Structured Products and Derivatives – Page 22

Seven Notes on the Current Market Mess

Posted on 27 July 2009 by David Merkel

1)? Avoid short-cycle data.? When writing at RealMoney, I encouraged people to ignore short-term media, and trust those that gave long-term advice.? After all, it is better to learn how to invest rather than get a few hot stock picks.

In general, I read writers in proportion to their long-term perspective.? I don’t have a TV.? I rarely listen to radio, but when I do listen to financial radio, I usually feel sick.

I do read a lot, and learn from longer-cycle commentary.? There is less of that around in this short-term environment.

When I hear of carping from the mainstream media regarding blogging, I shake my head.? Why?

Most bloggers are not anonymous, like me.
Many of us are experts in our? specialty areas.
Having been practical investors, we know far more about the markets than almost all journalists, who generally don’t invest, or, are passive investors.

Don’t get me wrong, I see a partnership between bloggers and journalists, producing a better product together.? They are better writers, and we need to get technical messages out in non-technical terms.

We need more long-term thinking in the markets.? The print media is better at that than television or radio — bloggers can go either way.? For example, I write pieces that have permanent validity, and others that just react to the crisis “du jour.” Investors, if you are focusing on the current news flow, I will tell you that you are losing, becuase you are behind the news flow.? It is better to consider longer-term trends, and use those to shape decisions.? There are too many trying to arb the short run.? The short run is crowded, very crowded.

So look to value investing, and lengthen your holding period.? Don’t trade so much, and let Ben Graham’s weighing machine work for you, ignoring the votes that go on day-to-day.

2)? Mark-to-Market accounting could not be suppressed for long in an are where asset and liability values are more volatile.? Give FASB some credit — they are bringing the issue back.? My view is when financial statement entities are as volatile as equities, they should be valued as equities in the accounting.

3)? Very, very, weird.? I cannot think of a man that I am more likely to disagree with than Barney Frank.? But I agree with the direction of his proposal on CDS.? My view is this: hedging is legitimate, and speculation is valid to the degree that it facilitates hedging.? Thus, hedgers can initiate transactions, wtih speculators able to bid to cover the hedge.? What is not legitimate is speculators trading with speculators — we have a word for that — gambling, and that should be prohibited in the US.? Every legitimate derivative trade has a hedger leading the transaction.

4)? I should have put this higher in my piece, but this post by Brad Setser illustrates a point that I have made before.? It is not only the level of debt that matters, but how quickly the debt reprices.? Financing with short-term dbet is almost always more risky than financing with short-term debt.

Over the last six years, I have called attention to the way that the US government has been shortening the maturity structure of its debt.? The shorter the maturity structure, the more likely a currency panic.

5)? Look, I can’t name names here for business reasons, but it is foolish to take more risk in defined benefit pension plans now in order to try to make up? the shortfall of liabilities over assets.? This is a time for playing it safe, and looking for options that will do well as asset values deflate.

6)? Junk bonds have rallied to a high degree; at this point I say, underweight them — the default losses are coming, and the yields on the indexes don’t reflect that.

7) Peak Finance — cute term, one reflecting a bubble in lending/investing.? Simon Johnson distinguishes between three types of bubbles — I’m less certain there.? Also, I would call his third type of bubble a “cultural bubble,” rather than a “political bubble,” because the really big bubbles involve all aspects of society, not just the political process.? It can work both ways — the broader culture can draw the political process into the bubble, or vice-versa.

The political process can set up the contours for the bubble.? The many ways that the US Government force-fed residential housing into the US economy — The GSEs, the mortgage interest deduction, loose regulation of banks, loose monetary policy, etc., created conditions for the wider bubble — subprime, Alt-A, pay-option ARMs, investor activity, flipping, overbuilding, etc.? In the process, the the federal government becomes co-dependent on the tax revenues provided.

I still stand by the idea that bubbles are predominantly phenomena of financing.? Without debt, it is hard to get a big bubble going.? Without cheap short-term financing, it is difficult to get a stupendous boom/bust, such as we are having.? That’s just the worry behind my point 4 above.? The US as a nation may be “Too Big To Fail,” to the rest of the world, but if the composition of external financing for the US is becoming more-and-more short-term, that may be a sign that the endgame is coming.

And, on that bright note, enjoy this busy week in the markets.?? Last week was a tough one for me personally; let’s see if this week goes better.

