Category: Structured Products and Derivatives

Fifteen Notes on the Markets

Fifteen Notes on the Markets

Posted on by David Merkel

1) Where are we?? Is the equity market cheap or dear?? Personally, I think it is cheap, and though it might rally in the short run, it could get cheaper.? When the financials are compromised, all bets are off.? Here are some article indicating that things are cheap:

And, not cheap, consider the arguments of this humble student of the markets.? He considers survivorship bias and war as factors that investors should consider.? I agree, and I would urge all to consider that wars often occur as a result of economic crises.

2) The trouble is, quantitative finance is tough.? We don’t have enough data.? Our models are poor, and until recently, often reflected two major bull cycles, and only one bear cycle.? My view is that the equity premium is more like 3% over the long run, and not the 6% bandied about by careless consultants.

3) During the “great moderation,” I argued over at RealMoney that volatility and credit spreads were too low, and would eventually snap back.? Okay, we are there now.? Volatility is high, and so are credit spreads.? The brain-dead VAR models used by Wall Street have been falsified again.? Quantitative investors have gotten savaged again; it only works when implied volatility is flat/declining — it is an implicit credit bet.

4) This is a global crisis.? Where is it appearing?

5) As I have mentioned before , the IMF, previously seeming irrelevant, has a new lease on life.? But how much firepower do they have, and will countries in crisis send them money to aid foreigners?

Consider their new plans for a short term lending facility, and the exogenous shocks facility.? They will have a lot to fund in this environment.

6) Might government programs to guarantee bank deposits have caused a shift from stocks to bank deposits?? Possible, though for every seller, there is a buyer.

7) How do we pay back what we borrow?? Who will borrow more from us?? Those are? the great unanswered questions as we attempt to bail out many troubled entities.? I’m a pessimist here, and think that we will have higher long rates as a result, and that “Bernanke” will become a cuss word.? (Among the cognoscenti, only “Greenspan” will do as a proper insult.)? On the despondent side, will the US default in 2009?? Doom-and-gloomers are always early, and ignore the flexibility in the financial system prior to failure.? I see default as more of a 2017-2020 issue.

8 ) Uh, let Lawrence Meyer pontificate.? There is nothing good about a zero Fed funds rate.? Let him wax grandiloquent about Japan over the past two decades.? Consider how low interest rates destroy money markets funds.? Consider as well how much low rates destroy saving, sometyhing that we have had too little of.

9) In an environment like this, every M&A deal is open to question.? M&A is credit sensitive, and higher volatility impairs the flow of credit.

10) I don’t think that GAAP mark-to-market accounting has had a material impact on this crisis.? True, many accounting firms have interpreted mark-to-market as mark-to-last-trade, but that is not what SFAS 157 specifies, and firms can ignore their auditors (with some risk).? The truth is that the firms that have failed choked on bad balance sheets and inadequate cash flow.? It doesn’t matter what the accounting rules are when a company is running out of cash.? Cash is impervious to accounting rules.

11) Want a closer view of the Fed and politics.? Read this piece at The Institutional Risk Analyst.? While at RealMoney I espoused a view that the Fed was more political than economic.? This article confirms it.

12) How do I view Greenspan’s apology?

13) At a prior employer, we often commented that credit risk in credit cards appears late in the credit cycle.? Well, we are there now.? It is seemingly the last form of credit to default on.? In this environment, one can lose their home, but losing financial flexibility can be bigger.

14) The FDIC can modify many mortgages, at a cost to taxpayers.? It could cost a lot, and many people who made dumb decsions could be bailed out by the prudent.

15) If John Henry were alive, he would be smiling.? Let humans make markets, and not machines.

Eight Notes and Comments on the Current Crisis

Eight Notes and Comments on the Current Crisis

Posted on by David Merkel

1) Greenspan — what a waste.? A bright, engaging man becomes a slave to the Washington political establishment.? Now he gives us a lame apology, when he should be apologizing for his conduct of monetary policy, which encouraged parties to take on debt because of the Greenspan Put.? Now the debts are too big to be rescued by the Bernanke/Paulson Put, where the Government finances dodgy debts.

