Category: Real Estate and Mortgages

Closing Out Ten Odd Lots

Closing Out Ten Odd Lots

Posted on by David Merkel

1) Do you need new investment ideas?? John Dorfman’s column at Bloomberg is back.? There are some good ideas in the second column.? I always liked it in the past, and so I recommend it to you.? They don’t have a page for him yet, so perhaps this link will help if you want to see his ideas in 2009.

2) I have never read Atlas Shrugged.? I have better things to do.? But, I still believe that much of what the government is doing will cause more harm than good, because they delaying the reconciliation of bad debts.

3) We must restore confidence!? But what is confidence?? Are we talking about some loony Keynesian idea like “animal spirits?”? (We are sentient men, not animals, and have our own unique follies.)

When am I confident about my economic status?? I am confident when I think my goods and services have adequate demand, and my assets are going to throw off cash flow because the economic processes they depend on have adequate demand.? But that is a bicycle stability answer.? What if I am in debt, and most of my economic contacts are in debt, and many of our assets rely on the repayment of debt that is coming from assets with impaired prospects?

Confident men are willing to take on debt; they are so confident that they are willing to take some risk of a large loss from borrowing.? Men who are frightened try to preserve some subset of what they have.

My point is this: in the bust phase of the economic cycle, it is normal for those that have not planned prudently, keeping debts down, and leaving enough in reserve, to be scared.? Given the foolish nature of our government to encourage, rather than discourage debt, it has left us all less confident in the future.? 1984-2007 was one incredible bull phase, and it will be followed by an similarly large bust phase, as debts will have to be reconciled.

Instead, our dear government layers on more debt to try to solve the problem, risking the national credit for political gains.? Some of the debt proceeds are used to buy up other bad debts, others are used to recapitalize marginal institutions.? Nothing much happens, and the big risk appears slowly, that needed change has been postponed through government intervention, leaving a larger problem to solve later.

4) Are Defined Contribution [DC] plans fatally flawed?? No more so than Defined Benefit [DB] plans.? From the article:

The most obvious pitfall is that 401(k) plans shift all retirement-planning risks — not saving enough, making poor investment choices, outliving savings — to untrained individuals, who often don’t have the time, inclination or know-how to manage them. But even when workers make good choices, a market meltdown near the end of their working careers can still blow their savings to smithereens.

“That seems like such a fundamental flaw,” says Alicia Munnell, director of Boston College’s Center for Retirement Research. “It’s so crazy to have a system where people can lose half their assets right before they retire.”

Uh, many of the same flaws apply to DB plans, which are also under stress now.? After large market losses, DB plans will look for ways to reduce their liabilities.? There’s no magic here.? When the market goes down, everyone gets hurt, and corporations do not want to contribute more to their DB plans — they would rather terminate them, or shed them to the PBGC after bankruptcy.

5) As an example, consider the pensions of the automakers.? I was somewhat skeptical about the health of their DB plans, partly because GM had contributed a big slug of its own common stock as an asset in the past.? Where was the PBGC when the bailout discussion was active?? They could have derailed the talks by pointing out the underfunding.? Oh, wait.? They want more money to go to the automakers because it might minimize their liabilities.

6) What GSE (government sponsored enterprise) sounds like a mistake?? The Federal Home Loan Banks [FHLBs, pronounced “flubs.”]? They lurk behind the banks that own them, and provide credit to their owners.? As it is now, a large portion of the FHLBs may no longer deserve their AAA ratings because of the losses they may take from risky mortgage assets.

If the Treasury has to rescue the FHLBs, we are truly in sad shape.? They have operated behind the scenes for so long that few know about them.? Better that the owners bail out the FHLBs than the taxpayers.? As it is, the owners are already taking pain.

7) Do you need a free reading on your credit score?? Consult quizzle.com.? I tried it and found it to be free and safe.

8 ) Need some productivity enhancement tools?? Jack Ciesielski provides a year end list at his blog.

9)? I was unimpressed to say the least with this piece by Dean Baker on Social Security.? If all that he is saying is that some benefits will be paid in some form for some time, then I have no argument.? But if he is saying there is no plausible scenario where benefits will not be paid over the long term, then I disagree.? Here’s my argument:

Consider my piece The Biggest, Baddest Bubble of Them All.? The present value of the net liabilities of the US Government on a consolidated basis was $25 Trillion at fiscal year end 2002, $50 Trillion in 2007, and $53 trillion at the most recent reading.? We are facing deficits verging on $1 Trillion for the near future, and on an accrual basis, those deficits are over $1 Trillion, as we take in more than we pay out on our social insurance programs.