The Lost Post

Posted on 23 July 2009 by David Merkel

I lost an 800-word post last night, and WordPress did not keep a backup as it usually does.? Occasionally, I have also rescued posts by grabbing the post from the RSS feed, but the RSS feed was a blank as well.? So, no post from last night.? If it’s any consolation, a large part of the post dealt with the rating agencies, and my views are well-known there — most of the so-called solutions fail to serve the market as intended, because:

ratings are needed for regulatory capital levels
there is no concentrated interest to pay for ratings aside from the issuer
sophisticated investors do their own analyses and ignore ratings
creation of a public rating agency will suffer the same fate as the the NAIC SVO — if one thinks the analysts were weak at S&P, Moody’s, and Fitch, they were weaker at the NAIC SVO.
regulators were asking the impossible of the rating agencies in asking them to rate immature securities that never been through a “bust” in the credit cycle.
At the bust in the credit cycle, there is always some embarrassing error that causes the rating agencies to whipsaw.? It may be CMBS today; it was ratings triggers and covenants in 2002.
It is rough for anyone relying on ratings during the bust of the cycle, because the philosophy shifts from “ratings are made over a full credit cycle” to “ratings should last until lunchtime, maybe, uh, look the stock price is down 5%, post a downgrade.”

That’s why I think that most of the solutions will fail.? The present system has its problems, but the problems are well-known and sophisticated investors know how to deal with them.? New systems will have new problems that we don’t immediately know how to deal with, particularly if they don’t reflect the realities that I listed above.

Okay, there’s one-third of the post back, but I can’t remember the rest.? I delete bookmarks after I do links, and Firefox does not send them to the recycle bin; they just disappear.? Maybe I should do my posts in a word processor, and then post them at the end.? Trouble is, when I do that, the formatting often doesn’t work out right.

Odd Question

Enough of my troubles.? I do have one odd question for my readers before I close off here.? Does anyone know of any financial institution actively lending to churches today?? My congregation is in the midst of a building project.? 10,000 minds are better than one, and I hope one of you has some knowledge here that? I don’t.

Seven Miscellaneous Notes

Posted on 19 July 200919 July 2009 by David Merkel

1) I am proud of my two middle children, Peter and Jonathan (#4 and 5 out of my 8 ) who have started an “odd jobs” business in this environment, doing yard work, pet sitting, etc.? As other neighbors in our area have seen their good work, all of a sudden, they are gaining a lot of new business.? They are both workers, and hard work pays off.

2)? I appreciate this article in Barron’s where the thoughts of Doug Kass are featured.? I have very high respect for Mr. Kass, because he marries two qualities: he has a keen sense of market timing, and yet a sense of relative value also.? I agree with him the intermediate-term returns should be blah, because it is more difficult to lever up at present.

3)? The states are in more trouble than the US Government, because they have to run balanced budgets, and can’t print money.? California can send out IOUs, which aren’t a currency (yet).? Philadelphia can stiff vendors for now, but what of the future?? California may come to some sort of short -term agreement that postpones real troubles until next year.? Same for Philadelphia.? And, true for many municipalities that are finding cash to be short, because capital gains, sales, and real estate taxes are flagging.

Unlike Gregor (bright man that he is), I do not think that the US Government will bail out California.? Why?

Every state will ask for a bailout.
States have no bankruptcy code, so those pressing them for money have few options.? (That said, say goodbye to the municipal bond market.)
The US Government has enough problems as it is — if you want help, take a number and get in line.

As it is California is a basket case, with dysfunctional politics from the referendum process.? Let California get its own house in order, and reform its government, including the initiiative process.? If it still has problems once it is in as good a shape as other states, fine, let it petition the Federal Government.? It won’t get there anytime soon.

4) Regarding the Fed, I’m not the only one suggesting that there be more regulation.? You can listen to Allan Meltzer, or William Greider.?? I give Dr. Meltzer more weight here, but one thing is clear — the Fed is an undemocratic institution with few avenues for accountability.

5)? Will we have robust growth soon?? Former Federal Reserve Governor Laurence Meyer, thinks we won’t see full employment until 2015.? Truth is, with aging demographics, we may not see full employment for a longer time, as baby boomers that can’t afford to retire continue to work.

6)? Aside from regulatory sloppiness, why does Goldman Sachs get a free pass on their VAR calculation (and also here)?? What is VAR for, except to constrain risk?? No one should get exemptions.

7)? My view is that derivative and cash positions should be treated the same in a regulatory sense.? But derivatives were unregulated compared to cash positions.? Investment decisions with the same economic result should be equally regulated.? Much as I am not crazy about government regualtion, with regulated institutions, derivatives should be decomposed into their cash equivalents, and regulated the same way.

Toward a New Concept of Asset Allocation

Posted on 10 July 2009 by David Merkel

To my readers: thanks for your responses to yesterday’s article.? I will do a follow up piece soon.? If you have more comments please make them — they will help me with the piece.? Main new concepts coming — need for a deliverable, speculators can’t trade with speculators, only hedgers.

