Speculation – Page 37 – The Aleph Blog

The Boom-Bust Cycle, Applied to Many Markets

Posted on 7 February 2008 by David Merkel

Every now and then, valuation metrics in a market will get changed by the entrance of an aggressive new buyer or seller with a different agenda than existing buyers or sellers in the marketplace.? Or conversely, the exit of an aggressive buyer or seller.

Think of the residential mortgage marketplace over the last several years.? With an “originate and securitize” model where no one enforced credit standards at all, credit spreads got really aggressive, and volumes ballooned. Many marginal mortgage lenders entered the market, because it was strictly a volume business.? Now with falling housing prices, there are high levels of delinquency and default, and mortgage volumes have shrunk, leading to the failures/closures of many of those marginal lenders.? Underwriting standards rise, as capacity drops out.? Even prime borrowers face tougher standards.? In two short years, fire has given way to ice.

If you’ll indulge another story of mine, I worked for an insurer who had a well-run commercial mortgage arm.? Very conservative.? They did small-ish loans on what I would call “economically necessary real estate.”? See that ugly strip mall with the grocery anchor?? Everyone in the area shops there; that’s a good property.

Well, in 1992, the head of the Commercial Mortgage area had a problem.? The company had only three lines of business, and two lines representing 60% and 20% of the assets of the firm were full up on mortgages.? What was worse, was they didn’t want to even replace maturing loans, because the ratings agencies had told the company that commercial mortgage loans were a negative rating factor.? Never mind the fact that the default loss rate was 40% of the industry average.

He stared down the possibility that he would have to close down his division.? He had one last chance.? He called the actuary that ran the division that I was in (my boss), and pitched him on doing some commercial mortgages.? The conversation went something like this:

Mortgage Guy: I know you haven’t liked commercial mortgages in the past, but my back is against the wall, and if you don’t take my originations, I’ll have to shut down.? You’ve heard that the other two divisions won’t take any more mortgages at all.?

Boss: Yeah, I heard.? But the reason we never took commercial mortgages was that we didn’t like the credit spread compared to the risks involved.? 150 basis points over Treasuries just doesn’t make it for us.

M: Well, because many companies have reduced originations, the spreads are 300 basis points now.

B: 300?! But what about the quality of the loans?

M: Only the best quality loans are getting done now.? I can insist on additional equity, in some cases recourse, and faster amortization.? My loan-to-values are the lowest I’ve seen in years.? Coverage ratios are similarly good.

B: Well, well.? Perhaps I’ve been right in the past, but I’m not pigheaded.? Look, we could take our percentage of assets in mortgages from 0% to 20%, but no more.? At your current origination rate, that would allow you to survive for two years.? We will take them all, subject to you keeping high credit quality standards.? Okay?

M: Thank you.? We’ll do our best for you.

And they did.? For the next two years, our line of business and the mortgage division had a symbiotic relationship, after which, spreads tightened significantly as confidence came back to the market.? We had 20% of our assets in mortgages, and the other two lines of business now felt comfortable enough with commercial mortgages to begin taking them again — at much lower spreads (and quality) than we received.

It’s important to try to look through the windshield, and not the rear-view mirror in investing.? Analyze the motives of current participants, new entrants, and their likely staying power to understand the competitive dynamics.? I’ll give one more example: the life insurance industry was a lousy place to invest for years.? Why?? A bunch of fat, dumb, and happy mutual companies were willing to write life insurance business earning a minimal return on capital.? As another boss of mine once said, “It doesn’t take mere incompetence to kill a mutual life insurer; it takes malice.”? Well, malice, or at least its cousin, killed a number of insurers, and crippled others in the late 80s to mid 90s.? Investment policies that relied on a rising commercial real estate market failed.

But that was the point to begin investing in life insurers.? They began pricing capital economically, and the industry began insisting on higher returns as a group.? Many mutuals demutualized, and the remaining large mutuals behaved indistinguishably from their stock company cousins.? The default cycle of 2001-2003 reinforced that; it is one of the reasons that the life insurance industry has had only modest exposure to the current difficulties afflicting most financials.? After years of being outperformed by the banks, the life insurers look pretty good in comparison today.