To close annual gap of $1 trillion, or even $450 billion (most recent cash deficit) through tax increases and spending reductions will be painful.? Much of the budget involves entitlement programs like Social Security that would be hard, but not impossible to change.? As William Proxmire said back in the early 80s in this famous exchange:

    Senator William Proxmire: “…there are 37 million people, is that right, that get Social Security benefits?”
    Social Security Commissioner James Cardwell: “Today between 32 and 34 million.”
    Proxmire: “I am a little high; 32 to 34 million people.? Almost all of them, or many of them, are voters. In my state, I figure there are 600,000 voters that receive Social Security. Can you imagine a senator or congressman under those circumstances saying, ‘We are going to repudiate that high a proportion of the electorate?’ No.
    Furthermore, we have the capacity under the Constitution, the Congress does, to coin money, as well as to regulate the value thereof. And therefore we have the power to provide that money. And we are going to do it. It may not be worth anything when the recipient gets it, but he is going to get his benefits paid.”
    Cardwell: “I tend to agree.”

    My point here is that benefits may get paid in dollars that aren’t worth that much. The cost of living adjustments will be limited or eliminated.

    Increased means testing will eliminate benefits to those that are better off, and turn the program into an old age welfare program, which will bring back the stigma of receiving benefits, and reduce its political legitimacy, because it would no longer have the useful fiction of something that is everyone’s right.? The “contributions” to Social Security are just another tax to support

    Benefits will be cut, and taxes will be raised, to be sure.? The point is that the government took the excess “contributions” and spent them on whatever the government needed at that time.? There was little care for future generations — spend it now.? Each succeeding generation gets a progressively worse deal from Social Security, paying in more relative to what will be received.? (As an aside, I know of few that are more pessimistic about the situation than the actuaries I have met at the SSA.)

    It is not impossible that younger generations might finally rebel against the burdens placed on themselves over which they have no say.? Social Security could be dramatically scaled back in such a crisis, to the point where it no longer resembles the current program.? At least that would be better than a failure of the nation as a whole.? There is some level of indebtedness at which the US government would fail, whether through internal or external debt repudiation, or inflation.? I guess we have to test how much US debt the rest of the world can take down before the door finally shuts to the US Government borrowing in its own currency.

    10) On that note, I want to close by mentioning my friend Cody Willard‘s new website SpokeUp.com.? Cody has been amazed at the anger he has been hearing over the current crisis, and our government’s seemingly unfair methods of handing out relief.? SpokeUp.com is an effort to enable people to connect over political issues, and possibly organize to effect political change.

    Book Review: Dear Mr. Buffett

    Book Review: Dear Mr. Buffett

    Posted on by David Merkel

    This is not your ordinary Buffett book.? In one sense, that is because it is not a Buffett book.? When I read other early reviews on the web, I concluded that they hadn’t read the book.? I read almost all of the books that I review at my blog.? If I have not read the book, but have skimmed it, I tell you so in the first few paragraphs.? I also purposely avoid reading the stuff that the PR flacks include with the books.? I find it fascinating how many reviewers rely on the crutches provided.

    Why is this not an ordinary Buffett book?? Because it concerns how an expert on derivatives came to know Mr. Buffett, and how the current crises were seen in advance by both of them.? This book’s greatest strength comes from its ability to explain the messes we are currently in.? No solutions, mind you, and Mr. Buffett ain’t handing out any of those either, but understanding how we got to where we are is of value, and Janet Tavakoli is nothing if not a good writer on those points.

    There is a second theme — how a derivatives expert came to appreciate value investing.? After all, when short term investing is focused on a variety of arbitrage situations, why not think long, and look for long term capital appreciation?

    In the book, much of the current crisis gets examined up through September 2008.? Unlike many, she was right in advance on many of the topics that would eventually bite us:

    • CDOs
    • Subprime mortgages
    • Hedge fund underperformance
    • Failing Financial Guarantors
    • And more…

    She also disses the overrated Nassim Taleb, saying that the current events are not a “black swan,” but predictable, given the overage of leverage.? I agree, having written about these thing before the bust hit, while still admiring Taleb’s focus on nonlinearity and feedback cycles.

    Janet Tavakoli and Warren Buffett share a similar philosophy on derivatives.? That is what motivates this book.

    • How can they be a systemic hazard?
    • How might one use them properly?

    I heartily recommend this book.? One reading this will understand our current crisis very well, and will gain in his understanding of how our markets work.? That said, the virtues of the book do not come from Mr. Buffett, but from one who intelligently admires his views on derivatives and other matters.

    You can buy the book here: Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street

    PS — I write book reviews, and I hope you like them, because unlike other reviewers, I read the books.? I use Amazon because their service is good, and they offer a fair commision to those influencing those that buy through them.? My view is that if you need to buy something through Amazon, entering the site through one of my links will not increase your costs, and I will get a small commission.? Thanks to all who buy on Amazon through me.

    Cramming Down on Whom?

    Cramming Down on Whom?

    Posted on by David Merkel

    I favor cramdowns for now, becauseLike the recently departed Tanta at Calculated Risk, I also favor the concept of cramdowns in mortgage foreclosure proceedings.? It would bring balance to the negotiations, and discourage banks from making bad loans.? If a bank could be forced to compromise during? a foreclosure (odd because it is secured lending), the result could leave more homeowners in their homes, and with mortgages where the principal balances reflect current conditions.