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Longtime readers know that I am not a fan of modern portfolio theory.? It is a failure for many reasons:

It assumes there is one type of risk, the occurence of which is random.
It assumes that this risk can be approximated by volatility (variance of returns), rather than probability of loss, and the likely severity thereof.
Mean return estimates, volatility estimates, and correlation coefficient estimates aren’t stable.
In crises, correlations head to 1 or -1.? Assets divide into safe and “not safe.”
Problem: some assets always fall into the “not safe” bucket, but what falls into the safe bucket can vary.? Long Treasuries and commodities could be examples of assets that vary during a crisis, depending on the type of crisis.
It does not recognize multiple time horizons easily.? Bonds held to maturity have a different risk profile than a constantly rebalanced portfolio.
Risk is the same for all people, and their decision-making time horizons are the same as well.
And more…

I’m still playing around with the elements of what would make up a new asset allocation model, but a new model has to disaggregate risk into risks, and ask some basic questions:

Where am I getting paid to take risk?
Where am I getting paid to avoid risk?
What aspects of the financial landscape offer the potential for a change in behavior, even if it might take a while to get there?? What major imbalances exist?? Where are dumb people making money?
Where options are available, how is implied volatility relative to long-term averages?
What asset classes have momentum to their total returns?

One good example of an approach like this is Jeremy Grantham at GMO.? Asset allocation begins by measuring likely cash flow yields on asset classes, together with the likelihood of obtaining those estimates.? With domestic bonds, the estimates are relatively easy.? Look at the current yield, with a haircut for defaults and optionality.? Still there is room to add value in bonds, looking at what sectors are cheap.

Are corporate spreads narrow or wide?
How are residential mortgage bonds priced relative to agency bonds, after adjusting for negative optionality?
How steep is the yield curve, and where is Fed policy?
What is the speculative feel of the market now?? Bold? Scared? Normal?
Related, how are illiquid issues doing?? Are they permafrost, or are molasses not in January?
If every risk factor in domestic bonds looks lousy, it is time to make a larger allocation to foreign bonds.
Cash is underrated, and it is safe.

Understanding bonds is an aid to understanding the rest of the market.? The risk factors in play in the bond market are more transparent than elsewhere, but the rest of the markets eventually adjust to them.

With stocks and commodities, the answer is tougher — we have to estimate future demand and supply for commodities.? Tough.? With stocks, we need to estimate future earnings, and apply a P/E multiple that is consistent with the future yield on BBB corporate bonds.? There is some degree of mean-reversion that can help our estimates, but I would not rely on that too heavily.

There is one more aspect to layer in here: illiquidity of equity investments.? With limited partnerships of any sort, whether they are hedge funds, venture capital, private equity, etc., one has to analyze a few factors:

Where is the sector in its speculative cycle?? Where are secondary interests being sold?
How much capacity do you have for such investments?? How much of your liability structure is near-permanent?? Is the same true of peer institutions?
Is the public equity market overvalued or undervalued?? Public and private tend to track each other.

Beyond that we get to the structure and goals of the entity neding the assets allocated.? Time horizon, skittishness, and understanding levels are key for making a reasonable allocation.

This is just my initial brain dump.? It was spurred by this article in the WSJ, on how asset allocation had failed.? Add in the article on immediate annuities, which are a great aid in personal retirement planning.? For those that think that immediate annuities reduce the inheritance to the children, I would simply say that it is longevity insurance.? If the annuitant lives a long time, he might run out of assets, and might rely on his children for help.? The immediate annuity would be there to kick in something.

Why did asset allocation fail in 2008?? All risk assets failed.? Stocks, corporate bonds, venture capital, private equity, CMBS, RMBS, ABS… nothing held up.? There were just varying degress of loss.? Oh, add in Real Estate, and REITs.? Destroyed.? Destroyed…

When the system as a whole has too much leverage, all risky asset classes get affected.? That’s what happened in 2008, as speculators got their heads handed to them, including many who did not realize that they were speculators.

Sorry, Doctor Shiller, not Everything can be Hedged

Posted on 9 July 20099 July 2009 by David Merkel

Many people don’t think through questions systematically.? That includes very bright people like Dr. Robert Shiller, who said in this article in Fortune, “We should be able to hedge everything from the rising costs of health care and education to national income risk and oil crises.”

Ugh.? And this from an esteemed professor at a significant university?? And one with which I have sometimes agreed?

I’ve written about this before in some of my market structure articles, where I tried to dig into the difference between natural, hedging, and gambling exposures.? I’ll use an ordinary example to illustrate this: the bankruptcy of IBM.

I use IBM as an example because it is so unlikely to go under.? But who would be directly affected if IBM went under?

Stockholders, both preferred and common
Bondholders
Banks that have loaned money
Trade creditors
Workers

Let’s talk about the bondholders.? They could buy protection via credit default swaps [CDS] to hedge their potential losses.? In order for that to happen a new class of risk-takers has to emerge that wants to take IBM credit risk, that don’t own the bonds already.? It’s not always true, depending on the specualtive nature of the market (and synthetic CDO activity), but one would suspect that those that want to take on the risk of a default of IBM would only do it at a concession to current market bond pricing, or else they would buy the bonds and pay fixed, receive floating on a swap.

