Category: Real Estate and Mortgages

Why I Don’t Think the Troubles in Financials are Over Yet

Why I Don’t Think the Troubles in Financials are Over Yet

Posted on by David Merkel

When I was a investment grade corporate bond manager back in 2002, there were three “false starts” before the recovery began in earnest. The market started rallies in December 2001, August 2002, and October 2002. I remember them vividly, and I behaved like the estimable Doug Kass during that period, buying the dips, and selling the rips.

In this bear market for the financials, we are only through the first leg down. Here is what remains to be reconciled:

  • Residential housing prices are still too high by 10-20% across the US on average.
  • The same is true of much of commercial real estate.
  • The mortgage insurers have not failed yet. Triad Guaranty is close, but at least two of them need to fail.
  • There is still too much implicit leverage within the derivative books of the investment banks.
  • Too many credit hedge funds and mortgage REITs are left standing.

I have tried to avoid being a pest on issues like these, but the overage of leverage has not been squeezed out yet.

Federal Office for Oversight of Leverage [FOOL]

Federal Office for Oversight of Leverage [FOOL]

Posted on by David Merkel

I want to go back to an article that I wrote early in the history of this blog, when nobody read me except a few RealMoney diehard fans — Regulating Systemic Risk From Hedge Funds.? It was a critique of the ?Agreement Among PWG And U.S. Agency Principals On Principles And Guidelines Regarding Private Pools Of Capital.?? Yes, the “shadowy” President?s Working Group on Financial Markets.? Some will call it the “Plunge Protection Team.”? Well, if they are that, they are certainly not playing up to their billing.? As an aside, I tend not to believe in conspiracy theories, because most bad plans of our government don’t require them.? As Chuck Colson pointed out regarding the Nixon Administration and Watergate leaks — he felt that information tightness in the Nixon White House was so effective, that if a conspiracy could work, it would have worked there.? (Since it didn’t work, and the information leaked out, it had a surprising effect on Colson’s life, as he concluded that the disciples of Jesus (Y’Shua) could not have conspired to steal the dead body, hide it, and fake a resurrection.? But that’s another story.)?? Suffice it to say that I don’t think the government intervenes in the major financial markets of our country — there would be too many accounting entries to hide, and someone would have a real incentive to leak the information, or write a book about it.

Going back to my article, I tried to point out the difficulty of gathering data and analyzing it.? It was also somewhat prescient as I said, “Let me put it another way: if the government wants to reduce systemic risk, let them create risk-based capital regulations for investment banks, and let them increase the capital requirements on loans to hedge funds and investment banks. Or, let the Fed change the margin requirements on stocks. These are simple things that are within their power to do now. In my opinion, they won?t do them; they are friends with too many people who benefit from the current setup. If they won?t use their existing powers, why would they ask for new ones?

We will have to wait for the next blowup for the Federal Government to get serious about systemic risk. They might not do it even then. Upshot: be aware of the companies that you own, and their exposure to systemic risk. You are your own best defender against systemic risk.”

There is another reason why they would not act then, as I had pointed out at RealMoney over the years.? Bureaucrats are resistant to offering changes where if thy would get harmed if the changes led to a market panic.? Once the market panic starts, they can move with greater freedom, because no one will be able to tell whether changes imposed during the panic intensified the panic or not.

So, color me skeptical on efforts to monitor and control systemic risk.? It would be very hard to do effectively, and there are too many powerful interests against it.? Also, it would be difficult to get the gross exposure data necessary for inhibiting crisis, because many financial instruments would have to be split in two or more pieces.

As to the articles I have read on Treasury Secretary Paulson’s plan, they divide into credulous (one, two), mixed, and skeptical/hostile (one, two).? Let me simply observe that any plan for the control of systemic risk has to overcome:

  • Political opposition
  • Lack of effective data
  • Lack of an effective model
  • Lack of willingness to implement the conclusions generated by the staff/modeling
  • Inter- and Intra-agency disagreements
  • Data and action lags

If it is already difficult for the Fed to implement contracyclical monetary policy, just imagine how difficult it will be for them to deal with a problem that is far more tricky because of its multivariate nature.? Imagine them trying to analyze the effects from currencies, commodities, operating businesses, credit, ABS, RMBS, CMBS, equity-related businesses, counterparty risk, etc.? This is not trivial, and Paulson I suspect knows it all too well, which has led him to make a modest proposal that will likely not be effective, but will likely run out the shot clock for the Bush administration, leaving the issue for the next President to deal with.

The Fed is not by nature an activist institution, and it would have to become far more activist in order to effectively regulate the bulk of all financial institutions in the US.? I don’t see it happening.

