Structured Products and Derivatives – Page 23

Problems with Constant Compound Interest (2)

Posted on 11 June 200911 June 2009 by David Merkel

I had many good comments on part 1 of this series.? One was particularly good that focused on the economy as a whole, and how the promises made by the government were unlikely to be fulfilled with Social Security and Medicare.? Our government attempts to finance programs on the cheap by relying on future growth, which does not always happen.? They move up spending rapidly if growth is large, and small if growth is negative.? In either case, the government grows as a fraction of the economy.

But let me consider asset allocation projections.? It is really difficult to consider average projections of asset returns, whether in real or nominal terms.? Asset returns vary considerably, and the number of years from which average returns are calculated are few relative to the volatility of returns.

We have created an industry of asset allocators, many of which have allocated off of foolish long-term historical assumptions, as if the past were prologue.? Even if they use stochastic models, the central tendency is critical.? What do they assume they can earn over long-dated investment grade debt?? The higher that margin is, the more they lead people astray.? Stocks win in the long run, but maybe by 1-2%, not 4-6%.

Consider defined benefit pension funds — after all, it is the same problem.? What is the right long term rate to assume for asset performance?? Alas there is no good answer, and with private DB plans continuing to terminate because of underfunding, the answer is less than clear.

Scoundrels use the mechanism of discounting to their own ends — they make future obligations seem smaller than they should be, magnifying profits, and minimizing capital needs.? Cash flows are inexorable, though.? There are few ways to avoid the promises from pensions.

Investors, be aware.? Realize that long term investment assumptions are probably liberal.? Also realize that long term assets and liabilities that rely on those assumptions have liberal valuations as well.? After all, who wants to under-report income when the accounting is squishy?

Now, for my readers, what have I missed?

Fruits and Vegetables Versus Assets in Demand (2)

Posted on 11 June 2009 by David Merkel

Thanks to all of my readers who commented on the original piece.? You were a real help to me.? Okay, what are the differences between fresh produce and financial assets?

Time horizon — fresh produce is perishable, whereas most risky assets are long-dated, or in the case of equities, have indefinite lives.
Ease of creation — New securities can be created easily, but farming takes time and effort.
Excess Supply vs. Excess Demand — With a bumper crop, there is excess supply, and the supply is typically high quality.? Now to induce buyers to buy more than they usually do, the price must be low.? With financial assets, demand drives the process.? Collateralized Debt Obligations were profitable to create, and that led to a bid for risky debt instruments.? The same was true for many structured products.? The demand for yield, disregarding safety, created a lot of risky debt and derivatives.
Low Supply vs. Low Demand — With a bad crop, there is inadequate supply, and the supply is typically low quality.? Prices are high because of scarcity.? With financial assets, low demand makes the process freeze.? What few deals are getting done are probably good ones.? Same for commercial and residential mortgage lending.? Only the best deals are getting done.

Fresh produce is what it is, a perishable commodity, where quantity and quality are positively correlated, and pricing is negatively correlated.? Financial assets don’t perish rapidly, quantity and quality are negatively correlated, and pricing is often positively correlated to the quantity of assets issued, since the demand for assets varies more than the supply.? Whereas, with fresh produce, the supply varies more than the demand.

That’s my take after your excellent comments.? Any more improvements that can be made?

Loss Severity Leverage

Posted on 10 June 2009 by David Merkel

I’ve been analyzing on some surplus notes from a mutual life insurer which is part of a group of mutual insurers.? Mutual insurers are opaque, because there are no large private interests external to the company with a concentrated interest in the well-being of the company.? This company lost significant money in 2008 and the first quarter of 2009.? Most of it was writedowns on non-GSE (not Fannie, nor Freddie) residential mortgage bonds, where they bought mezzanine or subordinated bonds.

Wait.? Some definitions:

Senior bonds: those rated AAA, representing the group that gets paid first in a securitization.? In a securitization where the loss experience is so bad that the senior bonds take losses, typically all of the senior bonds get paid pro-rata.

Subordinate bonds: Bonds that receive high yields in a securitzation (rated BBB and below), but take losses first as losses emerge.? High risk, high return (maybe).

