Category: Real Estate and Mortgages

The Humility of Realism, Redux

The Humility of Realism, Redux

Posted on by David Merkel

I want to return to this topic to deal with some comments that I received.? Before I start, I want to repeat a comment that I made at Barry’s blog:

Barry, I?m going to toss out a third possible cause for the end of the Great Depression. The first two are FDR?s programs and WWII, both of which I don?t find compelling.

I grew up in this business as a risk manager, and a bit of a innovator there. I had experience with nonlinear dynamic modeling which most actuaries and financial analysts, even most quants, don?t get or use. The economy, and most industries are nonlinear dynamic systems, which means there will be cyclical behavior, and that behavior will be more volatile the greater the level of fixed commitments in the system that must be satisfied.

Economies that primarily use equity finance are more stable than those that primarily use debt finance. It becomes easier to have a cascade of failure the greater the overall debt burden is on the system. So, the total debt level has a major impact on the behavior of the economy. In 1929, total debt to GDP was 280%. By 1941, that level was 160% or so, where it stayed (more or less) until 1985.

After that, debt to GDP moved up parabolically to 360% by 2007, and now we find ourselves in the soup in two ways: 1) total level of debt, 2) complexity of debt because of securitization and to a lesser extent, derivatives.

Why did the depression end around 1941? Reason 3 (my reason): enough debt had been paid down or written off, and loans could be made to good borrowers, but only enough that financial sector would grow slowly (not faster than GDP).

The answer today, in my opinion, is that we need expedited procedures for bankruptcy to reset the system, getting lenders to compromise with borrowers, and bring down the debt to GDP ratio. I don?t think the present programs will work, and they may actually prolong the crisis, a la Japan. In my opinion, we won?t see significant economic growth until the debt to GDP ratio falls into the 150-200% range.

That is my opinion in a nutshell.? Or, as I commented regarding Hank Paulson here:

He could have tried a more modest solution of expediting bankruptcy processes, because the most pressing need for the economy is to turn bad debts into lesser equity stakes, so that the debt overhang can clear.

This probably includes streamlining personal bankruptcy such that lenders receive back loans with smaller principal balances, plus property appreciation rights.

Total debt levels must be reduced below 180% of GDP, and then the Fed must add a new constraint to their policy. Tighten when Debt/GDP rises above 180%, and raise bank capital thresholds in response to the overall indebtedness of the economy.

Better to go back to a gold standard, I say, but if you’re going to have fiat money, at least do it intelligently, so that debt does not get out of control, as it did in the 20s, and 1985-2007.

In essence this would give a third mandate to the Fed.? When total debt to GDP levels get above 180%, tighten, and make bank exams tougher.? Below 120%, flip it (sending a nickel to my pal Cody).

Now, I received a number of responses to my original article.? I’d like to mention a few of them here, and respond.

From Ray Taylor — ?.hmmm ? ?I say Big Bang???so you?re a financial analyst with a wife and eight children and you don?t mind being unemployed for a few years?or, alternatively, bagging groceries at Kroger (if it?s still in business)?you might want to ask the rest of your family for their opinion.

Good point.? I have a decent amount of safe assets laid away, but I am an equity manager, so I am not in a great spot.? I am more than willing to bag groceries, though, or work at other more mundane tasks if things get really bad.? My father taught me the value of hard work.? I am not worried for my family if our nation survives.? I am concerned over whether our nation survives.? Present policies are lowering the odds of survival.

Also, I have many friends in my church that will help me if things get bad.? I helped in the good times; they will help in the bad.

From Michael M. — First, I have a deep suspicion that people who advocate we take our medicine sharply, are generally in positions where the pain will not happen to fall sharply on them, but on other people. I suspect the author is one of these. I am pretty appalled at the indifference such people show to the enormous suffering real depression would bring to huge numbers of people.
Second, I do not know of strong agreement that the Great Depression cured itself; most seem to think the fortuitous enormous spending of World War II finished it off, not an automatic self-regulating process.

Michael, I am 65% exposed to equities relative to my net worth.? Part of that is a promise that I made to my long only investors that I would always have a minimum amount of my net worth exposed to what they are investing in.? I speak what I think is the truth because that is what I am supposed to do ethically, whether it hurts me or not.

Also, I believe my proposals would cause the most people the least pain.? The present proposals of our government point in the direction of FDR and Japan, prolonging the pain.

You are right that there is no consensus saying the Great Depression healed itself.? As I said to Barry above, what I am saying is that the consensus is wrong, and that the Austrian School and those that understand nonlinear systems theory are right.? We can’t establish prosperity by government actions (leaving aside infrastructure); prosperity comes through private actions.

From Mike in NOLa — With respect to protectionism, Michael Pettis has pointed out that China today is much like the US was in the late 1920?s, with huge foreign currency reserves and manufacturing overcapacity. As such, China may be the one to go protectionist, either explicitly, or by monetary manipulation. See his last two posts:

http://mpettis.com/

I read everything Michael Pettis writes.? I agree totally.

From JVDeLong:— David – a question for you. I cannot claim a good grasp of macro, but my intuitive sense is that the key is your comment about the ratio of debt to GDP. Some of these claims must be wiped out by default – but the chief political characteristic of the system is an utter inability to inflict losses. Everyone must be bailed out.

So if we cannot allow piecemeal bankruptcies to clear the system, then what is the alternative except national bankruptcy ? which takes the form of meeting all the claims in nominal terms and then hyper-inflating?

I have stayed with stock market investments on the theory that either the crisis will be brought under control and the stocks will recover, or that the efforts will fail and national bankruptcy will ensue, which means that money-equivalents are not a conservative investment. I do not think the Fed/Treasury will repeat the deflation scenario of the 1930s.

BTW – I heard James Grant speak last week, and he is bearish on money and bullish on high yielding corporate bonds, but I dunno ? that looks like threading a needle.

Your thoughts (and I would be happy to be told that I am crazy)?

With respect to Mr. Grant and high yield, I would agree with him.? I am also bearish on the dollar, and would consider oil, gold, or yen as alternatives at present.