I could go on, and talk about the CDO and CLO markets, and how they changed the high yield bond and loan markets, or how credit default swaps have changed fixed income.? Instead, I want to close with an observation about a very different market.? Who likes Treasury bonds at these low yields?

Well, I don’t.? At these yield levels the odds are pretty good that you will lose purchasing power over a 2-3 year period.? Then again, I’m a bit of a fuddy-duddy.? So who does like Treasury yields at these levels?

Players who are scared.
Players who have no choice.

There is a “fear factor” in Treasury yields now.? Beyond that, there is the recycling of the current account deficit, which is still large relative to the issuance of Treasuries.? The current account deficit is large, but shrinking, since the US dollar at these low levels is boosting net exports.? As the current account deficit shrinks, Treasury yields should rise, because foreign demand has been a large part of the buyers of Treasuries.? The Fed can hold the short end of the curve where it wants to, but the long end will rise as the current account deficit shrinks.

I think the current account deficit does shrink from here, because the cost of buying US debts, and not buying US goods is getting prohibitive.? Also, fewer retail buyers will take negative real yields.

That’s my thought for the evening.? Analyze the motives of other players in your markets, and don’t assume that the current state of the market is an equilibrium.? Equilibria in economics are phantoms.? They exist in theory, but not reality.? Better to ask where new entrants or exits will come from.

All or Nothing at All

Posted on 5 February 2008 by David Merkel

I had some “down time” today (taking my third child to junior college), when I could sit and think about some of the issues in the markets, when all of a sudden, a weird correlation hit me.? Similarities between:

The near bankruptcy of the Equitable back in the early 90s.
Neomercantilism
The relationship of Moody’s and S&P to MBIA and Ambac.

Now, I write as I think, so at the end of this, I hope to have a theory that links all of these.? For now, let me tell a story.

When I was younger, I worked for AIG in their domestic life companies.? While I was there 1989-92, the life insurance industry was undergoing a lot of troubles from overinvestment in mortgages and real estate.? Many companies were under stress.? A few went bankrupt.? One big one was probably insolvent, and teetered in the balance — the Equitable.? I was the juniormost member of AIG’s team.? I have a lot of stories about what happened, and why AIG lost and AXA won.? If readers want to read about that, I’ll write about it.? For now though let me mention what I did:

Produced an estimate of value of the annuity lines in four days.
Estimated the “hole” in reserving for the Guaranteed Investment Contract line of business (accurate within 10%, according to the writedown they took later)
Wrote an analysis of AXA that indicated that we should take them seriously (probably ignored).
Analyzed the Statutory statement, the Cash Flow testing, and Guaranteed Separate Account filing (Reg 128), and came to the conclusion that the latter two were in error.? (Those filings, I later learned, forced the NY department to
tell Equitable that it had to find a buyer, because they could not believe the rosy scenarios.)
Analyzed the investment strategies that the Equitable employed in the late 80s.? (They doubled down.)

Two years after that, I was at the Society of Actuaries annual meeting, where I met a well-known actuary who had worked inside the corporate actuarial area of the Equitable during the critical years.? I.e., he watched and analyzed the assets and the liabilities as they arose.? The conversation went something like this:

David: What was it like working inside the Equitable during that period of fast growth?

Corporate Actuary: It was amazing.? It took everything we could do to stay on top of it, and still we fell behind.

D: Didn’t you think that perhaps you were offering guaranteed rates that were too attractive?

C: We wondered about it, but with money coming in, everyone felt great about the growth.? We simply had to find ways to productively deploy all of the cash flow.

D: But wait.? Didn’t the investment department have a difficult time investing all of the proceeds?? With that much money coming in, the likelihood of making severe errors would be high.

C: Were you a bug on the wall at our meetings?? Yes, that is exactly what happened.? The money came in faster than we could invest it prudently.

D: Wow.? I thought that was what happened, but it amazes me to hear it confirmed.

They offered free options, and surprise, investors took them up on them.? They couldn’t make enough to fund the promises, and undertook a risky strategy in the late 80s that I called “double or nothing.”? The strategy failed, and they almost went broke, except that AXA bought them, pumped in a little capital, and then the real estate market turned.

