Real Estate and Mortgages – Page 42

Thinking About the Bear Stearns Bailout

Posted on 15 March 2008 by David Merkel

When I go to prayer meeting on Thursday evenings, I have recently begun requesting prayer for the economy and policymakers.? Ordinarily, I resist doing that, because it usually doesn’t sound right.? I remember one time two years ago explaining why we should pray about a given economic issue, and my dear wife said, “Let me get this straight.? We’re praying for the World Economy, that we don’t have a disaster?”? But when I was asked to explain my concern recently, I said, “Things are breaking in the financial system that no one a year ago would expect to break, and the costs could be high.? A second Great Depression is not impossible, and a repeat of something similar to the 70’s is more likely, minus the ugly clothes.”? That said, I am satisfied with praying for my daily bread, and the daily bread of others.

I didn’t expect to start the post this way, but that’s what’s on my heart.? Things are breaking that should not break, but what is happening is consistent with what I have been writing about here and at RealMoney for the past four years.? I am not a bear by nature, nor a bull.? I just try to analyze economic situations from a holistic perspective, and what I have seen over the past four years, was a massive increase in leverage that was not sustainable.? This affected the investment banks as well, and in this case, Bear Stearns in particular.

Confidence is tricky.? The investment banks are more highly levered than mortgage REITs, and we have seen the fallout there, even though real estate is more stable than the assets financed by most investment banks.

This is why in investing, I write about having a provision for adverse deviation, or in Ben Graham’s terms, “A margin of safety.”? With leverage, one should always calculate the maximum amount of? leverage consistent with prudence, and then take several steps back from there.? What is permissible in the boom phase has little relevance to the bust phase.

Now, I tell my children, “Don’t blame the Ump.”? In sports, if it is call of an umpire or referee that is the difference between victory and defeat, then you did not deserve to win.? You did not gain a commanding lead in the contest.? In this situation, Bear Stearns played close enough to the edge that rumors could begin to push at their short-term financing base, creating a crisis.? Investment banks must be like Caesar’s wife — there can’t be a hint of impropriety (with respect to financing).

Now, with a downgrade in credit ratings, Bear Stearns will have to find a buyer.? Why?? Major financial companies that lend have to have A-1/P-1 commercial paper ratings in order to make money.? The ability to borrow at cheap rates in the short run is important to profitability.

Naked Capitalism has some good points on this topic.? I would echo on the mortgage exposure.? More important is not being liked.? According to friends of mine, Lehman got rescued privately during the LTCM crisis because they convinced creditors to support them.? Bear walked out on the LTCM bailout, and it still leaves a bad taste in the mouth of Wall Street.? Wall Street does have honor, in a twisted way.? They remember who were their friends during tough times.? Bear was not one of them.

When there is a lot of worry around, it doesn’t take much to kick a marginal firm over the edge.? Bear had ample opportunity to move to lower level of leverage, and did not do it.? Now let’s talk about the rescuer.

The Omnipotent Federal Reserve

The Fed can’t run out of bullets, because it can always print money.? That comes with an inflation price tag attached, though.? In this case, they are providing funds freely to J. P. Morgan to the extent that they lend to Bear Stearns.? Now, I know why the Fed did this.? Bear Stearns my be small in a market capitalization sense, but is large when one considers all of the debts that they have, both in the cash and synthetic markets.? (As an aside, I was analyzing some muni bonds of a major issuer today, and it amazed me that Bear Stearns was their #2 counterparty.)

Now the Fed has Fed funds, the discount window, TAF, TSLF, and more.? I am not here to fault them for lack of creativity.? I am here to fault them for (like Bear Stearns) overtaxing their balance sheet.? There is only so much that the Fed can rescue before it chokes, because they (at that point) have no more safe assets to pledge.

I sold my capital markets exposure earlier this week, and I am glad that I did, late as that was.? The Fed is not big enough to rescue all of the investment banks, nor could they rescue the GSEs, without creating significant price inflation.? What a mess.? Avoid the depositary financials, and those that lend and intermediate aggressively.? This is not a time to be a hero in financials.

One Dozen Notes on Our Crazy Credit Markets

Posted on 13 March 200813 March 2008 by David Merkel

1) I typically don’t comment on whether we are in a recession or not, because I don’t think that it is relevant. I would rather look at industry performance separate from the performance of the US economy, because the world is more integrated than it used to be. Energy, Basic Materials, and Industrials are hot. Financials are in trouble, excluding life and P&C insurers. Retail and Consumer Discretionary are soft. What is levered to US demand is not doing so well, but what is demanded globally is doing well. Much of the developed world has over-leverage problems. Isn’t that a richer view than trying to analyze whether the US will have two consecutive quarters of negative real GDP growth?