But often the amount of CDS created exceeds the amount of debt covered.? I’m not suggesting that everyone owning bonds has hedged, either, but when the amount of CDS exceeds outstanding bonds, that means there is gambling going on, because it means that there are market players that are not long the bonds that are taking the side of the trade where they receive income in the short-run if the company survives, and pay if the company fails.

I call this a gambling market, because there are parties where the transaction takes place where neither has a relationship to the underlying assets.? There is no risk transfer, but only a bet.? My view is such gambling should be illegal, but I am in a minority on such points.

Now think about another asset: my house.? Aside from being somewhat dumpy, beaten-up by my eight kids, the house has a virtue — I live in it free and clear, with no debts to anyone, so long as I pay my property taxes.? So what is there to hedge here?? I’m not sure, maybe future property taxes?

Aside from the county, and my insurance company, I’m not sure who has a real interest in my house.? If I knew that there were many people betting on the value of my house, I might become concerned.? What actions might people take against me in bad or good times?

But maybe no one would have interest in my house.? It’s just one house, after all.? Who would have a concentrated enough interest in it to wager on it?

Now, some would say, we don’t have an interest in your house specifically, but we do have an interest in houses on average? in your area.? That’s fine, but there is no one with a natural exposure to all of the houses in my area, aside from the county itself.

This is why I think that most real estate derivatives involve gambling.? There is no significant natural exposure hedged.? It is only a betting market.

And such it would be for most real assets.? Few would want to create markets where the owner know more than they do, or, where there a few options for gaining control if things go bad.

At the end of the day, all of the assets of our world are owned 100%.? Everything else is a side-bet.? Personally, I would argue that the side bets should be prosecuted and eliminated, which would bring greater stability to the economic system.? No tail chasing the dog.? Let derivative transactions go on where here is real hedging taking place; away from that, such transactions are gambling, and should be illegal.

To Dr. Shiller, many markets are thin.? The concept that everything can be hedged assumes deep markets everywhere, which is not the case.? Time for you to step outside the university bubble and taste the real world.? It’s not as hedgeable as you might imagine.

Seven Notes, Primarily on the Financial Sector

Posted on 7 July 2009 by David Merkel

1)? I have been arguing for a while that commercial mortgages are an unresolved issue with most banks, who still hold their loans at par.? Contrast that with the pricing on Commercial Mortgage Backed Securities [CMBS] or REIT stock prices, which show commercial real estate pricing in the dumps.? Look at these articles: (one, two, three).? How many commercial properties are inverted?? Who knows, but when properties sell for significantly less than replacement costs, it is not a good scene.

Regarding CMBS, as the loss estimates ratchet up, the credit ratings ratchet down.? Securities sold in 2005 and after will suffer, as well as marginal CMBS from earlier vintages.

2)? Outside of conforming mortgages, losses in residential mortgages are considerable.? Consider how S&P is raising its loss assumptions on alt-A loans.? Or consider how being underwater, or close to underwater affects the willingness of people to default.

3)? That last article helps point out a truth that is neglected.? Defaults predominantly happen when borrowers are underwater, or nearly so.? Changing? the mortgage interest rate is cheaper in the short run, but does not cure? the situation as well as reducing the principal (forgiving part of the loan).? Why less loan forgiveness?? Two reasons: Accounting would require a bigger short-term loss, and the government prefers subidizing a piece at a time, so it prefers smaller annual subsidies, rather than a once-and-for-all cure.? They would rather pay over time, and overcommit future budgets, than pay the full freight now, even if it is cheaper in the long run to do so.

4)? But many defaults are strategic.? The owners know which side their bread is buttered on, and they default when their properties are too far underwater (one, two).

5)? The states can’t print money like the Federal government can.? Excluding California, of course, which has its new currency, the IOU.? (We are still waiting for a secondary market to arise.? Perhaps some enterprising bank? will offer to buy IOUs at a discount.? As it is, banks either honor in full or refuse to honor the IOUs.)? The states represent the current troubles better than the Federal government does, because they must meet the challenge through expense cuts and tax increases, both of which are painful.

All that said, next year may be more painful, because of greater unemployment, and lower taxes from real property.

6)? Beware junior debt.? I know that at other times I have used trust preferred securities offensively to make money as the credit cycle turned in 2002, but that is a very hard game to play, and we aren’t there yet for this cycle.

7) I’ve had many people writing me for investment advice, and in the near term, I will try to write a piece that summarizes my views of what to do now.? In broad, I lean toward reducing risk exposure, and sitting on high quality short term debt.? For those that hedge, quality will be rewarded, and structure penalized over the next? 6-12 months.? And, avoid financials, aside from exchanges and insurers with clean assets.

