Category: Real Estate and Mortgages

Time to Begin Increasing Credit Risk Exposure

Time to Begin Increasing Credit Risk Exposure

Posted on by David Merkel

Ugh, today was a busy day.? My views of the FOMC were validated as to what they would do and say, though I was wrong on the stock market direction on a 50 bp cut.? The bond market direction I got right.

Look at this post from Bespoke.? Ignore the percentage increase, and just look at the raw spread levels.? Better, add an additional 3%+ (for the average Treasury yield) to the current 685 spread, for a roughly 10% yield.? When you get to 10% yields, the odds tip in your favor on high yield.? That said, today’s crop of high yield corporate debt is lower rated than in the past.? Don’t go hog wild here, but begin to take a little more risk.? I was pretty minimal in terms of credit risk exposure for the last three years, owning only a? few bank loan funds, the last of which I traded out of in June 2007.

With fixed income investing, if I have a broad mandate, I start by asking a few simple questions:

  • For which of the following risks am I being adequately rewarded?? Illiquidity, Credit/Equity, Negative Convexity (residential mortgages), Duration, Sovereign, Complexity, Taint, Foreign Exchange…
  • What are my client’s tax needs?
  • How much volatility is my client willing to tolerate?
  • How unconventional can I be without losing him as a client?
  • What optical risks does he face from regulators and rating agencies, if any?

One of my rules of thumb is that if none of the other risks are offering adequate reward, then it is time to increase foreign bond positions.? That is where I have been for the past three years, and now it is time to adjust that position.? With respect to the list of risks:

  • Illiquidity: indeterminate, depends on the situation
  • Credit/Equity: begin adding, but keep some powder dry
  • Negative Convexity: attractive to add to prime RMBS positions at present.
  • Duration: Avoid.? Yield curve will widen, and absent another Great Depression, long yields will not fall much from here.
  • Sovereign Risks: Avoid.? You’re not getting paid for it here.
  • Complexity/Taint:? Selectively add to bonds that you have done due diligence on, that others don’t understand well, even if mark-to-market may go against you in the short run.
  • FX: Neutral.? Maintain core positions in the Swiss Franc and the Yen for now.? Be prepared to switch to high-yield currencies when conditions favor risk-taking.

That’s where I stand now.? The biggest changes are on credit risk and FX.? That’s a big shift for me.? If you remember an early post of mine, Yield = Poison, you will know that I am willing to have controversial views.? Also, for those that have read me here and at RealMoney.com, you will know that I don’t change my views often.? I’m not trying to catch small moves.? Instead, I want to average into troughs before they hit bottom.? If you wait for the bottom, there will not be enough liquidity to implement the change in view.

Miscellaneous Musings on Our Manic Markets

Miscellaneous Musings on Our Manic Markets

Posted on by David Merkel

1) I had another good day today, but my body is telling me otherwise.? As I wrote at RealMoney:


 David Merkel
Two Positive Surprises; Two Things I Don’t Do
1/24/2008 3:11 PM EST

Two more news bits. I don’t buy for takeovers, but today Bronco Drilling got bought out by Allis-Chalmers Energy. (Now I have three open slots in the portfolio.) I also don’t buy to bet on earnings. But I will ignore earnings if I feel it is time to buy a cheap stock. With yesterday’s purchase of RGA, I did not even know that earnings were coming today. What I did know was that they are the best at life reinsurance, and that it is a constricted field with one big (in coverage written) damaged competitor, Scottish Re. So, today’s good earnings are a surprise, but the quality of RGA is not.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Scottish Re to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: long RGA BRNC

2)? There’s a lot of commentary going around on the Financial Guarantors and bailouts, whether to profit-seeking individuals like Wilbur Ross, or a consortium of investment banks who will not do so well without them.? For a good summary of what will make a consortium bailout of the industry as a whole tough, read this piece at Naked Capitalism.? I will say that Sean Egan’s estimate of $200 billion is too high (maybe he is talking his book).? Just on a back of the envelope basis, the whole FG industry earned about $2 billion per year.? If they needed $200 billion more capital to be solvent, their pricing would have to expand about 5-10 times to allow them to earn an acceptable ROE.? No one would pay that.? So, if the $200 billion is right, it is just another way of saying that the FG industry should not exist.? (Well, the Bible warns us of the dangers of being a third-party guarantor…)

Then again, there are many risks that Wall Street takes on where the probability of ruin is high enough to happen at least once in a lifetime, but adequate capital is not held because protecting against the meltdown scenario would make the return on equity unacceptable.? The risk managers bow to pressure so that the businesses can make money, and hope that the markets will stay stable.