2) So Moody’s is moving Munis to the same scale as corporates? Well, good, but don’t expect yields to change much. The muni market is dominated by buyers that knew that the muni ratings were overly tough, and they priced for it accordingly. The same is true of the structured product markets, where the ratings were too liberal… sophisticated investors knew about the liberality, which is why spreads were wider there than for corporates.

3) Back to the voting machine versus the weighing machine a la Ben Graham. It is much easier to short credit via CDS, than to borrow bonds and sell them. There is a cost, though. The CDS often trade at considerably wider spreads than the cash bonds. It’s not as if the cash bond owners are dumb; they are probably a better reflection of the true expectation of default losses, because they cannot be traded as easily. Once the notional amount of CDS trading versus cash bonds gets up to a certain multiple, the technicals of the CDS trading decouple from the underlying economics of the bond, whether the bond stays current or defaults. In a default, often the need to buy a bond to deliver pushes the price of a defaulted bond above its intrinsic value. Since so many purchased insurance versus the true need for insurance, this is no surprise.. it’s not much different than overcapacity in the insurance industry.

4) If you want a quick summary of the troubles in the residential mortgage market, look no further than the The Lehman Brothers Short Swaption Volatility Index. The panic level for short term options on swaps is above where it was for LTCM, and the credit troubles of 2002. What a take-off in seven months, huh?

5) Found a bunch of neat charts on the mortgage mess over at the WSJ website.

6) I have always disliked the concept of core inflation. Now that food and fuel are the main drivers of inflation, can we quietly bury the concept? As I have pointed out before, it doesn’t do well at predicting the unadjusted CPI. Oh, and here’s a fresh post from Naked Capitalism on the topic of understating inflation. Makes my article at RealMoney on understating inflation look positively tame.

7) The rating agencies play games, but so do the companies that are rated. MBIA doesn’t want to be downgraded by Fitch, so they ask that their rating be withdrawn. Well, tough. Fitch won’t give up that easily. Personally, I like it when the rating agencies fight back.

8 ) Jim Cramer asks if Bank of America will abandon Countrywide, and concludes that they will abandon the bid. Personally, I think it would be wise to abandon the bid, but large companies like Bank of America sometimes don’t move rapidly enough. At this point, it would be cheaper to buy another smaller mortgage company, and then grow it rapidly when the housing market bounces back in 2010.

9) Writing for RealMoney 2004-2006, I wasted a certain amount of space talking about home equity loans, and how they would be another big problem for the banking system. Well, we are there now. No surprise; shouldn’t we have expected second liens to have come under stress, when first liens are so stressed?

10) In crises, hedge funds and mortgage REITs financed by short-term repo financing are unstable. No surprise that we are seeing an uptick in failures.

11) As I have stated before, I am not surprised that there is more talk of abandoning currency pegs to the US dollar. That said, it is a getting dragged kicking and screaming type of phenomenon. Countries get used to pegs, because it makes life easy for policymakers. But when inflation or deflation gets to be odious, eventually they make the move. Much of the world pegged to the US dollar is importing our inflationary monetary policy.

12) Finally, something that leaves me a little sad, people using their 401(k)s to stay current on their mortgages. You can see that they love their homes, as they are giving up an asset that is protected in bankruptcy, to fund an asset that is not protected (in most states). Personally, I would give up the home, and go rent, and save my pension money, but to each his own here.

Brief Note on the Fed Actions

Posted on 12 March 2008 by David Merkel

I’ve been puzzling about the recent Fed actions, and I think there is less there than meets the eye.? Don’t get me wrong, the Fed has acted.? It is changing the composition of its balance sheet in the short run, absorbing MBS, and pushing out Treasuries.? But it is not expanding its balance sheet.? After several novel policy initiatives, it should be painfully obvious to Fed-watchers that the lack of increase in the monetary base is intentional.

The Fed is trying to influence financing in the residential mortgage market versus Treasuries, in the short run.? It is not trying to stimulate the economy through expanding the monetary base.

The short-run aspect of the program hobbles it to some degree.? The Fed can say that they will continue to finance in the short term indefinitely, but nothing says that louder than expanding the terms from 28 days to two years.? If it’s in the agreement, the expanded length of financing will get a much bigger result than a rolling four week window.? Think of it this way: the Fed might want to continue the short-term financing indefinitely, but there have been times in the past where the Fed has felt forced to abandon a plan because of global macroeconomic events (think 1986-7, when the dollar fell, then the bond market fell, then the stock market fell…).? Promises are one thing, contractual terms are another.

I’m not a fan of central banking, but if we are going to have central banking, this is a time when the monetary base should be expanding, at least modestly.? I think the Fed in this case is being “too clever” and needs to do a permanent injection of liquidity.? If they don’t want to do that, well, let’s move back to the gold standard, and privatize monetary policy.

