Category: Structured Products and Derivatives

Ten Notes on Our Quasi-Government and the Financial System

Ten Notes on Our Quasi-Government and the Financial System

Posted on by David Merkel

Personal notes before I get started: I’ve been busy studying for the Series 7 (and also reviewing the compliance manual for my new firm — wow it is big). The two of them fit together, as I get to see how the regulations get applied. I’ve made through the study guide (what do you do when it is wrong — not that I found a lot of errors, maybe half a dozen?), and I am 20% through my first practice test. Went and got fingerprinted for the fourth time in my life yesterday. (The other three times were for adoptions.)

My links are back 🙂 but I had to give up my descriptive permalinks. 🙁 Maybe I’ll get them back when I upgrade the blog to WordPress 2.5.1. Beyond that, I am working on a book review for Gene Marcial’s forthcoming book, “7 Commandments of Stock Investing.”

Catching up on the markets:

Our Unorthodox Federal Reserve, GSEs and Government

1) Repo rates may not be negative now, but they were so recently. Fails (failures to deliver securities) become common, because of the lack of a penalty. Today we should see whether the TSLF has any impact on the scarcity of Treasuries. We should learn more about the direct landing program as well after the close today. It got off to a big start last week. Watch for the H.4.1 report after the close. Given all that is going on, it is becoming the critical weekly Fed document.

2) Now, because of all these actions on the asset side of the Fed’s balance sheet, some are calling the actions of the Fed, including the Bear Stearns bailout, revolutionary. Well, maybe. It’s certainly different than before, but there is a cost to doing business this way. Bit by bit the Fed loses flexibility as more and more of its highest quality assets become encumbered for a time.? The more that they do, also, the harder it will be to unwind, in my opinion.

3)? Greenspan…? If we turn off the spotlight, will he go away?? (Then again, he has enough money to buy his own spotlight.)? It is tough for anyone to defend a legacy, and I don’t blame him for trying, but the Fed became too integrated with the political establishment under his tenure, which made it too activist in avoiding short-term pain.? It made him look like a hero at the time, but now we are paying the price.? Overly loose monetary policy and financial supervision led to gluts of borrowing to finance assets that appreciated dramatically, until the ability to service the debt began to decrease.? I don’t think history will treat him kindly.? He said too much in the past that he is contradicting today.

4) Will the Fed buy agency MBS outright?? I think the answer to that one is yes, if the crisis persists. If housing prices drop enough further, like say 15%, the actions of the Treasury, Fed, FHLB, Fannie, Freddie, FHA, and whatever new lending monstrosity our imaginative Government comes up with will have to be closely coordinated.? At some level, if the Fed can’t trust the implicit guarantee of Fannie and Freddie, why should the rest of us?? That guarantee is as sound as a dollar! 😉

5)? It’s interesting to see the tide shift with respect to GSE involvement in the mortgage market:

6)? On a consolidated basis, our government, with its enterprises, are levering up.? This is a substitution of public debt for private, and more, just a lowering of capital standards for the GSEs.? (I wonder how comfortable the rating agencies are with this?)? This works while Treasury yields are low.? I wonder, though, how much impact this will have on the willingness of foreign buyers of Treasuries to continue their funding of our government?? One thing for sure, this will all get funded by the US taxpayers, together with those who lend to the US (dollar depreciation).

7) Now, it’s not as if the US is the only place in the world with central banking problems.? Consider the Eurozone, where there is still no lender of last resort.? How would they deal with a financial crisis?? I’m not sure; the ECB has quietly helped out some Spanish banks, but it is not really in their jurisdiction.? Under conditions of deflationary stress, it would not be impossible to see a nation whose financial system was in trouble either directly bail out the dud institutions, or even, exit the euro (last resort, but not impossible).

Or consider China, where inflation is getting a nice head of steam.? Their neomercantilism, with their crawling peg against the dollar is forcing them to import loose monetary policy from the US.? As the article cited points out, they need to significantly revalue their currency upward, which would would whack their exports, at least for a time.

8 )? For those that remember the files that I created for my piece, A Social View of the FOMC, it looks like I will have to update the file soon.? We have a successor to Bill Poole nominated, James Bullard.? When he is approved, I will update the file.? (I will miss Poole.? Though he was occasionally out of step with the rest of the FOMC, he always spoke his mind, which was usually more hawkish than the rest of the FOMC.)