As an aside, I am ambivalent about Federal regulation of insurance, and this RealMoney article of mine still expresses my views adequately.? Still, it would make sense to hand over oversight of financially sensitive insurers, such as the financial guarantee insurers and the mortgage insurers to the Feds, together with whoever oversees the ratings agencies.? An integrated solution is preferable.? (I still like my proposed name for the new regulator, “Federal Insurance Bureau” [FIB… well, it can’t be the FBI].

As for some of the fog that a regulator of investment banks would exist in, consider these two articles on hedge fund distress.? What affects the hedge funds, affects the investment banks.? They are symbiotic.

As a joke, given that it is the first of April, if we do get a regulator for overall financial solvency and systemic risk, I believe it should be called the Federal Office for Oversight of Leverage [FOOL].? After all, I think it is taking on a fool’s bargain.

Two Monetary Policy Graphs for the Evening

Two Monetary Policy Graphs for the Evening

Posted on by David Merkel

A few notes before I begin this evening. I tried posting twice, but my system failed twice, and the auto-save did not do its job faithfully. So, one reduced post, if I can get it out. Next week, I should publish a small primer on how monetary policy works. Also coming up is my next portfolio reshaping.

Well, there is certainly no more stigma in borrowing directly from the Fed. Just look at the discount window:

That’s a new record since the beginning of my data (1980), and more than doubles the last peak in 2001.

The following graph (look at the lower green graph) is the ratio of my M3 proxy (Total Bank Liabilities) to high-powered money (Total Fed Credit, the Monetary Base).

This ratio measures the willingness of the Fed to allow the banking system to lever up their deposit base relative to the size of the Fed’s own balance sheet. The data only goes back to 1980, but we are knocking at the door of a new high. The recent move up began in earnest at the beginning of the last tightening cycle, but has persisted into the loosening cycle, as the FOMC has not let the monetary base grow, but has permitted the banks to continue to gather deposits (banking, savings, CDs, money market funds). Some capital requirements have been loosened, and I suspect the bank examiners are not playing hardball at present, at least compared to the attitude 18 months ago.

After all, the banks don’t have to pay much interest to those who deposit money with them with a curve this low and steep, and many people are afraid of the equity markets, and are letting balances at the banks grow. The banks get cheap funding, and they use it to buy short-duration agency RMBS yielding 3-4%, which is a winner, at least for now.

Our Not-So-Elastic Currency

Our Not-So-Elastic Currency

Posted on by David Merkel

Before I start this evening, I want to point to a blog post of Barry’s. I have never heard James Grant as agitated as he is in this Bloomberg interview. I’ve heard James Grant disappointed or discouraged, but not annoyed. It was interesting to listen to, and compatible with my views on the credit markets.

This small PDF file contains my summary of the Fed’s H.4.1 report at two points in time: early August 2007, and the latest. I chose early August, because it was prior to the FOMC being willing to advertise that they might consider unorthodox monetary policy solutions. How have things changed? Let’s start with what hasn’t changed. For the most part, the Fed hasn’t expanded its balance sheet. Total assets are up only 2.5%, or 3.8% annualized. The liability side of the balance sheet has expanded even less — 1.7% or 2.7% annualized. The issuance of Federal Reserve Notes has crept up 0.5%, or 0.7% annualized. For a loosening cycle, this is unusual.

But what has changed? The composition of assets on the balance sheet, and the level Fed net worth.

  • Treasury bills down $163 billion
  • Treasury notes and bonds down $18 billion
  • Repurchase agreements up $82 million
  • Term Auction Credit up $80 million
  • Other loans (direct lending to dealers) up $37 million
  • Fed net worth up $7 billion (21%, I will not annualize that)

What you are seeing is a substitution of T-bills and T-notes for short-term lending against collateral with greater credit risk (though with haircuts). If you net all of the changes that I highlighted on the asset side, it adds up to the change in assets less $3.5 billion. As for the net worth of the Fed, it is curious to see it rising so much. I need to look at that series over time to see how it changes.

In short, the FOMC is providing a little more credit to the economy as a whole through the expansion of its own balance sheet. In the process, it is changing the composition of its own balance sheet (at least for a little while) in order to induce more liquidity into the mortgage markets, while offering out T-bills that are in hot demand. Both aim to narrow the spread between mortgage bonds and Treasuries, particularly on the short end.

That said the bond market is big, making the $200 billion allocated by the Fed look small. Now, there are also the actions of the GSEs, which are perhaps another $300 billion. Is that enough to right the prime residential mortgage market? It looks small to me, though in the short-run, it can change market psychology.