    In order for loan modifications to work, there has to be forgiveness of principal owed, though perhaps by granting the banks a part of the upside if the property is sold at a gain in later days.? Forgiveness of principal allows the LTV ratio to remain whole, while reducing the payment at the same time.

    But what does that do to the banks?? The cramdowns cram immediate losses onto the banks.? What if the actions of judges lead to the insolvency of banks?? What if the possibility of future cramdowns lead mortgage rates to rise, in order to account for the risk?? This is not a costless exercise in fairness.

    Articles on the cramdown proposal:

    I favor cramdowns for now, because it can be a win-win for the borrowers and banks.? Leave the homeowner in place, who values the home, while making him pay something close to maximum sustainable monthly amount.

    It makes the system more flexible, and at this point, that is a good thing.

    Financial History is Valuable

    Financial History is Valuable

    Posted on by David Merkel

    I’ve said it before, but I came into the investment business through the back door as a risk manager.? Unlike most quantitative analysts, I came with a greater depth of knowledge of economic history, and a distrust of the assumptions behind most quantitative finance models, because things can be much more volatile than most current market participants can imagine. As a result, I often ran my models at higher stress test levels than required by regulation or standards of practice.

    Can countries fail?? Sure.? It has happened before.? Can leading countries fail?? Yes, and consider France, Germany and Japan.? Consider earlier history — the failure of a major power has significant effects on the rest of the world.

    Understanding economic history can keep one from saying, “That can’t happen.”? Indeed when governments are pressed, they do their best to extract additional revenue out of those that will complain the least.? Qualitative analyses, if done properly, incorporate a wider amount of variation than the quantitative statistics will reveal in hindsight.? Do you incorporate the idea that all novel securities (new industries) go through a big boom bust cycle?? If so, you would have avoided most of the complex debt securities born in the last ten years, and would have been light on risky debt that was the building blocks for those securities.

    Though the job should fall to regulators to bar institutions of trust from investing in novel instruments, and they used to do that, the legal codes and regulators, forgetting history, removed those restrictions, and left many financial institutions to their own wisdom in managing their risks.? Some of those institutions were careful and speculated modestly if at all.? Others went whole hog.

    The speculators (not called that at the time) pointed to loss statistics that had been generated during the boom phase of the cycle.? They showed how the junk-rated certificates would even be money good under “stressed” conditions.? All of the way through the boom, they pointed to their backward looking statistics, as leverage levels grew, and underwriting quality fell in hidden ways.

    We know how it has ended.? In some cases, even AAA securities will not be money good (i.e., principal and interest will not be repaid in full).? Alas for the poor non-US buyers who sucked down much of the junk securities.

    This forgetfulness regarding booms and busts affects societies on a regular basis. It happens everywhere, but the freewheeling nature of the US makes it a model country for this exercise (boom period in parentheses):

    • Residential Housing (2002-6)
    • Commodities (2001-8)
    • Financial Innovation — hedge funds, securitization, credit default swaps (1995?-2007)
    • Cetes (1992-1994)
    • Commercial Real estate (20s, 80s, 2000s)
    • Guaranteed Investment Contracts (1982-1991)
    • Negative convexity trade in residential mortgages (think of Orange County, Askin, Bruntjen) 1990-1993
    • Stocks (20s, mid-to-late 60s “Go-go era,” 1982-1987, 1994-2000, 2003-2007)
    • Energy (1973-82)
    • Developing country lending (late 70s)

    This list isn’t exhaustive, but it’s what is easy for me to rattle off now.? Cycles are endemic to human behavior.? Governments and central banks may try to eliminate the negative part of a cycle of cycles, but it is at a price to taxpayers, savers, and increased moral hazard.? Why limit risk when the government has your back?

    All that said, relying on historical patterns to recur, or simple generalizations that say that “the current crisis will follow the same track as the Great Depression,” are too facile and subject to abuse.? The fine article by Paul Kedrosky that prompted this piece makes that point. Too often the statistics cited are from small data sets, or unstable distributions generated by processes that are influenced by positive and/or negative feedback effects.

    Studying economic history gives us an edge by giving us wisdom to avoid manias, and avoid jumping in too soon during the bust phase.? I’m still not tempted by housing or banks stocks yet.

    That’s why I write book reviews on older books dealing with economic history (among others).? As Samuel Clemens said, “History doesn’t repeat itself, but it does rhyme.”? It doesn’t give a simple roadmap to the future, but it does aid in developing scenarios.? As Solomon said in Ecclesiastes 1:9, “That which has been is what will be, That which is done is what will be done, And there is nothing new under the sun.”

    I’ll close the article here, but I have an application of this for politicians and regulators that I want to develop in part two.

    Fair Value Accounting — It Is What It Is

    Fair Value Accounting — It Is What It Is

    Posted on by David Merkel

    I’ve written on mark-to-market accounting before.? Searching my blog, I was surprised to find how many pieces I have written in 2008 on the topic.