On a related note, Gretchen Morgenstern is right when she calls the apologies hypocritical.? I would only add that Congress also needs to apologize; they did not do oversight of the Administration properly.? Many members of the oversight committees are not economically literate enough to do their jobs; they can only score political points.

2) I found this post highly gratifying, because it points out the disconnect between macroeconomics and finance, which I have been writing about for years.? When I was an economics grad student, I felt economics had gone astray by trying to apply statistics/mathematics to areas that could not be precisely measured.? In this case, if your models of macroeconomics can’t accommodate the boom/bust cycle, you don’t deserve to be an economist.

3) You want accounting reform?? Start with accounting that disallows gains-on-sale in a financial context.? WIth modern life insurance products, gain from sale is not allowed under SFAS 97, and I would modify SFAS 60 to be the same way.? No profits at sale.? Profits are earned in a level way over the life of the business as risk decreases.? Let other financial firms use something akin to SFAS 97, and many business problems would be solved.

4) What freaks me out about this article is that Taiwan is refusing the full faith and credit of the US Government, which stands behind GNMA securities.? Don’t bite the hand that feeds you; who knows but that you might be traded for the elimination of Kim Jong Il.

5) It figures that the moment the PBGC buys the specious arguments of a pension consultant that the equity markets crash.? Whaat makes it worse is that the PBGC tended to buy long Treasury debt which has been one of the few securities rallying? recently.

Given all the furor over investing in long duration bonds for pensions versus equities, it is funny that the PBGC rejected the growing conventional wisdom that DB plans should invest in safe long bonds.? Once they reject their current pose, the equity market could rally.

6) Is the economy weak?? Well, look at the states.? If their tax receipts are going down, so is the economy.? We are in a recession, and maybe a depression, given the lack of strength in the banks.

7) Do we need a new system for managing the global economy?? The Chinese certainly think so.? They finance the US and don’t get much in return.? Perhaps China could host the new global reserve currency?? I don’t think so.? Their banking system isn’t real yet, and they still want to subsidize their exports.? The global reserve currency role will flow to the largest economy allowing free flow of capital.? Now, who is that?? Japan?? Too small, but the world now recognizes that their banks may be in better shape than many other countries.? Plus, they have been through this sort of crisis for a while, and may be closer to the end of it than the rest of us.? The alternative is that Japanese policymakers still don’t have the vaguest idea of what to do, much like the rest of the world now.

Thing is, we don’t have a logical alternative to the US Dollar as the global reserve currency.? The Euro is a creation of an alliance of nations untested by economic crisis.? Perhaps the rest of the world should consider the possibility of no global reserve currency, or keep the US Dollar, or, move to a commodity standard like gold or oil.

For now, though currencies will follow the path of panic, as carry trades unwind, as countries that had too much borrowing see loans repaid (Japan, Switzerland), and countries with high interest rates see a demand for liquidity, which perversely will push rates higher.? (Isn’t everything perverse in the bust phase, just as everything is virtuous in the boom phase?)

8 ) On the bright side, some boats are rising.? After seeming irrelevant, the IMF has found a reason to exist again with loans to Iceland, Hungary, and Ukraine, with more to come.? The small/emerging markets once again learn that they were at the end of the line in this economic game of “crack the whip.”? That said, the developed market banks financing them will get whipped too.? This is truly a global crisis.

And given that it is a global crisis, I wonder how willing the developed nations will be to add more funds into the IMF when they have crises at home to deal with?? I’m skeptical, as usual.? Perhaps the Treasury can send them a raft of T-bills.? The IMF can ask the Fed for contact info.

