Category: Real Estate and Mortgages

Book Review: Bailout Nation

Book Review: Bailout Nation

Posted on by David Merkel

I liked Financial Shock.? But it was kind of like listening to the news on the radio, versus watching it on television, in comparison to Bailout Nation.? What can I say, Barry writes ably and amusingly, without losing erudition.? With help from Aaron Task, the book sings.? Having written for RealMoney, I have experienced the superb editing by editors that understand finance.? (I always enjoyed interacting with Aaron in the CC.)

Also, the writing is simple to understand, but you don’t get a simplistic view of who was to blame, similar to my Blame Game series.? There are a lot of culprits who took advantage of the boom times, leaving themselves and all of us more vulnerable in the eventual bust.

Barry begins the book by describing the normal temptation of nations to bail out large private interests when things go south.? The US resisted these temptations until the creation of the Federal Reserve, an quasi-public entity that I like to say was created so that the Treasury Department could take actions that would otherwise be unconstitutional.

He then describes early bailouts (Lockheed, Chrysler) that set the pattern for what will come later.? But the greater factor that Barry describes are the implicit bailouts where Greenspan threw liquidity at every crisis, which avoided the reconciliation of bad lending decisions.? Great examples include: commercial mortgages in the early ’90s, Mexico and mortgages in 94, Russia/Asia/LTCM in 98, and the Nasdaq in 2000-2.

Liquidity was never absent in the Greenspan era, and debts built up, realizing that since the Fed would protect them, why not take more risk?

The idea backfired on the Fed.? Investors took more risk because they thought the Fed would protect them, and so they leveraged up on investments at narrow spreads over risk-free investments in order to meet return targets.

Any policy that reduces risk-consciousness is a bad one.? Ditto for those that say follow the crowd.

As I have said before, if a country has fiat money, it must also regulate credit.? Conditions in the banking sector deteriorated through the Bush Jr., administration, leading to the credit crises we are seeing today.? Conservative, it is not.

Barry also details the crisis in 2008 as it unfolded, and questions the motives of parties involved, or, why they didn’t act earlier.

Personal Notes

  • The 1996 Greenspan comment on “irrational exuberance” is treated well by Barry.? Greenspan was long on words but short on deeds.
  • Barry could have done more with the Banking crisis 1989-93, which prompted the aggressive Fed policy which is similar to today’s policy.
  • Big as the Federal Reserve is, they certainly did not do their regulatory job with respect to lending terms.
  • Barry agrees with me that the CPI is understated.
  • On AIG, I would note that AIG Financial Products was not the only problem, though it was the biggest.? The domestic life companies had real issues.
  • I was gratified to see how many experts that Barry cited favored increased immigration to the US of those that are wealthy.
  • Finally, on the second to last page, he quotes an obscure economist with a weirdly-named blog.? Hey Felix, yes, he quoted few bloggers, but you missed this one.

All in all, a great book.? If there is a better one to describe the crisis, I will be very surprised.

If you want to buy it you can buy it here:?? Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy

For one final note, I love the cover of the book where they morph the Wall Street Bull into a pig.? It symbolizes the era we are in in.

Monetary Policy is Loose — The Yield Curve is Steep

Monetary Policy is Loose — The Yield Curve is Steep

Posted on by David Merkel

With a headline like that, you might be inclined to say, “Duh! Next you’re going to tell me that the sky is blue.”? Guilty, I am, but I won’t mention the azure sky; it’s raining here. ;)? I got here through analyzing the swap curve and asking the question, “When has the swap curve been shaped like this in the past?”

Swap curve.? Time for explanations.? The interest rate swap market is big — very big.? It allows parties to exchange a fixed yield over a period, for a floating rate, 3-month LIBOR [London Interbank Offered Rate], or vice-versa.? The fixed rates at different tenors/maturities define the swap curve. Typically, these swaps are done with AA-rated banks, so credit spreads versus Treasuries are low.

Personally, I find swap rates more comparable across countries than sovereign obligations.? Why?? The maturities are more similar, as is the credit quality.? Anyway here is my graph of comparable swap curves.? I would post it as a picture, but my browser keeps crashing on me.

Broadly, the shape of the current swap curve if very similar to the curves in October 1992 (no 30-year swap data), February 2002, and May 2004.? What was the state of economic policy at each of those times?