Mezzanine bonds: If the subordinate bonds get wiped out, the Mezzanine bonds (rated AA and A) are next.? Not much extra yield, but less chance of loss.

When a securitization goes bad, the juniormost bonds get losses allocated to them until they wiped out, then it goes to the next most junior class.? This highlights a difference between the loss severities of corporate bonds and structured bonds.? With corporate bonds, there is some recovery of principal — not all of the principal, of course, but 40% on average.? With structured bonds, typically you get all of your principal paid, or none of your principal paid (excluding early amortization).

I realized this for the first time when I analyzed the Criimi Mae Securitizations back in 1999.? The securitization trusts contained mostly junk-rated CMBS tranches, and junk-rated securitizations of other CMBS deals, and they sold off investment grade participations in the securitizations.? This was the messiest set of deals that I ever analyzed.? It reinforced one idea to me, that if you are not senior in a deal, you may lose it all.? With structured finance, there is loss severity leverage in mezzanine and subordinate bonds.

Going back to the firm I was analyzing, When I looked at their performance last year, I thought, “Stable company.? Bread and butter life company.? As my old boss said, ‘It takes more than incompetence to kill a mutual life insurer, it takes malice.’ ”

Today I am not so sure.? I once was a mortgage bond manager, and I bought senior securities because the yield spreads on the lower-rated securities were so small.? This company, like Principal Financial, bought mezzanine and subordinate bonds in significant measure, though they did slow down after 2005.

I have estimated the likely losses on the bonds that the company owns, and it is unlikely but not impossible that the company dies in the next few years.? The parent mutual company has ponied up money recently, and will probably do so in the future.? Who can tell?

My estimates of loss are less than those that the bond market is estimating.? If we marked the assets of the company to market, it would be significantly insolvent.? Insurance policies are high credit quality obligations, they don’t vary as much as bonds that are risky.? Now, if I had the Actuarial Opinion and Memorandum, perhaps I could know the truth.? That group of documents analyzes the long-term ability of a life insurance company to survive.? That document is sadly not public.? If it suggested that the company in question needed additional capital, that would be reflected in the public filings, and there is no such reference for the company in question.

Can You Afford To Lose It All?

Anytime one buys a mezzanine or subordinated security, or buys a surplus note, or trust-preferred security, or other bit of junior debt or preferred stock, one must ask, “Can I afford to lose it all?”? When there are senior investors, investors that are more junior can get whacked.? Senior investors ordinarily must be paid in full before junior investors get paid.

This applies even to AA and A-rated structured securities.? They aren’t senior, so they can lose all their principal.? And that’s what this life insurance company bought a lot of, picking up a princely few extra tenths of a percent in interest over the AAA bonds for a lot more risk.

How Did These Securities Get Such High Ratings?

Uh, seemed like a good idea at the time?? ;)?? As I’ve said before, it is impossible to set regulatory capital levels or subordination levels for assets that have not been through a failure cycle.? New asset classes have no track record of failure, and as such, estimating the likely expected present value of losses, and how variable losses could be is just an educated guess.? Sometimes they would apply models of related asset classes and tweak them.? That’s still a guess, though.

Also, using statistics for assets held on balance sheets, and applying them to securitizations, where the originator has little skin in the game, made the assumptions made for losses on residential mortgage lending too low.

The rating agencies did have competitive pressures to get business, but my view is that they did not have sufficient relevant loss experience to guide them.

What Should Have Been Done?

Regulators abdicated their duties by merely relying on the rating agencies. Ratings are fine in theory, and someone has to make judgments of relative risk, but the macro decision of what classes of investments are permitted, and what capital level to hold against them belongs to the regulators.? The regulators haven’t done well in setting up rating agencies of their own, so let the rating agencies continue on, but let the regulators be smarter in how they set the capital levels (higher for structured products than for corporates and munis, because of loss severity leverage), and what they allow regulated entities to invest in.

My view is that any new asset class has to go through a failure cycle before regulators allow regulated entities to invest in them.? Investments in such new assets? should be treated as a deduction from equity.

Wait, We Need to Invest in Those Assets to Stay Competitive!