The Benefits of Dumb Regulation

Posted on 29 June 200930 June 2009 by David Merkel

Apologies to readers.? I have been gone last week at my denomination’s annual meeting.? As I often say at this time of year, I never work harder than at that time, so please forgive my lack of posts.? As it is now, I am worn out, but at least I am home.? Home is my favorite place.

I am presently reading a book by Justin Fox, The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.? So far, a good book.? He has a recent blog post that impressed me as well: Dumbing Down Regulation.

Should regulation be dumb?? In one sense yes, in others, no.? It really depends on how well the regulators understand the risks involved, and how much they can encourage professionalism among marketers and risk managers.? As those two increase, regulation can be smart.? “Follow these detailed rules to calculate the capital you need to be solvent 99% of the time.”

But when either of those two aren’t true, dumb regulation may be in order:

Strict leverage limits, reflecting the worst outcome from underwriting poor quality loans.
Disallowing risky types of lending, regardless of capital level.
Disallowing liabilities that can run easily.
Disallowing products that commonly deceive buyers.
Disallowing certain types of contracts that fuddle accounting.

If everyone were smart, things could be different.? Deceiving people would not take place, and managements would not take undue risks.? Limits could be more loose, and products would be designed for discriminating buyers.

But, face it, we are dumber than we think, myself included.? Consumer choice is a good thing, though it implies that some will be deceived, no matter where one places the line of demarcation.? Along with that, some bank will not fit the rules and go insolvent, though it does not register so on the solvency tests.

My poster child for relatively good dumb regulation is the insurance industry in the US.? The industry is far less free-wheeling than the banking industry, and under most circumstances, the solvency margins are set high enough to have few insolvencies.? There is room for improvement, though:

Make risk based capital charges countercyclical.? Perhaps tinkering with the Asset Valuation Reserve would do that.
Have some sort of rigorous testing for capital relief from reinsurance treaties.
Ban surplus notes in related party transactions.
Ban all forms of capital stacking, especially where the transactions go both ways.? I.e., subsidiaries can’t own securities of any companies? in their corporate family.? All subsidiaries must be owned by the holding company.
More rigorous testing for deferred tax assets.
Assets as risky as equities, including limited partnerships, should be a deduction from capital.
Securitized bonds that are not “last loss” should have higher RBC charges than comparable rated corporates.
A standardized summary of cash flow testing results should be revealed.

As for the banks, they need to do that and more:

Insurance companies list all of their assets.? Banks should as well.
Intangible assets should be written to zero for regulatory capital purposes.
Risk-based capital standards need to be tightened to at least the level of insurance companies, if not tighter.
Some sorts of lending to consumers should be banned.? I am talking about complex agreements, that individuals with IQs less than 120 can’t understand.? Insurance policies have to be Flesch-tested.? Bank lending agreements should be the same.? If some argue that the poor need access to credit, I will say this: the poor need to get off of credit.? Credit is for the upper-middle-class and rich.? Poor people should not go into debt.
Standardized summaries of terms and fees must be created for consumer lending, with large, friendly letters, and simple language that all can read.

What I am saying is that accounting has to be more conservative, and that regulators have to require larger amounts of capital to support their business, particularly at the banks.? Financial products must be made more simple for consumers to understand.? More transparency is needed everywhere, and if the financial companies complain, tell them that they will all be in the same goldfish bowl, so no one will gain an unfair advantage.

Dumb regulation bars certain lending practices, and raises capital levels higher than is needed over the long run.? So be it.? Smart regulation is far more flexible, and trusting that companies and consumers know what they are doing.? Unfortunately, when financial firms fail, there are often larger repercussions.? It is better to limit regulated financial companies to businesses where the risks are well-understood.? Let the less understood risks be borne by those outside the safety net, and bar those inside the safety net from holding any assets in those companies.