  • October 1992 — FOMC policy had just reached its most generous level for that cycle, where it would stay at 3% until the speculative pressure built up from overly cheap money would rapidly change in 2004.? There was considerable doubt as to whether monetary policy would be effective, and commercial real estate was still in the tank.? The great concern should have been getting monetary policy out of boom/bust mode — letting a recession take its course, and not trying to artificially make them shorter or more shallow than they need to be to clear away bad debts.? As it was, the great monetary ease was the prelude to the bond market’s annus horribilis in 1994, together with the collapse of the negative convexity trade, and the speculation in Mexican cetes, all of which required easy money.
  • February 2002 — nearing the effective end of the loosening cycle, and panic is considerable.? Many worries over technology and industrial companies.? The stock market was going down almost every day.? European financials, overloaded with equity-linked and other risk assets, were getting crushed.? Bright spot: US banks were in good shape, as was the housing market.
  • May 2004 — the easing cycle was just about to end, and about 18 months too late, with at least 1% more easing than was needed.? The US residential housing markets are in a feeding frenzy, and clearly, the recession is long since past.? The curve was steep only because Fed policy had not budged, and the market anticipated a considerable adjustment.

Three very different situations, and different than what we face today.? The one commonality is the loose monetary policy.? Some will say monetary policy doesn’t feel loose today.? That is because the Fed funds rate is down at the zero bound, and monetary policy is being conducted through “credit easing” — using the Fed’s balance sheet to benefit troubled lending markets, rather than the economy as a whole.

The present rise in long rates is partially a repudiation of the Fed’s ability to control the long end of the curve in Treasuries, Agencies, and Mortgage rates.? The Fed is too small to achieve such a task, so once the emotional shock of their buying program wore off, the curve steepened, pushed by hedging in the residential mortgage market, once the move became great enough.

We’re in uncharted waters here, so in whatever role you play in investing, be careful.? Unusual situations beget more unusual situations.? More on this in future posts.

PS — Other posts worth perusing:

“Just Gimme the Answer, Will Ya?”

“Just Gimme the Answer, Will Ya?”

Posted on by David Merkel

Half of my career, I have worked for bosses who were actuaries, and half not.? Half of my career, I worked for bosses that were intellectually curious, and half not.? There was a strong, but not perfect correlation between the two — most actuaries are intellectually curious, but there are a few that aren’t.

Those that know me well, know that I am a pragmatic idealist.? I have strong beliefs, but I also have a strong desire to solve the problem.? Where I run into difficulty is where the problem is ill-constructed, and does not admit a good answer.? Any answer would be subject to numerous qualifications and explanations.? Perhaps I can give some examples:

“What’s my illiquid structured finance bond worth?”

Oh my.? Whether residential mortgage, commercial mortgage, or asset-backed, that depends a lot upon future loss activity across the whole financial sector.? Typically I only get this question when the bond is worth little, but the entity thinks it is worth a lot, but can’t get a bid anywhere near that.? Often they have been misled by third-party pricing services doing a facile job in exchange for a fee.

“How will this equity portfolio behave versus the market?”

Ugh. Beta is unstable, and estimates often lead to erroneous conclusions.? More detailed modeling can come up with a reasonable answer, but also state that the correct beta is a weak tendency, and is swamped by other effects.

“This investment will eventually come back, right?”

No.? Most will, but not all will.? Some do go to zero, or something really close.? Mean-reversion exists in the markets, and over long time periods it is strong on average, but in specific over short horizons it does not work.

“What’s the interest rate sensitivity of this illiquid structured finance bond?”

Often there is not a good model of prepayment/extension risk.? Or, the model exists, but the security in question is dominated by credit risk.? Will that tranche pay off or not?? In such a situation, the wrong question is being asked, because interest rate risk is not the main risk.

“What’s the right spread to Treasuries for this illiquid bond?”

Sorry, but the answer will be regime-dependent, and will vary by the liquidity of the era.? During times of high liquidity, it will trade near liquid bonds of similar risk.? In times of low liquidity, it will trade far behind its liquid cousins.

What’s the right yield tradeoff between bonds of different credit quality classes?

Again, it varies.? Even across a whole cycle, there is no right answer.? Personally, I would try to estimate the likelihood, subjectively, that we would enter the other side of the cycle within the life of the asset in question.? There are boom valuations, and bust valuations, and scarce little time in-between.