3) There’s been even more musing about the Fed 75 basis point cut, with a hint of more to come.? No surprise that I agree with Caroline Baum that the Greenspan Put is alive and well, or with Tony Crescenzi that we could call it the Bernanke Pacifier.? But Bill Gross leaves me cold here.? He and Paul McCulley consistently argued against raising rates during the recent up cycle, and in the prior down cycle cheered the lowering of the Fed funds rate down to 1%.? These policies, which overstimulated housing, helped lead to the situation that Mr. Gross now laments.

I also think that David Wessel and many others let the Fed off too easily on their misforecasting. ? Who has more Ph.D. economists than they do?? I’m not saying that the Fed should read my writings, but there is a significant body of opinion in the financial blogosphere that saw this coming.? Also, they basked in their aura of invincibility when it suited them, particularly in the Greenspan era.

As I commented last night, Bernanke is a bright guy who will not let his name go down in the history books as the guy who allowed Great Depression #2 to emerge.? So as? the bubble bursts, the Fed eases aggressively.? Even Paul Krugman points to the writings of Bernanke on the topic.

One last note on the Fed: Eddy Elfenbein points out the basic mandate of the Fed.? I’m not sure why he cites this, but it is not a full statement of the Fed mandate, unless one interprets it to mean that the Fed has to promote the continuing growth of the credit markets (I hate that thought).? Since the Fed is a regulator of banking solvency, and must be, because money and credit are similar, the Fed also has a mandate to preserve the banking system under its purview.? That’s difficult to do without overseeing the capital markets, post Glass-Steagall.? Unfortunately, that is what creates at least the appearance of the “Greenspan Put.”? And now the market relies on its existence.

4)? But maybe the Fed overreacted to equity markets getting slammed by SocGen exiting a bunch of rogue trades.? Perhaps it’s not all that much different than 2002, when the European banks and insurers put in the bottom of the US equity markets but being forced to sell by their regulators. If so, maybe the current lift in the markets will persist.
As for SocGen, leaving aside their chaotic conference call, I would simply point out that it is a pretty colossal failure of risk control to allow anyone that much power inside their firm.? Risk control begins with personnel control, starting with separating the profit and accounting functions.? Second, the larger the amounts of money in play, the greater the scrutiny should be from internal audit, external audit, and management.? I have experienced these audits in my life, and it is a normal part of good business.

Because of that, I fault SocGen management most of all.? For something that large, if they didn’t put the controls in place, then the CEO, CFO, division head, etc. should resign.? There is no excuse for not having proper controls in place for an error that large.

That’s all for the evening.? I am way behind on my e-mail, so if you are waiting on me, I have not given up on responding to you.

Full disclosure: long RGA BRNC

Thirteen Notes on the Nexus of Woe: Financials and Real Estate

Thirteen Notes on the Nexus of Woe: Financials and Real Estate

Posted on by David Merkel

1) Let’s start on a positive note: Doug Kass says it is time to buy the financials.? I may never be as successful or clever as Mr. Kass, but I think he is early by one year or so.? And this is from someone who is technically overweight financials — I own six insurers, two high-quality mortgage REITs, and two European banks.? When it comes time to own financials, I may have a portfolio with 50% financial stocks, and I will pare back the insurers.

2) What of the Financial Guarantors?? Forget that I said I would flip the 14% MBIA surplus note, I did not expect that it would do so badly so quickly.?? The rating agencies are all concerned to potentially downgrade MBIA, Ambac, and others.? Downgrades are death, and rating agencies would only consider such measures if they knew that other companies would step in to continue their AAA franchise if they kick the losers over the edge.? Berky, by entering the financial guarantee space, has signed a death warrant for at least one of MBIA and Ambac, and who knows, Berky might buy the loser.

3)? Away from that, PartnerRe, one of my favorite companies, has written off its entire stake in Channel Re, which provided reinsurance to MBIA.? Leave it to that classy company to write off the whole thing, which implies bad things for MBIA as it relies on reinsurance from Channel Re, which it also partially owns.