A Redacted Copy of the June FOMC Statement

Posted on 24 June 200924 June 2009 by David Merkel

April 2009	June 2009	Comments
Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract, though the pace of contraction appears to be somewhat slower.	Information received since the Federal Open Market Committee met in April suggests that the pace of economic contraction is slowing. Conditions in financial markets have generally improved in recent months.	The FOMC is following trends in the financial markets. The stock market is higher, and credit spreads are tighter, but what of tomorrow?
Household spending has shown signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit.	Household spending has shown further signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit.	The FOMC sees further signs of stabilization of household spending.
Weak sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories, fixed investment, and staffing.	Businesses are cutting back on fixed investment and staffing but appear to be making progress in bringing inventory stocks into better alignment with sales.	They view much of the weakness as being an inventory correction that will end soon.
Although the economic outlook has improved modestly since the March meeting, partly reflecting some easing of financial market conditions, economic activity is likely to remain weak for a time.	Although economic activity is likely to remain weak for a time,	They are more certain that economic conditions have improved.
Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.	the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.	Materially the same.
In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.	The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.	They trust that slack capacity will keep inflation low, despite rising commodity prices. They are less worried bout deflation. Stagflation is not a word in their vocabulary.
In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.	In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.	Identical
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	They are trying to lengthen the view of the market on how long the FOMC is able to maintain a low fed funds rate.
As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year.	As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year.	Identical.
In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn.	In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn.	Identical.
The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.	The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.	Identical.
The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs. The Committee will continue to carefully monitor the size and composition of the Federal Reserve’s balance sheet in light of financial and economic developments.	The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.	Much language change; not much substantive change.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.	Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.	Identical.

Quick Hits:

The FOMC is following trends in the financial markets. The stock market is higher, and credit spreads are tighter, but what of tomorrow?
They view much of the weakness as being an inventory correction that will end soon.
They trust that slack capacity will keep inflation low, despite rising commodity prices. They are less worried bout deflation. Stagflation is not a word in their vocabulary.
They are trying to lengthen the view of the market on how long the FOMC is able to maintain a low fed funds rate.
They are projecting calm to all who will listen, but will inflation and the dollar cooperate?? Will economic weakness not deepen from here?? The jury is out.

Unchangeable

Posted on 19 June 2009 by David Merkel

When people look at this crisis, they look for simple answers — they want to find one or two parties to blame, not many, a la my Blame Game series.? The economic system is an interconnected web, and it is not easy to change one part without affecting many others.? Intelligent ideas for change consider second order effects at minimum.? This piece, and any that follow under the same title, will attempt to point at things that are not easily done away with.? Some of these will be controversial, others not.

1) Derivatives.? What is a derivative?? A derivative is a contract where two parties agree to exchange cash flows according to some indexes or formulas.? There are some suggesting today that all derivatives must be standardized, and/or traded on exchanges.? That might make sense for common derivatives where there are large volumes, but many derivatives are “out in the tail.”? Not common, and standardization of what is not common is a fool’s errand.

To regulate derivatives fully is to say that certain types of contracts between private parties may not exist without the consent of the government.? Thinking about it that way, what becomes of free enterprise?? Granted, there are some contracts that cannot be considered enforcable, like that of a hit man, arson for hire, etc.? Those are matters that any healthy government would oppose.

What makes more sense is to bring the derivatives “on balance sheet.”? Let the effects of the notional value play out, showing owners what is happening, rather than hiding it.

2) Rating agencies — Moody’s, S&P, and Fitch deserve some blame for what happened, but the regulators needed the rating agencies.? They still do.? The rating agencies make imperfect estimates of relative credit quality for a wide munber of instruments, which then feed into the risk-based capital formulas of the regulators.? To rate such a wide number of instruments means that the issuers must pay for the rating, because there is no general interest for most ratings.

Yes, let more rating agencies compete, but they will find that the “issuer pays” model is more compelling than the “”buyer pays” model.? The concentrated interests of issuers in a rating trumps the diffuse interests of buyers.? Bond buyers need to learn to live with this, and employ buy-side analysts that don’t take the opinion of the rating agencies blindly.? What the analysts at the rating agencies write is often more valuable than the rating itself, though it doesn’t change capital charges.

Rating agencies make the most errors with new asset classes.? Better that the regulators do their jobs and prohibit immature? asset classes where the loss experience is ill-understood.

I don’t think that rating agencies are going away any time soon.? I do think that the government and regulators contemplated this, but concluded that the changes to the system would be too drastic. (Contrary opinions: one, two)

3) Yield-seeking — the desire to seek yield is near-universal.? As a bond manager, I found it rare that a manager would do a “reduce yield, improve quality or certainty” trade.? The pattern is even more pronounced with retail accounts.? They underestimate the value of the options that they are selling, and take a modicum of yield in exchage for lower certainty of return.

Can this be banned, as some are proposing with reverse convertibles?? I don’t think so, there are too many variables to nail down, and too many people in search for a yield higher than is reasonable.? Yield-hogging is an institutional sport, not only one for retail fans to grab.? As one of my old bosses used to say, “Yield can be added to any portfolio.”? How?

Offer protection on CDS
Lower the quality of your portfolio.
Buy all of the dirty credits that trade cheap to rating.
Buy securities from securitizations — they almost always trade cheap to rating.? (Ooh! CDOs!)
Sell a call option on the securities you hold.
Buy mortgage securities with a lot of prepayment or extension risk.
Accept the return in a higher inflation currency, assuming that their central bank will tighten.
Do a currency carry trade.
Lever up.
Extend the length of your portfolio.
Underwrite catastrophe risk through cat bonds.