“Just Gimme the Answer, Will Ya?!? I need an Answer!”

Yeah, I got it.? I’m a practical man also, but I try to understand where I can go wrong.? Process is as important as the result.? For many investors, institutional as well as retail, they don’t understand the broader environment that we are in, and they think there are these long term averages that don’t vary that much.? Just invest, and you will make good money over a 2-5 year period.

Sorry, but life is more variable than that.? Investment processes are a function of human processes.? Where humans play a game of follow-the-leader for a long time, with positive results, the cycle will be long, and the unwind severe.? Truth is, the real economy grows at a 1-3%/year rate in inflation adjusted terms, with a lot of noise, absent rampant socialism, or war on our home soil.? The result over the long term should not be much more than 2% more than bond returns, with moderate risk.

You mean there are no answers?

No, there are answers, but there are confidence bands around the answers, and the answers are subject to the overall well-being of the financial economy.? We are playing a complex game here, because the boom-bust cycle is less than predictable on average.? Thus the advantage goes to those that play with excess margin, particularly when things are running hot, and they? pull back.? It is a tough discipline to maintain, but it yields results over the long term.

I will say it this way: focus on where we are in the risk cycle, and? it will aid you in where to invest.?? As Buffett says, “Be greedy when others are fearful, and fearful when others are greedy.”

I encourage caution.? Ask what can go wrong.? Consider what a prolonged downturn in the economy would do.? If the answer is “little,” then be a man and take real risks.

Be skeptical, but don’t be paralyzed in decision-making.? Look to the long-run as a weak tendency, and realize that over many years and with moderate certainty, the trend will revert on average, buit not necessarily for individual investments.

So what should I do?

  • Keep a reserve fund of safe assets.
  • Be skeptical of short, intermediate, and long-term results, but for different reasons.
  • Resist trends during normal times, but during times of extreme movement, let it run.
  • Always consider what could go wrong.? WHat is the upside and the downside, and the likelihood of each.

There is no single formula or answer for all investment problems, but a conservative attitude, and a reasonable analysis of where we are in the risk cycle will help.

Unstable Value Funds (5 – CMBS Edition)

Unstable Value Funds (5 – CMBS Edition)

Posted on by David Merkel

Over the last two months, the assets underlying most stable value funds have done well, and short ABS, CMBS, and RMBS bonds have rallied.? Insurance debt as well.? But just when you think you can relax, S&P comes in to jolt confidence.? Here are some articles:

You don’t have to read all of these.? The main ideas are:

  • Super-senior AAA CMBS is not bulletproof.? From the S&P report, “In particular, 25%, 60%, and 90% of the most senior tranches of the 2005, 2006, and 2007 issuances, respectively, could be downgraded.”
  • Some view S&P’s new criteria as draconian.
  • Rents from properties underwritten in the boom period 2005-7 are definitely declining.?? The stress tests impose a 25%-ish haircut for rents in everything but multifamily, whose haircut would be around 6%.? These would be adjusted for geography and quality.
  • Prior to the announcement the quote? in Markit CMBX AAA 4 — 2007 super senior exposure was in the low $80s.? Now it is in the low $70s.
  • That’s more than a 1% move up in yields.
  • Many maturing loans will not be able to refinance at the same principal levels.? Property owners will need to feed the properties, and equity capital is scarce.
  • This undermines the Fed?s efforts to expand the TALF to some legacy CMBS that will be downgraded below AAA.

There’s one more knock-on effect.? This review by S&P will also incude a review on how CMBS Interest Only [IO] securities will be rated.? The old philosophy was “Since IOs have no principal, they can’t lose principal, and securities that can’t lose principal are AAA.”? But when I would review CMBS securities 1999-2001, my models would indicate credit risk akin to BBB or BB securities.? Underwriting standards were much higher back then, so the new ratings for CMBS IOs will likely range between BBB to CCC.? Think single-B and below for vintages since 2005.

Though it won’t change the underlying cash flows of the CMBS IOs, it will change the ability of regulated financial institutions to hold them, particularly if Moody’s and Fitch follow along, which I think it makes sense to do.? With lower ratings, financial instutions will have to hold more capital against them, which lowers their desirability.? The regulatory arbitrage goes away.