9)? Now, Bullard is an Economics Ph. D.? (Surprise!) ? In my earlier piece, Jeff Miller took note of a few of the things that I said, and perhaps attributed to me an anti-Academic bias.? I don’t have a bias against academics, per se.? (Hey, can we put Steve Hanke on the Fed?!? One of my professors…)? I do have concerns about not having enough real debate.? If the neoclassical view of monetary policy is correct, then we don’t have problems, because everyone on the FOMC is either a neoclassical economist, or a monetarist.

Now, I do know the difference between politics and policy formation, and if I hadn’t been trying to keep the number of pages down, I might have had two columns.? (Getting it down to 15 pages was hard.)? But most of the FOMC members had either one or the other, but not both, so I left it as one column.? Next time I change the column heading.? That said, even if one is in a policymaking capacity in the executive branch, there is typically some political affiliation that helps get that person the job.? Those are relevant bits of experience, just as I noted everyone that had foreign experience, or military experience.? But what worries me is a lack of real diversity in views of how economics works.? (Perhaps we could get someone from the Santa Fe Institute?)

10) Finally, there will be a lot of pressure in the future to re-regulate our financial system.? Personally, I don’t think it is possible to create a regulatory scheme that eliminates crises.? The regulator shapes the type of crisis that will come, and when it will come, but it is impossible to wipe out the boom-bust cycle.? (We put off this bust for a long time, and now we are getting it with compound interest for time delay.)? If a regulatory regime is too tight, the financial companies complain because their ROEs are too low.? To the extent that it can, capital begins to exit the industry, or, the stock prices languish, and financials trade at low multiples on book, because they can’t earn much off their net worth.

Financial companies find the weak spots in any risk-based capital formula.? They also lobby the executive branch and Congress effectively.? Unless we slide into Great Depression II, I don’t think things will change remarkably from here.

I? agree that we need to re-regulate, but perhaps after this crisis is done, we can consider systemic reforms, and not the piecemeal stuff we have been dished up in the name of crisis management.? My re-regulation would be to reduce the Federal Government’s role in the credit markets, but then, I am walking out of step, and realize that is not what is going to happen.

Book Reviews — The Alchemy of Finance, and Soros on Soros

Book Reviews — The Alchemy of Finance, and Soros on Soros

Posted on by David Merkel

One trap you can fall into in life is to not learn from those that you disagree with, for one reason or another. George Soros would be an example of that. His politics are very different from mine, as well as his religious views. He’s a far more aggressive investor than I am as well. I am to hit singles with high frequency over the intermediate term. He played themes to hit home runs.

The Alchemy of Finance made a big impression on me 15 years ago. Perhaps it was a book that was in the right place at the right time. It helped to crystallize a number of questions that I had about economics as it is commonly taught in the universities of the US.

First, a little about me and economics. I passed my Ph. D. oral exams, but did not receive a Ph. D., because my dissertation fell apart. Two of my three committee members left, and the one that was left didn’t understand my dissertation. What was worse, I had moral qualms with my dissertation, because I knew it would not get approved.

My dissertation did not prove anything. All of my pointed to results that said, “We’re sorry, but we don’t know anything more as a result of your work here.” I have commented before that the social sciences would be better off if we did publish results that said: don’t look here — nothing going on here. But no, and many grad students in a similar situation would falsify their data and publish. I couldn’t do that. I also couldn’t restart, because I had put off the wedding long enough, so for my wife’s sake, I punted, and became an actuary.

That said, I was a skeptical graduate student, and not very happy with much of the common theories; I wondered whether cultural influences played a larger role in many of the matters that we studied. I thought that people satisficed rather than maximized, because maximization takes work, and work is a bad.

I saw how macroeconomics had a pretty poor track record in explaining the past, much less the present or future. In development economics, the countries that ignored the foreign experts tended to do the best. Even in finance, which I thought was a little more rigorous, I saw unprovable monstrosities like the CAPM and its cousins, concepts of risk that existed only to make risk uniform, so professors could publish, and option pricing models that relied on lognormal price movement.

Beyond that there was the sterility of economic models that never got contaminated by data. I was a practical guy; I did not want to spend my days defending ideas that didn’t work in the real world. And, I felt from my studies of philosophy that economists were among the unexamined on methodology issues. They would just use techniques and turn the crank, not asking whether the metho, together with data collection issues made sense or not. The one place where I felt that was not true was in econometrics, when we dealt with data integrity and model identification issues.

