would never start acting when a recovery is barely underway, if it is underway at all.

But maybe that’s the wrong question.? Ignoring the Fed funds futures market for a moment, ask this question instead:? Subjectively, have the odds risen recently that they might tighten sooner, and maybe even in 2009?? Certainly.? There have been other times when the Fed has acted, tightening when conditions were less than optimal.? I’ll give you two of them:

After the dollar tanked in 1986, with inflation still pretty benign, starting in December of 1986, the Fed began to raise rates, primarily to defend the dollar.? Not realizing all of the second order effects that would take place, the tightenings led to a bear market in bonds, and eventually the crash later that year as bonds became compelling compared to stocks.
From 1973 to 1982, the Fed often raised rates when the economy was less than strong.? Inflation was out of control, and it didn’t much matter whether industrial capacity or labor capacity were fully used — there was still inflation, and thus, stagflation.

It’s possible we may run into the same thing here, though if the only thing we experience is commodity price inflation because the dollar is weak, that doesn’t feed back into consumer prices that much,? because raw commodity prices play a small role in consumer prices.? Labor costs are much more important.? Would it be possible to get rising wages when unemployment is high?? Yes, look at the ’70s.

4)? But maybe the Fed can tighten without tightening.? They can begin lightening up on their credit easing programs.? Might work.? Maybe they could reverse their trade in long Treasuries, Agencies, and Mortgage bonds.? Uh, yeah, unlikely, but maybe they slow down a little.? In a case like this, moving the Fed Funds rate might be the least painful option.

So maybe a move in the Fed funds rate isn’t impossible in 2009.? The difficult part here is forecasting:

What conditions will be in the real economy will be like
How well the global economy turns
Whether the large amount of incremental Treasury debt and guarantees will be readily digested on favorable terms
Whether the financial economy won’t hit a few more roadblocks from commercial mortgages, corporate and personal insolvencies, unemployment, etc.
Whether there is some “bolt from the blue” like a new war, weakness in the Chinese economy, etc.

What isn’t hard is looking at the overall debt levels relative to GDP, and realizing that we have only rationalized a part of them.

5) Residential Housing is still weak, and getting weaker, but the pace of the decline has slowed.? The market still has issues in front of it:

As mentioned before, mortgage rates have been rising.
Alt-A resets and recasts are still mainly in front of us, but the losses are pretty severe when they come.? This fits in with my housing mismatch thesis — we have too many expensive homes, and losses on the Alt-A mortgages will be severe, because there are few logical move-up buyers in this environment.
We are seeing more losses on prime loans, because slumping housing prices have even inverted prime some loans.? Then, when a trouble hits (one of the 6 Ds — see point 5), and cash flow to service the mortgage falls, we get another foreclosure.? Shiller makes a similar argument in the NYT.

As I said in an old CC post:

		David Merkel
		Hear Cody on Housing
		8/24/2007 1:25 PM EDT

Much, but not all of the upset in the lending markets (which, if you look at swap spreads, the current manifestation of the crisis seems to be passing — down 4 basis points today), is from deflating values in housing. My estimate for how much further real estate has to decline on average in the US is 10-20%. We need to find owners for about 4% of the US housing stock that is vacant. The pain that has been felt in subprime and Alt-A loans will get felt in prime loans, and possibly conforming loans as well. Fannie and Freddie won’t get killed, but they will take credit losses.

So, listen to Cody. Residential real estate markets do not clear as rapidly as a futures exchange. The illiquidity and variations in lending standards tends to lead to markets that adjust slowly, and autocorrelatedly. I.e., if it went up last period, odds are it will go up next period, and vice-versa.

It will take a while for the residential real estate market to clear. When the inventory gets down to 3% it will be time to start speculating on homebuilders and mortgage lenders again, but real estate prices won’t start rising in aggregate until the inventory of unsold homes gets below 1.5-2.0%.

Position: none

In hindsight, I was way too optimistic, but I could never bring myself to write that things could be much worse, because then you get labeled a “perma-bear,” and then you get ignored.? So, if you want pessimism, here it is from T2 partners.? We may be near fair value now, but given that our housing stock is misfinanced (too much debt, terms that are too short), we will definitely go below fair value.? The only question is how much we go below fair value.