(more to come)

When What Cannot Happen Happens, More Surprises Likely Await

When What Cannot Happen Happens, More Surprises Likely Await

Posted on by David Merkel

After not feeling well for a few days, I am back to writing.? Let me start with a blast from the past from RealMoney, during happier times:


 David Merkel
Swap Curve Inverts a Teensy Bit, for a Moment
2/17/2006 12:29 PM EST

Nothing big here, but the swap curve briefly inverted twos to tens a few minutes ago. There is no reason to panic here; I’m just pointing out something that is highly unusual in the bond market. Having successfully traded bonds 2001-2003, I can say that strangeness tends to beget more strangeness. If this inversion gets larger and persists, I will have a post on the topic, but for now, this is just a curiosity.

Position: none, but the swap market affects us all in a wide number of quiet ways…



 David Merkel
The Deepening Inversion
2/22/2006 11:06 AM EST

I did not expect the inversion in the Treasury curve to get so deep so quickly. At present, the Treasury curve is inverted 15 basis points from twos to tens. Does this mean the market is falling apart? No, only the economics of spread-based lenders.

Whoever taught me (way back when) that the swap curve can’t invert deserves a few whips with a wet noodle. It’s small, but swaps are inverted two basis points twos to tens. What will I see next? Inverted corporate curves for BBB bonds? I can’t imagine what that would imply for the economy. It would deepen my feeling that we are in uncharted waters in a low nominal world.

On the CPI, it is an advantage for TIPS buyers that the bond market focuses on the core CPI, when TIPS buyers get paid off of the unadjusted CPI. It allows us to get more yield off of our TIPS.

Inflation is higher than the core CPI indicates for a wide number of reasons, but the simplest one is that they exclude food and energy, whose prices have risen at faster than everything else for the past 10-20 years.

Eventually the long end of the Treasury curve will react badly when market players revise their long run inflation expectations, which in my opinion are too low. But for now, international flows dominate because US yields are higher than those in most other countries, and pension fund flows dominate because of a need to fund long liabilities. Until those factors quit, we will continue to live in a weird bond market, with uncertain implications for GDP and the equity markets as a whole.

This doesn’t make me change any of my strategies yet, but it does leave me uneasy.

Position: long long-dated TIPS, bank floating rate loan funds

Back then the yield craze was upon us, and credit risk forgotten.? The swap curve was theoretically never supposed to invert on a yield basis.? That was then, this is now.? A new yield craze is upon us, where credit risk is omnipresent, even in securities of the highest quality.? It reads, “I don’t care about the yield, just give me guarantees for a long time, and keep me safe.

That is manifesting in (at least) three ways right now:

  • Failure to deliver in repurchase markets. (Alea, Jesse’s Cafe Americain)
  • Swap spreads going negative on the long end of the curve. (Across the Curve, FT)
  • What bond deals are getting done for investment grade names are getting done at amazing spread levels.? (Baker Hughes, Pepsi — in 2002, spread levels for single-A names never got this wide, though some cyclical BBBs got that wide.)

The grab for safety is relentless, and the efforts of our Government are small relative to the size of the economy.? The yields of the investment grade bond market are a truer measure of the troubles, because no one is fiddling with it yet.? Even so, the fiddling may not turn even the manipulated markets around.

PS — As a final note, a kind word for the CDS market — their netting procedures work admirably, as pointed out by Alea (numerous times), and Derivative Dribble (a valiant start for a new blog).? Here’s a wild thought: we need the same thing on a broader and more complex scale, allocating the embedded losses in our financial system to their rightful recipients, wiping out common, preferred equity, and subordinated debt as needed, and forcing the conversion of debt claims to equity, delevering the system in a colossal way.

CDS netting does that in a flash for synthetic debt exposures, but how do you do it for a wide number of assets at once?? I’m not sure it can be done.? My question is this: do the present actions of policymakers genuinely help, as they shift debts from private to public hands, or do they merely delay the inevitable?? I hope the former, but I think it is the latter.

Full disclosure: long PEP

The Collapse of Carry Trades

The Collapse of Carry Trades

Posted on by David Merkel

In his usual brief style, jck at Alea displays the collapse of carry trades through the appreciation of the yen.

Put on your peril-sensitive sunglasses before viewing.? When I was at RealMoney, I wrote a lot about carry trades, and how the end would be ugly.? We are experiencing that now.