    So, it’s interesting to me to see the FASB interested in continuing with Fair Value accounting, despite all of the criticism.? It’s not to say that MTM accounting is perfect — all accounting methods are approximations and are imperfect, but does it convey the best information needed for investors to make? reasonable decisions, at an acceptable cost?

    If MTM accounting were proposed in the ’80s it would never have been approved.? The value of common financial instruments did not usually change much; unless an equity had a public market, revaluations occurred only for reasons of impairment.? But derivatives and structured security prices vary considerably, and their prices often vary in a way that approximate valuations can be calculated from the prices of other publicly traded securities.

    Now, that many financial companies trade below their net worth is a proof in this environment that investors don’t trust the value of the assets, nor their earning power.?? Many assets have not been marked down to their fair value.

    I will defend SFAS 157, and the other mark-to-market accounting standards, but I won’t defend an application of them that is too rigid.? When trades are infrequent, and there are strong reasons why the security deserves a different value than last trade, then let the security be marked to model.? It is the best that can be done.? But merely that a security is at an unrealized loss for several years should not in itself be a reason to mark the security down, if the management concluded that it was “money good.” (they get their principal back.)

    The mark-to-market rules as stated have flexibility in them, aiming for a fair statement of the net worth of the firm.? Given the nature of the investments and hedges employed, this is a good thing if done properly and fairly.

    Can these rules be used to distort accounting?? Of course, in the short run.? In the intermediate-term, the errors catch up, and destroy the cheater.? In the long run, cash flows determine the value of a business.

    So, be wary in the present environment.? Just because a financial institution trades below book value does not mean that it is cheap.? Much of the cheapness stems from the opaqueness in pricing of unique risks.

    The challenge is analyzing what an asset is truly worth, and when that value can be realized.? That is the challenge with financials today.

    Twenty Comments on the Current Economic Scene

    Twenty Comments on the Current Economic Scene

    Posted on by David Merkel

    1) There are firsts for everything.? Americans paid down debt for the first time, according to a Federal Reserve Study that started in 1952.? America has always been a pro-debt and pro-debtor nation.? It goes all the way back to the Pilgrims, who paid back the merchant adventurers who funded them at a rate of nearly 40%/yr over a 15-20 year period.? But, the Pilgrims did extinguish the debt.? Us, well, I’m amazed at the decrease, but we need more of that to restore normalcy to financial institutions.

    2) Dropping to 45%, though, is the amount of aggregate home value funded by equity.? With the decline in housing values, the fall in the ratio was inevitable.? The low ratio puts downward pressure on home prices, because it means that more homes are underwater.? Perverse, huh?

    3) It’s a long interview, but Eric Hovde (my former boss) has a lot of important things to say regarding the financial sector.? Few hedge funds focused on financials remained bearish on the sector, but Hovde’s funds survived to 2007-2008 where his bets paid off.

    4) Is there a Treasury bubble?? Yes, but it may persist for a while because of panic, central bank buying, buying from pension funds and endowments, mortgage hedging, and more.

    5) Now these same low yields whack Treasury money funds. How many will close?? How many will cut fees?? How many will break the buck, and credit negative interest?? An unintended consequence of monetary policy.? Another unintended consequence reduces liquidity in the repo markets.? Yet another unintended consequence is the reduction in investment from Japan and other nations that don’t want to hold dollars at low rates.

    6) Brave Ben Bernanke is fighting the Depression.? If his theories are right (and mine wrong), if he succeeds, he will face a difficult challenge in collapsing the Fed’s balance sheet as inflation re-emerges, without taking the wind out of the economy.? But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed and the US Government to handle.

    7) Inflation is the lesser evil at this point.? It would raise the value of collateral over the value of the loans, dealing purchasing power losses to those that made the bad loans, but not nominal losses.

    8 ) I have said before that the Fed and Treasury are making it up as they go, and Elizabeth Warren now confirms it for the Treasury.? My Dad (turned 79 yesterday) used to say, “The hurrier I go, the behinder I get.”? So it is for the TARP bailout.? Policy made hastily rarely works.? Spend more time, get it right.? The market won’t die as you work it out.

    9) But will AIG die, or the automakers?

    10) Even VCs are looking at the survivability of their portfolio holdings.? Who can survive and become cash-flow positive in a tough environment.? Who needs little additional funds?

    11) Leveraged loans are attractive, but it is a situation of too many loans with too few native buyers.? Watch the loan covenants, so that you can get good recoveries in a default.? If you are an institutional investor, this is a place to play now that will deliver reliable returns net of defaults.? For retail investors, the closed end funds typically employ too much leverage — it is possible that one could collapse before this crisis is over.

    12) Residential mortgages continue to weaken along with property prices.? Two examples: Alt-A loans and second mortgages.

    13) I have a lot of respect for Dan Fuss.? This is a tough time for anyone taking credit risk.? That said, it could be a good time to take on credit risk now, if you have fresh money to deploy.

    14) Two views of the crisis: one that focuses on structured finance, particularly CDOs, and one that focuses on macroeconomics.? I favor the latter, but both have good things to say.