Adding yield is easy.? The transparency of that addition of yield is another matter.? Reverse convertibles have been the hot issue recently since this article.? Here is a small sample of the articles that followed: (one, two, three).? Reverse convertibles, and other instruments like them give bond-like performance if things go average-to-well, and stock-like performance if things go badly.? The inducement for this is a high yield on the bond in the average-to-good scenario.

What to do?

I have three bits of advice for readers.? First, don’t buy any financial instruments tht you don’t understand well. This especially applies when the party selling them to you has options that they can exercise against you.? Wall Street excels at products that give with the right hand and take with the left, so beware structured products sold to retail investors.

Second, don’t buy any financial product that someone appears out of the blue and says, “Have I got a deal for you!”? Stop.? Take your time, ask for literature, maybe, but say that you need a month or more to think about it.? Haste is the enemy of good financial decision-making.? Instead, do your own research, and buy what you conclude that you need.? Consult trusted advisors in either case.

Third, don’t be a yield hog.? Yield is rarely free.? There are times to take risk and accept higher yields, but those are typically scary times.? At other times, make sure you understand the portfolio of risks that you accept, and that you are being adequately paid for those risks.? Better to have a ladder of high quality noncallable debt, and take some risk with equities than to take risk in a series of yieldy and illiquid bonds that you don’t understand so well.? At least you will be able to know what risks you have, and that is an aid to asset management.

Final Question

This article began as a discussion of things that are very hard to change in the current environment.? I thought of several here:

The continuing need for derivatives, and the impossibility of full standardization
The continuing need for rating agencies
Human nature makes us yield hogs.
Wall Street builds traps for investors off of that weakness.

What other things are very hard to change in the current environment?

Ten Points — Mainly About the Debt Markets

Posted on 12 June 2009 by David Merkel

1) Why have long interest rates been rising?

Increased supply.
Mortgage bond/supply hedging. (also one, two)
Belief in a strengthening economy.
Long-term inflation expectations have been rising.
Some foreign investors are selling.
Flight to trash.

Number 1 is incontrovertible.? Number 2 is close.? Number three is true, though the economy is not strengthening that much in inflation adjusted terms.? As for 4, yes, TIPS inflation breakevens have been steadily rising, both short- and long-term.

The last one is the most interesting.? It is the analogue to the equity investors that are buying financials.? Since the financials have been hot, equity managers lagging in performance have encouraged the purchase of hot financials.? Same for junk bonds among broad mandate bond managers.? Many managers are buying long financial corporates for speculative gains, while selling long Treasuries to fund the purchases.

With a few exceptions, it has paid recently for bond managers to play on the riskier areas of their mandates, with the exception of high quality long duration bonds, which were the big winners last year, and the big losers this year so far.

So when you look at the rise in high-quality long rates (prices down), and the rally in junk (prices up), etc., realize that these are part of a larger phenomenon.?? There is not one simple reason for the recent moves, there are many, and they are loosely related.

2)? That’s not to say that the Fed publicly understands this (one, two, three) .? When they announced their plan to buy long Treasuries, Agencies, and Mortgage bonds, there was some hope that they could keep mortgage rates down and stimulate the economy by making cheaper to finance homes.? That dream is in tatters now (one, two, three, four, contrary opinion from Paul Kasriel, who I generally respect).? The six forces listed above are bigger than the Fed’s ability to control.

3)? Will the Fed start tightening rates in 2009?? Yes or no?? When you phrase the question that way, most thoughtful observers will answer no, saying that the Fed would never start acting when a recovery is barely underway, if it is underway at all.

But maybe that’s the wrong question.? Ignoring the Fed funds futures market for a moment, ask this question instead:? Subjectively, have the odds risen recently that they might tighten sooner, and maybe even in 2009?? Certainly.? There have been other times when the Fed has acted, tightening when conditions were less than optimal.? I’ll give you two of them:

After the dollar tanked in 1986, with inflation still pretty benign, starting in December of 1986, the Fed began to raise rates, primarily to defend the dollar.? Not realizing all of the second order effects that would take place, the tightenings led to a bear market in bonds, and eventually the crash later that year as bonds became compelling compared to stocks.
From 1973 to 1982, the Fed often raised rates when the economy was less than strong.? Inflation was out of control, and it didn’t much matter whether industrial capacity or labor capacity were fully used — there was still inflation, and thus, stagflation.

It’s possible we may run into the same thing here, though if the only thing we experience is commodity price inflation because the dollar is weak, that doesn’t feed back into consumer prices that much,? because raw commodity prices play a small role in consumer prices.? Labor costs are much more important.? Would it be possible to get rising wages when unemployment is high?? Yes, look at the ’70s.