So what then for Stable Value funds?? It’s a PR, marketing and a liquidity issue.? AAA CMBS plays a large role in stable value, particularly the short stuff that could be financed by the TALF.? If TALF is off the table, then prices have slipped considerably.? That doesn’t affect cash flows of the securities, but it? does mean that:

  • The difference between book and market widens.
  • Any SV fund with a need for liquidity can’t find it in their CMBS, because it is likely below the amortized cost.
  • There will be optical problems for current and prospective clients as they see the credit quality of the SV fund decline.
  • Those with a significant allocations to CMBS IOs (I hope there aren’t any) will see those assets go to junk, fall in current value, and be even harder to trade.

This is just another issue for Stable Value Funds — by itself, it is not likely to be enough to break the funds.? That would require something really nasty, like a quick run upward in short- and intermediate-term interest rates, or credit stress beyond this.? For the former to happen would require the FOMC to begin tightening, and absent a major dollar panic, they are not doing that anytime in the near term.? As for the latter, we have not yet seen the impacts from Alt-A recasts and resets, and the declines in commercial property values.? We will wait, pray and see.

Fifteen Thoughts on Advantage in the Markets

Fifteen Thoughts on Advantage in the Markets

Posted on by David Merkel

1) I made the point last week when I talked about my experiences in the pension division of Provident Mutual.? The investment choices of 90% of individuals follows recent performance.? This is another factor in why markets overshoot, and why mean-reversion is a weak tendency.? Thus when I see many leaving the stock market for absolute return, bonds, cash, commodities, it makes me incrementally more bullish, though I am slightly bearish at present.

2) Has this been a “suckers rally?”? That’s too severe, but there is some truth to it. Many of the large financials may be safe, but at a cost of higher taxes and inflation.? Also, the losses on commercial real estate have not been felt yet on the balance sheets of banks.? I think we will break the recent lows on the S&P 500 before this is all done.? Debt deflation and dilution continues on.? We have an overhang in residential housing that will require prices to go below equilibrium in order to clear.? Global growth is anemic, even if some of the emerging markets are doing well.

3) When writing for RealMoney, I was usually diffident about buybacks, because I liked to see strong balance sheets.? Now in this era, those that bought back a lot in the past are paying the price.? Buy high, dilute low is a recipe for big underperformance, and we are seeing it in financials now.? (The comments about pension design in the article are spot-on as well.)

4) Behavioral economics does justice to what man is really like, both individually and collectively.? We are prone to laziness, greed and fear.? There is a weak tendency for a minority of individuals to break free from the fads and fashions of men, and pursue profit exclusively.? Remember, thinking hurts, so people conserve on it, unless the reward for thinking exceeds the pain.

5) Quantitative managers have gotten whacked, and few more than Cliff Asness of AQR.? It doesn’t help that you are outspoken, or that you took time away to aid the CFA Institute.? When the business goes south, thereare no excuses that work.? In times like this, be quiet, analyze? failure, and stick to your knitting.

6)? Ken Fisher made an argument like this in his book The Wall Street Waltz.? Eddy’s argument is ordinarily right; buy during bad times.? The only time that is not true is when you are in a depression, and there is much more debt to be liquidated, and more jobs to be lost.

7)? From Quantifiable Edges, there is some evidence that the ratio of the Nasdaq Composite to the S&P 500 can be used as a timing indicator.? Nasdaq Composite outperformance presages more positive returns in the S&P.

8 )? I read the article on the “purified VIX” and other “purified” indicators, and I get it.? Adam is still correct that periods where the VIX and SPX move in the same direction tall you something about future SPX performance.? If both are up, then the trend for the SPX tends to be up.?? Vice-versa if both are down.

9) Regarding this article on David Rosenberg, I think the earnings? are too optimistic, but the P/E multiple is too pessimistic.? Things may be ugly for a while, but I can see an S&P 500 above 1000 in 2011.? (That may be inflation.)

This phrase is problematic “As for the multiple, Rosie believes the P/E should approximate a Baa bond yield, leading to an “appropriate” multiple of 12x.”? E/P on average should be equal to a Baa bond average less 4%, making a fair P/E at 20+.

10) Beta stinks.? You knew that.? Here’s more ammo for the gun.? I have doubted the CAPM for almost 30 years.? It’s only value is to confuse other wise intelligent comptetitors.

11) Is small cap value still relevant?? Is winning relevant?? Please ignore the studies that use betas that adjust for small cap, value, and momentum — using each of those is a management choice, and those of us that choose to be smart take credit for following research, not that research should discount our actions.