4) Though this is a test of the financial guarantors, it is also a test of the rating agencies, which are in damage control mode now.? My view is the Moody’s and S&P will survive the ordeal, and come back fighting.

5) For a lot of nifty graphs on the subprime lending crisis, look at this article from the BBC.

6) Now, a lot of the subprime crisis is really a stated income crisis.? Think about it: income is such a standard metric for loan repayment.? If one lets borrowers or agents fuddle with income, should we be surprised that loan quality declines?

7)? Even the black humor of the credit crunch in residential real estate points out how much more residential real estate might fall in price, and with it the values of companies that rely on residential real estate.

8) The boom/bust nature of Capitalism can not be repealed.? As an example, at the very time that you want banks to want to lend more to support the real estate market, they insist on larger down payments.

9) At my last employer, and at RealMoney, I would often say that the biggest crater to come in residential housing was in home equity loans.? JP Morgan is a good example of this.? Should this be surprising?? I noted from 2004-2007 how much of the ABS market had gone to home equity loans, and felt it was unsustainable.? Now we are facing the music.

10) Now consider credit cards.? Even cards on the high end are reporting deteriorating loan statistics.? Unlike past history, many people are paying on their cards to maintain access to credit, and letting their home loans slide.? Worrisome to me, and to the real estate markets as well.

11) Even auto loans are getting dodgy in this environment. ? No surprise, given that lending quality and consumer credit behavior have both declined.

12) Commercial rents may seem to rise in some areas, but there are tricks that owners use to occlude the economics in play.

13) Now for long term worries, consider what will happen to the real estate market as the baby boomers age.? Houses in colder areas will get sold, and houses in warmer areas will be bought.? This article does not take into account reverse mortgages, which will also be prominent.? Aside from that, the idea that baby boomers will be able to cash out of their homes to fund retirement will be hooey, unless we let wealthy foreigners buy into the US.? There will not be enough buyers for all of the houses to be sold without immigrants buying them.

Relying on the Kindness of Strangers as an Investment Strategy

Relying on the Kindness of Strangers as an Investment Strategy

Posted on by David Merkel

In 2002, when many credits were troubled, I would look at some of troubled positions that we held and do a recovery analysis, to see what we might get if the company filed for insolvency. Often in that process, I would find that investors elsewhere in the capital structure had different motivations than we did. The bank might prefer to liquidate the stinker, while the bondholders, in a more junior position, would prefer it kept as a going concern. Or, the equity investors that have control of the company might pursue a unprofitable strategy that encumbers the assets of the firm, leaving the bondholders with a less valuable entity for their debt claims. Or, the company could issue secured debt, effectively subordinating bondholders, while providing cash that could be used to buy back stock. Another case is when you have a valuable company with a liquidity problem. The banks will be willing to lend against that trapped value so that the company can repay bondholders, right? Right?! (Sigh.) In most of these situations, a bond investor finds that he is implicitly relying on the kindness of strangers. That is rarely a good place to be. 🙁

Now, a few judicious debt covenants could partially level the playing field, but with investment grade bonds those are rare. (Covenants work a lot better than fraudulent conveyance lawsuits, etc….) My main point here is that it pays to analyze situations in advance to understand when your bargaining power is weak. Risk control is best done on the front end, not the back end. Equity/Management will always hold the “capital structure” option to some degree, and unsecured lenders will always have a weak hand there.

So when I read this article about ladies in Baltimore losing their homes because they didn’t do enough scrutiny of the mortgage documents, partly because they were deceived by people who were seemingly experts, who said that they would be able to refinance the rate when the reset date hit, I thought about relying on the kindness of strangers again. It would be one thing if guaranteed refinance terms were offered at the initial refinancing, but absent that, credit conditions are fickle, and it can be a short interval between loose credit and tight credit. Relying on the ability to refinance a debt is always risky.

Today, consumer credit terms are tight. A year ago, they were moderately loose. Two years ago, terms were stupid loose. Who knows, later this year, terms could become stupid tight, where even good quality borrowers with adequate security can’t get credit.

Again, in investing, and even in personal finance, strive to understand your bargaining position. Do you hold the options? If it’s not you or those with you in your position, then others hold the options to control the assets. Usually those are held by the equityholders (or management, who sometimes act in their own interest, not that of the shareholders), and senior or secured debtholders. Those with weak positions, like preferred stockholders, unsecured and junior debtholders must be compensated for the weak position with extra yield or covenant protections.