 David Merkel
The Craving for Yield, Part 2
2/6/2007 2:55 PM EST

If you hang around bond investing long enough, you run into the phrase “carry trade.” It’s a simple concept where one borrows at a lower rate, and lends at a higher rate, just like any bank would do.

Free money, right? Yes and no. People make money in these trades often enough to make them popular, but there are often points where they blow up. The simplest example is when the Treasury yield curve is very steep, like it was in late 1993, or mid-2003 right after Alan Greenspan finished his last contest of “How much liquidity can I provide?” At that point, it seemingly paid to borrow short and buy longer dated Treasuries, clipping the interest spread. That works well when interest rates are falling, or when the FOMC is on hold at the bottom of the cycle, but once the hint that the first tightening might occur, it doesn’t work well until the first loosening is hinted.

Carry trades can involve other factors as well. Some creditworthy entity can borrow cheaply, and invest in less creditworthy or more illiquid paper, capturing a spread. That trade also goes in cycles; good to do it when everyone is scared to death, as in late 2002. Bad to do it in late 1999-2000, as the negative side of the credit cycle kicks in.

Carry trades can involve different currencies. Borrow in the low interest rate currency (Yen, Swiss Francs, Offshore Yuan), and invest in the high interest rate currency (US dollars, NZ dollars, Australian dollars, Korean Won, Indian Rupee, etc.) Again, it all depends where you are in the cycle, as to whether this is a good trade or not. The weak tendency will be for low interest rate currencies to appreciate versus high interest rate currencies, but in the short run, currency movements are somewhat random.

What fascinates me in the current environment is the size and variety of all the carry trades being put on at present. CDOs of all sorts. Borrowing in developed markets and investing in emerging markets currencies. Levering up nonprime commercial paper. Borrowing offshore in Yuan. Borrowing short to finance paper with short embedded call options. Corporate, RMBS, CMBS and ABS spreads are tight.

When I think of all of the different risks that can be taken in bonds (duration, convexity, credit/equity, illiquidity, currency, etc.) they are all being taken now, and at relatively high levels. There is an exception. Duration risk is not being taken because of invested yield curves. (But who is borrowing long to lend short? Not many I hope.)

The danger here is not immediate. As with most topping processes, it is just that, a process. Bubbles pop when cash flow proves insufficient to finance them. Cash flow is still sufficient now. Banks are still growing their balance sheets faster than their central banks. Petrodollars and Asian surpluses are still being recycled. Wealthy investors are still for the most part bullish. We’re not to the point of no return yet; the sun is shining amid large cumulus clouds. But as those clouds cumulate, we should prepare for rain. Okay, snow.

Position: none

Alas, but the boom has given way to a bust, and “All the king’s horses and all the king’s men, Couldn’t put Humpty together again.” Sad times these, but they had to come. There was too much leverage in the the system, and now leverage is collapsing, and the value of assets whose prices were artificially high due to the temporary additional purchasing power that leverage afforded.

Have a wonderful day amid the chaos, and be grateful if you have food, shelter, clothing, family, friends, and peace with God.

Blame Game III

Blame Game III

Posted on by David Merkel

I went on a shopping trip today to buy a desk for my two youngest children (10, 6), both girls.? As I drove, I listened to radio C-Span, because it is “guilt week” for the NPR stations in the area.? In hindsight, I would have rather listened to the begging from the NPR affiliates than what I heard on C-Span.

The program that I heard was hearings on the financial crisis.? All of the testimony fell into the bucket of “not me, there are evil people who tricked us.”? My daughters must have found my negative commentary to be funny.

We have the government that we deserve.? Congress listens to self-interested loonies, rather than seek out those with intelligence that don’t have an axe to grind.? When I wrote the pieces, Blame Game, and Blame Game, Redux, what I tried to express is that there are a lot of parties to blame in our current crisis, and that everyone should ‘fess up their culpability.

With that, I want to add on a few more responsible parties:

29) FICO srcoring enabled loan underwriting to decouple from the local bank investigating the character of the borrower.? There is something lost when the underwriter does not explore the qualitative aspects of the borrower.