What’s my point here?? Twofold: one, rapid growth in financial institutions is rarely a good thing; it usually means that an error has been made.? Two, there is a barrier in many financial decisions, where responsible parties are loath to cry foul until it is way past obvious, because the cost of being wrong is high.

So what of my other two cases?? With the neomercantilists, which I have written about more at RealMoney, they entered into the following trade: sell goods to the US and primarily take back bonds.? This suppressed inflation in the US, and lowered interest rates, because their bond buying reduced the excess supply of bonds.? In one sense, through export promotion, the neomercantilistic countries sold their goods too cheaply, and then had little current use for the US Dollars, since they did not want their people buying US goods.? So, they took the money and bought US bonds, probably too dearly.? Certainly so, after taking the falling US Dollar into account.

With the major rating agencies and the major financial guarantors, they are locked in a co-dependent relationship, one that I highlighted in a RealMoney article three years ago.? The financial guarantors are next to a cliff, and the rating agencies have a choice:

The guarantors are clearly in trouble, but how bad is it?? Do we push them over the edge to save our franchise, at a cost of a lot of forgone revenue in the short run?
Or do we sit, wait, and hope that things are not as bad as the equity markets are telling us?? This could preserve our ability to make money, and the government is giving us pressure to go this way, for systemic risk reasons.? Besides, someone could bail them out, right?

Ugh, I went through this back in 2001-2002, when the rating agencies changed their methodology to become more short-term in nature.? Funny how they always do that in bear markets for credit.

So, what’s the common element here?? Each situation has a major financial entity at the core.? Underpriced goods or promises were made in an effort to attract revenue.? When the revenues came too quickly, errors were made in deploying the revenues, whether into goods or bonds.? The faster and the larger the acquisition of the revenues, the larger the problem in deployment.

In each of these situations, then, there is a cliff:

Do the rating agencies push the guarantors over?
Does the NY department of insurance force Equitable to find a buyer?
Do neomercantilistic nations keep sucking down dollar claims in exchange for goods, importing inflation, or do they finally give up, and purchase US goods, and slow down their own economies, and the inflation thereof?

This is what makes practical economics tough.? Cycles that are self-reinforcing eventually break, and when they break the results can be ugly.? Why else are credit cycles long and benign in the bull phase, and short and sharp in the bear phase?

Getting an Initial Read on a Deal

Posted on 1 February 2008 by David Merkel

I wrote at RealMoney.com today:

		David Merkel
		What Would Make More Sense to Me, Redux
		2/1/2008 10:14 AM EST

Nine months ago, I wrote this: Microsoft and Yahoo! are in several different businesses with modest synergies between them. Buried inside such a merger would be (at least):

An Internet advertising company

A web/(other media) content producing company

An operating system/applications software company

A consumer entertainment products company

A web search company, and

A web marketing company.

Going back to our discussion of GE earlier this week, Microsoft does not need more businesses in its portfolio. It needs to focus its activities on what it does best. Same for Yahoo! but their problems are less severe unless they do this merger.

If I were Microsoft, I would accept defeat, and sell all web properties to Yahoo! If I were Yahoo!, I would spin off all content production in a new company to shareholders. You would end up with three focused companies that would be able to hit their markets with precision, in a business where scale matters inside your market, but not across markets. The ending configuration would be:

A software company for everything except the web — Microsoft, which would pay another huge special dividend with the proceeds from the sale.

A web search, advertising and marketing company — Yahoo!, which could focus on competing with Google, and

A web/(other media) content production company (would it make money?)

This to me would be rational, but corporate cash gets spent by self-aggrandizing folks with egos, so this is not likely to happen in the short run. But I think the eventual economic outcome will resemble something like this.

Microsoft has not shown a lot of competence in the areas that Yahoo! has focused on, and because of their long history of growth, I’m not sure they get how to run a company that is transisting into maturity. I would be bearish on the total concept.