    15) Michael Pettis is one of my favorite bloggers.? He notes the weakness in China, and notes that the current economic situation is ripe for trade disputes.

    16) You can give the banks funds, but you can’t make them lend.? Would you lend if you didn’t have a lot of creditworthy borrowers?

    17) The export boom is dead, for now.? Fortunately, imports are falling faster, so the current account deficit is falling.

    18) I blinked when I saw this Wall Street Journal Op-Ed.? Sorry, but the secret to changing the residential real estate market is not lowering interest rates, but writing-off? portions of loan balances.? Most delinquents can’t make even reduced payments, half re-default, and can’t refinance because the property is underwater.? Yes, I know that the government is pressing to have Fannie and Freddie suck down more losses by letting underwater loans refinance, but if you’re going to do that, why not be more explicit and let the losses be realized today by resetting the loan’s principal balance to 80% of the property value, and giving the GSE a property appreciation right on any growth in the home value on sale, of say 150% of the amount written down?

    19) On commercial property, when do you extend on a loan vs foreclosing?? In CMBS, if the special servicer has no bias, or if a healthy insurer/bank holds the loan on balance sheet, you extend when you are optimistic that this is just a short-term difficulty with the property, and you think that the property owner just needs a little more time in order to refinance the loan.? More cynically, extensions can occur in CMBS because the juniormost surviving class directs the special servicer to extend because it maximizes the value that they will get out of their investment, because a foreclosure will wipe out a portion of their interests, since they are in the first loss position.? With a less than healthy bank or insurer, the same procedure can happen if they feel they can’t take the loss now.? (I know that in a extension/modification there should be some sort of writedown, but some financial entities find ways to avoid that.)

    20) Time to go bungee jumping with the US Dollar?? As Bespoke pointed out, the Dollar Index has just come off its biggest 6-day loss ever.? Should we expect more as the US heads into a ZIRP [zero interest rate policy], with aggressive expansion of the Fed’s balance sheet, much of which might be eventually monetized?? The best thing that can be said for the US Dollar is that it is already in ZIRP-land, and much of the rest of the rest of the world is being dragged there kicking and screaming.? As the interest rate differentials narrow in real terms, the US Dollar should improve.

    But, there are complicating factors.? Future growth or shrinkage of the demand for capital will have an impact, as will future inflation rates.? Even if the whole world is in a global ZIRP, there will still be differences in the degree of easing, and how much easing the central bank allows to leak into the money supply.

    This is a mess, and over the next few years, expect to see a whole new set of metrics develop in order to evaluate monetary policies and currencies.? For now, put your macroeconomics books on the shelf, because they won’t be useful for some time.

    Redacted FOMC Statement

    Redacted FOMC Statement

    Posted on by David Merkel

    The Federal Open Market Committee decided today to lower its establish a target range for the federal funds rate 50 basis pointsof 0 to 1/4 percent.

    The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

    Since the Committee’s last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined.? Financial markets remain quite strained and credit conditions tight.? Overall, the outlook for economic activity has weakened further.

    Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters to levels consistent with price stability.

    Recent policy actions, including today?s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee Federal Reserve will monitor economic and financial developments carefully and will act as needed to promoteemploy all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

    The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level.? As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant.? The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.? Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. ?The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

    Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice ChairmanChristine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

    In a related action, the Board of Governors unanimously approved a 5075-basis-point decrease in the discount rate to 1-1/4/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco. The Board also established interest rates on required and excess reserve balances of 1/4?percent.

    The Upshot

    • We’re done with Fed Funds in entire.
    • On to quantitative easing.? (Japan had the advantage of running a current account surplus… how will it work for us with a deficit?)
    • The princely rate of 1/4% gets paid on all reserve balances at the Fed, both required and excess.
    • The Fed is looking at deflation, not price stability.
    • The Fed will possibly invest more into long Treasuries, with uncertain prospects.
    • The Fed will continue to make it up as it goes, and keep expanding its balance sheet, adding liquidity where it wills, and replace functions of the private lending markets in the name of fixing the lending markets.
    Twenty-five Facets of the Current Economic Scene

    Twenty-five Facets of the Current Economic Scene

    Posted on by David Merkel

    1) So many managers lose confidence near turning points, like Bruce Bent in this article.? Still others maintain their discipline to their detriment, not realizing that they have a deficiency in their management style.? Alas for Bill Miller.? A bright guy who did not get financials, or commodity cyclicals.

    2) We will see rising junk bond defaults in 2009.? Some defaults will be delayed because covenants are weaker than in the past.? But defaults primarily occur because cash flow is insufficient to finance the interest payments on debts.? That can’t be avoided.? After Lehman, what can you expect?

    3) As housing prices fall, which they should because housing is in oversupply, more homeowners find themselves in trouble.? Remember, defaults occur because a property is underwater, and one of the five Ds hits:

    • Divorce
    • Disability
    • Death
    • Disaster
    • Dismissed from employment

    As it stands now, the jumbo loan market is looking at more trouble — there was a lot of bad underwriting there during the boom.