12) Yes, the Q-ratio works.? Don’t tell anyone about it, though.? Shh…

13) Dow 36,000.? Yes, in 2030.? Glassman and Hassett were sensationalists that pushed an idea of rationality too hard, suggesting that people could accept a near-zero risk premium to invest in stocks, versus treasury bonds.? Bad idea.? The E/P of stocks averages near the Baa bond yield less 4%.? Stocks need 4% earnings growth to compete with bonds on average.

14) Homes are for living in; they are only secondarily investments, if you know what you are doing.? Compared to TIPS, gains in homeowning, less expenses, are comparable.

15)? As this post points out, and I have said it before, “The vast majority of currency ETFs represent stakes in an interest-bearing?bank account denominated in a foreign currency. They derive all their?return from two sources: the cash yield of the foreign currency over the expense ratio of the fund and changes in the exchange rate against the dollar.”? Be careful with foreign currency funds; they often embed financial credit risk.

Phase Change

Phase Change

Posted on by David Merkel

Longtime readers know that my investing interests are broad.? I almost decided to name this blog, “The Investment Omnivore,” but took the name of the investment fund that I deeply considered creating in the 90s, and used that.

So, when notable things happen, I tend to switch to where the action is.? On a day like today, that means the high quality, long duration band markets, because they are falling dramatically.? Now, there are other high quality observers following this phenomenon, including:

Let me give you my perspective. Big moves in Treasury, Interest Rate Swap, and Mortgage rates tend to persist.? Why?? Three reasons:

  • Mortgage originators hedge their pipelines.? As rates rise/fall, they receive floating/pay fixed in order to lower their exposure to changes in interest rates.? As mortgage rates rise, mortgages get longer, because fewer people refinance.? Vice-versa for when mortgage rates fall.? Receiving a short rate like LIBOR, and paying fixed rates makes money when LIBOR rates are rising, which hedges those originating mortgages.
  • Those managing mortgage bond portfolios against a benchmark find themselves in the same situation.? As mortgage rates rise, mortgage bonds get longer versus their benchmark, and managers sell longer assets in order to adjust, sending the yields on longer-dated assets higher.
  • Speculators pile on when they sense that the first two factors are in play.

That’s why big moves in Treasury, Interest Rate Swap, and Mortgage rates tend to persist.? Thus for those who trade those markets, it is best to stand aside, or follow during big moves, and let the momentum run.

Wednesday we experienced what I would call a phase change, where the losses in the bond market since its apex in mid-to-late December have been consolidated.? Consider this graph of the yield curve as it has progressed over the last five months:

Short end stays firm because of confidence that the FOMC is on hold.? Long end runs because of new high borrowing needs of the US government, both recent and future issues.

Now what is this doing to the mortgage market?

That’s a graph of 10-year swap yields, which correlate closely (under ordinary circumstances) with 30-year mortgage yields.? The yellow line is the 18-month trailing moving average.? When rates are above that level, refinancing tends to slow; when rates are below that level, refinancing tends to speed up.

So how is the move in the yield curve affecting mortgage rates?

Rates have gone up considerably, but with the government interventions in the bank lending and residential mortgage markets, ordinarily stable market relationships got out of kilter.? This graph has the difference between 10-year swap yields and Fannie 30-year mortgage yields:

An ordinarily stable showed a lot of stress from the end of 2007 until now.? Present levels are close to “normal” over the the life of the series over the past 20 years where excluding the stress period, the difference was typically 0.60%, and we are at 0.67% now.

One more graph.? What period in the recent past is the current yield curve shaped like?? September 2003.

What was the economy like in September 2003?? Accelerating growth with little goods price inflation — it would be neat if that were the scenario ahead.? What is different this time is that the banks still have problems to work through, not the least of which are losses from commercial real estate lending.