National bankruptcy, or significant inflation, is a possibility that everyone should consider.? I agree with you, the Fed and the Government do not want to repeat the 30s, which is why I think inflation is more likely, unless pressure from international interests makes the US government soak its own populace to pay foreigners.

Kevin Murphy says — David: Would a reverse ETF such as the Proshares Ultrashort treasury funds be a good hedge against inflation or a failure of the Government to finance it?s obligations at current interest rates?

Though I don’t like levered ETFs because they usually underperform their targets, yes, that would be a good strategy.

Ben Says: — Has anyone tried to estimate what the economic situation would have been in the US had we not won the war? I know it sounds stupid, but I?m very dubious about this ?WWII ended the depression theory?. Winning WWII was such a profound positive shock to the US economy that attempts to draw economic analogies and quantify an equivalent amount of peacetime stimulus seem stretched at best.

In terms of the question of how much stimulus we need, there must be many more examples of countries applying economic stimulus to study than the few people are bantering about at the moment. OK, so modern day Japan, Britain in the 70?s and the total experience of the New Deal are not encouraging for Keynesians. Where are the happy endings?

Good points, the Keynesian remedies have not generally worked. Policymakers follow those remedies not because they work, but because they maximize their own power.

VennData Says:– The claim that ?this will give a chance to see who was truly correct about what to do then versus now?? is an exaggeration of the benefit of ex post outcomes of economic cause and effect.

The idea that a ?Bling Standard? is somehow realistic, desirable, is wrong, Even the Swiss have dumped theirs. It makes you vulnerable to whomever buys up ?all the? gold: SWFs, foreign central banks, Private equity, Hedge funds etc? The Fed may have had a hand in too much leverage, but the system self-corrects. The biggest problem after Reagan?s appointment of Greenspan was Bush?s administrative fiat: the 2004 leverage ruling and Congress?s post-Clinton budget busting.

One change we need is addressed correctly above: government policies need to be counter cyclical during boom times – no nation wants to be hamstrung by the pro-cyclical ?Bling Standard? – government systems should be counter-cyclical.

At a minimum, the Fed needs to be allowed into VIP lounge where the punch bowl resides.

VennData, I agree with you that policy needs to be countercyclical under a fiat money or gold standard.? In general, governments are averse to doing so, because it reduces their power.? For that reason, I believe that the government should not be in the money business; it gives them power that they have not managed well, and don’t deserve.

But, you misunderstand my comment that you quoted.? I expect the government to interfere massively, and that the malaise will be prolonged as a result.? Bernanke’s methods, and those of the Treasury, will be ineffective, showing that we really did not learn the right lesson from the Great Depression.? The right lesson would be that in fiat money environment, the central bank must limit the creation of leverage.

Russ Wood Says: JVDeLong wrote — So if we cannot allow piecemeal bankruptcies to clear the system, then what is the alternative except national bankruptcy ? which takes the form of meeting all the claims in nominal terms and then hyper-inflating?

The alternative lies in the denominator of the Debt/GDP ratio. We have to grow GDP as fast as possible. Unfortunately, no one wants to talk about creating incentives for growth. The only discussion is how to cushion everyone from slower growth.

Russ, I sympathize with your views, but growing GDP rapidly is impossible in a credit-based economy when the banks are compromised.? Debt reduction is the main way out, intially.

=–=-==-=-=-=-=-=–==-=-=-

So, my views remain unchanged, and perhaps affirmed.? Depressions, like popped bubbles, are primarily phenomena of finance.? They happen when cash flows from assets are insuffiicient to cover liability cash flows.

Would that our government would wake up and realize that the right policy is the one that feels wrong in the short run.? Aside from that, does anyone care about the implications regarding individual freedom?? Or, that group freedoms are affected as well?

What is a Depression?

What is a Depression?

Posted on by David Merkel

Before I try to explain what a Depression is, let me explain what a bubble is.? A bubble is a self-reinforcing boom in the price of an asset class, typically caused by cheap financing,? with the term of liabilities usually shorter than the lifespan of the asset class.

But, before I go any further, consider what I wrote in this vintage CC post:


 David Merkel
Bubbling Over
1/21/05 4:38 PM?ET
In light of Jim Altucher’s and Cody Willard’s pieces on bubbles, I would like to offer up my own definition of a bubble, for what it is worth.A bubble is a large increase in investment in a new industry that eventually produces a negative internal rate of return for the sector as a whole by the time the new industry hits maturity. By investment I mean the creation of new companies, and new capital-raising by established companies in a new industry.This is a hard calculation to run, with the following problems:

1) Lack of data on private transactions.
2) Lack of divisional data in corporations with multiple divisions.
3) Lack of data on the soft investment done by stakeholders who accept equity in lieu of wages, supplies, rents, etc.
4) Lack of data on corporations as they get dissolved or merged into other operations.
5) Survivorship bias.
6) Benefits to complementary industries can get blurred in a conglomerate. I.e., melding “media content” with “media delivery systems.” Assuming there is any synergy, how does it get divided?

This makes it difficult to come to an answer on “bubbles,” unless the boundaries are well-defined. With the South Sea Bubble, The Great Crash, and the Nikkei in the 90s, we can get a reasonably sharp answer — bubbles. But with industries like railroads, canals, electronics, the Internet it’s harder to come to an answer because it isn’t easy to get the data together. It is also difficult to separate out the benefits between related industries. Even if there has been a bubble, there is still likely to be profitable industries left over after the bubble has popped, but they will be smaller than what the aggregate investment in the industry would have justified.

To give a small example of this, Priceline is a profitable business. But it is worth considerably less today than all the capital that was pumped into it from the public equity markets, not even counting the private capital they employed. This would fit my bubble description well.

Personally, I lean toward the ideas embedded in Manias, Panics, and Crashes by Charles Kindleberger, and Devil take the Hindmost by Edward Chancellor. From that, I would argue that if you see a lot of capital chasing an industry at a price that makes it compelling to start businesses, there is a good probability of it being a bubble. Also, the behavior of people during speculative periods can be another clue.