30) The fools who wrote that said that it is easy to make money in stocks or real estate.? They always show up near the end of the cycle.

31) Dojo suggests the Prime Brokers — How about the Prime Brokerage business model followed by most banks and investment banks which allowed their speculative clients to go ?nuclear? in any marketplace as long as they had a credit facility and a cell phone. A $10 million hedge fund run out of a basement in Westchester County NY or Orange County CA could control $1 Billion worth of goodies in many cases. Yikes!! A bit severe, but there is some validity there.

32) dlr suggests the FDIC — The bank regulators at the FDIC. It was their JOB to maintain oversight of the banking industry. Every regulator who allowed the banks they were monitoring to giving liar loans, or pick a rate loans, or zero down payment loans, and didn?t call a halt, should be fired for malfeasance. The regulators who had oversight of Washington Mutual and Indy Mac should be fired. And their BOSSES should be fired. Right up to Shiela [sic] Blair. I think that all of the banking regulators deserve blame here, plus the Bush administration, who encouraged malign neglect.

My main point is this: if you are defending your core constituency in this crisis, you are at least partially wrong.? There are so many culpable parties, that few are blameless.

Final note: in many ways, this is a proper comeuppance to US policy that encourages home ownership.? Policy was trying to push home ownership to 70%+, when reality should have said “be happy with a stable 60%.”? Home ownership is not an unmitigated good.? Many cannot truly afford it, and the government tricks them into buying what they cannot afford with reasonable probability.

Curves and Corporate Credit

Curves and Corporate Credit

Posted on by David Merkel

Just a brief note on corporate bonds.? When I was a corporate bond manager 2001-2003, I learned a lot about inverted curves.? It was a tough time.? But what kind of inversion am I talking about?

Ordinarily, when there is little doubt over the creditworthiness of a company, the amount of incremental yield over Treasuries (spread) rises with the length of the security.? This is normal, leaving aside times when the yield curve is flat or inverted, because usually, the risk of default rises with time with even the best securities, because the future is less certain than the present.

The second stage is an inverted spread curve for a given company, which given a positively sloped Treasury yield curve, might leave the corporate yield curve positively sloped, but less so than Treasuries.? This indicates moderate worry over the credit risk of the company in question.? (Note: during a time of credit stress, the Treasury curve is almost always positively sloped, as the Fed tends to loosen during times of credit stress.)

Next is an inverted yield curve, where short term yields are moderately higher than long term yields.? This indicates significant worry over the credit risk of the company.

Finally, there is an inverted dollar (price) curve for the company.? This is where default is viewed as a likelihood.? The prices of the longest-dated bonds reflect current estimated recovery levels after default.? Short-dated bonds may trade near par. (Par: usually $100, also usually the amount of principal remaining to be received.)

This is a qualitative/quantitative way of thinking about the corporate bond market during a time of credit stress.? What percentage of the market falls into each bucket?

  • Not inverted
  • Inverted spread curve
  • Inverted yield curve
  • Inverted dollar price curve
  • In default

The more names in lower categories, the greater the degree of credit stress.? For companies with multiple issues of bonds, it is a simple way of characterizing the market, even in the absence of rating agencies.? (As a closing aside, equity implied volatility tends to rise as a company goes down the list.)

Wait, that’s not quite a close, and not an aside.? That is another way to lookat corporate bonds.? As the implied volatility of the equity gets higher, the more they migrate down the list.? Remember, leaving aside bank loans, usually only stable companies issue corporate debt.? As their prospects get less certain, implied volatility of the equity rises, and their debt moves down the list.

Fixing Securitization

Fixing Securitization

Posted on by David Merkel

After reading jck’s piece Securitization: Not Guilty, I said to myself, “well said.” He cited a study that showed that misaligned incentives were more to blame than secutritization itself.? (Academic paper here.)? And he cited this clever piece from the seemingly erstwhile blog Going Private.