The market has awarded an additional $3.7 billion to the combined valuations on Microsoft and Yahoo! off of this news. After some time, that premium should reverse, and it will come out of the valuation of Microsoft. But then, I only play in tech when it is trashed, so what do I know?

Position: none

=-=-=-=-=-=-=-=-=-

By the end of the day, that initial valuation premium of $3.7 billion turned into a deficit of $1.2 billion, and that was against a rising market. I’m not that kind of trader, but some deals make sense, and some don’t. When you find one that doesn’t make sense, and the market value of the package rises, one can short both the acquirer and the target, and wait for rationality to arrive.

That’s not to say that all deals are bad. Value can be added through synergies or improved management, or unlocked through expense savings and more leverage. Microsoft-Yahoo is unlikely to fit any of those descriptions in any major way.

Book Review: The Volatility Machine

Posted on 1 February 2008 by David Merkel

There are some books that were important to forming the way I think about economic problems, but if I write about it, I feel that I can’t do justice to the quality of the book. The Volatility Machine, by Michael Pettis, is one of those books. Michael Pettis was a managing director at Bear Stearns, and an adjunct professor at Columbia University when he wrote it.

The book was written in 1999-2000, and published in 2001. It explains how economic activity in the developed world travels into the smaller markets of the developing world, amplifying booms and busts. Coming off the Asian/Russian crises of 1997-1998, it was a timely book. During boom periods, capital flows from the developed countries to the developing countries; during bust periods, capital gets withdrawn. There is a kind of “crack the whip” effect, where the tail feels the change in direction the most.

Borrowing short is a weak position to be in, as the Mexican crisis in 1994 showed us, as the Fed raised rates and the tightening spilled into Mexico, which was financing with short-term debt, cetes. The same is true of corporations that finance with short debt; they are ordinarily less stable than firms that finance long. The Volatility Machine explains why the same forces apply to both situations.

Buffett has said, “It’s only when the tide goes out that you learn who’s been swimming naked.” Rising volatility is that tide going out, and it reveals weak funding structures and bad business/government plans. Booms set up the overconfidence that leads some economic parties to presume on future prosperity, and choose financing terms that are less than secure if the market turns.

Countries that are small and reliant on continued capital inflows are vulnerable to volatility. In the 1970s-1990s, that was the developing countries. Today, the developing countries vary considerably. Some have funded themselves conservatively, some have not, and a number are net capital providers. The US is the one reliant on capital inflows. So what would Michael Pettis have to say in this situation?

You don’t have to look far. Today, Michael Pettis is a professor at Peking University’s Guanghua School of Management. He is studying China from the inside, and writes about it at his blog (I read it every day, and will add it to my blogroll the next time I update it), China financial markets. Among his most interesting recent posts:

China’s latest batch of numbers aren’t good

Chinese pro-cyclicality makes predictions so difficult

More on why high share prices don?t mean Chinese banks are in good shape

The new China-Europe-US world order

Things have gotten grimmer in China

His views are complex and nuanced, and reflect the sometimes asymmetric incentives that politicians and policymakers face.? When I read his writings on China, I am simultaneously impressed with the rapid growth, and with the potential fragility of the situation.

So, enjoy his blog if that is your cup of tea.? If you want to learn how international finance affects developing economies, buy his book.

Full disclosure: if you buy the book through the link above, I will receive a pittance.

I’m Not Afraid Of Derivatives

Posted on 10 January 2008 by David Merkel

In one state that I worked in, I managed to push a bill through the legislature that modernized that life insurance investment code, bringing it from the mid-50s to the late ’90s.? The bill had the D-word in it, and prominently: derivatives.? I had structured the bill so that derivatives could only be used for the purposes of risk reduction.? We had two investors and two lawyers on our team, and I was the “quant” who happened to have a good handle on economic history.? When testifying before the Senate, they asked us three questions:

How can you make sure that Procter & Gamble doesn’t occur?
How can you make sure that LTCM doesn’t occur?
How can you make sure that Orange County doesn’t occur?

Three derivative disasters.? I pointed to the protections embedded into the proposed law prohibiting speculation, and the detailed reports that the valuation actuary must submit on interest rate and investment risks, and that all transactions had to be reported to the insurance department, which could disallow transactions.