It leaves me for now on the side that though the Internet boom created some valuable businesses, but in aggregate, the Internet era was a bubble. Most of the benefits seem to have gone to users of the internet, rather than the creators of the internet, which is similar to what happened with the railroads and canals. Users benefited, but builders/operators did not always benefit.

none

Bubbles are primarily financing phenomena.? The financing is cheap, and often reprices or requires refinancing before the lifespan of the asset.? What’s the life span of an asset?? Usually quite long:

  • Stocks: forever
  • Preferred stocks: maturity date, if there is one.
  • Bonds: maturity date, unless there is an extension provision.
  • Private equity: forever — one must look to the underlying business, rather than when the sponsor thinks he can make an exit.
  • Real Estate: practically forever, with maintenance.
  • Commodities: storage life — look to the underlying, because you can’t tell what financing will be like at the expiry of futures.

Financing terms are typically not locked in for a long amount of time, and if they are, they are more expensive than financing short via short maturity or floating rate debt.? The temptation is to choose short-dated financing, in order to make more profits due to the cheap rates, and momentum in asset prices.

But was this always so?? Let’s go back through history:

2003-2006: Housing bubble, Investment Bank bubble, Hedge fund bubble.? There was a tendency for more homeowners to finance short.? Investment banks rely on short dated “repo” finance.? Hedge funds typically finance short through their brokers.

1998-2000: Tech/Internet bubble.? Where’s the financing?? Vendor terms were typically short.? Those who took equity in place of rent, wages, goods or services typically did so without long dated financing to make up for the loss of cash flow.? Also, equity capital was very easy to obtain for speculative ventures.

1998: Emerging Asia/Russia/LTCM.? LTCM financed through brokers, which is short-dated.? Emerging markets usually can’t float a lot of long term debt, particularly not in their own currencies.? Debts in US Dollars, or other hard currencies are as bad as floating rate debt,? because in a crisis, it is costly to source hard currencies.

1994: Residential mortgages/Mexico: Mexico financed using Cetes (t-bills paying interest in dollars).? Mortgages?? As the Fed funds rates screamed higher, leveraged players were forced to bolt.? Self-reinforcing negative cycle ensues.

I could add in the early 80s, 1984, 1987, and 1989, where rising short rates cratered LDC debt, Continental Illinois, the bond and stock markets, and banks and commerical real estate, respectively. That’s how the Fed bursts bubbles by raising short rates.? Consider this piece from the CC:


 David Merkel
Gradualism
1/31/2006 1:38 PM EST

One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

  • 2000 — Nasdaq
  • 1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed
  • 1994 — Mortgages/Mexico
  • 1989 — Banks/Commercial Real Estate
  • 1987 — Stock Market
  • 1984 — Continental Illinois
  • Early ’80s — LDC debt crisis

    • So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.

    But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it.

    Position: None

    Bubbles end when the costs of financing are too high to continue to prop up the inflated value of the assets.? Then a negative self-reinforcing cycle ensues, in which many things are tried in order to reflate the assets, but none succeed, because financing terms change.? Yield spreads widen dramatically, and often financing cannot be obtained at all.? If a bubble is a type of “boom phase,” then its demise is a type of bust phase.

    Often a bubble becomes a dominant part of economic activity for an economy, so the “bust phase” may involve the Central bank loosening rates to aid the economy as a whole.? As I have explained before, the Fed loosening monetary policy only stimulates parts of the economy that can absorb more debt.? Those parts with high yield spreads because of the bust do not get any benefit.

    But what if there are few or no areas of the economy that can absorb more debt, including the financial sector?? That is a depression.? At such a point, conventional monetary policy of lowering the central rate (in the US, the Fed funds rate) will do nothing.? It is like providing electrical shocks to a dead person, or trying to wake someone who is in a coma. In short: A depression is the negative self-reinforcing cycle that follows a economy-wide bubble.

    Because of the importance of residential and commercial real estate to the economy as a whole, and our financial system in particular, the busts there are so big, that the second-order effects on the financial system eliminate financing for almost everyone.

    How does this end?

    It ends when we get total debt as a fraction of GDP down to 150% or so.? World War II did not end the Great Depression, and most of the things that Hoover and FDR did made the Depression longer and worse.? It ended because enough debts were paid off or forgiven.? At that point, normal lending could resume.

    We face a challenge as great, or greater than that at the Great Depression, because the level of debt is higher, and our government has a much higher debt load as a fraction of GDP than back in 1929.? It is harder today for the Federal government to absorb private sector debts, because we are closer to the 150% of GDP ratio of government debts relative to GDP, which is where foreigners typically stop financing governments. (We are at 80-90% of GDP now.)

    We also have hidden liabilities through entitlement programs that are not reflected in the overall debt levels.? If I reflected those, the Debt to GDP ratio would be somewhere in the 6-7x GDP area. (With Government Debt to GDP in the 4x region.)

    We are in uncharted waters, held together only because the US Dollar is the global reserve currency, and there is nothing that can replace it for now.? In the short run, as carry trades collapse, there is additional demand for Yen and US Dollar obligations, particularly T-bills.

    But eventually this will pass, and foreign creditors will find something that is a better store of value than US Dollars.? The proper investment actions here depend on what Government policy will be.? Will they inflate away? the problem?? Raise taxes dramatically?? Default internally?? Externally?? Both?

    I don’t see a good way out, and that may mean that a good asset allocation contains both inflation sensitive and deflation sensitive assets.? One asset that has a little of both would be long-dated TIPS — with deflation, you get your money back, and inflation drives additional accretion of the bond’s principal.? But maybe gold and long nominal T-bonds is better.? Hard for me to say.? We are in uncharted waters, and most strategies do badly there.

    Last note: if you invest in stocks, emphasize the ability to self-finance.? Don’t buy companies that will need to raise capital for the next three years.

    Ten Notes For the Current Crises

    Ten Notes For the Current Crises

    Posted on by David Merkel

    1) General Growth Properties — another case of too much leverage, illiquid assets, and liquid liabilities.? I live near Columbia and Baltimore, so I know of a lot of property owned by General Growth that was bought when they acquired the Rouse Corp.? I can hear the Rouses in the distance congratulating themselves on a good sale.