    4) I am not a fan of workouts on residential mortgage loans.? Most of them don’t work out.? Loans typically default because of one of the 5 Ds, and modifying terms is adequate to help a small number of the borrowers.

    5) I’ve talked about this for a while, but Defined Benefit pensions (what few remain) have been damaged in the recent bear market.? What should we expect?? When companies offer a fixed benefit, and rely on the markets to fund it, they rely on the kindness of strangers, who they expect to buy equities when they need to make cash payments on net.

    6) There are two credit markets.? Those that the government stands behind, and those that it does not.? That is the main distinction in this credit market, with Agency securities falling into a grey zone.

    7) If we were dealing with your father’s financial instruments, we would use his financial rules.? As it is, more complex financial instruments that are more variable in their intrinsic value must be valued to market, or, the best estimate of market. There are problems here, but remember that market does not equal last trade for illiquid, complex securities.? Also, there should be caution over level 3 modelled results.? From my own work, those results are squishy.

    8 ) During a crisis, many relationships boil down to liquidity.? Who has it? Who needs it, and at what tradeoff?? The same is true of venture capital today.? Who will fund their commitments?? Beyond the issue of dilution looms the issue of survival.? VC backed companies lacking cash will have a hard time of it in the same way their brother public companies do.

    9) The Fed ain’t what it used to be.? Today it has all manner of targeted lending programs, and a disdain for stimulus through ordinary lending.

    10) General Growth Properties relied on continual prosperity, and look where it led them.? Better, consider the Rouses who sold to them near the peak.? Good sale.

    11) How can SunTrust be in this much trouble, needing a second does of TARP funds so soon?? I don’t get it, but it is endemic of our banking sector.? The TARP Oversight Panel is supposedly going to ask a bunch of questions to the Administration regarding past use of TARP funds, but the questions are vague and easy to answer in generalities.

    12) There were warnings of trouble inside both Fannie and Freddie, as well as a few recalcitrant analysts outside as well (including me).? Now they recognize the trouble they are in, maybe.? (Also: here.)? Congress does what it can now, not to identify what went wrong, but to divert attention and blame away from themselves.? No one supported the expansion of Fannie and Freddie more than Congressional Democrats.? Political critics were marginalized.

    Now, it is possible that Congress could double down on its stupidity, and cause Fannie and Freddie to not require appraisals on refinanced loans.?? They have enough credit risk as it is; should they do loans that are not adequately secured by the property?

    13) The euro makes it to its ten-year anniversary, and we are told… see, as sound as a Deutschmark.? Well, maybe.? Having a strong currency might be fine for Germany, but what of Greece, where the credit default swap market is pricing in a 12%+ probability of default over the next five years?? They might like a weaker euro.

    14) Is Britain a greater default risk than McDonalds?? Is the US a greater default risk than Campbell Soup?? Sovereign default is a different beast than corporate default.? Corporations don’t control their own currency (hmm… does that make Greece more like a corporation of the Eurozone? or more like California in the US?), and so bad debt decisions compound over longer periods of time, until we end up with inflation, a forced debt exchange, or an outright default.? It is possible for the US to default without Campbell Soup defaulting, but the life of any US corporation would be made so much more difficult by an outright default of the US government, that I would expect an outright default to cause most US companies, states, and other nations to fail as well, because of implicit reliance on the creditworthiness of the Treasury.

    15)? What is stronger now, fear or greed?? Let’s take up greed.? I got a large-ish amount of responses to my pieces Does Not Pass the Japan Test, A Reason to Sell Stocks Amid the Rally, and my more bullish piece Momentum in the S&P 500.? There are a lot of bulls here:

    Bottom-callers are out in droves, with many sophisticated arguments.? They all hinge on one idea: that we can return to normalcy soon with a compromised financial system, and debt levels that are record percentages of GDP.

    16) On the fear front, we have:

    Here’s the main graph from the second piece:

    The basic idea behind the two pieces is this: sure, we’re at average valuation levels now, but in a real bear market values can get cut in half from here.? My view is this: we’re not at table-pounding valuation levels yet, but someone with a value and quality bent will make money over the next ten years.

    17) Less helpful are pieces like this one: Five Sparks for a Stock Market Comeback.? His five sparks are:

    1. No More Downward Revisions to GDP Growth
    2. An Enormous Government Stimulus Package
    3. An End to Redemption-Related Selling by Hedge and Mutual Funds
    4. Increased Lending
    5. Tax Cuts

    I fear this confuses the symptoms with the disease. Yes, it would be nice if many of these happened, but with the deficit hitting record levels, 2 and 5 are problematic.? In an over-indebted economy 1and 4 are tough as well.? As for point 3, you may as well argue with the sunrise, because most investors are trend-followers, whether they know it or not.? Redemptions typically end after the market has turned significantly.? It’s not a leading indicator, nor is it necessarily an “all clear.”