The bill passed unanimously.? Eight years later — no disaster yet.

This brings me to a piece by Bill Gross, and a critique by Felix Salmon.? As I have commented before, I am not horribly worried about counterparty risks at the investment banks.? Past history shows that they are very good at preserving their own hides while kicking their overleveraged customers over the edge.? Unless there are significant losses from counterparty risks, it is difficult to have large systemwide losses, because with derivatives, for every loser, there is a gainer.? It’s a zero-sum game.? I think Felix has the better part of the argument by a wide margin.? Also, PIMCO is a large user of derivatives; they write significant exposures that are the equivalent of out-of-the-money calls to enhance their returns.? If large losses are coming, what is PIMCO doing to limit losses, or better yet, profit?

That’s not to say that those that have taken risky positions won’t lose.? They very well might lose, but someone else will win.? That doesn’t make the analysis easy, because derivatives and securitization obscure what is going on with any one entity, even if the system as a whole is unchanged.? Even Moody’s is scratching their heads on the matter.? If the rating agencies which have inside information, are puzzled, the rest of us can feel better about being puzzled as well.

Two last notes: CDOs are ugly beasts, and there are really only two places to invest in them: at the most senior level, and at the most junior level.? At the senior level, you have some protection, and can control the deal in a crisis.? The most junior investors can make a lot of money if everything goes right.? Not generally true now, but in the right environment, it can be a winner.

Second, I don’t think CMBS market is as bad off as the CMBX indexes would indicate.? CMBS are more carefully underwritten and serviced than other securitized asset classes.? The only thing that gives me worry is that recent vintages have relied on rising rental rates, and property values that may temporarily have overshot.? Things aren’t great in CMBS-land, but there are other places more worthy of scrutiny.? Again, my comments about being senior or being junior (equity) apply here as well.

Securitization and derivatives are tools, and they can be used wisely or foolishly.? They can destroy individual companies, but not whole economies.

Make Money While You Sleep — II

Posted on 9 January 2008 by David Merkel

Thanks to Eddy Elfenbein for sending over the data on how the market does over multiple nights when the market is closed.? Unfortunately, the data is skewed because of 9/11, where the market was closed for seven days, and the change from the close to the open was -4.59%.? What should be done with that data point?? When the market closed on Monday 9/10/01, traders expected that the market would reopen as normal on Tuesday, but it didn’t.? The seven day hiatus was not planned, so traders treated it as a one night gap on Monday, but it opened as a seven night gap the next Monday, with negative results.

Now, if you throw out the 9/11 data point, the average price return over a one night gap is 0.005% over the last eight years.? For a multiple night gap, the return is higher — 0.012%.? If you include in 9/11, it is lower — 0.002%.

But what of dividends?? Where do they belong?? They belong to the nighttime returns, because on the morning that a stock goes ex-dividend, on average the price drops at the open to reflect that.? Now, assume a 1.5%/year dividend rate (rounding, the actual is a little higher).? Now the returns for a one night gap are 0.010%, and for a multiple night gap it is 0.024%.? Even counting in 9/11, the result is 0.014%, higher than the single night gap.

One commenter on last night’s post commented that it might not be the risk of holding stock overnight as much as the possibility or occurrence of news flow.? Before the fact, risk and potential news flow are similar concepts.? After all, how does risk shift, but often through news flow changing the opinions that people hold regarding assets?

For a long term investor like me, this all doesn’t matter much.? I’m not going to buy a bunch of futures contracts or ETFs near the close and sell them into the open.? Still, this could be another example of a market anomaly that stems from the perception of a risk which does not occur on average.

Fifteen Points on Credit Where Credit Ain’t Due

Posted on 8 January 20088 January 2008 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.

Depression, Stagflation, and Confusion

Posted on 26 December 2007 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.

Investment Bank Counterparty Risks are Probably Modest

Posted on 22 December 2007 by David Merkel

I’ve seen a number of articles recently about what dangers the investment banks face from counterparty risk.? Counterparty risk is what happens when an investment bank enters into a derivative transaction with another party (the counterparty), and when the investment bank ends up on the winning side of the trade, the counterparty is unable to make good on the necessary payments to the investment bank.