Why I titled this “Our Not-So-Elastic Currency” is that the amount of stimulus to the economy as a whole is small; the action is focused on fixing the mortgage markets, and the broker-dealers. That M2 and other broader monetary aggregates are rising aggressively stems from a willing ness of the banks to take on leverage at present. For banks that are healthy, funds are cheap; they can expand.

TSLF Auction

I had earlier predicted that direct lending to broker-dealers would limit the need for the Term Securities Lending Facility. Well, that’s not true, but the need for the TSLF was not that great today. $75 billion of credit was offered, with only $86 billion of bids. The rate that the exchange of collateral priced at was only 33 basis points, which was only 8 basis points above the minimum acceptable. The auction was close to failing, except that failure would be a good thing. If bids had not been sufficient, it would have indicated a lack of need for the facility, which would indicate that conditions aren’t so bad after all.

My guess is that the TSLF will not be one of the new credit systems that survives the current crisis. The direct lending through the Primary Dealer Credit Facility may prove harder to discontinue because of its greater flexibility.

Ten Notes on Our Quasi-Government and the Financial System

Ten Notes on Our Quasi-Government and the Financial System

Posted on by David Merkel

Personal notes before I get started: I’ve been busy studying for the Series 7 (and also reviewing the compliance manual for my new firm — wow it is big). The two of them fit together, as I get to see how the regulations get applied. I’ve made through the study guide (what do you do when it is wrong — not that I found a lot of errors, maybe half a dozen?), and I am 20% through my first practice test. Went and got fingerprinted for the fourth time in my life yesterday. (The other three times were for adoptions.)

My links are back 🙂 but I had to give up my descriptive permalinks. 🙁 Maybe I’ll get them back when I upgrade the blog to WordPress 2.5.1. Beyond that, I am working on a book review for Gene Marcial’s forthcoming book, “7 Commandments of Stock Investing.”

Catching up on the markets:

Our Unorthodox Federal Reserve, GSEs and Government

1) Repo rates may not be negative now, but they were so recently. Fails (failures to deliver securities) become common, because of the lack of a penalty. Today we should see whether the TSLF has any impact on the scarcity of Treasuries. We should learn more about the direct landing program as well after the close today. It got off to a big start last week. Watch for the H.4.1 report after the close. Given all that is going on, it is becoming the critical weekly Fed document.

2) Now, because of all these actions on the asset side of the Fed’s balance sheet, some are calling the actions of the Fed, including the Bear Stearns bailout, revolutionary. Well, maybe. It’s certainly different than before, but there is a cost to doing business this way. Bit by bit the Fed loses flexibility as more and more of its highest quality assets become encumbered for a time.? The more that they do, also, the harder it will be to unwind, in my opinion.

3)? Greenspan…? If we turn off the spotlight, will he go away?? (Then again, he has enough money to buy his own spotlight.)? It is tough for anyone to defend a legacy, and I don’t blame him for trying, but the Fed became too integrated with the political establishment under his tenure, which made it too activist in avoiding short-term pain.? It made him look like a hero at the time, but now we are paying the price.? Overly loose monetary policy and financial supervision led to gluts of borrowing to finance assets that appreciated dramatically, until the ability to service the debt began to decrease.? I don’t think history will treat him kindly.? He said too much in the past that he is contradicting today.

4) Will the Fed buy agency MBS outright?? I think the answer to that one is yes, if the crisis persists. If housing prices drop enough further, like say 15%, the actions of the Treasury, Fed, FHLB, Fannie, Freddie, FHA, and whatever new lending monstrosity our imaginative Government comes up with will have to be closely coordinated.? At some level, if the Fed can’t trust the implicit guarantee of Fannie and Freddie, why should the rest of us?? That guarantee is as sound as a dollar! 😉

5)? It’s interesting to see the tide shift with respect to GSE involvement in the mortgage market:

6)? On a consolidated basis, our government, with its enterprises, are levering up.? This is a substitution of public debt for private, and more, just a lowering of capital standards for the GSEs.? (I wonder how comfortable the rating agencies are with this?)? This works while Treasury yields are low.? I wonder, though, how much impact this will have on the willingness of foreign buyers of Treasuries to continue their funding of our government?? One thing for sure, this will all get funded by the US taxpayers, together with those who lend to the US (dollar depreciation).

7) Now, it’s not as if the US is the only place in the world with central banking problems.? Consider the Eurozone, where there is still no lender of last resort.? How would they deal with a financial crisis?? I’m not sure; the ECB has quietly helped out some Spanish banks, but it is not really in their jurisdiction.? Under conditions of deflationary stress, it would not be impossible to see a nation whose financial system was in trouble either directly bail out the dud institutions, or even, exit the euro (last resort, but not impossible).