The same analysis applies to structured securities, whether the credit enhancement comes from a guarantor or a senior-subordinate structure. In the good times, the equity controls the deal. In the really bad times, control often slides to those who are most senior in the capital structure.

On a personal level, a house is controlled by the owner if he can stay current on the payments (if any). Absent that, the bank controls the situation, subject to the rights of other claimants (the taxman, home equity lenders, mortgage insurers, etc.)

If strangers are kind to you, that is a good thing. Be grateful for a society that encourages that kindness. But don’t rely on it in investing or personal finance.

PS — sometimes even a good analysis of your rights and options can go awry. The KMart bankruptcy was a good example of that, where KMart had assets worth more than their liabilities, and could have gotten financing to continue. But a bankruptcy judge allowed their petition, and they were able to give creditors and lessors the short end of the stick. Those that controlled KMart post-bankruptcy made out handsomely. It would be difficult to repeat that aspect of the success.

Thus, you might look at this good article on Sears Holdings (successor name for KMart) in a slightly different light. The financial engineering gains can’t be repeated. It now must make its money as a retailer. As the article gently points out, being a good investor and a good retailer don’t naturally go together.

Bringing this back to topic, does management of Sears act in the best interests of shareholders? Management has the incentives to do so, but sometimes the intellectual gratification of the CEO can get in the way of making good business decisions. Management has control, the outside passive minority investors do not. Their only options are to ride on the Sears bus, or get off. If an investor doesn’t think the management of Sears is doing it right, he would be foolish to trust them with his money.

The Fed, Financial Guarantors, and Housing

The Fed, Financial Guarantors, and Housing

Posted on by David Merkel

This post will be a little more disjointed than others. One housekeeping note before I start: I’m behind on my e-mail. I will catch up on it next week, DV.

Fed and Federal Government Policy

I don’t know; it seems like there are rumblings that the Fed will imminently take action, and that does not resonate with me. You can also read the stuff from Doug Kass at RealMoney, or consider the rebirth of the Plunge Protection Team. We are not so far from the next Fed meeting that waiting would make that much of a difference, particularly since the Fed tipped its hand when Bernanke spoke recently. There is a decent-sized cut coming, and the Treasury yield curve reflects it.

Now, I have my doubts as to the long-term efficacy of unusual measures from the Fed or the Treasury. You can’t get something by government fiat. Even a Fed Governor thinks we expect too much from the Fed, a sentiment with which I heartily agree, even though the Fed is partially responsible for creating that illusion. If the Fed took more of a “we do our best, but our powers are not that large in the long run” approach, market players might not give them so much credence.

Now, I’m not going so far as Anna Schwartz, who thinks the current Fed isn’t up to the task. That may or may not be true; what is hard to dispute is that Alan Greenspan dealt the existing FOMC a bad hand from a prior monetary policy that too easily responded to minor crises, rather than letting the economy take some pain. Moderate recessions are good for the economy; save the heroics for depression-like conditions.

Financial Guarantors

I may fail at it, but I try to be honest and self-critical here at my blog. For example, I did not suggest that Warren Buffett would buy Ambac, but I was misinterpreted as saying so. Now that Ajit Jain says that Berky might buy into one of the financial guarantors, I am not going to say that I predicted that, because I didn’t. It would be amusing if Buffett announced his new entry into the financial guaranty space to drive their prices down so he could buy a stake cheaper, but that is not his style. He values his reputation. That said, the NY regulator may not have thought enough steps ahead in pushing for Berky to set up a new guarantor. Good for new issues; perhaps not as good for old ones at legacy carriers.

Now, I admire Marty Whitman and Aldo Zucaro, but so far, their forays into the mortgage guaranty space have not worked out. I’m not counting them out, but it still may be early for that trade. Maybe we should wait for one of the companies to fail. The remaining companies should do well, once capacity drops out.

As for MBIA, they cut their dividend, which to me indicates a lower future level of profitability. Then they raise $1 Billion through surplus notes at their operating subsidiary, and pay 14% to do that. That has to be a record spread for a new-issue nominally AA-rated bond. Personally, I think I would pass on the notes, except for a flip. I would rather hold the common. Scenarios that would kill the common would most likely also kill the surplus notes. The common has more upside potential.