Summary

  • What a rapid move in the long end yield curve over the past five months, with most of the moves concentrated in January and May.
  • This move may go further, but not much further, because we are at historic levels of steepness for the yield curve.
  • Refinancing opportunities should dry up.
  • The Fed would have to do a lot in order to bring mortgage rates lower versus swaps because we are close to the normal relationship of swaps versus mortgage yields.
  • The yield curve is very steep, which usually foreshadows rapid growth in the economy, but we have issues in the financial system that may resist that stimulus.? Liquidity in private hands is tight, so opportunities to make money borrowing short and lending long are limited.
Thirteen Aspects to our Current Economic Situation

Thirteen Aspects to our Current Economic Situation

Posted on by David Merkel

1) Last night I started out with the concept of a “housing mismatch.”? Today, with a hat tip to Calculated Risk, I can make my case better.? The low end of the market is humming, as new buyers come in.? Makes sense.? Who get the capital together for a downpayment?? New homebuyers for homes on the lower end.? But homeowners that want to upgrade are stuck, because the buying power of the equity of their current home has deflated.? Thus few upgrading buyers, and they are typically a large part of the housing scene.? Good article — helps point out why this cycle in residential real estate may have prices drop below equilibrium levels.? We are close to equilibrium now, but nowhere near reversing.

2) How should bank solvency be regulated?? If sticking with the existing model, the bank examiners must be more rigorous, and they should consider some stressful scenarios, such as we are experiencing now, or worse.? Perhaps a market-based solution would help, such as that which former Fed Governor Poole has proposed.

His objective is the toobig to fail institutions, but he says that all banks would have to issue subordinated debt.? This would be difficult to implement for small banks. Small issue sizes in the debt market are tough to place, and rolling over 1% each year makes the sizes smaller still. The sub debt would have to be at the operating bank subsidiaries, which are smaller than the holding companies.

I like the idea, though. Maybe a market would develop for small bank sub debt? maybe even funds specializing in it. The yields could be significant, and even protected to some degree, given the need to roll it over to stay operating.

That said, loss incidence might be infrequent, but loss severity and correlation would be high. That?s true of losses on unsecured financial debt generally, but it would be worse with sub debt.

This idea is not new, but it is worth a try. The financial analysis of banks by regulators who have little economic incentive to be right, and hampered by politics has not worked well. It would be replaced by profit-seeking analysts who do have an incentive in the health of the bank in question.

3) Given the fall in global trade, export-driven nations are getting hit hard.? Maybe that can help explain why Treasuries are selling off on the long end — aside from excess supply due to the humongous deficit, there is less need to recycle excess dollars by buying Treasuries.

4) Okay, I was wrong about the Indiana Pension System winning in the short run regarding secured Chrysler debt.? Given the time pressures, the suit was rejected.? Maybe they will win on appeal, but how that works out after the deal is done is messy.

5) GM bondholders have rejected a settlement, and so the company will likely go through chapter 11.? I do not get the large amount of financing that the US government is putting up.? What? Do they want to repeat the losses they will experience through AIG?

6) With the shrinkage in market capitalizations, the number of sell side analysts declines.? No surprise here.? The number of sell side analysts is proportional to the money that can be made by investment banks off of underwriting and trading.? As market capitalizations fall, so do revenues for investment banks.

7) Yesterday, I said that if California defaulted, we would face a constitutional crisis.? I still think that is true.? I ran across Felix’s thoughts on the matter today, though they are one month dated.? The upshot to me is that there are no ways of enforcing payment if a state won’t pay on their municipal debts.? This is a hole in the system, and one that could pinch many in the US, not just Californians.

8 ) Federal Reserve Transparency act of 2009?? Bring it on.? Yea, Ron Paul, one of the few economically literate memebers of Congress.? The Fed gets away with a lot because they aren’t purely private or public.? They use their dual status to hide — when it is more useful to be a government institution, they are that.? Vice versa, when being private allows the avoidance of FOIAs.

9) This is one long article.? How sunk are we regarding peak oil/hydrocarbons?? I have revised my estimates of oil production downward, and will buy more energy related stocks at my next rebalancing.

10) Though I am not a dollar bull, there is no easy replacement for the US Dollar on the global scene.? Euro, too experimental.? Yen, too small.? I have not advocated that the Chinese currency could replace the Dollar (as some have), because their economy would have to become far more open.? They aren’t willing to do that.

11) It’s tough being a corporate director. 😉 No, it’s altogether too easy, which leads to complacency.? Consider the situation at the banks, or at the FHLBs.? Years of leverage expansion, where the livin’ was easy, made them lazy, and unwilling to challenge their managements.? No surprise that their reasons for existence are being chalenged now.