That scream came the regulated entities.? Sorry guys, the risks of untried asset classes belongs to unregulated entities that don’t have deposit insurance, state guarantee funds, etc., where there is no systemic risk.? If they go under, no one in the public domain should care.

In principle, it shouldn’t matter within a group of regulated companies what the rules are, so long as they are enforced similarly by the regulators.

Anything else?

One final note — there is one medium-sized mutual insurer flying under the radar that I think its state regulator is unaware of the risks that it faces, and the rating agencies as well… it carries high ratings from all the main insurance raters.? Given the project that I am currently working on, I can’t reveal the name, but the guaranty funds would be more than capable of handling the failure.

Book Review: Bailout Nation

Posted on 9 June 20099 June 2009 by David Merkel

I liked Financial Shock.? But it was kind of like listening to the news on the radio, versus watching it on television, in comparison to Bailout Nation.? What can I say, Barry writes ably and amusingly, without losing erudition.? With help from Aaron Task, the book sings.? Having written for RealMoney, I have experienced the superb editing by editors that understand finance.? (I always enjoyed interacting with Aaron in the CC.)

Also, the writing is simple to understand, but you don’t get a simplistic view of who was to blame, similar to my Blame Game series.? There are a lot of culprits who took advantage of the boom times, leaving themselves and all of us more vulnerable in the eventual bust.

Barry begins the book by describing the normal temptation of nations to bail out large private interests when things go south.? The US resisted these temptations until the creation of the Federal Reserve, an quasi-public entity that I like to say was created so that the Treasury Department could take actions that would otherwise be unconstitutional.

He then describes early bailouts (Lockheed, Chrysler) that set the pattern for what will come later.? But the greater factor that Barry describes are the implicit bailouts where Greenspan threw liquidity at every crisis, which avoided the reconciliation of bad lending decisions.? Great examples include: commercial mortgages in the early ’90s, Mexico and mortgages in 94, Russia/Asia/LTCM in 98, and the Nasdaq in 2000-2.

Liquidity was never absent in the Greenspan era, and debts built up, realizing that since the Fed would protect them, why not take more risk?

The idea backfired on the Fed.? Investors took more risk because they thought the Fed would protect them, and so they leveraged up on investments at narrow spreads over risk-free investments in order to meet return targets.

Any policy that reduces risk-consciousness is a bad one.? Ditto for those that say follow the crowd.

As I have said before, if a country has fiat money, it must also regulate credit.? Conditions in the banking sector deteriorated through the Bush Jr., administration, leading to the credit crises we are seeing today.? Conservative, it is not.

Barry also details the crisis in 2008 as it unfolded, and questions the motives of parties involved, or, why they didn’t act earlier.

Personal Notes

The 1996 Greenspan comment on “irrational exuberance” is treated well by Barry.? Greenspan was long on words but short on deeds.
Barry could have done more with the Banking crisis 1989-93, which prompted the aggressive Fed policy which is similar to today’s policy.
Big as the Federal Reserve is, they certainly did not do their regulatory job with respect to lending terms.
Barry agrees with me that the CPI is understated.
On AIG, I would note that AIG Financial Products was not the only problem, though it was the biggest.? The domestic life companies had real issues.
I was gratified to see how many experts that Barry cited favored increased immigration to the US of those that are wealthy.
Finally, on the second to last page, he quotes an obscure economist with a weirdly-named blog.? Hey Felix, yes, he quoted few bloggers, but you missed this one.

All in all, a great book.? If there is a better one to describe the crisis, I will be very surprised.

If you want to buy it you can buy it here:?? Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy

For one final note, I love the cover of the book where they morph the Wall Street Bull into a pig.? It symbolizes the era we are in in.

What to do with a Negative Swap Spread

Posted on 6 June 20097 June 2009 by David Merkel

From a recent article of mine, this is what I was asked, and how I responded:

matt Says:
June 6th, 20097:19 pm at EditMr. Merkel:

I think that I saw somewhere (recently) that swap spreads on the long end were negative. I assume (correct me if I?m wrong) that this is the spread over treasuries. How is this possible? What does/did it mean?