    For those that haven’t read me much, the deadly trio of too much leverage, illiquid assets, and liquid liabilities is what causes most corporate defaults of financial companies, not lesser issues like mark-to-market accounting.

    2) The government thinks it is doing something good, and then it realizes that it is in over its head.? Consider AIG and Fannie Mae.? Where does the bailout end?? The government does not have a team of financial analysts competent to dig into murky balance sheets, and they have the mistaken notion that they must act fast.? Having worked on several takeovers of large financial firms, I can tell you that work done quickly destroys value.? Either there is an underestimate that leads to losing the bid, or an overestimate that leads to overpaying, and an eventual writeoff of part of the investment.

    With Fannie Mae and AIG, (and probably Freddie also) the government clearly did not know what it was doing.? What were the main drivers of the loss, and how much worse could they get?? Is this scenario self-reinforcing?? The cursory work led to a bad result that is getting worse.

    3) Amazing that we are almost to the end of the first $350 billion of bailout capital.? The government is behaving like a person that just won the lottery, and is profligate with spending, because they’ve never had that much money to throw around with complete discretion until now. As it says in Proverbs 13:11, “Wealth gained by dishonesty will be diminished, but he who gathers by labor will increase. [NKJV]”? Easy come, easy go.? I am not surprised in the slightest that the US Government has mis-estimated the loss exposures.? They don’t have anyone with a concentrated interest (a profit motive) in the result.

    4) Here’s another angle in the Fed refusing to disclose what assets they are financing.? If we knew who they were buying from, and what they were buying, the markets would ask the question, “How much more firepower are they willing to expend?”? If the judgment is “little”, market players would sell what the Treasury/Fed was buying, and if the judgment is “a lot”, market players would buy what the Treasury/Fed was buying.

    That leads me to believe that the Treasury/Fed doesn’t want to commit a lot more resources to this fight.? If they felt they had a lot more firepower, they would happily disclose their actions, because the private markets would aid their actions.

    5) I’ve been talking about it for over a decade, so pardon me if I point at the great pensions disaster.? We have had a lost decade where DB pension money needed to earn 8-9%/yr, and earned around 1%/year.? That gap of 7-8%/yr over 10 years is enough to destroy most well-funded plans at the beginning of the period.? The problem exists for DC plans as well, because as people age, they lose time to compound their money.? Hey, think of this — the dumb guys that put all their money in the stable value fund did much better than those that put their money at risk.? So much for the equity premium in hindsight, but now it’s time to begin committing funds to riskier assets.? (Don’t do it all at once.)

    6) At least Mr. Obama can make one market go up — muni bonds.? Wait, that’s not good?!? At least healthy municipalitiestheir borrowing rates improve as higher taxes lead the wealthy to shelter income from taxation.

    7) Maybe Obama’s tax poicy could have more bite.? Close down tax havens.? This is something I can get behind.? I like low tax rates, but I don’t like the ability for some to lower their tax rates, and not others.? Let there be a level playing field in the tax code, such that there is no advantage to moving profits offshore.

    Now, could Obama enact real tax reform that would be fair, and cause Buffett (and others) to pay taxes on his unrealized capital gains?? He could, but he won’t, because he is a slave of Democratic special interests.

    8 ) I understand why the Treasury did it.? They wanted an opaque way of encouraging the purchase of weak banks by stronger banks.? So, they let them absorb tax losses of the acquired bank.? Too bad it is not legal, but legality doesn’t affect our government much these days.

    9) Give Spain a hand — they managed to increase capital requirements on their banks during the good times.? Things aren’t perfect now, but Spanish? banks are in decent shape given all of the credit stress.

    10) Why is the Fed funds rate so low?? The 75 basis fee point forces the effective Fed funds rate from 1.00% to 0.25%.? Though some see the Fed hemmed in here, I think that as they reduce the Fed funds rate, they will also reduce the 75 bp fee.

    We Have a Debt to Discharge

    We Have a Debt to Discharge

    Posted on by David Merkel

    There is a common error with contrarian investing.? It is not a question of identifying things that people believe that are wrong, but finding things that people rely on that are wrong.? Reliance is the critical component.? I don’t care about what people think if they don’t have any skin in the game.? When someone relies on a certain result happening (or not happening), then there will be series of behaviors that happen as what he believes in fails, from intensifying the bet in the early phases, to throwing in the towel in disgust at the end.

    I’m going to take this idea and twist it a different way tonight.? One thing that the Democrats and Republicans (except Ron Paul) agree and rely on is that they know how to avoid a repeat of the Great Depression.? The textbook answer is:

    • Easy Money
    • Fiscal Stimulus
    • Don’t Raise Trade Barriers

    Ben Bernanke learned this as a young college student, and built it up in his Ph. D. dissertation.? He has the same moral certainty about this that George Bush, Jr. does about fighting terrorism.? And, I’m going suggest that Bernanke, and most of the political establishment (which hasn’t really changed in the last few days) are wrong.

    What is a bubble?? My definition: a bubble is a self-reinforcing cycle where monies invested obtain a negative return in aggregate over the long haul.? It is characterized by significant borrowing at low rates to invest in already appreciated assets in order to profit from a momentum-driven market.? When cash flow is insufficient to pay the interest to finance the bubble, the bubble pops, and a self-reinforcing bear market ensues.? When that bear market encompasses most of the financial system, we call it a depression.

    What is a depression?? A severe recession where the banks are impaired.? In an ordinary recession, lowering the Fed funds rate can stimulate the banks to lend.? Not so now; the banks are licking their wounds, and letting profits grow by financing at lower rates, and sucking in bailout cash to shore up their balance sheets against future real estate lending losses.