Wait. This is supposed to be a book review. 🙁 Um, after getting my Fellowship in the Society of Actuaries, I was still looking for unifying ideas to aid me in understanding economics and finance. I had already read a lot on value investing, but I needed something more.

On a vacation to visit my in-laws, I ended up reading The Alchemy of Finance. A number of things started to click with me, which got confirmed when I read Soros on Soros, and later, when I began to bump into the work of the Santa Fe Institute.

I was already familiar with nonlinear dynamics from a brief meeting with a visiting professor back in my grad student days, so when I ran into Soros’ concept of reflexivity, I said “Of course.” You had to give up the concept of rationality of financial actors in the classical sense, and replace them with actors that are limitedly rational, and are prone to fear and greed. Now, that’s closer to the world that I live in!

Reflexivity, as I see it, is that many financial phenomena become temporarily self-reinforcing. ? We saw that in the housing bubble.? So long as housing prices kept rising, speculators (and people who did not know that they were speculators) showed up to buy homes.? That persisted until the? effective cashflow yield of owning a home was less than the financing costs, even with the funky financing methods used.

Now we are in a temporarily self-reinforcing cycle down.? Where will it end? When people with excess equity capital look at housing and say that they can tuck it away for a rainy day with little borrowing.? The cash on cash yields will be compelling.? We’re not there yet.

Along with that, a whole cast of characters get greedy and then fearful, with the timing closely correlated.? Regulators, appraisers, investment bankers, loan underwriters, etc., all were subject to the boom-bust cycle.

Expectations are the key here.? We have to measure the expectations of all parties, and ask how that affects the system as a whole.

In The Alchemy of Finance, Soros goes through how reflexivity applied to the Lesser Developed Country lending, currency trading, equities, including the crash in 1987, and credit cycles generally.? He gives a detailed description of how his theories worked in 1985-6.? He also gives you some of his political theorizing, but that’s just a small price to pay for the overall wisdom there.

Now, Soros on Soros is a series of edited interviews.? The advantage is that the interviewers structure the questioning, and forces more clarity than in The Alchemy of Finance.? The drawback (or benefit) is that the book is more basic, and ventures off into non-economic areas even more than The Alchemy of Finance.? That said, he shows some prescience on derivatives (though it took a long time to get to the promised troubles), though he missed on the possibility of European disintegration.

On the whole, Soros on Soros is the simpler read, and it reveals more of the man; the Alchemy of Finance is a little harder, but focuses more on the rationality within boom/bust cycles, and how one can profit from them.

Full disclosure: if you buy through any of the links here I get a small commission.

Mark-to-Market Accounting Is not the Major Problem

Mark-to-Market Accounting Is not the Major Problem

Posted on by David Merkel

I?m not a fan of mark-to-market accounting, partially due to the loss of comparability across firms. It introduces a level of flexibility that can be gamed by the unscrupulous. That said, any accounting method can be gamed. Accounting attempts to assign the value of economic activity at and across points in time.

Now, with financial firms, there are typically several accounting bases going on at the same time. There?s GAAP, Regulatory, Tax, and then the accounting for special agreements, which may be different than any of the three major accounting bases.

Why has mark-to-market come up as an issue recently? Because it has seemingly created downside volatility in the financial statements, leading investors to panic, which pushes down security prices.

In my opinion, the greater problems are how a firm finances itself, how it is regulated, and negative optionality in its assets and positive optionality in its liabilities. I?ll give some examples to illustrate:

With Thornburg, the problem was over-reliance on short-term lending to finance long term assets. It doesn?t matter how you do the GAAP accounting here. The brokers will look at the day-to-day market value of the positions versus the capital supporting them. If the capital becomes insufficient to carry the position, the positions will be liquidated. Given that there were a lot of players with similar trades, and funding in the repo market, that created an ideal setup for the most levered to lose a lot as financing dried up.

Bear Stearns also relied on short-term financing. Bear ran with high leverage that made them vulnerable to attacks from those that bought credit protection in the credit default swap market? as those spreads went up, the willingness to extend credit went down. Ratings downgrades pushed up, and in some cases eliminated the willingness of lenders to extend short term credit. (Bear also lacked friends to help them in their time of need, a payoff for not helping on LTCM. Lehman had similar leverage, but the Street supports it.) Also, derivative agreements often specify a need for more collateral if downgrades occur, which is exactly the wrong time to have to provide more collateral. Again, this has nothing to do with GAAP accounting, but it has a lot to do with positive optionality in the liabilities of the firm. (I.e., the liability can get more onerous under conditions of stress.)