PS: Good luck to all of the CFA candidates who took there exams today?
David Merkel Says:
June 6th, 200911:36 pm at EditI was taught way back when that it should be impossible. I was taught that it was impossible for the swap curve to invert, but it did it at the end of the last tightening cycle.

John Jansen has written about this, and others have commented at his excellent blog on this topic. This is my take: there are many who want to receive fixed, and pay floating for a long time. This depresses the 30-year swap yield.

Some want to do so because they are hedging exotic instruments that do the opposite, others because they might be hedging long term guarantees for long-dated liabilities (pensions, etc.), looking to minimize losses synthetically.

I?m not sure anyone has the definitive answer. But here?s a game to play. Swap rates reflect AA counterparties. Take a 30-year Treasury. Pay fixed on the swap, receive back 3-month LIBOR. The package now pays 20 bp over 3-month LIBOR. Put it in a trust, get Moody?s and S&P to rate it, and call it ?The Floating Rate Treasury Trust.? Sell participations to money market funds. This beats three-month T-bills by a little less than 60 basis points before expenses.

Now, I wouldn?t buy that if I were managing a money market fund just because of the illiquidity versus Treasuries. But there is a tweak we could try:

On top of the trust, offer protection on a basket of 100 single-A names on a five year rolling basis. Now the yield really swings; negotiate terms with the rating agencies so that it can be rated A1/P1/F1.? The excess yield is worth the illiquidity.

=–==-=-=-=–==-==-=-=-=-=-=-

Okay, 30-year swap yields have been less than Treasuries for some time.? I’m not totally certain as to why.? There are a lot of games going on in the derivatives markets, and they seem to favor buying long and financing short.? I do know that there are gains to be made in the short run from taking the opposite position, unusual as that is… but as with any anomaly in the market, be cautious, because the motives of other players shift, making opportunities more attractive, less attractive, or unattractive.

Monetary Policy is Loose — The Yield Curve is Steep

Posted on 5 June 20095 June 2009 by David Merkel

With a headline like that, you might be inclined to say, “Duh! Next you’re going to tell me that the sky is blue.”? Guilty, I am, but I won’t mention the azure sky; it’s raining here. ;)? I got here through analyzing the swap curve and asking the question, “When has the swap curve been shaped like this in the past?”

Swap curve.? Time for explanations.? The interest rate swap market is big — very big.? It allows parties to exchange a fixed yield over a period, for a floating rate, 3-month LIBOR [London Interbank Offered Rate], or vice-versa.? The fixed rates at different tenors/maturities define the swap curve. Typically, these swaps are done with AA-rated banks, so credit spreads versus Treasuries are low.

Personally, I find swap rates more comparable across countries than sovereign obligations.? Why?? The maturities are more similar, as is the credit quality.? Anyway here is my graph of comparable swap curves.? I would post it as a picture, but my browser keeps crashing on me.

Broadly, the shape of the current swap curve if very similar to the curves in October 1992 (no 30-year swap data), February 2002, and May 2004.? What was the state of economic policy at each of those times?

October 1992 — FOMC policy had just reached its most generous level for that cycle, where it would stay at 3% until the speculative pressure built up from overly cheap money would rapidly change in 2004.? There was considerable doubt as to whether monetary policy would be effective, and commercial real estate was still in the tank.? The great concern should have been getting monetary policy out of boom/bust mode — letting a recession take its course, and not trying to artificially make them shorter or more shallow than they need to be to clear away bad debts.? As it was, the great monetary ease was the prelude to the bond market’s annus horribilis in 1994, together with the collapse of the negative convexity trade, and the speculation in Mexican cetes, all of which required easy money.
February 2002 — nearing the effective end of the loosening cycle, and panic is considerable.? Many worries over technology and industrial companies.? The stock market was going down almost every day.? European financials, overloaded with equity-linked and other risk assets, were getting crushed.? Bright spot: US banks were in good shape, as was the housing market.
May 2004 — the easing cycle was just about to end, and about 18 months too late, with at least 1% more easing than was needed.? The US residential housing markets are in a feeding frenzy, and clearly, the recession is long since past.? The curve was steep only because Fed policy had not budged, and the market anticipated a considerable adjustment.