Here’s my view.? I have lived through the first era of securitization, and I always thought that the equity/originator got off too easily.? They got their money out of the transaction too quickly, allowing themselves to profit if the deal survived for a while, and then died.? The equity of the deal should take the largest risks, rather than the subordinate certificates (most junior aside from equity).

Here’s my solution.? Require that the deal sponsor and originators retain the full equity piece, and that the size be regulated to make it significant.? Further require that the equity is a zero interest tranche, where the excess interest builds up to protect the subordinate securities.? They get paid last out of any residual cash flows of the deal.? The size of the equity piece might vary from 1% of principal on credit card, auto and stranded cost ABS, to 10% on CDOs.? Note that the equity pieces cannot be traded here, they must be owned by the sponsors or originators.

Now, if the equity only gets paid at the end, several things occur:

  • Sponsors/Originators have to be well capitalized.
  • They will be a lot more careful about credit selection, and not accept high-interest risky borrowers.
  • The subordinate certificates will get paid less interest, but with more certainty.

Does this change the nature of securitization?? Yes, and in a good way.? Securitization is useful, but in its initial phases, it suffered from the equity not having enough at risk.? My proposal solves that.? Put the equity at the back of the cash flow bus, such that the originator never makes a gain on sale, and that part of the financial system will be sound once again.

Debt and Sweat

Debt and Sweat

Posted on by David Merkel

Ordinarily, when I sit down top blog, I know what I want to write.? That’s not true now.? Yes, I could do a few book reviews.? I have six books read, and ready to go, but given the volatility of the markets, I feel I have to say something about the current activity.

I am a strong believer that there are few free lunches.? If there are simple policies that will easily produce prosperity, they would likely have been done by now.

As I have commented before, what we are seeing now is a shift in debt from the banks to the government.? Banks get capital, the government gets debt, and the money for the debt comes from three places: taxpayers, foreign lenders (central banks, probably) and perhaps at some point, the Federal Reserve could buy it (whether they monetize it or not is another question).? As jck noted yesterday, this has led to a selloff in Treasuries.? (Interesting that it happened on a day when the cash markets were closed, but the futures markets were open.? The reaction of cash bond market today is similar to that which the futures market exprerienced yesterday.)

Which brings me to my first point.? Today, when the rally in the fixed income markets gets reported (the markets again, were closed yesterday, you will likely hear that spreads rallied sharply.? But watch for the discussion of yields and prices (if there is any).? It’s quite possible that yields rise from Friday to the close of business today.

Second point, today $250 billion of the $700 billion got used on nine big/critical banks.? Now, this may have been somewhat coercive to some of the nine banks; as was said at Bloomberg:

None of banks getting government money was given a choice about it, said one of the people familiar with the plans. All of the banks involved will have to submit to compensation restrictions, said the person.

The government will also guarantee the banks’ newly issued senior unsecured debt, making it easier for them to refinance their liabilities, the person said.

Possibly the following message was delivered, “Be a good boy and get in line.? This is good for the nation, and we won’t be around for a decade.? You want to be a survivor, right?? You want friendly regulators when we review the levels at which you are marking your illiquid assets?? We thought so.? Sign here.”? (No surprise that Goldman then applies for a NY State, rather than Federal bank charter.? State regulation, particularly when you are a local champion, is much more flexible.? Just ask AIG. 😉 )

Though this leads to a short-term bounce in bank share prices, the long term effects are less clear, which brings me to my third point.? It’s one thing to bolster their balance sheets.? It is another to get them to lend, particularly in the bear phase of the credit cycle.? Also, as leverage comes down, and it will come down, so will profitability at the investment banks, and probably other banks as well.? Securitization will be less common, eliminating hidden leverage that allowed for less capital.

The same thing is going on in Europe, though they actually think about how they might pay for the bailouts.? In the UK, it pushes the national debt to GDP ratio to 100%.? As it gets closer to 150%, the international debt markets usually start to choke.? We have traded bank credit risk for national solvency risk at the margin.? Maybe that will be different here, if only government creditworthiness is perceived to be safe.? It is a “new era,” right? 🙁

I find it interesting that Barclays is refusing help.? Either the UK regulators aren’t so coercive as those in the US, or Barclays is not as levered as I thought.? Or, it could be hubris on the part of Barclays’ management team.