    The Great Depression ended when the Debt to GDP ratio dropped below 150%.? When enough debts were extinguished by payoff or default, the system could once again be normal.? Virtually none of the efforts of FDR focused on eliminating debts; in my opinion, he lengthened and intensified the Depression by not encouraging the liquidation of bad debts.? And now we do the same thing.? We perpetuate the misallocation of resources by trying to keep house prices high, by bailing out institutions that should go through the bankruptcy process.? This fails to convert bad debts into equity in newly solvent businesses.

    All the US government is doing is creating a bigger bubble.? What will happen when the Treasury auctions fail, or, stretch the yield curve so wide that there is panic.? We don’t want our financial institutions to fail, so we are willing to wager the creditworthiness of the nation in order to save them.? I don’t like that bet.? Many empires have died choking on debt.? Is the US to be next?

    When I wrote articles opposing the bailout, I did so because I did not think it would work, and that one-off conservations/liquidations would be preferable, but not optimal.? Optimal to me would be using the bankruptcy code on a expedited basis, wiping out junior capital, and making senior capital take haircuts.

    But in the present, we contemplate borrowing to bail out all manner of problems — bail out homeowners, automakers, banks, insurers, guarantors, etc.? The end to this phase will come when the creditors of the US write off their prior lending, and decide not to throw good money after bad.? I have no idea when that time will come, but the dreamy schemes of politicians aiming to solve every financial hurt will help to force such a time to happen.

    Conducting Reverse Auctions for the US Treasury

    Conducting Reverse Auctions for the US Treasury

    Posted on by David Merkel

    I regularly read “A Dash of Insight,” and greatly appreciate the commentary of Dr. Jeff Miller.? What I write here is an effort to encourage what he wrote in this piece advising President-Elect Obama.? (I would have my own advice for the President, but there are so many vying for his ear now, that I sigh and say “Let the poor man get on with it.? He will be imprisoned for the next four years, and likely find less capability of doing what he wants than he imagined.”)

    How would one implement what Dr. Jeff suggests?? As a bond manager, I was pretty good at price discovery.? I would convene a committee of large holders of the illiquid instruments and ask them what are the largest classes of homogeneous structured securities that no longer have markets now.? Once they agree on the classes (probably the AAA portions of the senior-sub structured ABS, RMBS and CMBS deals), the agent for the Treasury picks a subset of the largest deals, and announces how much of each security (say 10% of each tranche) they will offer to buy.

    Market participants are then invited to submit binding offers to sell any amount of the securities up to the maximum.? The Treasury’s agent could require a minimum amount of bids in order for an auction to be valid (say 2-3x the purchase amount).

    One tweak I would put in would be to award the bonds to the winning bidders at the price offered by the bidder with the highest bid not receiving bonds.? I used this successfully for years in bond auctions, and though it makes the trader shake his head initially, when I would say, “I’m offering protection against regret in advance, besides, I want aggressive bids.” they would say, “Okay, I get it.”

    After the auctions, there would be benchmark prices, yields, and spreads for a wide number of securities, and then the modelers would apply those prices to the mezzanine and maybe the subordinate tranches, which are too small to hold auctions for.

    Similar securities might find trading levels as well, but if not, the Treasury could run another set of auctions, and repeat as necessary.? Given the most of the securities auctioned are AAA, at worst, the Fed might have an interest in the short-to-intermediate AAA paper.

    If the Treasury followed a procedure like this, it could unjam the securitized fixed income markets, and do so at prices where the taxpayer bears modest losses at best.? I am not as optimistic as Bill Gross or Warren Buffett on this matter.? The point of the auction is to get the sellers to compete against each other, not compete with the government’s agent.

    Now, price discovery is a two-edged sword.? FInding the market clearing price will make the markets start moving again, but it also might prove that some financial institutions are inverted (negative net worth), if not insolvent (can’t get enough cash to pay all immediate claims).? If we are willing to stomach the possible insolvencies that this will reveal, then I am game for Dr. Jeff’s proposal.

    And, maybe this will show the need for RTC II, successor to the old Resolution Trust Company.? Bad financial institutions need to be conserved/liquidated, so that leverage can be reduced in the financial system of the US.

    So, let something like this be tried, but be ready for adverse consequences if the pricing turns out to be worse than anticipated.

    Ten Points About the Markets

    Ten Points About the Markets

    Posted on by David Merkel

    1) It is a wonderful thing to be the world’s reserve currency; we can milk the rest of the world until things change.? There is some push from emerging markets to have a change, but the effectiveness of that push is questionable.? Someone has to give the US an ultimatum, and no one is there yet.

    2) With the decline in fixed income volatility, mortgage yields are falling.? Good for mortgages, but the real question is what happens when the Treasury starts borrowing like a maniac.

    3) Many hedge funds have raised the gates.? Capital cannot easily exit.? GIven the weak balance sheets that hedge funds have, this is normal for a bear market.? The only surprise is that investors did not anticipate the troubles.

    4) Perhaps the money to banks from the government is going only to relatively sound institutions.? That is consistent with the idea of making some institutions sound, and letting them buy up marginal banks.? Upshot: don’t expect an early increase in lending.

    5) Analyze those that are on the other side of the table.? If they have a reputation for being smart, be extra careful.? Many municipalities and other entities lost money dealing with investment banks.? No surprise.

    6) Many do not understand mark-to-market accounting.? First, GAAP is the least of the problems — collateral agreements require MTM.? Regulators can ignore MTM as they please. Second, MTM is misapplied by auditors; it does not mean “last trade,” but an estimate of where a liquid market would trade.

    7) Shut the barn door after the cow has escaped.? Yes, loan underwriting standards have tightened, in the middle of a credit bust.

    8 ) There is less cash flow to service; the financial sector should shrink.

    9) S&P 500 at 600?? Not impossible, and not likely, but if profit margins crush down, possible.

    10) where could longs make money in October 2008? Nowhere.? Real bear markets crush almost everyone.

    In closing, I am not concerned about the victory of Obama.? The new president will have little freedom, and will face significant unsolvable problems.