Redirection of Liquidity, Not Creation of Liquidity

Posted on 11 March 2008 by David Merkel

These short-term financing arrangements (TAF & TSLF) are an attempt of the Fed to redirect liquidity from ordinary channels (fed funds and the like), to the short-term funding of banks and dealers with acceptable collateral. Acceptable collateral varies, with differing haircuts depending on the collateral and the financing program. At this point, Agency MBS and AAA whole loans (not on review for downgrade — presumably that means no negative outlooks from any ratings agency) are encouraged.What I find most interesting in all of this how little true liquidity the FOMC has injected in this cycle. The monetary base is flat. What this looks like is an attempt to selectively reflate the economy — help the banks and dealers, but keep total liquidity close to fixed.

And, in the face of this, total bank liabilities keep expanding at a 10%+ clip. It almost feels like any source of liquidity is good liquidity to the banks. Of course, they get a lot of it from the FHLB, which has been the big unconstrained lender in this cycle. Fannie and Freddie may now be able to make larger loans, which loosens up hosing finance a bit, but only the FHLB has the balance sheet to do so in this cycle, and they have done it. Call them the “shadow Fed.” But even their balance sheet is finite, and they are only implicitly backed by the US Government, like Fannie and Freddie.

So where does this leave us? Muddling along. Even the redirection of liquidity will not get the banks and dealers too jazzed, because they are only short term measures, with uncertain long-term funding availability and cost. More attractive than the “free” market for now, but that’s about it.

The Fed is trying some clever ideas. I have just two concerns — what happens when you unwind them, and are they perhaps too clever?? There may be unintended consequences…

Negative Real Interest Rates and Asset Deflation

Posted on 8 March 20089 March 2008 by David Merkel

I always try to separate my views of what I think the FOMC will do, versus what the FOMC should do. It’s hard for me now, because I think the FOMC is pursuing the wrong strategies. The yield curve is steep enough now, that further easing will not yield much incremental benefit. Further, a loose monetary policy only stimulates healthy areas of the economy that can absorb more borrowing, not areas with impaired balance sheets.

But what will the Fed do? Loosen. Aggressively. Don Quixote would be proud. They will make the TAF permanent and big, and the discount window will be a relic of a simpler age.

Let’s think of the short run versus the long run. In the short run, the FOMC wants to get the economy moving again, and is willing to tolerate negative real interest rates in order to do so. The Fed funds target is already 1%+ below the CPI, and the argument is over whether the next move will be to loosen 50 or 75 basis points. Negative real interest rates promote goods and services price inflation. (I don’t know about everyone else, but when filling up my gas tank nears $100 I begin to worry. Eight kids — 15-seat van, 10 cylinders…) In the long run, the FOMC will have to deal with price inflation. Even with the current yield curve, I can tell you that goods price inflation will worsen, leading to monetary tightening that will be painful, or no tightening, and inflation that rivals the 70s.

The Fed could target lending to the weak areas of the economy, while leaving monetary policy alone. That would invite charges of favoritism, which is why it won’t happen.

So, in my opinion, asset deflation will persist, and goods price inflation will increase. As for me, I will likely sell my positions in Deerfield Capital, Royal Bank of Scotland, and Deutsche Bank on Monday, replacing the exposure with an index for now. I have agonized over the seemingly cheap capital markets names for some time now, and I have been the loser there. I will return, but for now, it is safer to have no investment banking or mortgage exposure. The asset deflation is hitting them hard, and lending is contracting.

Full disclosure: long DB RBS DFR

One New Bit of Data on Prime Agency Collateral

Posted on 8 March 2008 by David Merkel

Well, it looks like the collateral haircut for repo financing of agency mortgages has gone up, from 3%, to somewhere between 4 and 5%.? That may account for some of the panic, especially regarding Carlyle.? It also may mean that Deerfield Capital is kaput.? I am presently long, but I may sell next week.? This company would be my personal biggest blunder ever, and my apologies to those who were influenced by me to own the company.

full disclosure: long DFR

Bill Pass

Posted on 7 March 2008 by David Merkel

First permanent injection of funds in 10 months.? A bill pass.? Now, it qualifies as permanent, but the $10 billion injection will only last 2-3 months.? Not very permanent to me.

The Fed is doing all it can to cram liquidity into the short end of the market.? They have expanded the TAF to $100 billion, and might go beyond that.

I suspect that these measures can succeed in bring the TED spread down for now, but unless they make the TAF permanent, there will be an effect when they unwind it. ? What these measures can’t do is unjam our mortgage markets.? A coupon pass where they buy some agency debt would make a nice statement.

Buy Agency Bonds. Buy Agency Passthroughs.

Posted on 7 March 2008 by David Merkel

This will not be a long post.? Ask yourself this: in this environment, would the US government step away from the mortgage agencies?? I think not.? If anything, they might invest in its subordinated debt, particularly if there were a conversion into common stock feature.