Three very different situations, and different than what we face today.? The one commonality is the loose monetary policy.? Some will say monetary policy doesn’t feel loose today.? That is because the Fed funds rate is down at the zero bound, and monetary policy is being conducted through “credit easing” — using the Fed’s balance sheet to benefit troubled lending markets, rather than the economy as a whole.

The present rise in long rates is partially a repudiation of the Fed’s ability to control the long end of the curve in Treasuries, Agencies, and Mortgage rates.? The Fed is too small to achieve such a task, so once the emotional shock of their buying program wore off, the curve steepened, pushed by hedging in the residential mortgage market, once the move became great enough.

We’re in uncharted waters here, so in whatever role you play in investing, be careful.? Unusual situations beget more unusual situations.? More on this in future posts.

PS — Other posts worth perusing:

“Just Gimme the Answer, Will Ya?”

Posted on 3 June 2009 by David Merkel

Half of my career, I have worked for bosses who were actuaries, and half not.? Half of my career, I worked for bosses that were intellectually curious, and half not.? There was a strong, but not perfect correlation between the two — most actuaries are intellectually curious, but there are a few that aren’t.

Those that know me well, know that I am a pragmatic idealist.? I have strong beliefs, but I also have a strong desire to solve the problem.? Where I run into difficulty is where the problem is ill-constructed, and does not admit a good answer.? Any answer would be subject to numerous qualifications and explanations.? Perhaps I can give some examples:

“What’s my illiquid structured finance bond worth?”

Oh my.? Whether residential mortgage, commercial mortgage, or asset-backed, that depends a lot upon future loss activity across the whole financial sector.? Typically I only get this question when the bond is worth little, but the entity thinks it is worth a lot, but can’t get a bid anywhere near that.? Often they have been misled by third-party pricing services doing a facile job in exchange for a fee.

“How will this equity portfolio behave versus the market?”

Ugh. Beta is unstable, and estimates often lead to erroneous conclusions.? More detailed modeling can come up with a reasonable answer, but also state that the correct beta is a weak tendency, and is swamped by other effects.

“This investment will eventually come back, right?”

No.? Most will, but not all will.? Some do go to zero, or something really close.? Mean-reversion exists in the markets, and over long time periods it is strong on average, but in specific over short horizons it does not work.

“What’s the interest rate sensitivity of this illiquid structured finance bond?”

Often there is not a good model of prepayment/extension risk.? Or, the model exists, but the security in question is dominated by credit risk.? Will that tranche pay off or not?? In such a situation, the wrong question is being asked, because interest rate risk is not the main risk.

“What’s the right spread to Treasuries for this illiquid bond?”

Sorry, but the answer will be regime-dependent, and will vary by the liquidity of the era.? During times of high liquidity, it will trade near liquid bonds of similar risk.? In times of low liquidity, it will trade far behind its liquid cousins.

What’s the right yield tradeoff between bonds of different credit quality classes?

Again, it varies.? Even across a whole cycle, there is no right answer.? Personally, I would try to estimate the likelihood, subjectively, that we would enter the other side of the cycle within the life of the asset in question.? There are boom valuations, and bust valuations, and scarce little time in-between.

“Just Gimme the Answer, Will Ya?!? I need an Answer!”

Yeah, I got it.? I’m a practical man also, but I try to understand where I can go wrong.? Process is as important as the result.? For many investors, institutional as well as retail, they don’t understand the broader environment that we are in, and they think there are these long term averages that don’t vary that much.? Just invest, and you will make good money over a 2-5 year period.

Sorry, but life is more variable than that.? Investment processes are a function of human processes.? Where humans play a game of follow-the-leader for a long time, with positive results, the cycle will be long, and the unwind severe.? Truth is, the real economy grows at a 1-3%/year rate in inflation adjusted terms, with a lot of noise, absent rampant socialism, or war on our home soil.? The result over the long term should not be much more than 2% more than bond returns, with moderate risk.

You mean there are no answers?