    The Biggest, Baddest Bubble of Them All

    The Biggest, Baddest Bubble of Them All

    Posted on by David Merkel

    It’s election day, and I may as well try to fuse economics and politics for a moment.? Personally on an economic basis, I don’t think this election means that much.? Consider this post at RealMoney from earlier this year:


    		 David Merkel
    Cultures are Bigger than Economies, Which are Bigger than Governments
    1/7/2008 1:19 PM EST

    To start this off, I don’t fit neatly on the political spectrum. I am an economic libertarian, socially a conservative, but utterly against the recent wars that we have pursued. I also think that we need to find a way to dismantle the two party system, but that will never happen. So now you have enough to disregard me if you like.

    I don’t think the primaries make any difference at all. The three leading Democrats are all very alike. It doesn’t matter which one wins the primary. The Democrats would have their best chance with Obama, because general elections tend to be won on (sadly) which candidate is more likeable.

    As for the Republicans, there are differences, but not to any great degree on likely economic policy. I say “likely economic policy” because none of their differential policies are likely to survive if one of them wins the general election. Any Republican win is unlikely to have that much of a mandate.

    There are differences between the Republicans and Democrats on economic policy, but this is where my headline comes into play: “Cultures are Bigger than Economies, Which are Bigger than Governments.” Given the mismanagement of our government, particularly with respect to entitlement programs, though also costly wars, future governments will have less wiggle room. Raise spending, cut taxes? Go ahead and try. No surprise that the US Dollar continues to fall. Outsiders will eventually tire of funding US deficits in US currency.

    The Republicans will leave the micro-economy more free than the Democrats, but aside from that, I don’t think the election matters much, at least as far as economics goes. There may be other reasons to vote for one side or the other, but pocketbook issues rank low for me, and in this election, the payoff from the differences will not be big.

    Now, cultural change, in the unlikely event that it would occur, is another matter. But American history has been replete with big shifts before, and the economy and politics get dragged along. Perhaps the question to ask is what will be the next big shift in American culture? I don’t have any read on that now, but then, when it happens, it is often fast.

    Position: none

    Our biggest bubble, which is still inflating, are the debts of the US Government, both explicit and those not accrued for.? We are going to have a difficult time borrowing in the present for all of these new bailout/stimulus/pork programs.? Our debts are getting deeper, not shallower.

    Consider this graph from this article at Clusterstock:

    We may have a slight breather from the increase in total debt recently (2006-7), but it is going up in the near term.? My view is that we need delevering, and that will be a big theme in coming years once the government tires of the new policy of shifting private debts onto the public balance sheet.

    Now, I’m still dubious that the bailout policy will work.? Reasons:

    When a foreign holder of Treasuries is willing to give up 40 basis points of yield on a 10-year T-note yielding 3.80%, so that they can get paid off in Euros if there is a repudiation of US Treasury obligations, there is significant uncertainty over the creditworthiness of the US Government.? (That’s just an example, there are other reasons to enter into such a CDS.)

    Now, the debt-to-GDP graph above doesn’t take into account pension and entitlement underfunding/non-funding.? From another comment at RealMoney:


    		 David Merkel
    Digging a Hole to China (So We Can Borrow Some More)
    10/28/03 08:26 AM?ET
    With a gracious assist from one of our readers at Economy.com, here is the link I promised yesterday. The report does not break out one final number — one has to look at the “balance sheet” on page 58, and the “Statements of Social Insurance” on page 65, which they count as an off balance sheet liability, and add them up. It looks like this (in USD):

  • Net Liability: $6.8 trillion
  • Soc Sec, Pen & Dis: $4.6 trillion
  • Medicare, part A: $5.1 trillion
  • Medicare, part B: $8.1 trillion
  • Total: $24.6 trillion

    • This doesn’t take into account the value of land and certain less tangible assets that the U.S. Government has. It also does not take into account the considerable operating and capital lease liabilities, deferred maintenance, or liabilities for the GSEs, and other lending guarantee programs of the federal government.

    np

    That $24.6 trillion figure was from September 2002. As of September 2007, it would now be around $50 trillion. ( Here’s the link to the 2007 figures.? New figures out in two months.)? By the way, thanks Mr. Bush, for being such a reformer of Social Security and Medicare. You added on another $10 trillion of unfunded liabilities that future generations will have to fight over bear in your prescription drug program.? You have been the most damaging president on economics since Nixon.? (Sorry, I lost my cool. 🙁 )

    That $50 trillion does not count in state and corporate underfunding of pensions and benefits.? Oh, and with the fall in the markets, they want a bailout also.

    Who doesn’t want a bailout?? The US Government can just borrow some more to aid us on our way to prosperity.? Those debts and unfunded promises will have to be paid someday, either through taxes, inflation, or repudiation (total or external).? The economic mess at that point will be far worse than it is today for all those who rely on the US Dollar.

    Our problems in the US are larger than our politics.? It goes down to our very culture, borrowing from the future to take care of the present.? It is true for our Government, and many corporations and individuals.? The pain will come, the only question now is what form it will take.

    Fifteen Notes on the Markets

    Fifteen Notes on the Markets

    Posted on by David Merkel

    1) Where are we?? Is the equity market cheap or dear?? Personally, I think it is cheap, and though it might rally in the short run, it could get cheaper.? When the financials are compromised, all bets are off.? Here are some article indicating that things are cheap:

    And, not cheap, consider the arguments of this humble student of the markets.? He considers survivorship bias and war as factors that investors should consider.? I agree, and I would urge all to consider that wars often occur as a result of economic crises.

    2) The trouble is, quantitative finance is tough.? We don’t have enough data.? Our models are poor, and until recently, often reflected two major bull cycles, and only one bear cycle.? My view is that the equity premium is more like 3% over the long run, and not the 6% bandied about by careless consultants.

    3) During the “great moderation,” I argued over at RealMoney that volatility and credit spreads were too low, and would eventually snap back.? Okay, we are there now.? Volatility is high, and so are credit spreads.? The brain-dead VAR models used by Wall Street have been falsified again.? Quantitative investors have gotten savaged again; it only works when implied volatility is flat/declining — it is an implicit credit bet.

    4) This is a global crisis.? Where is it appearing?