Or consider China, where inflation is getting a nice head of steam.? Their neomercantilism, with their crawling peg against the dollar is forcing them to import loose monetary policy from the US.? As the article cited points out, they need to significantly revalue their currency upward, which would would whack their exports, at least for a time.

8 )? For those that remember the files that I created for my piece, A Social View of the FOMC, it looks like I will have to update the file soon.? We have a successor to Bill Poole nominated, James Bullard.? When he is approved, I will update the file.? (I will miss Poole.? Though he was occasionally out of step with the rest of the FOMC, he always spoke his mind, which was usually more hawkish than the rest of the FOMC.)

9)? Now, Bullard is an Economics Ph. D.? (Surprise!) ? In my earlier piece, Jeff Miller took note of a few of the things that I said, and perhaps attributed to me an anti-Academic bias.? I don’t have a bias against academics, per se.? (Hey, can we put Steve Hanke on the Fed?!? One of my professors…)? I do have concerns about not having enough real debate.? If the neoclassical view of monetary policy is correct, then we don’t have problems, because everyone on the FOMC is either a neoclassical economist, or a monetarist.

Now, I do know the difference between politics and policy formation, and if I hadn’t been trying to keep the number of pages down, I might have had two columns.? (Getting it down to 15 pages was hard.)? But most of the FOMC members had either one or the other, but not both, so I left it as one column.? Next time I change the column heading.? That said, even if one is in a policymaking capacity in the executive branch, there is typically some political affiliation that helps get that person the job.? Those are relevant bits of experience, just as I noted everyone that had foreign experience, or military experience.? But what worries me is a lack of real diversity in views of how economics works.? (Perhaps we could get someone from the Santa Fe Institute?)

10) Finally, there will be a lot of pressure in the future to re-regulate our financial system.? Personally, I don’t think it is possible to create a regulatory scheme that eliminates crises.? The regulator shapes the type of crisis that will come, and when it will come, but it is impossible to wipe out the boom-bust cycle.? (We put off this bust for a long time, and now we are getting it with compound interest for time delay.)? If a regulatory regime is too tight, the financial companies complain because their ROEs are too low.? To the extent that it can, capital begins to exit the industry, or, the stock prices languish, and financials trade at low multiples on book, because they can’t earn much off their net worth.

Financial companies find the weak spots in any risk-based capital formula.? They also lobby the executive branch and Congress effectively.? Unless we slide into Great Depression II, I don’t think things will change remarkably from here.

I? agree that we need to re-regulate, but perhaps after this crisis is done, we can consider systemic reforms, and not the piecemeal stuff we have been dished up in the name of crisis management.? My re-regulation would be to reduce the Federal Government’s role in the credit markets, but then, I am walking out of step, and realize that is not what is going to happen.

Book Reviews — The Alchemy of Finance, and Soros on Soros

Book Reviews — The Alchemy of Finance, and Soros on Soros

Posted on by David Merkel

One trap you can fall into in life is to not learn from those that you disagree with, for one reason or another. George Soros would be an example of that. His politics are very different from mine, as well as his religious views. He’s a far more aggressive investor than I am as well. I am to hit singles with high frequency over the intermediate term. He played themes to hit home runs.

The Alchemy of Finance made a big impression on me 15 years ago. Perhaps it was a book that was in the right place at the right time. It helped to crystallize a number of questions that I had about economics as it is commonly taught in the universities of the US.

First, a little about me and economics. I passed my Ph. D. oral exams, but did not receive a Ph. D., because my dissertation fell apart. Two of my three committee members left, and the one that was left didn’t understand my dissertation. What was worse, I had moral qualms with my dissertation, because I knew it would not get approved.

My dissertation did not prove anything. All of my pointed to results that said, “We’re sorry, but we don’t know anything more as a result of your work here.” I have commented before that the social sciences would be better off if we did publish results that said: don’t look here — nothing going on here. But no, and many grad students in a similar situation would falsify their data and publish. I couldn’t do that. I also couldn’t restart, because I had put off the wedding long enough, so for my wife’s sake, I punted, and became an actuary.

That said, I was a skeptical graduate student, and not very happy with much of the common theories; I wondered whether cultural influences played a larger role in many of the matters that we studied. I thought that people satisficed rather than maximized, because maximization takes work, and work is a bad.

I saw how macroeconomics had a pretty poor track record in explaining the past, much less the present or future. In development economics, the countries that ignored the foreign experts tended to do the best. Even in finance, which I thought was a little more rigorous, I saw unprovable monstrosities like the CAPM and its cousins, concepts of risk that existed only to make risk uniform, so professors could publish, and option pricing models that relied on lognormal price movement.