Even Japan is getting into the act, though these measures seem so weak that I wonder why they would bother.? The government and Bank of Japan stop selling bank shares, and allow companies to buy shares back more aggressively.? That may push share prices up in the short run, but it substitutes debt for equity, which shouldn’t have much of a long-term impact.

On the Central Banking Front

Now, with the seemingly limitless amount of US liquidity being to the short end of the US money markets, you would think that we would get a bigger move than we have gotten so far. This will take time, but watch the yield as well as the spread.? Also remember that LIBOR has become somewhat of a fiction at present.? There many quotes, but not so many loans to validate the quotes.

What is being done that is new?

  • TAF expanded to $900 billion.
  • New commerical paper program where the Fed backstops the A-1/P-1/F1 CP market, including ABCP.? Terms here.? FAQ here.? This is big, and it is much easier to start such a program than to end it.? It is difficult to end any program where credit is granted on less than commercial terms.? My guess is that it will be extended past its April 30th, 2009 planned expiry date.
  • Swap agreements allowing unlimited dollar liquidity to foreign entities through agreements with their central banks.
  • The Fed can now pay interest on reserve balances held at the Fed, which allows them to increase their balance sheet significantly.? In one sense, they become the Fed funds market.

What is not new is the idea that all we have to do is restore confidence, and everything will be fine.? No, we have to delever, and the US Gowernment is included in the list of those that need to delever.? There is no national reform going on here, but merely a shifting of obligations from private to public hands.

For investors:

For those that are investors, the biggest bounces tend to occur during depressionary conditions.? I would not get overly excited about the rally yesterday.? As John Authers at the FT points out, given the extreme changes being made, there should have been a bounce.? The question is whether it will persist.? I was a net seller into the rally toward the end of the day.? I think we have more troubles ahead.? Two things to watch:

  • LIBOR, CP yields and the TED spread. (The short end)
  • Overall yields of medium-to-long Treasuries and other long-dated debt.? (The long end.)

I expect yields to rise, even if some spread relationships fall.? The added financing needed by the US government is large.? Let us see where Treasury buyers have interest.

There are elements of this that remind me of my The US Dollar and the Five Stages of Grieving piece. This is for two reasons: first, we are asking foreign entities to hold more dollar claims at a time when they are stuffed full of them.? Second, this phase of the credit crisis reminds me of the “bargaining” phase of the five stages of grieving.? We are past a long denial phase, and the anger continues, but now we bargain that these proposals will allow us to escape the pain that comes from delevering.

I’m skeptical, but I hope that I am wrong, lest we get to the fourth stage “depression,” before we finally reach “acceptance.”? As it is, I am looking for companies with blaance sheets strong enough to survive the worst.? That is my task for the next few days.

Recession or Depression?

Recession or Depression?

Posted on by David Merkel

Back to the crisis.? I want to be a bull, really.? I read what Barry wrote on 10 bullish signals, and I think, yes that’s what history teaches us.? I have used that for profit in the past.? I even have a few more.

Here’s my knockoff of S&P’s proprietary oscillator:

That’s the lowest reading ever, with statistics going back to 1990.? For more, consider the discounts on closed-end funds — they are lower than ever.? Or, consider that the IPO market is closed.? Or consider that every implied volatility measure under the sun is through the roof in ways that we haven’t seen since 1987.? The yield curve of the US is wide.? Fed policy is accommodative; don’t fight the Fed.? Consider that well-respected value investors like Marty Whitman are finally excited about the market.? Credit spreads are at record highs in the money markets and in the corporate bond markets.? Finally, consider that the lack of insider transactions indicates a potentially bullish situation:

I have a hard time accepting the bullish thesis at this point because of troubles in most of the major banks, and the disappearance of all of the major investment banks.? I have a saying that when you have a major market malfunction, there tend to be many things going screwy at the same time.? I don’t like to say that it is different this time, but rather, we have to be careful whenever there is a significant hint of depressionary conditions.? If that is the case, we should see many abnormalities:

This is a global crisis, affecting most governments and firms.?? Our most severe crises, aside from the Great Depression, tended to be local, or limited to just a segment of the world.