    5) As I have mentioned before , the IMF, previously seeming irrelevant, has a new lease on life.? But how much firepower do they have, and will countries in crisis send them money to aid foreigners?

    Consider their new plans for a short term lending facility, and the exogenous shocks facility.? They will have a lot to fund in this environment.

    6) Might government programs to guarantee bank deposits have caused a shift from stocks to bank deposits?? Possible, though for every seller, there is a buyer.

    7) How do we pay back what we borrow?? Who will borrow more from us?? Those are? the great unanswered questions as we attempt to bail out many troubled entities.? I’m a pessimist here, and think that we will have higher long rates as a result, and that “Bernanke” will become a cuss word.? (Among the cognoscenti, only “Greenspan” will do as a proper insult.)? On the despondent side, will the US default in 2009?? Doom-and-gloomers are always early, and ignore the flexibility in the financial system prior to failure.? I see default as more of a 2017-2020 issue.

    8 ) Uh, let Lawrence Meyer pontificate.? There is nothing good about a zero Fed funds rate.? Let him wax grandiloquent about Japan over the past two decades.? Consider how low interest rates destroy money markets funds.? Consider as well how much low rates destroy saving, sometyhing that we have had too little of.

    9) In an environment like this, every M&A deal is open to question.? M&A is credit sensitive, and higher volatility impairs the flow of credit.

    10) I don’t think that GAAP mark-to-market accounting has had a material impact on this crisis.? True, many accounting firms have interpreted mark-to-market as mark-to-last-trade, but that is not what SFAS 157 specifies, and firms can ignore their auditors (with some risk).? The truth is that the firms that have failed choked on bad balance sheets and inadequate cash flow.? It doesn’t matter what the accounting rules are when a company is running out of cash.? Cash is impervious to accounting rules.

    11) Want a closer view of the Fed and politics.? Read this piece at The Institutional Risk Analyst.? While at RealMoney I espoused a view that the Fed was more political than economic.? This article confirms it.

    12) How do I view Greenspan’s apology?

    13) At a prior employer, we often commented that credit risk in credit cards appears late in the credit cycle.? Well, we are there now.? It is seemingly the last form of credit to default on.? In this environment, one can lose their home, but losing financial flexibility can be bigger.

    14) The FDIC can modify many mortgages, at a cost to taxpayers.? It could cost a lot, and many people who made dumb decsions could be bailed out by the prudent.

    15) If John Henry were alive, he would be smiling.? Let humans make markets, and not machines.

    A Puzzle

    A Puzzle

    Posted on by David Merkel

    Okay, here’s a question that I don’t know the answer to.? Why are current coupon Ginnie Mae MBS yielding roughly the same as Fannie Mae MBS?? THe Ginnie Maes are government guaranteed, so they should have a lower cost of funds.? Why isn’t the spread bigger?

    I write this because there are many who think that folding Fannie and Freddie into the US Government could lower their funding costs, and lower mortgage rates. Well, Ginnie Mae is already there, and it does not seem to be making much difference. The Feds could have put the pedal to the metal with Ginnie Mae, but there does not seem to be much advantage, and I don’t know why.

    Fifteen More Notes and Comments on the Current Crisis

    Fifteen More Notes and Comments on the Current Crisis

    Posted on by David Merkel

    1) Do Fannie and Freddie deserve some blame for the crisis that we now face? Yes, but not without blaming Congress and the Executive Branch for pushing homeownership far beyond the natural rate of ownership, which I wager is around 60% rather than the 72% that it touched for a brief time.

    But here are some ways that F&F went out of their way to help create the current crisis:

    • F&F did push loan growth and growth of their retained portfolios in order to benefit their shareholders.
    • They bought significant amounts of Alt-A and other lower quality loans for their retained portfolio.
    • They aggressively lobbied to protect their position.
    • They argued for capital standards that were lower than would be needed in a crisis (so did many financial institutions)
    • They lowered underwriting standards in order to meet competition from private lenders. They could have given up business, delevered, and been stronger companies for when the crisis would hit.
    • They managed to their GAAP financials. A prudent financial institution manages to a stressed version of their most stringent capital constraint.

    Finally, I would add that this was an area where Greenspan was right on policy, along with a few of the more conservative members of Congress. If you are going to have F&F at all, then use them contra-cyclically. When the mortgage markets are lending, F&F should sit on their hands, and let the market do its work. If F&F?s balance sheets weren?t impaired now, they could be doing some real good here, but because their credit quality is suspect, as well as the commitment to their solvency from the Federal Government, their cost of fresh capital is high, making mortgages more expensive than they otherwise would be.

    Note the current rise in Fannie 30-year mortgage rates.? This series tends to peak out at 6.20% but I am expecting rates to exceed that and soon.

    Personally, I don?t think the government should be in financial businesses. Government agencies tend to overlend, and lend to bad risks with insufficient compensation. Then again, I don?t think governments should be in the money business either; they abuse the privilege, stealing from us in the process.

    2) Will contractual terms be honored by the courts? Some hedge funds will press for their rights. My guess is that they won?t win in this environment. The system has a tendency to fight individual rights in a crisis. But, there is no free lunch. To the extent that contractual rights are infringed, rates will rise when lending resumes to compensate for expropriation risk.

    3) Get financing when you can, not when you have to. Others have pointed to this post, but it bears repeating.The banks ran for too long on capital bases that were too slender.Now they are paying the price.The only pseudo-equity capital available is that from government sources.

    Now, there may be a competition for that capital from the government, and perversely, it might lead to banks using the capital to buy other institutions (PNC has already done it to Nat City), rather than make loans, and on net, I would expect that to result in still fewer loans being made than in the absence of a merger. So let the competition begin for who can gobble their cheap competitors with cheap government capital.

    4) Away from that, the Fed is having a hard time controlling Fed funds since they started paying interest on reserves deposited at the Fed.

    Though I have written on the changing balance sheet of the Fed [link] and its implications, Jim Hamilton of Econbrowser has a very good post on it as well. The only place where I think we differ is that I think this will eventually be inflationary to goods prices when the Fed is forced to stop sterilizing.