Consider PXRE, which recently merged with Argonaut Group. When the storms of 2005 hit, they claims against them were bad enough, but many of their reinsurance agreements had downgrade clauses, saying they would have to post collateral. Though it didn?t bankrupt them, it could have, and they had to find a buyer. Nothing to do with GAAP accounting.

General American wrote a bunch of floating rate Guaranteed Investment Contracts that had 7-day put provisions after a ratings downgrade. They wrote so much of them, that they comprised 25% of their liability structure. When they got downgraded, they could not meet the call on liquidity. They wen insolvent. Nothing to do with GAAP accounting.

CIT got downgraded and drew down their revolver because of a liquidity shortfall. The stock has fallen more then 80% in the past year. Mark-to-market accounting to blame? No, deteriorating assets and too much short-term financing.

I could go on. Regulators are under no obligation to use mark-to-market accounting, and they can set capital levels as they please. Optimally, regulators should look at risk based liquidity. How likely is it that a financial firm will have adequate liquidity in all circumstances? How safe and liquid are the assets? Is the liability structure long enough to support them? Can the liability structure dramatically shorten? (I.e., a run on the bank.)

Deterioration in the value of assets has to be addressed by accounting somehow. But regardless of the method, those that finance the company will look beyond the published GAAP financials, and will look at the cash generation capacity of the firm over the life of the loan, and how prone to change that could be. Even if a firm could take an asset worth 80 cents and mark it at $1.00, the sophisticated lenders would only assign 80 cents of value.

Along with The Analyst?s Accounting Observer, I don?t see mark-to-market accounting as a major threat to the solvency of firms. The companies that have gotten into trouble recently have held assets of dubious quality, and have financed themselves with too much leverage, borrowing short-term, and/or implicitly sold short options against their firms that weakened themselves during a crisis. Dodgy assets and liquid liabilities are poisonous to any firm, regardless of the accounting method.

Fifteen Notes on the Credit Markets (and other markets)

Fifteen Notes on the Credit Markets (and other markets)

Posted on by David Merkel

1)? A number of blogs pointed to this piece by Howard Marks of Oaktree, and I thought it was very well-thought out for the most part.? There are few people who think about history in the markets; they just follow present trends.? Learning how to see unsustainable trends and avoiding them not only reduces risk, but enhances long-term return.

2) Crisis!? Choose how you want to view it:

3) Tony Crescenzi sounds an optimistic note on the short-term lending markets.? His opinion should be taken seriously.? The money markets are a specialty of his.

4) To err is human, but to really mess things up, you need derivatives.? With Bear Stearns, different parties have different incentives regarding the firm.? Senior bondholders and derivative counterparties owed money by Bear are much, much larger than the teensy equity base of the small-cap firm.? It is my guess that they are protecting their interests by buying stock at prices over the terms of the deal.? They want the deal to go through.

5) How are the European investment banks?? My guess is that they have greater accounting flexibility, and things are better than US investment banks, but worse than currently illustrated.

6) Save our markets by risking our national credit?? I’m skeptical of many government solutions that bail out the markets, including those the Fed is pursuing.? Same for the GSEs… it seems like a free lunch to allow the GSEs to lever up further, but the losses are growing at Fannie and Freddie from all of the guarantees that they have written.? The US government backstops the whole thing implicitly, but even the capacity of the US government to fund these bailout schemes is limited.? Calling Fitch! — you often have more guts (or less to lose) than S&P and Moody’s.? Let’s have a shot across the bow, and downgrade the US to AA+.

7) Are mortgage rates finally falling?? I guess if the expectations of Fed policy get low enough, it will overcome the increase in swaption volatility.? Then again, PIMCO, Fannie, Freddie, and many others are buying prime mortgage paper again.

8 ) Thornburg, alas.? Dilution and more dilution, in order to survive.? (That could be the fate of many financial and mortgage insurers.)? Misfinancing in the midst of a crisis gives way to a need for equity that kills existing shareholders.