Residential Real Estate

I am fascinated by the willingness of some of the courts to insist on strict standards before they allow lenders to foreclose. Examples:

In general, I think there are legitimate flaws in the documentation that got ignored before the number of attempted foreclosures became so large. This is pointing out some stresses in the system. When this is done, securitization will not vanish; it will just be better managed.

Now as a final note, it is somewhat shameful that banks can’t follow FAS 114. The calculations aren’t hard; they just don’t want to recognize losses that they should recognize. That’s the real issue, so FASB and Congress should not give in here.

Fifteen Points on Credit Where Credit Ain’t Due

Fifteen Points on Credit Where Credit Ain’t Due

Posted on by David Merkel

I’ve wanted to do a post on credit for a while, but I’ve just had too many things to think about. Well, here goes:

1) From the “We Keep Him in a Bubble” file there is James Glassman with his prediction that Spring 2008 would bring the end of the housing troubles. Why does this guy still get air time? Why wasn’t Dow 36,000 enough? There are too many vacant homes to reconcile, there is no way for Spring 2008 to be it….

2) For an excellent summary of where we are in housing, Calculated Risk has this review piece.

3) Not all defaults are subprime. They are happening with Option ARMs, and even prime loans where they had to get Private Mortgage Insurance.

4) Is the subprime mortgage bust bigger or smaller, or similar to the size of the the S&L crisis? I’ll go with bigger. I don’t buy DeKaser’s smaller argument because securitization has provided more credit to small and medium sized businesses. I do think Portfolio.com is on the right track by looking at the amount of the housing price rise that has happened.

5) Personally, I find it delicious that the banks get stuck footing the bill in particularly bad foreclosure situations. So much for structural complexity in lending.

6) Americans are the most overhoused people in the world. No one else gets as much space, or stores as much stuff, broadly speaking. This book review of “House Lust,” will take you through the whole matter, in probably too much detail. (And yes, my house is large also, but I have ten people here… Americans can be unusual in other ways too; as a culture, we are more optimistic about children.)
7) From Calculated Risk, a tale of why lenders tend to forbear with marginal borrowers that are having difficulties with their current loans. One thing they don’t mention, the Residential MBS market does not have special servicers like the Commercial MBS does. When a loan gets into trouble, the CMBS special servicer gets paid adequately, but the ordinary RMBS servicer does not, particularly when lots of loans are in trouble. It is a weakness in the RMBS system.

8 ) As the TED spread declines, market players begin to relax about liquidity. But what of solvency? As losses are realized by banks, some will have to shore up their capital positions, and to do that, they will have to ratchet back lending.

9) How similar is the US today to Japan back in the early ’90s? There are some similarities, given the property bubbles in both places, and the interest rates that get lower and lower, but there are differences — a healthier banking system in the US, and a more market-oriented economy here as well. A depression is possible in the US, but I would not assume it at present.

10) Is the US consumer spent-up? Could be. Consider this article on auto loans as well. Personally, I am surprised at the degree to which lenders will make consumer loans with inadequate security, but that is just a normal aspect of American life today. For now.

11) What of corporate bonds? It certainly seems like junk bonds will be seeing more defaults in 2008. (Here also.) This shouldn’t surprise us, because the credit quality was low and the volume of high yield bond issues was high 2004-2006. It takes a little while for bad debt to season, and we should see the results in 2008.

12) When I did my “Fed model” I used BBB corporate yields as my comparison to earnings yields on equities. Given the backup in credit spreads, my Fed model is not nearly as favorable as those using Treasuries. But those looking only at credit spreads get the wrong result also. With Treasury yields so low, most high quality bonds are not attractive now.

13) On the bleak side, I tend to agree with Naked Capitalism and the FT that there is a transfer of power going on in the world, away from the US, and toward China and the Middle East. Power follows capital flows, and they are funding the US at present. They will own more and more of US businesses over time. They increasingly won’t be satisfied by owning our debts.

14) I found this piece from Credit Slips to be educational. There are certain types of income that can’t be garnished; nonetheless, garnishing happens. The only way to protect yourself is to fight back, and that article highlights how it is done.