Final notes: I warned about this disaster in advance, though I am not as prominent as a George Soros or Jeremy Grantham.?? I can dig up the references at RealMoney if necessary.? Last, as in the Great Depression, some moves by the government exacerbated the crisis, that may be true here as well.

With that, I conclude that we are back to the one key question: are we facing a recession or a depression?? If a recession, we should be buying with both hands, but if a depression, there will be better bargains later. At present, given the condition of the banks and the global scope of the problem, I lean toward the depression side of the argument, but I am not totally sold on the idea. There are bright people on both sides of the question. That said, I am not jumping to buy at present, even with many indicators that are favorable. The state of the financial system matters more.

Blame Game, Redux

Blame Game, Redux

Posted on by David Merkel

When I write, I don’t always know what will be popular, and what won’t.? Personally, I thought my article
Rethinking Insurable Interest was the more innovative of my two articles last night, but Blame Game made the splash.? Well, perhaps no surprise, the crisis has the attention of all of us.? I just have broader interests; I want to write about a wide number of things.

My readers took me up on my request, and gave me more targets to blame.? Let me expand on them:

21) The Rating Agencies — that was a popular choice.? Yes, the rating agencies messed up.? They always do.? Their job is an impossible one.? Should they be proactive or reactive?? Should they rate over the cycle, or be instantaneous?? Should they care about systemic risk issues?

Where they did err?? They competed for business, leading underwriting standards lower in structured finance.? They overrated the financial guarantors, who were their major clients.? Away from that, they made mistakes, but every firm offereing opinions makes mistakes.? I make mistakes regularly here.

22) Matt give me another party to blame, and I will let him speak for himself: I have one more to add – the Office of the Comptroller of the Currency. Not only did they fail to regulate the national banks, they also stone-walled State and local governments from bringing suit (claiming jurisdiction, but never following up on claims).

Add to that the divided regulatory structures that encouraged regulatory arbitrage.? That encouraged diminished underwriting standards.

23) Investment banks.? They asked the SEC to waive their leverage limts, and now none of the big guys are left as standalone publicly traded institutions.? They made a lot for a while, and then lost more.

24) Then there were the carry traders who have now gotten carried out on their shields. There were too many players trying to clip uncertain interest spreads, from hedge funds to Japanese housewives?

25) House flippers — whenever investors get to be more than 10% of a real estate market, beware.? Sad, but I heard an ad on the radio for buying residential real estate in order to rent it out.? It is not time for that yet.

26) The quants — they enabled models that gave a false sense of security.? They did not take into account decreased lending standards, and assumed that housing prices would continue to go up, albeit slowly.

They also assumed that various classes of risky business would be less correlated, but when hedge funds and fund-of-funds take many risks, returns become correlated because of investoors enter ing and exiting sectors.

27) The tax havens and hedge funds.? Hedge funds are weak holding structures for assets.? In a crisis they can be sellers, because they want to lower leverage.

28) Mainstream financial media — CNBC, etc.? They were relentless cheerleaders for the bull markets in stock and housing.? This isn’t a compliment, but financial radio makes CNBC sound cautious.? FInancial radio seems to be a home for hucksters.

And, that’s all for now.? If you have more parties to blame, feel free to respond.? One final note on my point 16, diversification, from the prior post: many quants did us wrong by focusing on correlations stemming from only boom periods.? There are many problems with correlation statistics in finance, but the big problem is that correlations are not stable even during boom times, much less between booms and busts.? In a bust, all risky assets become highly correlated with each other, invalidating ideas of risk control through diversification.

My view of diversification is holding safe assets and risky assets.? High quality short-term debt does wonders to reduce the volatility of results.? Other hedges are less certain.? Nothing beats cash, even when money market funds are open to question.

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