No, there are answers, but there are confidence bands around the answers, and the answers are subject to the overall well-being of the financial economy.? We are playing a complex game here, because the boom-bust cycle is less than predictable on average.? Thus the advantage goes to those that play with excess margin, particularly when things are running hot, and they? pull back.? It is a tough discipline to maintain, but it yields results over the long term.

I will say it this way: focus on where we are in the risk cycle, and? it will aid you in where to invest.?? As Buffett says, “Be greedy when others are fearful, and fearful when others are greedy.”

I encourage caution.? Ask what can go wrong.? Consider what a prolonged downturn in the economy would do.? If the answer is “little,” then be a man and take real risks.

Be skeptical, but don’t be paralyzed in decision-making.? Look to the long-run as a weak tendency, and realize that over many years and with moderate certainty, the trend will revert on average, buit not necessarily for individual investments.

So what should I do?

Keep a reserve fund of safe assets.
Be skeptical of short, intermediate, and long-term results, but for different reasons.
Resist trends during normal times, but during times of extreme movement, let it run.
Always consider what could go wrong.? WHat is the upside and the downside, and the likelihood of each.

There is no single formula or answer for all investment problems, but a conservative attitude, and a reasonable analysis of where we are in the risk cycle will help.

Unstable Value Funds (5 – CMBS Edition)

Posted on 2 June 2009 by David Merkel

Over the last two months, the assets underlying most stable value funds have done well, and short ABS, CMBS, and RMBS bonds have rallied.? Insurance debt as well.? But just when you think you can relax, S&P comes in to jolt confidence.? Here are some articles:

You don’t have to read all of these.? The main ideas are:

Super-senior AAA CMBS is not bulletproof.? From the S&P report, “In particular, 25%, 60%, and 90% of the most senior tranches of the 2005, 2006, and 2007 issuances, respectively, could be downgraded.”
Some view S&P’s new criteria as draconian.
Rents from properties underwritten in the boom period 2005-7 are definitely declining.?? The stress tests impose a 25%-ish haircut for rents in everything but multifamily, whose haircut would be around 6%.? These would be adjusted for geography and quality.
Prior to the announcement the quote? in Markit CMBX AAA 4 — 2007 super senior exposure was in the low $80s.? Now it is in the low $70s.
That’s more than a 1% move up in yields.
Many maturing loans will not be able to refinance at the same principal levels.? Property owners will need to feed the properties, and equity capital is scarce.
This undermines the Fed?s efforts to expand the TALF to some legacy CMBS that will be downgraded below AAA.

There’s one more knock-on effect.? This review by S&P will also incude a review on how CMBS Interest Only [IO] securities will be rated.? The old philosophy was “Since IOs have no principal, they can’t lose principal, and securities that can’t lose principal are AAA.”? But when I would review CMBS securities 1999-2001, my models would indicate credit risk akin to BBB or BB securities.? Underwriting standards were much higher back then, so the new ratings for CMBS IOs will likely range between BBB to CCC.? Think single-B and below for vintages since 2005.

Though it won’t change the underlying cash flows of the CMBS IOs, it will change the ability of regulated financial institutions to hold them, particularly if Moody’s and Fitch follow along, which I think it makes sense to do.? With lower ratings, financial instutions will have to hold more capital against them, which lowers their desirability.? The regulatory arbitrage goes away.

So what then for Stable Value funds?? It’s a PR, marketing and a liquidity issue.? AAA CMBS plays a large role in stable value, particularly the short stuff that could be financed by the TALF.? If TALF is off the table, then prices have slipped considerably.? That doesn’t affect cash flows of the securities, but it? does mean that:

The difference between book and market widens.
Any SV fund with a need for liquidity can’t find it in their CMBS, because it is likely below the amortized cost.
There will be optical problems for current and prospective clients as they see the credit quality of the SV fund decline.
Those with a significant allocations to CMBS IOs (I hope there aren’t any) will see those assets go to junk, fall in current value, and be even harder to trade.