    18 ) There are other reasons for concern, among them low t-bill yields.? There is significant fear, such that short term investors will take zero, rather than put principal at risk.? Maybe we should call t-bills the biggest mattress in the world to hide money under.

    19) From the “read your bond prospectus with care department,” Catastrophe bonds are only as good as the collateral backing the deal or creditworthiness of the obligor.? Though it may have seemed a good idea at the time, allowing for lower quality collateral has caused the creditworthiness of several catastrophe bonds to suffer as Lehman defaulted, and as losses on subprime mortgages rose.? My take is this: analyze all the risks on a bond, even the obscure ones.? A lot of exchange traded note [ETN] investors probably wish they had paid more attention to who they were lending the money to, rather than the index attached to the notes.

    20) The “read your bond prospectus with care department” does have a humorous side, as Paul Kedrosky points out on this amendment to some new Illinois GO bonds.? They don’t sound too worried, but maybe the lawyers have to be more pro-active, and put the following new risk factor into the prospectus:

    Endemic Political Corruption

    Your investment in the state of Illinois is subject to risks involving political corruption, which is a normal fact of life in Illinois. In lending to the State the lender bears the risk that the corruption level gets so great that it affects the trading value of these securities, and that interest and principal repayment could be impaired.

    21)? Even if you don’t have 5 of your last 9 Governors removed due to scandal, like illinois, it’s tough to be a state nowdays.? Now you have the credit default swap [CDS] market spooking investors in your bonds.

    22) So what would it mean for the Fed to issue debt?? Is it just an alternative to Treasuries and the Fed’s present relationship with the US Treasury?? A way to pay interest to those that participate in the Fed funds market, but can’t leave excess reserves at the Fed?? Or, a way to have a sovereign default without a sovereign default?

    I’m not sure, but I would be careful here.? What can be used for a single limited pupose today can be put to unimaginable uses tomorrow.? The Fed’s balance sheet is already at much higher levels of leverage than it was three months ago.? Does it really want to take on more?? Granted, seniorage gains/losses go back to the Treasury, which then can borrow less or more in response, but as the Fed’s balance sheet gets more complex, it makes it more difficult to gauge their policy responses, and I think it will lead to a lack of trust in the Fed and the US Dollar.

    23) With conditions like these, should we be surpised that volatility is high in the equity markets?? By some measures, it is higher than that in the Great Depression.? I’m not sure I would call it a “bubble” though.? Extreme Value Theory tells us (among other things) that when a probability distribution is ill-defined, don’t assume that the highest value that you have seen is as high as it can get.? Records beg to be broken.

    24) It’s not as if I am the only one thinking about issuing longer US Treasury debt.? Now the Treasury is thinking about it as well.? It will fill a void in our debt markets that life insurers, endowments, and DB pension plans will want to invest in (and create a bunch of new leveraged fixed income investments for speculators).

    25) Three articles to close with:

    Risk the Credit of the Republic for Homeowners

    Risk the Credit of the Republic for Homeowners

    Posted on by David Merkel

    Yesterday, I was contacted by UrbanDigs, one of my regular readers, and he asked:

    UrbanDigs Says:

    December 3rd, 20087:10 pm at Edit

    David, Can you please email me, its provided on this comment.

    I would like your opinion on an alternative to stimulate housing instead of the govt meddling with rates to 4.5% and buying up loans from GSE?s..

    Its such a bad idea and they are digging this country into a debt ridden hole.

    Why not tweak the tax code for investors from a 1031 deferrement to a 5 YR qualification primary residence like exemption?

    http://www.urbandigs.com/2008/12/instead_of_meddline_w_rates_wh.html

    GRANT THE PRIMARY TAX CAPITAL GAINS EXEMPTION BENEFIT TO INVESTORS AND CHANGE THE QUALIFICATION TERMS SO THAT THE PROPERTY PURCHASED BY THE INVESTOR MUST BE HELD FOR A MINIMUM PERIOD OF 5 YEARS

    Thoughts? As an alternative to help the hoousing supply problem without the unintended consequences of govt meddling, moral hazard, taking on more risky assets, and trying to convince people to buy for the wrong reasons, like 4.5% rates.

    Okay, here are my thoughts:

    1) Regarding taxation, my view is that all income should be taxed equally and regularly.? I’m not generally in favor of deferring or exempting taxes on asset classes of any sort.

    2) The Federal Reserve is buying up mortgage assets.? Now the Treasury is thinking of subsidizing mortgage rates.? Don’t we do enough in the US to overinvest in housing?

    Call me a skeptic here.? In credit crunches, the value of the collateral is far more important than the rate charged.? I care more as a lender about the return of my money, than the return on my money.? Lending to entities where the loan-to-value is high is fraught with peril.? Losses occur with little regard for the interest rates charged.? Life events matter more: death, disaster, disability, divorce, and dismissal from employment.? Negative life events cause borrowers to choke on interest payments when refinancing is impossible.