12) Though Samuelson misses the point that trust fund exhaustion is not the trouble point, his article is a welcome addition to the discussion.? Time is not on the side of the social insurance programs of the US Government, but as I have stated, that trouble comes when revenues are less than expenses, because the trust funds, invested in Treasuries, are a farce.? The only way the US government can pay off on those is through taxation, borrowing, or inflation.

13) What are implied breakeven levels of inflation implying from TIPS?? That many people fear that inflation will run out of control, given the reckless actions of the Fed and the US Government.

Fifteen Notes on our Current Economic Situation

Fifteen Notes on our Current Economic Situation

Posted on by David Merkel

1) I don’t think that residential real estate prices are turning in general.? But even if residential housing recovers, and demand returns, there will be a “housing mismatch.”? There will be too many high end homes relative to buyers.? Financing for high end homes is sparse, and too many expensive homes were built during the boom years.

2) Inflation.? What a debate.? In the short-run, deflationary pressures are favored, but what can you expect when so many dollar claims are being created by the Fed?? The output gap may indicate inflation is impossible, but stagflation is possible when monetary policy exceeds the need for dollar claims amid a collapsing economy, as in the 70s.

3) At the time, I suggested that the banks forced to take TARP funds had been coerced because the regulations could be lightly or tightly enforced.? Looks like that was true.? Why does this matter?? The TARP was supposed to be stigma-free because all major banks were taking it.? Coercion should make the government more lenient on payback terms.

4) I never did all that much with the cramdown that the Obama administration did with Chrysler secured creditors.? All that said:

5) Can global trade patterns be changed to avoid the dollar?? Some are trying.? In the long run, if the US is only a capital importer, the US Dollar will lose its reserve status, and weaken considerably.

6) Union jobs are magic.? They provide these incredible benefits, but with one small problem: they kill the companies that are forced into them.? GM may be sold to the government, but unless the burden of total compensation being above productivity is lifted, there will be no substantive change.

7) Dilution.? I was never a fan of McClatchy, but this seals the story on the newspapers.? Sell equity interests cheaply, so that you can survive.? The same is happening with many banks, and it is forcing the share prices of the industry lower.

8 ) Commercial real esate is the final shoe to drop in our credit bust.? Prices are 20% below the peak.? Refinancing will prove tough.? There are no sectors in commercial real estate that are not overbuilt.

9) The PBGC is taking its share? of losses at present.? This is no surprise here, given all I wrote about the PBGC at RealMoney.? The losses on a market value basis are even greater, because firms with underfunded pensions are more likely to default.

10) Residential real estate has not stabilized yet.? The bottom will come after the resets on Alt-A lending.

11) Are there difficulties with lending in the farm belt?? To a greater degree than I expected, yes.

12) Will California survive?? We can only hope.? Given that there is no bankruptcy code for states, California could prompt a Constitutional crisis if it defaults.

13) Should the Fed regulate systemic risk?? Perhaps when it stops creating it.? My position was, and continues to be that the Fed has been incompetent with monetary policy, bringing us to where we are today.? We need to eliminate the Fed and its bureaucracy, which produces little value for the US.? Monetary policy could be conducted with a far smaller staff; it might even be better.? Remember, bureaucries hit economies of scale rather rapidly.? Small is beautiful with bureaucracies.

14) In the recent slowdown, there has been inventory decumulation.? Those at the end of the supply chain have been hit the hardest.? Welcome to the cyclical world when it has to slow down.? The tail always gets it the worst in a game of “crack-the-whip.”

15) Ending with inflation, John Hussmann makes the case that the current economic policy must result in inflation.? If you are reading this, John, given that we live in the same city, perhaps we could have lunch someday?

Book Review: Financial Shock

Book Review: Financial Shock

Posted on by David Merkel

Note to readers: for this review, I read the first chapter, and skimmed the rest of the book. (full disclosure)? I usually read the entirety of every book I review, but I did not this time.? Why?? Chapter 1 is the backbone of the book, and tells the whole story in a nutshell.? The remaining chapters flesh out Chapter 1.? Most of my writings over the past five years shadow what Mr. Zandi has written, and he has created an integrated description that covers every major area of the crisis, with particular attention to mortgages, and the huge effect that the speculative mania in real estate had on the financial economy.

This is a serious book, one that explains the roots of our crisis.? If you haven’t understood it in a systematic way from reading my blog, or those that I recommend, this book will give you a coherent explanation of how we got here.