15) Finally, credit at its most basic level. Credit is trust; trust that repayment plus interest will occur. Who do you trust? Personally, I found the discussion following Barry’s post to be depressing, because so many commenters were cynical. here was my comment:

Capitalism is based on trust. Without trust, capitalism will slowly cease to exist. Yes, there will be barter-type transactions, but any complex long-term transaction or relationship is based on trust. Any multi-party transaction requires trust, because multiple parties can gang up on the weak one.

Even representative government requires trust. Now, that trust is often abused, but who wants to get rid of representative government?

There is a lot more trust within our society than most of us imagine. Woe betide us if trust drops to a minimum level.

Estragon (thank you) agreed with me at the end, but it is fascinating to consider the implications of a society where trust is declining. Ultimately, it means that credit will be declining.

The Financing of Last Resort

The Financing of Last Resort

Posted on by David Merkel

In 2002, we used to comment at the office that unless a company was dead, it could always get financing through a convertible bond offering.? The more volatile the situation (up to a point), the more the conversion option is worth, which can significantly reduce the effect of higher credit spreads, at a cost of possible dilution.

So, with the difficulties in getting financing at present, is it any surprise that we are having record issuance of convertible bonds?? I expect to see more of it, particularly for areas involved with housing, commerical real estate, mortgage finance, financial guarantee, and the investment banks.? High volatility and a need for financing begets convertible bond issuance.? That’s where we are now.

Depression, Stagflation, and Confusion

Depression, Stagflation, and Confusion

Posted on by David Merkel

I’m not sure what to title this piece as I begin writing, because my views are a little fuzzy, and by writing about them, I hope to sharpen them.? That’s not true of me most of the time, but it is true of me now.

Let’s start with a good article from Dr. Jeff.? It’s a good article because it is well-thought out, and pokes at an insipid phrase “behind the curve.”? In one sense, I don’t have an opinion on whether the FOMC is behind the curve or not.? My opinions have been:

  • The Fed should not try to reflate dud assets, and the loans behind them, because it won’t work.
  • The Fed will lower Fed funds rates by more than they want to because they are committed to reflating dud assets, and the loans behind them.
  • The Fed is letting the banks do the heavy lifting on the extension of credit, because they view their credit extension actions as temporary, and thus they don’t do any permanent injections of liquidity.? (There are some hints that the banks may be beginning to pull back, but the recent reduction in the TED spread augurs against that.)
  • Instead, they try novel solutions such as the TAF.? They will provide an amount of temporary liquidity indefinitely for a larger array of collateral types, such as would be acceptable at the discount window.
  • We will get additional consumer price inflation from this.
  • We will continue to see additional asset deflation because of the overhang of vacant homes; the market has not cleared yet.? Commercial real estate is next.? Consider this fine post from the excellent blog Calculated Risk.
  • The Fed will eventually have to choose whether it is going to reflate assets, or control price inflation.? Given Dr. Bernanke’s previous statements on the matter, wrongly ascribing to him the name “Helicopter Ben,” he is determined not to have another Depression occur on his watch.? I think that is his most strongly held belief, and if he feels there is a modest risk of a Depression, he will keep policy loose.
  • None of this means that you should exit the equity markets; stick to a normal asset allocation policy.? Go light on financials, and keep your bonds short.? Underweight the US dollar.
  • I have not argued for a recession yet, at least if one accepts the measurement of inflation that the government uses.

Now, there continue to be bad portents in many short-term lending markets.? Take for example, this article on the BlackRock Cash Strategies Fund.? In a situation where some money market funds and short-term income funds are under stress, the FOMC is unlikely to stop loosening over the intermediate term.

Clearly there are bad debts to be worked through, and the only way that they get worked out is through equity injections.? Think of the bailing out of money market funds and SIVs (not the Super-SIV, which I said was unlikely to work), or the Sovereign Wealth Fund investments in some of the investment banks.