Beyond that there was the sterility of economic models that never got contaminated by data. I was a practical guy; I did not want to spend my days defending ideas that didn’t work in the real world. And, I felt from my studies of philosophy that economists were among the unexamined on methodology issues. They would just use techniques and turn the crank, not asking whether the metho, together with data collection issues made sense or not. The one place where I felt that was not true was in econometrics, when we dealt with data integrity and model identification issues.

Wait. This is supposed to be a book review. 🙁 Um, after getting my Fellowship in the Society of Actuaries, I was still looking for unifying ideas to aid me in understanding economics and finance. I had already read a lot on value investing, but I needed something more.

On a vacation to visit my in-laws, I ended up reading The Alchemy of Finance. A number of things started to click with me, which got confirmed when I read Soros on Soros, and later, when I began to bump into the work of the Santa Fe Institute.

I was already familiar with nonlinear dynamics from a brief meeting with a visiting professor back in my grad student days, so when I ran into Soros’ concept of reflexivity, I said “Of course.” You had to give up the concept of rationality of financial actors in the classical sense, and replace them with actors that are limitedly rational, and are prone to fear and greed. Now, that’s closer to the world that I live in!

Reflexivity, as I see it, is that many financial phenomena become temporarily self-reinforcing. ? We saw that in the housing bubble.? So long as housing prices kept rising, speculators (and people who did not know that they were speculators) showed up to buy homes.? That persisted until the? effective cashflow yield of owning a home was less than the financing costs, even with the funky financing methods used.

Now we are in a temporarily self-reinforcing cycle down.? Where will it end? When people with excess equity capital look at housing and say that they can tuck it away for a rainy day with little borrowing.? The cash on cash yields will be compelling.? We’re not there yet.

Along with that, a whole cast of characters get greedy and then fearful, with the timing closely correlated.? Regulators, appraisers, investment bankers, loan underwriters, etc., all were subject to the boom-bust cycle.

Expectations are the key here.? We have to measure the expectations of all parties, and ask how that affects the system as a whole.

In The Alchemy of Finance, Soros goes through how reflexivity applied to the Lesser Developed Country lending, currency trading, equities, including the crash in 1987, and credit cycles generally.? He gives a detailed description of how his theories worked in 1985-6.? He also gives you some of his political theorizing, but that’s just a small price to pay for the overall wisdom there.

Now, Soros on Soros is a series of edited interviews.? The advantage is that the interviewers structure the questioning, and forces more clarity than in The Alchemy of Finance.? The drawback (or benefit) is that the book is more basic, and ventures off into non-economic areas even more than The Alchemy of Finance.? That said, he shows some prescience on derivatives (though it took a long time to get to the promised troubles), though he missed on the possibility of European disintegration.

On the whole, Soros on Soros is the simpler read, and it reveals more of the man; the Alchemy of Finance is a little harder, but focuses more on the rationality within boom/bust cycles, and how one can profit from them.

Full disclosure: if you buy through any of the links here I get a small commission.

“Should I be worried about the economy?”

“Should I be worried about the economy?”

Posted on by David Merkel

Most of my friends don’t follow the economy or the markets that closely, so it has been interesting for a number of them to ask me recently, “Should I be worried about the economy?”? The answer isn’t a simple one.

Part of the answer depends on your line of work.? Stuff that’s economically necessary (utilities, staples, government, common services) will probably do okay, though there will be some slackening of demand at the edges.? For example, I visited? a hair salon recently, and asked how business was.? The answer was that customer numbers were unchanged, but that the average purchase level had dropped.? Even government positions, stable as they are will experience some pressure, because budgets have to balance, and tax revenues are starting to sag a bit.

Now if you work in an export-oriented sector, with the dollar down, you will probably do okay.? Demand for food, energy, raw materials, industrial goods, and some technologies will continue relatively strong.

But institutions that rely on credit risk, whether borrowing or lending, will have it tough.? During the boom phase, more and more bodies get added to service the cash flow.? At his point, bodies are coming out of banking, investment banking, real estate, homebuilding, etc.

You can also ask how well capitalized and profitable your current firm is.? This is not a time that rewards high degrees of leverage and short-term financing (unless you are very well capitalized). Volatility rewards firms that have excess capital; it is worth more when times are panicky.

Another part of the answer is how dependent you are on the need for continued external financing.? Can you meet all of your obligations, with some room for error over the next two years?? Do you have excess assets to aid you if you have a sudden crisis?