    5) Now the Fed is in the business of short-term unsecured lending to corporations via buying CP. (I think this will help lead to the first real CP default since Penn Central.) Early indications are that CP funding costs are higher than before the crisis if CP is funded by the Fed.

    6) Never buy something you don?t understand, unless you have a friend who is smart and trustworthy by your side to advise you. Many municipalities got bamboozled by investment banks in much the same way that homebuyers got swindled by those offering subprime loans. Through derivatives, they offered a way to lower the current costs of debt by having the municipality sell options against their position that would force costs higher under certain circumstances which seemed unlikely, but were more likely than not.

    The same is true of many investment products created by Wall Street for retail investors.? Sell them something that offers a high yield with safety, subject to some options sold short that are unlikely to come into the money.? I see it often.? Don’t but complex structured products from your broker.? Odds are they are taking you for a ride.

    7) Those who have read me for a long time know that I think GM and Ford are eventual zeroes for the equity, and the subordinated debt.? Even the senior debt will get whacked severely.? There is no value in corporations that have huge promises to their employees way out into the future, when competing against better capitalized and better run foreign competitors like Toyota and BMW.

    So, don’t bother trying to rescue them.? Rather, let foreign competitors buy them out, if they want them.? That will be a good test as to whether there is value there or not.? Possible foreign buyers have worked under the assumption that the Big 3 cannot be bought.? If the US sends a message that they can be bought, would any of them be bought?? My answer is no, unless the US Government or the PBGC sweetens the pot.? Other notes:

    • Daimler thinks Chrysler is a zero. (no surprise here)
    • The Treasury should give up on lending to the automakers. (Much as other think they are critical.? If the plants are valuable, foreign capitalists will maintain them.)
    • The TARP may lend to auto financing arms, but that is probably a mistake as well.
    • We should not bail out the auto makers, regardless of how politically expedient is is.? Because of the employee benefit promises made, there is no way any US automaker can beat foreign competition.? It is time to let them fail, and let the unions take the rebuke that they royally deserve.
    • GM is not too big to fail.? Let them fail, and then expedite the bankruptcy process, so that senior debt becomes equity, the firm goes non-union, and the firm can compete globally for the first time in 40 years.

    8 ) Greg Mankiw asks if we have learned enough.? My view is no, we have learned little, and what Bernanke thinks he learned regarding the Great Depression is wrong.? This is not a crisis of confidence and liquidity, it is primarily a crisis of solvency, which drains liquidity.? High levels of total leverage make a financial system inherently unstable, and the only way to cure it is through expedited bankruptcy procedures.? As it is now, Bernanke and Paulson are trying to save the financial system by wagering the credit of the USA.? (My opinion is that our nation is great enough that we whould risk another Great Depression rather than give up our liberties to the Government.)

    9) A young friend e-mailed me from LIthuania (where she has a semester abroad), and asked me how serious the current economic situation is.? My response:

    To give you the quick summary, we may be headed into Great Depression 2.? Or, as I sometimes call it, the Not-so-great Depression.

    A Depression is a severe recession where the solvency of the banks is compromised.? Debt levels of financial companies, consumers and our Government have gotten to levels where repayment of debts in full is difficult if not impossible.? The system is overleveraged, and funded by leveraged institutions that could fail if they aren’t paid back.? There is kind of a “domino effect” here, where failures can cascade.

    That’s why the Government has stepped in, encouraging financial institutions to shift their debts over to the Government.? That will work for a while, but eventually parties will become reluctant to lend to our Government as it becomes a bottomless pit of promises.? Then inflation of the currency will begin.

    This is an ugly situation, one that is the product of sloppy monetary policy, poor regulation of financial companies (for two decades), poor risk controls, overlending by government institutions, and a cultural failure where we borrowed too much and saved too little.

    I wish I could be more chipper here, but this is ugly, and what the government is doing is not likely to solve the problems at hand.

    10) Slow moves tend to persist, sharp moves tend to mean-revert.? Don’t put much confidence in today’s sharp move up.? Strong one-day upside moves are characteristic of bear markets.

    11) My post last night neglected one item.? Stable value funds have more flexibility than many other financial entities.? Be wary if the credited rate drops a lot.? Better to withdraw funds in that scenario, because it implies that the market value of assets is significantly less than the book value.

    12) Be ready for a surprise in the GDP data, as I highlighted last quarter.? The implicit deflator for Gross Domestic Product will be extra high in the third quarter because of the fall in energy prices.? Just as it pushed “real” GDP higher in the second quarter, it will exact its pound of flesh in the third quarter.

    13) My pal Cody is red hot, and though he is less measured than I am, I agree with much of what he says.? We need to vote out Republicans and Democrats.? We need new options.? Personally, I think we need to radically change the Constitution, and move to have a parliment, where the head of state is the head of the majority party.? That will create government that is closer to the consensus.? Eliminate the Presidency — it is too dangerous of an institution.

    As Cody put it today: 2. Real headline today: ?White House Encourages Money-Hoarding Banks to Start Lending? ? I thought profit-motive was what was supposed to encourage banks to lend. And only profits make stocks go up, so why would shareholders want the banks to start lending if the bankers don?t think it?ll be profitable?

    I can’t agree more, and the Treasury is pushing on a string if they are trying to force the banks that they have financed to lend.

    14) Commercial Real Estate is the shoe yet to fall, yet the CMBS market has anticipated much of the decline.? Are the Fed and Treasury ready for this?? They weren’t ready for residential housing declines.

    15) The foolishness that exists today regarding the government buying stakes in financial companies has now transferred itself to policymakers who think the equity market is now cheap, so invest the Social Security surplus in the equity market.? Problems:

    • We have always avoided Socialism like this in the past.
    • How can a bureaucrat with no profit motive figure out whether out whether this is a good decision or not?? Or, how will the bureaucracy extract maximum value for the taxpayers?
    • Is the market really cheap now, or, only seemingly so.? The time to invest is during a baby bust, not a baby boom as it is now.

    As with so many of these decisions, the answer will only be clear in hindsight.

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