Think about history here for a moment.? Investment banks do take losses.? We saw that in the past week.? But almost all of that came from their own risk-taking, not from counterparties.? Now think about hedge funds that have gone bust.? What was the final trigger event?? The investment banks moving to foreclose when there was still enough margin to do so.? (LTCM, Granite, Amaranth, Neiderhoffer (how many times?) and more… the investment banks are very good at protecting their own hides.)

I have a few concerns about counterparty risk, but they aren’t big.? I worry more about mispricing within derivative books.? The risks that no natural counterparty wants to bear must be held by a speculator, who gets a bit of a bargain for taking down the risk. ? Speculators are usually not thickly capitalized, so the investment banks, while grateful that they got the toxic waste off their books, watches the margin of solvency like a hawk, and more so for larger players.

The record of the investment banks of cutting off leverage to the impaired is pretty good.? There is some modest reason for concern here, but I think the investment banks have more potent means of shooting themselves in the foot.

Options as an Asset Class

Posted on 20 December 200720 December 2007 by David Merkel

Well, my CDO model is complete for a first pass. There is still more work to do. Imagine buying a security that you thought would mature in ten years, but two years into the deal, you find that the security will mature in twenty years from then, though paying off principal in full, most likely. Worse, the market has panicked, and the security you bought with a 6.5% yield is now getting discounted at a mid-teens interest rate. Cut to the chase: that is priced at 40 cents per dollar of par. Such is the mess in some CDOs today.

Onto the topic of the night. There have been a number of articles on volatility as an asset class, but I am going to take a different approach to the topic. Bond managers experience volatility up close and personal. Why?

Corporate bonds are short an option to default, where the equity owners give the company to the bondholders.
Mortgage bonds are short a refinancing option. Volatile mortgage rates generally harm the value of mortgage bonds.
Even nominal government bonds are short an inflation option, should the government devalue the currency. (Or, for inflation-adjusted notes, fuddle with the inflation calculation.)

Why would a bond investor accept being short options? Because he is a glutton for punishment? Rather, because he gets more yield in the short run, at the cost of potential capital losses in the longer-term.

Most of the “volatility as an asset class” discussion avoids bonds. Instead, it focuses on variance swaps and equity options. Well, at least there you might get paid for writing the options. Bond investors might do better to invest in government securities, and make the spread by writing out-of-the-money options on a stock, rather than buying the corporate debt.

I’m not sure how well futures trading on the VIX works. If I were structuring volatility futures contracts, I would create a genuine deliverable, where one could take delivery of a three month at-the-money straddle. Delta-neutral — all that gets priced is volatility.

Here’s my main point. Volatility is not an asset class. Options are an asset class. Or, options expand other asset classes, whether bonds, equities, or commodities. Whether through options or variance swaps, if volatility is sold, the reward is more income in the short run, at the cost of possible capital losses in asset classes one is forced to buy or sell at disadvantageous prices later.

Over the long term, in equities, unlike bonds, being short options has been a winning strategy, if consistently applied. (And one might need an iron gut to do it.) But when many apply this strategy, the excess returns will dry up, at least until discouragement sets in, and the trade is abandoned. For an example, this has happened in risk arbitrage, where investors are short an option for the acquirer to walk away. For a long time, it was a winning strategy, until too much money pursued it. At the peak you could make more money investing in Single-A bonds. Eventually, breakups occurred, and arbs lost money. Money left risk arbitrage, and now returns are more reasonable for the arbs that remain.

Most simple arbitrages are short an option somewhere. That’s the risk of the arbitrage. With equities, being perpetually short options is a difficult emotional place to be. You can comfort yourself with the statistics of how well it has worked in the past, but there will always be the nagging doubt that this time it will be different. And, if enough players take that side of the trade, it will be different.

Like any other strategy, options as an asset class has merit, but there is a limit to the size of the trade that can be done in aggregate. Once enough players pursue the idea, the excess returns will vanish, leaving behind a market with more actual volatility for the rest of us to navigate.