Finally, if you have investments, look them over.? Examine what investments are sensitive to worsening credit problems, and remove weakly financed companies from your portfolio.? You should have some investments that are inflation-sensitive, like stock in industries that have pricing power (precious few 🙁 ), cash, TIPS, and foreign-currency demoninated bonds.? Now, carefully selected muni, mortgage and corporate bonds have value here, though don’t put on a full position at present.

In summary, it depends on your personal financial position, the firm and industry that you serve, and how much you have prepared to weather bad times in investing.? It’s not a pretty time as the leverage unwinds, but if you planned in advance for the possibility of trouble, then you should do adequately.

Mark-to-Market Accounting Is not the Major Problem

Mark-to-Market Accounting Is not the Major Problem

Posted on by David Merkel

I?m not a fan of mark-to-market accounting, partially due to the loss of comparability across firms. It introduces a level of flexibility that can be gamed by the unscrupulous. That said, any accounting method can be gamed. Accounting attempts to assign the value of economic activity at and across points in time.

Now, with financial firms, there are typically several accounting bases going on at the same time. There?s GAAP, Regulatory, Tax, and then the accounting for special agreements, which may be different than any of the three major accounting bases.

Why has mark-to-market come up as an issue recently? Because it has seemingly created downside volatility in the financial statements, leading investors to panic, which pushes down security prices.

In my opinion, the greater problems are how a firm finances itself, how it is regulated, and negative optionality in its assets and positive optionality in its liabilities. I?ll give some examples to illustrate:

With Thornburg, the problem was over-reliance on short-term lending to finance long term assets. It doesn?t matter how you do the GAAP accounting here. The brokers will look at the day-to-day market value of the positions versus the capital supporting them. If the capital becomes insufficient to carry the position, the positions will be liquidated. Given that there were a lot of players with similar trades, and funding in the repo market, that created an ideal setup for the most levered to lose a lot as financing dried up.

Bear Stearns also relied on short-term financing. Bear ran with high leverage that made them vulnerable to attacks from those that bought credit protection in the credit default swap market? as those spreads went up, the willingness to extend credit went down. Ratings downgrades pushed up, and in some cases eliminated the willingness of lenders to extend short term credit. (Bear also lacked friends to help them in their time of need, a payoff for not helping on LTCM. Lehman had similar leverage, but the Street supports it.) Also, derivative agreements often specify a need for more collateral if downgrades occur, which is exactly the wrong time to have to provide more collateral. Again, this has nothing to do with GAAP accounting, but it has a lot to do with positive optionality in the liabilities of the firm. (I.e., the liability can get more onerous under conditions of stress.)

Consider PXRE, which recently merged with Argonaut Group. When the storms of 2005 hit, they claims against them were bad enough, but many of their reinsurance agreements had downgrade clauses, saying they would have to post collateral. Though it didn?t bankrupt them, it could have, and they had to find a buyer. Nothing to do with GAAP accounting.

General American wrote a bunch of floating rate Guaranteed Investment Contracts that had 7-day put provisions after a ratings downgrade. They wrote so much of them, that they comprised 25% of their liability structure. When they got downgraded, they could not meet the call on liquidity. They wen insolvent. Nothing to do with GAAP accounting.

CIT got downgraded and drew down their revolver because of a liquidity shortfall. The stock has fallen more then 80% in the past year. Mark-to-market accounting to blame? No, deteriorating assets and too much short-term financing.

I could go on. Regulators are under no obligation to use mark-to-market accounting, and they can set capital levels as they please. Optimally, regulators should look at risk based liquidity. How likely is it that a financial firm will have adequate liquidity in all circumstances? How safe and liquid are the assets? Is the liability structure long enough to support them? Can the liability structure dramatically shorten? (I.e., a run on the bank.)

Deterioration in the value of assets has to be addressed by accounting somehow. But regardless of the method, those that finance the company will look beyond the published GAAP financials, and will look at the cash generation capacity of the firm over the life of the loan, and how prone to change that could be. Even if a firm could take an asset worth 80 cents and mark it at $1.00, the sophisticated lenders would only assign 80 cents of value.

Along with The Analyst?s Accounting Observer, I don?t see mark-to-market accounting as a major threat to the solvency of firms. The companies that have gotten into trouble recently have held assets of dubious quality, and have financed themselves with too much leverage, borrowing short-term, and/or implicitly sold short options against their firms that weakened themselves during a crisis. Dodgy assets and liquid liabilities are poisonous to any firm, regardless of the accounting method.

Fifteen Notes on the Credit Markets (and other markets)

Fifteen Notes on the Credit Markets (and other markets)

Posted on by David Merkel

1)? A number of blogs pointed to this piece by Howard Marks of Oaktree, and I thought it was very well-thought out for the most part.? There are few people who think about history in the markets; they just follow present trends.? Learning how to see unsustainable trends and avoiding them not only reduces risk, but enhances long-term return.