Now, one of my readers asked me to opine on this article by Peter Schiff, and this response from Michael Shedlock.? Look, I’m not calling for a depression, or stagflation, at least not yet.? At RealMoney, my favored term was “stagflation-lite.”? Some modest rise in inflation while the economy grows slowly in real terms (as the government measures it).?? A few comments on the two articles:

  • ?First, international capital flows from recycling the current account deficit provide more stimulus to the US economy than the FOMC at present.? Will they stop one day?? Only when the US dollar is considerably lower than now, and they buy more US goods and services than we buy from them.
  • Second, the Federal Reserve can gain more powers than it currently has.? If this situation gets worse, I would expect Congress to modify their charter to allow them to buy assets that it previously could not buy, to end the asset deflation directly, at a cost of more price inflation, and spreading the lending losses to all who hold longer-term dollar-denominated assets.? If not Congress, there are executive orders in the Federal Register already for these actions.
  • Third, in a crisis, the FOMC would happily run with a wide yield curve — they will put depositary institution solvency ahead of purchasing power.
  • Fourth, the Fed can force credit into the economy, but not at prices they would like, or on terms that are attractive.? In a crisis, though, anything could happen.
  • Fifth, I don’t see a crisis happening.? It is in the interests of foreign creditors to stabilize the US, until they come to view the US as a “lost cause.”? Not impossible, but unlikely.? The flexible nature of the US economy, with its relatively high levels of freedom, make the US a destination for capital and trade.? The world needs the flexible US, less than it used to, but it still needs the US.

One final note off of the excellent blog Naked Capitalism.? They note, as I have, that the FOMC hasn’t been increasing the monetary base.? From RealMoney:


 David Merkel
The Fed Has Shifted the Way it Conducts Monetary Policy
12/21/2007 11:56 AM EST

Good post over at Barry’s blog on monetary policy. Understanding monetary policy isn’t hard, but you have to look at the full picture, including the presently missing M3. I have a proxy for M3 — it’s total bank liabilities from the H8 report –> ALNLTLLB Index for those with a BB terminal. It’s a very good proxy, though not perfect. Over the last years, it has run at an annualized 9.4%. MZM has grown around 12.8%. The monetary base has grown around 3%, and oddly, has not been spiking up the way it usually does in December to facilitate year-end retail.

The Fed is getting weird. At least, weird compared to the Greenspan era. They seem to be using regulatory policy to allow the banks to extend more credit, while leaving the monetary base almost unchanged. This is not a stable policy idea, particularly in an environment where banks are getting more skittish about lending to each other, and to consumers/homebuyers.

This has the odor of trying to be too clever, by not making permanent changes, trying to manage the credit troubles through temporary moves, and not permanently shifting policy through adding to the monetary base, which would encourage more price inflation. But more credit through the banks will encourage price inflation as well, and looking at the TED spread, it seems the markets have given only modest credit to the Fed’s temporary credit injections.

I am dubious that this will work, but I give the Fed credit for original thinking. Greenspan would have flooded us with liquidity by now. We haven’t had a permanent injection of liquidity in seven months, and that is a long time in historical terms. Even in tightening cycles we tend to get permanent injections more frequently than that.

Anyway, this is just another facet of how I view the Fed. Watch what they do, not what they say.

Position: noneThe Naked Capitalism piece extensively quotes John Hussman.? I think John’s observations are correct here, but I would not be so bearish on the stock market.

After all of this disjointed writing, where does that leave me? Puzzled, and mostly neutral on my equity allocations.? My observations could be wrong here.? I’m skeptical of the efficacy of Fed actions, and of the willingness of foreigners to extend credit indefinitely, but they are trying hard? to reflate dud assets (and the loans behind them) now.? That excess liquidity will find its way to healthy assets, and I think I own some of those.

FOMC, Choose Your Poison

FOMC, Choose Your Poison

Posted on by David Merkel

We’re not there yet, but we are close.? The FOMC is likely facing inflation problems at the same time that it faces problems in the financial system.? Goods price inflation versus Asset price deflation.? There is a term for this, but it is easy to be marginalized if one uses the S-word too readily.? So I won’t.

On the other hand, I am almost done with James Grant’s Money of the Mind.? Several themes come to mind here regarding government policy in the late 20s and early 30s, most notable that the government tried to force credit onto an economy that had too much credit already.? First they tried to get the private sector to do their bidding.? When the private sector would not cooperate to the desired degree, the government entered the lending business itself.? This probably prolonged the Depression by not allowing bad debts to get liquidated on a timely basis.

But, if I use the D-word with respect to today, it is even worse than using the S-word as far as credibility goes.? So I won’t, except for historical reference purposes.

The thing is, though, the FOMC is running out of options.? Pretty soon, it will have to decide which pain is greater: goods price inflation, or asset deflation.? Given the current political demographics, I believe they will choose goods price inflation, while saying the exact opposite, or doing the intelligent equivalent of a mumble.