6)? Regarding the US Dollar fixed income, who is right?? The Russians, who are selling?? The Chinese, who are kvetching, but still buying??? Or the Japanese, who possess unshakable trust in US bonds??? Only time will tell.? Transitions from one currency regime to another can be messy in the absence of an anchor like gold.? There is some point where if the US keeps borrowing, and there seems to be no end in sight, that foreign creditors will finally write off their losses, and move on to some new arrangement.

In the short run, it is not in the interests of China or Japan to ditch the Dollar.? It would take something notable to get them to change, and I can’t see what that would be.? It certainly won’t be Yuan-denominated bonds from the US.

7)? Buy Corporate Bonds Now.? Aren’t we a bit late here?? The time to buy was back in the end of 2008.? Investment Grade Corporates are at fair value now, and I would reduce holdings of BBB corporates to below benchmarket levels. High yield is still a little cheap, so I would reduceallocations to high yield now to benchmark levels.? We still have significant financial stress ahead of us, and there is a lot of room for lower-rated credits to underperform.

8 ) As another example of this, consider how many junk-rated senior loans will need to be refinanced over the next five years.? Perhaps the bid from CLOs will come back, or the the banks will heal and bring it onto their balance sheets.? But absent that, there will be upward pressures on yields when refinancing senior loans.

9) I knew that I wrote something with respect to the Fed and Treasury using force to make banks take TARP funds.? I finally found it.? So, this isn’t hot news that the banks were forced to take TARP funds, (and here) but it’s nice to see that I guess right every now and then.? Barry was quite possibly right that the TARP was a ruse to protect Citi, but the bigger surprise would be how much Bank of America and Wells Fargo would need it.

10) Final note: if banks are opaque, regulators are more so.? Glad to see Matthew Goldstein continuing to put out good work on financials.? He was great at TSCM, and I’m sure will be great at Reuters.

Fruits and Vegetables Versus Assets in Demand (2)

Posted on 11 June 2009 by David Merkel

Thanks to all of my readers who commented on the original piece.? You were a real help to me.? Okay, what are the differences between fresh produce and financial assets?

Time horizon — fresh produce is perishable, whereas most risky assets are long-dated, or in the case of equities, have indefinite lives.
Ease of creation — New securities can be created easily, but farming takes time and effort.
Excess Supply vs. Excess Demand — With a bumper crop, there is excess supply, and the supply is typically high quality.? Now to induce buyers to buy more than they usually do, the price must be low.? With financial assets, demand drives the process.? Collateralized Debt Obligations were profitable to create, and that led to a bid for risky debt instruments.? The same was true for many structured products.? The demand for yield, disregarding safety, created a lot of risky debt and derivatives.
Low Supply vs. Low Demand — With a bad crop, there is inadequate supply, and the supply is typically low quality.? Prices are high because of scarcity.? With financial assets, low demand makes the process freeze.? What few deals are getting done are probably good ones.? Same for commercial and residential mortgage lending.? Only the best deals are getting done.

Fresh produce is what it is, a perishable commodity, where quantity and quality are positively correlated, and pricing is negatively correlated.? Financial assets don’t perish rapidly, quantity and quality are negatively correlated, and pricing is often positively correlated to the quantity of assets issued, since the demand for assets varies more than the supply.? Whereas, with fresh produce, the supply varies more than the demand.

That’s my take after your excellent comments.? Any more improvements that can be made?

Loss Severity Leverage

Posted on 10 June 2009 by David Merkel

I’ve been analyzing on some surplus notes from a mutual life insurer which is part of a group of mutual insurers.? Mutual insurers are opaque, because there are no large private interests external to the company with a concentrated interest in the well-being of the company.? This company lost significant money in 2008 and the first quarter of 2009.? Most of it was writedowns on non-GSE (not Fannie, nor Freddie) residential mortgage bonds, where they bought mezzanine or subordinated bonds.

Wait.? Some definitions:

Senior bonds: those rated AAA, representing the group that gets paid first in a securitization.? In a securitization where the loss experience is so bad that the senior bonds take losses, typically all of the senior bonds get paid pro-rata.

Subordinate bonds: Bonds that receive high yields in a securitzation (rated BBB and below), but take losses first as losses emerge.? High risk, high return (maybe).

Mezzanine bonds: If the subordinate bonds get wiped out, the Mezzanine bonds (rated AA and A) are next.? Not much extra yield, but less chance of loss.