2) Crisis!? Choose how you want to view it:

3) Tony Crescenzi sounds an optimistic note on the short-term lending markets.? His opinion should be taken seriously.? The money markets are a specialty of his.

4) To err is human, but to really mess things up, you need derivatives.? With Bear Stearns, different parties have different incentives regarding the firm.? Senior bondholders and derivative counterparties owed money by Bear are much, much larger than the teensy equity base of the small-cap firm.? It is my guess that they are protecting their interests by buying stock at prices over the terms of the deal.? They want the deal to go through.

5) How are the European investment banks?? My guess is that they have greater accounting flexibility, and things are better than US investment banks, but worse than currently illustrated.

6) Save our markets by risking our national credit?? I’m skeptical of many government solutions that bail out the markets, including those the Fed is pursuing.? Same for the GSEs… it seems like a free lunch to allow the GSEs to lever up further, but the losses are growing at Fannie and Freddie from all of the guarantees that they have written.? The US government backstops the whole thing implicitly, but even the capacity of the US government to fund these bailout schemes is limited.? Calling Fitch! — you often have more guts (or less to lose) than S&P and Moody’s.? Let’s have a shot across the bow, and downgrade the US to AA+.

7) Are mortgage rates finally falling?? I guess if the expectations of Fed policy get low enough, it will overcome the increase in swaption volatility.? Then again, PIMCO, Fannie, Freddie, and many others are buying prime mortgage paper again.

8 ) Thornburg, alas.? Dilution and more dilution, in order to survive.? (That could be the fate of many financial and mortgage insurers.)? Misfinancing in the midst of a crisis gives way to a need for equity that kills existing shareholders.

9) In terms of actual losses, Commercial Real Estate lending is not in as bad of a shape as residential lending.? That said, it’s not in great shape and the market is slowing dramatically.? What lending market is in good shape today? 🙁 We overlevered every debt market that we could…

10) When actual stock price volatility gets high, that is typically a sign of a bear market.? When it actual volatility peaks, that is often a sign of an intermediate term bottom.

11) Finally, an article on ETNs that mentions credit risk, if briefly.? Be wary of ETNs, they are obligations of investment banks, most of which have high credit spreads that you are not being compensated for in the ETNs.

12) Give the guys at Dexia some credit for being opportunistic during the crisis of financial guarantors… they had the balance sheet, conservative posture, and the team ready to take advantage of the dislocation in their subsidiary FSA.

13) Someone tell me otherwise if I am wrong, but I am not worried about the assets in my brokerage account.? In a crisis, there is SIPC and excess insurance.? Brokerages are prohibited from commingling client assets, and even if their are delivery failures from securities lending, those issues are solvable, given time and the insurance.

14) I worry about inflation in the US, because it is a global problem.? As the dollar declines, it slows foreign economies because they can’t export as much, and it raises prices here because imports cost more.

15)? This is an article that is just too early.? So the markets have rallied, and commodities have fallen?? It’s only one week, and that is no horizon over which to make the judgment that Fed policy is succeeding.? Look at it in 9-12 months, and then maybe we can hazard a good guess.

Another Dozen Notes on Our Manic-Depressive Credit Markets

Another Dozen Notes on Our Manic-Depressive Credit Markets

Posted on by David Merkel

This is what I sometimes call a “Great Garbage Post.”? I’ll cover a lot of ground, so bear with me.

1) How to do a bank/financial bailout: a) wipe out common and preferred equity and the subordinated debt (and offer some warrants to the debtholders).? Make the senior debt take a haircut of 50% (and offer warrants), and the bank debt a haircut of 20% (and offer warrants). Capital is offered in exchange for the equity interest, together with some senior financing pari passu with the banks.? If the management and other stakeholders do not like those terms (or something like them), then don’t bail them out.

Now, realize I’m not crazy about “lender of last resort” powers being in the hands of the government, but if we’re going to do that, you may as well do it right, and bail out depositors in full, while having others take modest to large haircuts.? There is no reason why the government/Federal Reserve should bail out common or preferred equityholders, and those that bought risky debt should pay part of the price as well.? This should only be done for institutions where significant contagion effects could affect other financial institutions.? The objective is to create a firewall for depositors, and the rest of the financial system.

2)? Bear Stearns.? Ugh, a bank run.? A testimony to leverage.? Book value is only fair if one can realize the value over time.? High leverage implies a haircut to book value in bad times, because the value of the assets can go down dramatically.? Will they get a buyer?? I don’t know, and I wouldn’t trust JC Flowers.? If what Jamie Dimon might be thinking is what the Bloomberg article states, then I think he has the right idea: keep the best businesses, dissolve the rest.