Final note: current FOMC policies are a bit of a joke.? The temporary nature of them (TAF), plus the reduction in T-bill holdings, particularly during year-end, when liquidity is needed for the “holidays” of some, is unusual to say the least.? If the Fed is serious about reflation of assets, they need to do a permanent injection of liquidity, and stop messing around with these temporary half-measures.

PS — All that said, if I were Fed Chairman, I would presently aim monetary policy to a yield curve that had a 1% spread between 2-years and 10-years, and then I would leave it there.? There would be screaming for a year, but the excesses would get bled out of the system.? After that succeeded, I would narrow the spread to 0.5%.? The economy would remain stable for a long time.

Should the FOMC Statement have been a Surprise?

Should the FOMC Statement have been a Surprise?

Posted on by David Merkel

Here?s the quick answer: no.? The Fed Statement was what I expected.? Read Dr. Jeff?s pieces on the reaction to the Statement; he hits the nail on the head.? No one should have been surprised at 25 bps, no differential change in the discount rate, and an evenhanded statement.? Real GDP is still growing, unemployment is low, and inflation is low also (pardon any differences on measurement issues).

There are too many people who are little better than cheerleaders for the equity markets, and think that the Fed should cater its policy for the good of public equity shareholders.? Forget what you think the FOMC should do.? I gave that up seven years ago, and it was amazing how much better my FOMC forecasting became.

The Fed only has three functions:

  • Keep inflation low (as they measure it)
  • Keep labor unemployment low (as they measure it)
  • Protect the security of the depositary financial system, particularly that which is affiliated with the Federal Reserve.

Three functions the Fed does not have:

  • The exchange value of the dollar, except as it affects inflation
  • Affecting the value of the bond market (though they occasionally mess around there trying to affect the shape of the yield curve)
  • Preserving the value of the stock market.

At some level of fall in the stock market, the Fed does care, but only because it affects soundness of the banking system and labor unemployment.? While the stock market is within 10% of record highs, it does not figure into the calculations of the FOMC.? Maybe at a decline of 30% it does matter to them.

Now, this doesn?t mean that the FOMC isn?t going to eventually lower the Fed funds rate to 3% at some point in 2008.? I believe they will still do that, largely because of the effect that falling housing prices will have on the credit of the residential mortgage market, and not just Subprime, but Alt-A, and Prime loans as well.

The thing is, the FOMC is off on a fool?s errand.? The cheap credit that they inject will overstimulate healthy assets, perhaps encouraging healthy US firms to level up using short-term finance, and buy back stock.? It?s one of the few areas of strength left.? What else could absorb the incremental credit?? The US government?? Maybe.

Cheap credit can?t reflate a sector in fundamental oversupply, like residential housing, unless the FOMC were willing to let inflation rip, perhaps leading the value of residential housing to rise, as it did in the ?70s.? More likely though, is that commodities that are in short supply globally would rise, like coal, steel, oil, gold, rare minerals, etc., and only after a while, would housing prices rise, as nominal incomes become large enough, and household formation great enough for the excess supply to disappear.

But inflation would lead mortgage rates to rise, which would cut against the ability to afford housing.? So, let this be a takeaway.? The FOMC is using their powers for other than there stated purposes, but grudgingly.? Their actions may preserve some marginal lenders, but will be inadequate to reflate housing, particularly in the short run.

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Now, I wrote the above while on a plane heading from LA to Baltimore, so I only found out about the Fed’s announcement about their term loan facility when I got home this evening.? Not to be a perpetual pessimist, but I think this idea is more show than substance.? The Fed can discontinue this program after two months.? The Fed has not done a permanent injection of liquidity since May 3rd, and growth in the monetary base is anemic.? All of the growth in broader monetary aggregates is coming from the banks stretching their balance sheets.

This may work in the short run to lower the TED spread, but unless the Fed makes a commitment that they will keep doing this until the market sees things their way, it will not have a major effect on the markets.? I don’t care how many different types of collateral they might take; if they won’t guarantee to take that collateral on favorable terms for a long time, it will amount to nothing by mid-2008.? For a clue to the market’s view, watch the change in 1-month LIBOR versus 12-month LIBOR.? True credibility will be measured by the change in the yield on 12-month LIBOR.

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