    Lowering the mortgage rate to 4.5% will subsidize borrowers who can refinance through conventional mortgages, but will do little good elsewhere.? The subsidy will also add to the financing needs of the US Treasury, which is getting stretched.

    The efforts of the Fed and Treasury may lower mortgage rates for a time, but as the government borrows more, there will be pressure for rates to rise.? For now, it may seemingly work, but it will eventually fail, and the outcome will be worse than if they hadn’t acted.

    So I’m not crazy about government action here.? Why should we risk the credit of the Republic over homeowners?? Let real estate prices find their levels where ordinary people con afford ordinary homes without incurring a boatload of debt.

    The More Things Change, The More They Remain The Same

    The More Things Change, The More They Remain The Same

    Posted on by David Merkel

    I’ve been asked by a number of readers for my opinion on the economic team being put together by the incoming Obama administration.? I’m not that excited, but then Bush Junior’s economic team was pretty consistently disappointing.? What we have is a bunch of Clinton-era retreads in Summers, Orszag, and Geithner.? Bob Rubin may not be there, but those that learned from him are there.

    And, this is change.? I have sixty cents sitting next to me.? That’s change also.? Moving from Paulson to Rubin’s students is exchanging one part of the intellectual framework of Goldman Sachs for its cousin.? As Ron Smith said to me off the air when I was recently on WBAL, the economic advisors of Bush and Obama are members of the same intellectual country club.? There is little real change there.

    But, look at it on the bright side.? The best part of the Clinton administration was the Treasury Department and the affiliated entities.? Perhaps that will be true of the Obama administration as well — pragmatism ruling over dogmatism, and a fear of freaking out the bond market.? Could be worse.? Save us from misguided idealists (perhaps Bernanke — a pity he didn’t pick a different dissertation topic), who think they know how to fight economic depression, but really don’t, and waste a lot of time and money in the process.

    As it is we get two new programs this morning that are more of the same😕 Keep expanding the Fed’s balance sheet; don’t think about the eventual unwind.? Create more protected lending programs that encourage lenders to flee unprotected areas of the market for protected areas.? Do anything to shift debt from private to public hands; but don’t do anything that truly reconciles bad debt.

    I do have a beef with the selection of Geithner, though.? This Bloomberg piece gives a sympathetic rendering of his attempts to deal with derivatives.? He tried to achieve consensus of all parties.? My view is that the areas where he could achieve compromise were areas that were important but not critical.? He needed to take a bigger view and question the incredible amounts of leverage, both visible and hidden, that we were building up and focus on what regulatory structures could properly contain the increased leverage, lest the gears of finance grind to a halt, as they have done today.

    We can be less sympathetic, though.? Chris Whalen’s (Institutional Risk Analytics) opinion of him is quite low, or, as he was quoted in this NYT article:

    ?We have only two things to say about Tim Geithner, who we do not know: A.I.G. and Lehman Brothers,? said Christopher Whalen of Institutional Risk Analytics. ?Throw in the Bear Stearns/Maiden Lane fiasco for good measure,? he said.

    ?All of these ?rescues? are a disaster for the taxpayer, for the financial markets and also for the Federal Reserve System as an organization. Geithner, in our view, deserves retirement, not promotion.?

    Ouch.

    ?He was in the room at every turn of the crisis,? said another executive who participated in several such confidential meetings with Mr. Geithner. ?You can look at that both ways.?

    This Wall Street Journal editorial is similarly bearish.? Geithner was in the room on every bad decision, and a few non-decisions.

    Or, just consider some of the questions that should be put to Geithner.? They are significant.

    My view is that he is a bright guy who is out of his league in trying to deal with the aftermath of the buildup in leverage, that has lead to the collapse in leverage that we all face.? Now, I can’t be that critical of him, because he has been cleaning up after the errors of many, a small fraction of which he bears some responsibility for.

    No one is equal to solving this crisis.? It is bigger than our government, which made an intellectual mistake in thinking that it could promote prosperity through Greenspan-like monetary policies, which almost everyone lionized while they were going on, except a few worrywarts like me, James Grant, etc., who followed the buildup of leverage in the Brave New World.? Now we face its collapse; let’s just hope and pray? that it doesn’t lead to worse government than what we have now.

    PS — If I were offered the opportunity to fix things, I would take it, and:

    The last one I like the least, but I’m afraid it would have to be done.? Phase two would be:

    • Move to a currency that is gold-backed.
    • Replace the Fed with a currency board.
    • Create a new unified regulator of all depositary institutions.
    • Slowly raise bank capital requirements, and make them countercyclical.
    • Bring all agreements onto the balance sheet with full disclosure.
    • Enforce a strict separation between regulated and non-regulated financials.? No cross-ownership, no cross-lending, no derivative agreements between them.
    • Bar investment banks from being publicly traded, and if regulated, with strict leverage/risk-based capital limits.
    • Move back to balanced budgets, and prepare for the pensions/entitlements crisis.

    On that last one, there are few good solutions there, but we would have to try anyway.? So it goes.

    Theme: Overlay by Kaira.