9) In terms of actual losses, Commercial Real Estate lending is not in as bad of a shape as residential lending.? That said, it’s not in great shape and the market is slowing dramatically.? What lending market is in good shape today? 🙁 We overlevered every debt market that we could…

10) When actual stock price volatility gets high, that is typically a sign of a bear market.? When it actual volatility peaks, that is often a sign of an intermediate term bottom.

11) Finally, an article on ETNs that mentions credit risk, if briefly.? Be wary of ETNs, they are obligations of investment banks, most of which have high credit spreads that you are not being compensated for in the ETNs.

12) Give the guys at Dexia some credit for being opportunistic during the crisis of financial guarantors… they had the balance sheet, conservative posture, and the team ready to take advantage of the dislocation in their subsidiary FSA.

13) Someone tell me otherwise if I am wrong, but I am not worried about the assets in my brokerage account.? In a crisis, there is SIPC and excess insurance.? Brokerages are prohibited from commingling client assets, and even if their are delivery failures from securities lending, those issues are solvable, given time and the insurance.

14) I worry about inflation in the US, because it is a global problem.? As the dollar declines, it slows foreign economies because they can’t export as much, and it raises prices here because imports cost more.

15)? This is an article that is just too early.? So the markets have rallied, and commodities have fallen?? It’s only one week, and that is no horizon over which to make the judgment that Fed policy is succeeding.? Look at it in 9-12 months, and then maybe we can hazard a good guess.

Another Dozen Notes on Our Manic-Depressive Credit Markets

Another Dozen Notes on Our Manic-Depressive Credit Markets

Posted on by David Merkel

This is what I sometimes call a “Great Garbage Post.”? I’ll cover a lot of ground, so bear with me.

1) How to do a bank/financial bailout: a) wipe out common and preferred equity and the subordinated debt (and offer some warrants to the debtholders).? Make the senior debt take a haircut of 50% (and offer warrants), and the bank debt a haircut of 20% (and offer warrants). Capital is offered in exchange for the equity interest, together with some senior financing pari passu with the banks.? If the management and other stakeholders do not like those terms (or something like them), then don’t bail them out.

Now, realize I’m not crazy about “lender of last resort” powers being in the hands of the government, but if we’re going to do that, you may as well do it right, and bail out depositors in full, while having others take modest to large haircuts.? There is no reason why the government/Federal Reserve should bail out common or preferred equityholders, and those that bought risky debt should pay part of the price as well.? This should only be done for institutions where significant contagion effects could affect other financial institutions.? The objective is to create a firewall for depositors, and the rest of the financial system.

2)? Bear Stearns.? Ugh, a bank run.? A testimony to leverage.? Book value is only fair if one can realize the value over time.? High leverage implies a haircut to book value in bad times, because the value of the assets can go down dramatically.? Will they get a buyer?? I don’t know, and I wouldn’t trust JC Flowers.? If what Jamie Dimon might be thinking is what the Bloomberg article states, then I think he has the right idea: keep the best businesses, dissolve the rest.

But remember, during crises, highly levered financial institutions are vulnerable, unless most of their financing is locked in long-term.? Most investment banks don’t fit that description, particularly with all of the synthetic leverage in their derivative books.

3) The downgrades on commercial bank credit ratings will continue to come, particularly for those that were too aggressive in lending to overlevered situations, e.g., home equity lending.? Home equity lending is very profitable in good times, but then it gets overcompetititive, and underwriting standards deteriorate.? Then a lot of money gets lost, as in 1998, where most of the main lenders went under.? In this case, most of the lenders are banks, and they aren’t concentrated in that line alone.

4)? Home builders are taking it on the chin.? Consider this article about joint venture failures of homebuilders.? It is my guess that we will see a few of the major homebuilders fail.? It will take us to 2010 to reconcile all of the excess inventory.? Personally, I would guess that the stable home ownership rate is still below the current level by maybe 2% of the households.? We tried to force homeownership on people that were not ready for it, people who didn’t have enough financial slack to make it through even a slight recession.

5) I find it amusing that Bob Rubin, the only guy in the Clinton Administration that I liked, says that few people anticipated this bubble. (Sounds like Greenspan, huh?)? Well, in a sense he’s right.? Probably fewer than 1% of Americans anticipated these results, but there were enough writers in the blogosphere that were saying that something like this would come (including me), that some could take warning.? As in the tech bubble, there were a number of notable commentators warning, but no one listens during the self-reinforcing cycle of the boom.