Spreads are wide, very wide, and I don’t think the government will let the GSEs fail, particularly after raising their lending limits.? The agencies will need more capital for lending , so I would expect more preferred stock issues, and perhaps an equity issuance, if to a key investor, like the US Government.

I don’t see the US Government guaranteeing all of the debt of the Agencies, but I could see it doing it for a period of years on new issues, particularly if the Government received equity warrants.

In this wide spread environment, I would be a buyer, particularly versus Treasuries.

“The Unwind”

Posted on 7 March 2008 by David Merkel

I invest like a moderate bull and I reason like a moderate bear.? Why?? In general, in free economies, the equity markets favor the bulls over long periods of time.? So, I stay invested in equities in almost all markets, and let my other risk reduction techniques do my work, rather than making large changes in asset allocation.? That said, I appreciate the risks that the markets have been throwing off lately, and I am somewhat worried.

I have been a bear on residential housing and residential housing finance for the last four years.? I expected that those that took a lot of credit risk — subprime, Alt-A mezzanine and subordinates, would get hurt.? What has surprised me, though, is the degree to which AAA whole loan collateral and agency loan collateral has been hurt.? I failed to see the amount of leverage being employed there.? I looked at that area and said, “You can lever this stuff 10x, and you probably won’t get hurt if you are smart.”? Fine if 10x is the limit, but you had players at over 30x, and now you have that paper being tossed back into the market, depressing prices, and raising yields.? This raises the risk of a self-reinforcing move that will only end when unlevered and lightly levered buyers soak up the high yielding safe assets that couldn’t find a home elsewhere.

Any asset can be overlevered. ? A house, a home loan, a corporation… there is some level of debt that will kill the owner of a given asset.? High quality mortgage paper got overlevered, and even though current market prices are attractive to unlevered buyers, there is the short-term risk that more players will be forced to delever.? So when is the right time to buy?

I have agonized on this one, because the problem is short-term financing.? Repo financing from brokers that have their own balance sheet worries.? (Note: some are talking about mark-to-market accounting — yes, that has a small effect here, but not as large as the financing issue.)? Repo financing is short-term collateralized lending.? 97% of the value of the agency loan collateral gets loaned, with 100% of the agency loan collateral as security.? If collateral prices move down, more margin must be posted. This is an unforgiving situation.? If you can’t meet the margin call (demand for more funds to support a losing position), your collateral will be liquidated.? (There also issues in how one hedges, but that is for another time.)

When to buy?? Most repo funding is short — a day to a week.? Some extends over 30-90 days, and Annaly uses 1-3 year repo financing (where do you get that?).? My sense is this: wait for two weeks after you hear of any major fund liquidation, and commit half a position.? After another two weeks, commit the other half, if no further liquidations have been heard.

At my last firm, I would talk with my boss about “The Unwind.”? All of the areas of the credit market where ordinary prudence was being ignored, and in the short run, leverage was increasing, because is paid to do so in a rising market.? Eventually, asset cash flow would prove insufficient to finance the interest costs, and then “The Unwind” would happen.? Leverage would have to come out of the system, both from explicit loans and from derivative contracts.

We are in “The Unwind” now.? Leverage is coming out, even in asset classes that I did not anticipate.? “The Unwind” will end when players with strong balance sheets hold most of the previously overlevered assets.

On Information Cascades and Lemmings

Posted on 4 March 2008 by David Merkel

I’ve never been comfortable with the concept of rationality in economics, at least, if rationality is defined as maximizing or minimizing a certain function, largely because maximizing and minimizing take effort, and people avoid effort (it is a bad not a good).? So when I read jive about information cascades, I roll my eyes.? Don’t get me wrong, I like Dr. Schiller; he’s a clever guy.? What is meant by information cascades is a sudden acknowledgment of things that were obvious, but ignored, because economic actors decided to follow the crowd.

Now, in the equity markets, momentum players can make money, but they have to cut their losses, and not stay at the game too long on any individual stock that is falling.? Houses are far less liquid than stocks, so the threshold to act is that much higher, plus for those that have mortgages, the leverage magnifies the pain when prices fall.? Thus people delay acting, and when they act, because a pain threshold has been crossed, they act all at once.

Is this an “information cascade?”? I think not.? It is more akin to “gunning the stops” in an equity market.? As prices fall, more people decide to sell to preserve some value, and prices go down more than anticipated.? It is not so much a question of information, but fear that drives the trade.

Information takes a different form.? Those who analyze their borrowings such that they know that it is unlikely that they will ever be forced to sell have genuine information.? They have sized their borrowings appropriately.? They are relying on the table model of stability, rather than the bicycle model (stable so long as you keep moving).

We don’t get dramatic moves in markets from information cascades, but from levered borrowers that are forced to sell for one reason or another.? These are borrowers that lacked information.? They became “informed” because of price moves that they did not anticipate.