This is just another issue for Stable Value Funds — by itself, it is not likely to be enough to break the funds.? That would require something really nasty, like a quick run upward in short- and intermediate-term interest rates, or credit stress beyond this.? For the former to happen would require the FOMC to begin tightening, and absent a major dollar panic, they are not doing that anytime in the near term.? As for the latter, we have not yet seen the impacts from Alt-A recasts and resets, and the declines in commercial property values.? We will wait, pray and see.

Fifteen Thoughts on Advantage in the Markets

Posted on 29 May 2009 by David Merkel

1) I made the point last week when I talked about my experiences in the pension division of Provident Mutual.? The investment choices of 90% of individuals follows recent performance.? This is another factor in why markets overshoot, and why mean-reversion is a weak tendency.? Thus when I see many leaving the stock market for absolute return, bonds, cash, commodities, it makes me incrementally more bullish, though I am slightly bearish at present.

2) Has this been a “suckers rally?”? That’s too severe, but there is some truth to it. Many of the large financials may be safe, but at a cost of higher taxes and inflation.? Also, the losses on commercial real estate have not been felt yet on the balance sheets of banks.? I think we will break the recent lows on the S&P 500 before this is all done.? Debt deflation and dilution continues on.? We have an overhang in residential housing that will require prices to go below equilibrium in order to clear.? Global growth is anemic, even if some of the emerging markets are doing well.

3) When writing for RealMoney, I was usually diffident about buybacks, because I liked to see strong balance sheets.? Now in this era, those that bought back a lot in the past are paying the price.? Buy high, dilute low is a recipe for big underperformance, and we are seeing it in financials now.? (The comments about pension design in the article are spot-on as well.)

4) Behavioral economics does justice to what man is really like, both individually and collectively.? We are prone to laziness, greed and fear.? There is a weak tendency for a minority of individuals to break free from the fads and fashions of men, and pursue profit exclusively.? Remember, thinking hurts, so people conserve on it, unless the reward for thinking exceeds the pain.

5) Quantitative managers have gotten whacked, and few more than Cliff Asness of AQR.? It doesn’t help that you are outspoken, or that you took time away to aid the CFA Institute.? When the business goes south, thereare no excuses that work.? In times like this, be quiet, analyze? failure, and stick to your knitting.

6)? Ken Fisher made an argument like this in his book The Wall Street Waltz.? Eddy’s argument is ordinarily right; buy during bad times.? The only time that is not true is when you are in a depression, and there is much more debt to be liquidated, and more jobs to be lost.

7)? From Quantifiable Edges, there is some evidence that the ratio of the Nasdaq Composite to the S&P 500 can be used as a timing indicator.? Nasdaq Composite outperformance presages more positive returns in the S&P.

8 )? I read the article on the “purified VIX” and other “purified” indicators, and I get it.? Adam is still correct that periods where the VIX and SPX move in the same direction tall you something about future SPX performance.? If both are up, then the trend for the SPX tends to be up.?? Vice-versa if both are down.

9) Regarding this article on David Rosenberg, I think the earnings? are too optimistic, but the P/E multiple is too pessimistic.? Things may be ugly for a while, but I can see an S&P 500 above 1000 in 2011.? (That may be inflation.)

This phrase is problematic “As for the multiple, Rosie believes the P/E should approximate a Baa bond yield, leading to an “appropriate” multiple of 12x.”? E/P on average should be equal to a Baa bond average less 4%, making a fair P/E at 20+.

10) Beta stinks.? You knew that.? Here’s more ammo for the gun.? I have doubted the CAPM for almost 30 years.? It’s only value is to confuse other wise intelligent comptetitors.

11) Is small cap value still relevant?? Is winning relevant?? Please ignore the studies that use betas that adjust for small cap, value, and momentum — using each of those is a management choice, and those of us that choose to be smart take credit for following research, not that research should discount our actions.

12) Yes, the Q-ratio works.? Don’t tell anyone about it, though.? Shh…

13) Dow 36,000.? Yes, in 2030.? Glassman and Hassett were sensationalists that pushed an idea of rationality too hard, suggesting that people could accept a near-zero risk premium to invest in stocks, versus treasury bonds.? Bad idea.? The E/P of stocks averages near the Baa bond yield less 4%.? Stocks need 4% earnings growth to compete with bonds on average.