I do have some quibbles with the book.? When he describes residential mortgage securitization on page 117, the mezzanine and subordinated tranches are too large, even for subprime.? Also, his recommendations in the last chapter — I can agree with most of them, but not with mark-to-market, and the uptick rule.

This edition of the book takes us up to the first quarter of 2009, allowing Zandi to comment on the initial actions of the Obama administration.

All in all a very good book.? If you have a relative that doesn’t understand the crisis, this will explain it to him in a simple way.? If you want to buy it, you can buy it here:

Financial Shock (Updated Edition), (Paperback): Global Panic and Government Bailouts–How We Got Here and What Must Be Done to Fix It

As with all of my reviews, if you buy something through Amazon after entering through my site, I get a small commission, and you don’t pay anything more.? Don’t buy anything that you don’t want to buy on my account, though.

One Dozen More Notes on the Economic Scene

One Dozen More Notes on the Economic Scene

Posted on by David Merkel

1) I may as well start out the evening with some predictions. I’m not an expert on this, but Chapter 9 of the bankruptcy code applies to municipalities, but not states. Given the problems with state & municipal pensions, we will probably see chapter 9 modified over the next two decades to allows states to default. There will also be some modification to retirement funding laws as applied to municipalities, states, and maybe the US Government, to allow for retroactive negotiation of pensions and healthcare benefits for an insolvent government.

2) California will lead the parade of states in trouble.? They want the US to guarantee their municipal debt.? Schwartzenegger did all he could to try to pass the referenda that might partially close the budget gap, but from what I see now, it looks like most of the important ones have failed.? Having been a California resident for seven years, I went though my share of referenda; the referendum process makes the politicians of California lazy… they pass the tough stuff off to the electorate, who then get to decide off of voters’ guides and soundbites.

3) California is an exaggerated version of the troubles that other states are having.? Social program spending rises, while taxes on wages, corporate profits, real estate, real estate transfers, etc., all fall.? If you can’t print your own money, and must balance your budget, life is tough, kind of like it is for most Americans.

4) Another municipal issue — can financial guarantors split in two?? I have argued “no,” but who cares what I think?? We do care about those that use the courts, and banks are suing to prevent the MBIA split.? It is a simple issue of fraudulent conveyance.

5) One last municipal issue: pension placement agents.? This is very similar to what I experienced in Pennsylvania regarding municipal pensions there.? Pension consultants would gain business through campaign contributions, and the Democratic and Republican consultants would collaborate and share to control the profits jointly.? Insurance companies providing pension services would pay? compensation to the consultants in exchange for business.? It’s a dirty business, and when I raised ethical objections to it, I was told that I was naive.? Perhaps I have more company now.

Anytime you have opaqueness of compensation, politics, and uncertainty of results (investing), there is always room for corruption.

6) Asset allocation.? The belief in a large equity premium led many to overweight stocks.? I have argued against that.? Now there are many who are finding the they have to start over, after bad equity returns.? There is no magic in any asset class.? Yes, equities do better than bonds in the long run, but only by 1-2%/yr, not 5-7%.

As for the arguments of Ayres and Nalebuff, only the most emotionally dead investors can live with levering up 1.9 times perpetually.? Most people panic.? They can barely deal with the volatility of the S&P 500, much less double that.

7) Mmmm… is it time to take on Bill Miller again?? Yeh.? Overweighting financial stocks?? That is quite a bet, and probably irresponsible again.? Here is my free advice — analyze your estimates of intrinsic value with commercial real estate prices 30% lower than today.? Aside from short-tail insurers, I don’t think you want to be overweight financials.

8 ) On the same note, many small and intermediate-sized banks face troubles under stress, particularly from commercial real estate lending.

9) I think we are in the second inning for declines in prices for commercial real estate, but perhaps the seventh inning for residential real estate.? So long as residential properties sell for less than their mortgages there is downward pressure on prices, because negative events lead to foreclosures, not sales.

10) How will derivatives be regulated?? That is the question.? Will it be as transparent as TRACE?? I doubt it.? The market is not that liquid.

11) Will the US Government likely get full value back on TARP buyouts? No, because they lack expertise at analyzing these situations.? They don’t know what a warrant is worth.

12) Will low-rate mortgages rescue the economy?? No, but many middle class people with equity will breathe easier after they refinance.? Also, some will buy homes, but who will have the downpayment necessary to qualify now that underwriting has tightened?? Not many.

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