But remember, during crises, highly levered financial institutions are vulnerable, unless most of their financing is locked in long-term.? Most investment banks don’t fit that description, particularly with all of the synthetic leverage in their derivative books.

3) The downgrades on commercial bank credit ratings will continue to come, particularly for those that were too aggressive in lending to overlevered situations, e.g., home equity lending.? Home equity lending is very profitable in good times, but then it gets overcompetititive, and underwriting standards deteriorate.? Then a lot of money gets lost, as in 1998, where most of the main lenders went under.? In this case, most of the lenders are banks, and they aren’t concentrated in that line alone.

4)? Home builders are taking it on the chin.? Consider this article about joint venture failures of homebuilders.? It is my guess that we will see a few of the major homebuilders fail.? It will take us to 2010 to reconcile all of the excess inventory.? Personally, I would guess that the stable home ownership rate is still below the current level by maybe 2% of the households.? We tried to force homeownership on people that were not ready for it, people who didn’t have enough financial slack to make it through even a slight recession.

5) I find it amusing that Bob Rubin, the only guy in the Clinton Administration that I liked, says that few people anticipated this bubble. (Sounds like Greenspan, huh?)? Well, in a sense he’s right.? Probably fewer than 1% of Americans anticipated these results, but there were enough writers in the blogosphere that were saying that something like this would come (including me), that some could take warning.? As in the tech bubble, there were a number of notable commentators warning, but no one listens during the self-reinforcing cycle of the boom.

6) I am sticking with a 50-75 basis point move from the Fed in the coming week.? They want to move aggressively, but they don’t want to use up all of their conventional ammo, when they are so close to the “zero bound.”? They might disappoint the markets, but not on purpose.? They will tend to follow what the markets suggest.

7) This Fed is more willing to try novel solutions than in the Greenspan era.? Even so, I expect them to run into constraints on their ability to deal with the crisis, which will force the Treasury Department (yes, even in the Bush Administration) to act.

8)? The glory of “core inflation” is not that it excludes the most volatile classes of goods, but the ones for which there is the most excess demand.? Food price inflation is running.? Farmers can’t keep up with the demand.? Poetic justice for the hard-working farmers of our country, who have had more than their share of hard years.? Agriculture is one of the industries that makes America great.? Let the rest of the world benefit from our productivity there.

9)? This is one of those times where one can get a “pit in the stomach” from considering the possibilities from a financial crisis.? As leverage dries up, those with the most leverage on overvalued asset classes get margin calls, leading to forced liquidations.? As it stands now, many credit hedge funds are finding it difficult to maintain their leverage levels, and other hedge funds are finding their lending lines reduced.? This forces a reduction in speculation, and the prices of speculative assets.

10)? Be careful using the ABX indices.? They are too easy to short, and do not represent the values that are likely to be realized in the cash markets.? The same is true of the CMBX indices.? This would lead me to be a bull, selectively, in AAA CMBS, after careful analysis of the underlying collateral.? (CMBS was a specialty of minewhen I was a mortgage bond manager.)

11)? Two interesting articles on character and capitalism.? This is a topic that I havea lot to say about, but every time I sit down to write about it, I am not satisfied with the results.? Let me make a down payment on an article here.? Capitalism is good, but Capitalists often abuse it.? Short-sighted capitalists play for short-term advantage, and end up burning up relationships.? Longer-term capitalists play fair, because they not only want deal one, but deals two, three, four, etc.? They play fair because they will do better in the long run, even if they are intelligent pagans.? (Christians should play fair anyway, because their Father in heaven looks at their deeds.? If we love Him, we will please Him.)

Economics isn’t everything.? Smart businessmen know that a good reputation is golden.? They also know that happy employees are more productive.? Suppliers that get paid on time are more loyal.? These are the benefits of ethical, long-run thinking.

12) In closing, a poke at quantitative analysis done badly.? Consider Paul Wilmott, or William Shadwick.? With bosses over the years, often they would ask me a seemingly simple quantitative question, and I would reply, “Here’s the standard answer: XXXXX.? But there are many reasons why that answer could be wrong, because the math makes too many assumptions about market liquidity, investor rationality, soundness of funding sources, etc.”? Most quants don’t know what they are assuming.? They are too good with the math, and not good enough at the human systems that inadequately lie behind the math.

As a quantitative analyst, I have generally been a skeptic.? At times like this, when the assumptions are breaking down, it gives me a bit of validation to see the shortfall.? That said, it’s no fun to be right when you are losing money, even if it is less than others are losing.

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