When a securitization goes bad, the juniormost bonds get losses allocated to them until they wiped out, then it goes to the next most junior class.? This highlights a difference between the loss severities of corporate bonds and structured bonds.? With corporate bonds, there is some recovery of principal — not all of the principal, of course, but 40% on average.? With structured bonds, typically you get all of your principal paid, or none of your principal paid (excluding early amortization).

I realized this for the first time when I analyzed the Criimi Mae Securitizations back in 1999.? The securitization trusts contained mostly junk-rated CMBS tranches, and junk-rated securitizations of other CMBS deals, and they sold off investment grade participations in the securitizations.? This was the messiest set of deals that I ever analyzed.? It reinforced one idea to me, that if you are not senior in a deal, you may lose it all.? With structured finance, there is loss severity leverage in mezzanine and subordinate bonds.

Going back to the firm I was analyzing, When I looked at their performance last year, I thought, “Stable company.? Bread and butter life company.? As my old boss said, ‘It takes more than incompetence to kill a mutual life insurer, it takes malice.’ ”

Today I am not so sure.? I once was a mortgage bond manager, and I bought senior securities because the yield spreads on the lower-rated securities were so small.? This company, like Principal Financial, bought mezzanine and subordinate bonds in significant measure, though they did slow down after 2005.

I have estimated the likely losses on the bonds that the company owns, and it is unlikely but not impossible that the company dies in the next few years.? The parent mutual company has ponied up money recently, and will probably do so in the future.? Who can tell?

My estimates of loss are less than those that the bond market is estimating.? If we marked the assets of the company to market, it would be significantly insolvent.? Insurance policies are high credit quality obligations, they don’t vary as much as bonds that are risky.? Now, if I had the Actuarial Opinion and Memorandum, perhaps I could know the truth.? That group of documents analyzes the long-term ability of a life insurance company to survive.? That document is sadly not public.? If it suggested that the company in question needed additional capital, that would be reflected in the public filings, and there is no such reference for the company in question.

Can You Afford To Lose It All?

Anytime one buys a mezzanine or subordinated security, or buys a surplus note, or trust-preferred security, or other bit of junior debt or preferred stock, one must ask, “Can I afford to lose it all?”? When there are senior investors, investors that are more junior can get whacked.? Senior investors ordinarily must be paid in full before junior investors get paid.

This applies even to AA and A-rated structured securities.? They aren’t senior, so they can lose all their principal.? And that’s what this life insurance company bought a lot of, picking up a princely few extra tenths of a percent in interest over the AAA bonds for a lot more risk.

How Did These Securities Get Such High Ratings?

Uh, seemed like a good idea at the time?? ;)?? As I’ve said before, it is impossible to set regulatory capital levels or subordination levels for assets that have not been through a failure cycle.? New asset classes have no track record of failure, and as such, estimating the likely expected present value of losses, and how variable losses could be is just an educated guess.? Sometimes they would apply models of related asset classes and tweak them.? That’s still a guess, though.

Also, using statistics for assets held on balance sheets, and applying them to securitizations, where the originator has little skin in the game, made the assumptions made for losses on residential mortgage lending too low.

The rating agencies did have competitive pressures to get business, but my view is that they did not have sufficient relevant loss experience to guide them.

What Should Have Been Done?

Regulators abdicated their duties by merely relying on the rating agencies. Ratings are fine in theory, and someone has to make judgments of relative risk, but the macro decision of what classes of investments are permitted, and what capital level to hold against them belongs to the regulators.? The regulators haven’t done well in setting up rating agencies of their own, so let the rating agencies continue on, but let the regulators be smarter in how they set the capital levels (higher for structured products than for corporates and munis, because of loss severity leverage), and what they allow regulated entities to invest in.

My view is that any new asset class has to go through a failure cycle before regulators allow regulated entities to invest in them.? Investments in such new assets? should be treated as a deduction from equity.

Wait, We Need to Invest in Those Assets to Stay Competitive!

That scream came the regulated entities.? Sorry guys, the risks of untried asset classes belongs to unregulated entities that don’t have deposit insurance, state guarantee funds, etc., where there is no systemic risk.? If they go under, no one in the public domain should care.

In principle, it shouldn’t matter within a group of regulated companies what the rules are, so long as they are enforced similarly by the regulators.

Anything else?

One final note — there is one medium-sized mutual insurer flying under the radar that I think its state regulator is unaware of the risks that it faces, and the rating agencies as well… it carries high ratings from all the main insurance raters.? Given the project that I am currently working on, I can’t reveal the name, but the guaranty funds would be more than capable of handling the failure.