14) Homes are for living in; they are only secondarily investments, if you know what you are doing.? Compared to TIPS, gains in homeowning, less expenses, are comparable.

15)? As this post points out, and I have said it before, “The vast majority of currency ETFs represent stakes in an interest-bearing?bank account denominated in a foreign currency. They derive all their?return from two sources: the cash yield of the foreign currency over the expense ratio of the fund and changes in the exchange rate against the dollar.”? Be careful with foreign currency funds; they often embed financial credit risk.

Phase Change

Posted on 28 May 2009 by David Merkel

Longtime readers know that my investing interests are broad.? I almost decided to name this blog, “The Investment Omnivore,” but took the name of the investment fund that I deeply considered creating in the 90s, and used that.

So, when notable things happen, I tend to switch to where the action is.? On a day like today, that means the high quality, long duration band markets, because they are falling dramatically.? Now, there are other high quality observers following this phenomenon, including:

The Big Picture Rising Interest Rates Finally Start to Matter
Accrued Interest Yeah but this time I’ve got the money!
and the always excellent Across the Curve, no specific post, because he said a lot of good things on Wednesday.

Let me give you my perspective. Big moves in Treasury, Interest Rate Swap, and Mortgage rates tend to persist.? Why?? Three reasons:

Mortgage originators hedge their pipelines.? As rates rise/fall, they receive floating/pay fixed in order to lower their exposure to changes in interest rates.? As mortgage rates rise, mortgages get longer, because fewer people refinance.? Vice-versa for when mortgage rates fall.? Receiving a short rate like LIBOR, and paying fixed rates makes money when LIBOR rates are rising, which hedges those originating mortgages.
Those managing mortgage bond portfolios against a benchmark find themselves in the same situation.? As mortgage rates rise, mortgage bonds get longer versus their benchmark, and managers sell longer assets in order to adjust, sending the yields on longer-dated assets higher.
Speculators pile on when they sense that the first two factors are in play.

That’s why big moves in Treasury, Interest Rate Swap, and Mortgage rates tend to persist.? Thus for those who trade those markets, it is best to stand aside, or follow during big moves, and let the momentum run.

Wednesday we experienced what I would call a phase change, where the losses in the bond market since its apex in mid-to-late December have been consolidated.? Consider this graph of the yield curve as it has progressed over the last five months:

Short end stays firm because of confidence that the FOMC is on hold.? Long end runs because of new high borrowing needs of the US government, both recent and future issues.

Now what is this doing to the mortgage market?

That’s a graph of 10-year swap yields, which correlate closely (under ordinary circumstances) with 30-year mortgage yields.? The yellow line is the 18-month trailing moving average.? When rates are above that level, refinancing tends to slow; when rates are below that level, refinancing tends to speed up.

So how is the move in the yield curve affecting mortgage rates?

Rates have gone up considerably, but with the government interventions in the bank lending and residential mortgage markets, ordinarily stable market relationships got out of kilter.? This graph has the difference between 10-year swap yields and Fannie 30-year mortgage yields:

An ordinarily stable showed a lot of stress from the end of 2007 until now.? Present levels are close to “normal” over the the life of the series over the past 20 years where excluding the stress period, the difference was typically 0.60%, and we are at 0.67% now.

One more graph.? What period in the recent past is the current yield curve shaped like?? September 2003.

What was the economy like in September 2003?? Accelerating growth with little goods price inflation — it would be neat if that were the scenario ahead.? What is different this time is that the banks still have problems to work through, not the least of which are losses from commercial real estate lending.

Summary

What a rapid move in the long end yield curve over the past five months, with most of the moves concentrated in January and May.
This move may go further, but not much further, because we are at historic levels of steepness for the yield curve.
Refinancing opportunities should dry up.
The Fed would have to do a lot in order to bring mortgage rates lower versus swaps because we are close to the normal relationship of swaps versus mortgage yields.
The yield curve is very steep, which usually foreshadows rapid growth in the economy, but we have issues in the financial system that may resist that stimulus.? Liquidity in private hands is tight, so opportunities to make money borrowing short and lending long are limited.