4)? But maybe the Fed can tighten without tightening.? They can begin lightening up on their credit easing programs.? Might work.? Maybe they could reverse their trade in long Treasuries, Agencies, and Mortgage bonds.? Uh, yeah, unlikely, but maybe they slow down a little.? In a case like this, moving the Fed Funds rate might be the least painful option.

So maybe a move in the Fed funds rate isn’t impossible in 2009.? The difficult part here is forecasting:

What conditions will be in the real economy will be like
How well the global economy turns
Whether the large amount of incremental Treasury debt and guarantees will be readily digested on favorable terms
Whether the financial economy won’t hit a few more roadblocks from commercial mortgages, corporate and personal insolvencies, unemployment, etc.
Whether there is some “bolt from the blue” like a new war, weakness in the Chinese economy, etc.

What isn’t hard is looking at the overall debt levels relative to GDP, and realizing that we have only rationalized a part of them.

5) Residential Housing is still weak, and getting weaker, but the pace of the decline has slowed.? The market still has issues in front of it:

As mentioned before, mortgage rates have been rising.
Alt-A resets and recasts are still mainly in front of us, but the losses are pretty severe when they come.? This fits in with my housing mismatch thesis — we have too many expensive homes, and losses on the Alt-A mortgages will be severe, because there are few logical move-up buyers in this environment.
We are seeing more losses on prime loans, because slumping housing prices have even inverted prime some loans.? Then, when a trouble hits (one of the 6 Ds — see point 5), and cash flow to service the mortgage falls, we get another foreclosure.? Shiller makes a similar argument in the NYT.

As I said in an old CC post:

		David Merkel
		Hear Cody on Housing
		8/24/2007 1:25 PM EDT

Much, but not all of the upset in the lending markets (which, if you look at swap spreads, the current manifestation of the crisis seems to be passing — down 4 basis points today), is from deflating values in housing. My estimate for how much further real estate has to decline on average in the US is 10-20%. We need to find owners for about 4% of the US housing stock that is vacant. The pain that has been felt in subprime and Alt-A loans will get felt in prime loans, and possibly conforming loans as well. Fannie and Freddie won’t get killed, but they will take credit losses.

So, listen to Cody. Residential real estate markets do not clear as rapidly as a futures exchange. The illiquidity and variations in lending standards tends to lead to markets that adjust slowly, and autocorrelatedly. I.e., if it went up last period, odds are it will go up next period, and vice-versa.

It will take a while for the residential real estate market to clear. When the inventory gets down to 3% it will be time to start speculating on homebuilders and mortgage lenders again, but real estate prices won’t start rising in aggregate until the inventory of unsold homes gets below 1.5-2.0%.

Position: none

In hindsight, I was way too optimistic, but I could never bring myself to write that things could be much worse, because then you get labeled a “perma-bear,” and then you get ignored.? So, if you want pessimism, here it is from T2 partners.? We may be near fair value now, but given that our housing stock is misfinanced (too much debt, terms that are too short), we will definitely go below fair value.? The only question is how much we go below fair value.

6)? Regarding the US Dollar fixed income, who is right?? The Russians, who are selling?? The Chinese, who are kvetching, but still buying??? Or the Japanese, who possess unshakable trust in US bonds??? Only time will tell.? Transitions from one currency regime to another can be messy in the absence of an anchor like gold.? There is some point where if the US keeps borrowing, and there seems to be no end in sight, that foreign creditors will finally write off their losses, and move on to some new arrangement.

In the short run, it is not in the interests of China or Japan to ditch the Dollar.? It would take something notable to get them to change, and I can’t see what that would be.? It certainly won’t be Yuan-denominated bonds from the US.

7)? Buy Corporate Bonds Now.? Aren’t we a bit late here?? The time to buy was back in the end of 2008.? Investment Grade Corporates are at fair value now, and I would reduce holdings of BBB corporates to below benchmarket levels. High yield is still a little cheap, so I would reduceallocations to high yield now to benchmark levels.? We still have significant financial stress ahead of us, and there is a lot of room for lower-rated credits to underperform.

8 ) As another example of this, consider how many junk-rated senior loans will need to be refinanced over the next five years.? Perhaps the bid from CLOs will come back, or the the banks will heal and bring it onto their balance sheets.? But absent that, there will be upward pressures on yields when refinancing senior loans.

9) I knew that I wrote something with respect to the Fed and Treasury using force to make banks take TARP funds.? I finally found it.? So, this isn’t hot news that the banks were forced to take TARP funds, (and here) but it’s nice to see that I guess right every now and then.? Barry was quite possibly right that the TARP was a ruse to protect Citi, but the bigger surprise would be how much Bank of America and Wells Fargo would need it.

10) Final note: if banks are opaque, regulators are more so.? Glad to see Matthew Goldstein continuing to put out good work on financials.? He was great at TSCM, and I’m sure will be great at Reuters.