6) I am sticking with a 50-75 basis point move from the Fed in the coming week.? They want to move aggressively, but they don’t want to use up all of their conventional ammo, when they are so close to the “zero bound.”? They might disappoint the markets, but not on purpose.? They will tend to follow what the markets suggest.

7) This Fed is more willing to try novel solutions than in the Greenspan era.? Even so, I expect them to run into constraints on their ability to deal with the crisis, which will force the Treasury Department (yes, even in the Bush Administration) to act.

8)? The glory of “core inflation” is not that it excludes the most volatile classes of goods, but the ones for which there is the most excess demand.? Food price inflation is running.? Farmers can’t keep up with the demand.? Poetic justice for the hard-working farmers of our country, who have had more than their share of hard years.? Agriculture is one of the industries that makes America great.? Let the rest of the world benefit from our productivity there.

9)? This is one of those times where one can get a “pit in the stomach” from considering the possibilities from a financial crisis.? As leverage dries up, those with the most leverage on overvalued asset classes get margin calls, leading to forced liquidations.? As it stands now, many credit hedge funds are finding it difficult to maintain their leverage levels, and other hedge funds are finding their lending lines reduced.? This forces a reduction in speculation, and the prices of speculative assets.

10)? Be careful using the ABX indices.? They are too easy to short, and do not represent the values that are likely to be realized in the cash markets.? The same is true of the CMBX indices.? This would lead me to be a bull, selectively, in AAA CMBS, after careful analysis of the underlying collateral.? (CMBS was a specialty of minewhen I was a mortgage bond manager.)

11)? Two interesting articles on character and capitalism.? This is a topic that I havea lot to say about, but every time I sit down to write about it, I am not satisfied with the results.? Let me make a down payment on an article here.? Capitalism is good, but Capitalists often abuse it.? Short-sighted capitalists play for short-term advantage, and end up burning up relationships.? Longer-term capitalists play fair, because they not only want deal one, but deals two, three, four, etc.? They play fair because they will do better in the long run, even if they are intelligent pagans.? (Christians should play fair anyway, because their Father in heaven looks at their deeds.? If we love Him, we will please Him.)

Economics isn’t everything.? Smart businessmen know that a good reputation is golden.? They also know that happy employees are more productive.? Suppliers that get paid on time are more loyal.? These are the benefits of ethical, long-run thinking.

12) In closing, a poke at quantitative analysis done badly.? Consider Paul Wilmott, or William Shadwick.? With bosses over the years, often they would ask me a seemingly simple quantitative question, and I would reply, “Here’s the standard answer: XXXXX.? But there are many reasons why that answer could be wrong, because the math makes too many assumptions about market liquidity, investor rationality, soundness of funding sources, etc.”? Most quants don’t know what they are assuming.? They are too good with the math, and not good enough at the human systems that inadequately lie behind the math.

As a quantitative analyst, I have generally been a skeptic.? At times like this, when the assumptions are breaking down, it gives me a bit of validation to see the shortfall.? That said, it’s no fun to be right when you are losing money, even if it is less than others are losing.

One Dozen Notes on Our Crazy Credit Markets

One Dozen Notes on Our Crazy Credit Markets

Posted on by David Merkel

1) I typically don’t comment on whether we are in a recession or not, because I don’t think that it is relevant. I would rather look at industry performance separate from the performance of the US economy, because the world is more integrated than it used to be. Energy, Basic Materials, and Industrials are hot. Financials are in trouble, excluding life and P&C insurers. Retail and Consumer Discretionary are soft. What is levered to US demand is not doing so well, but what is demanded globally is doing well. Much of the developed world has over-leverage problems. Isn’t that a richer view than trying to analyze whether the US will have two consecutive quarters of negative real GDP growth?

2) So Moody’s is moving Munis to the same scale as corporates? Well, good, but don’t expect yields to change much. The muni market is dominated by buyers that knew that the muni ratings were overly tough, and they priced for it accordingly. The same is true of the structured product markets, where the ratings were too liberal… sophisticated investors knew about the liberality, which is why spreads were wider there than for corporates.

3) Back to the voting machine versus the weighing machine a la Ben Graham. It is much easier to short credit via CDS, than to borrow bonds and sell them. There is a cost, though. The CDS often trade at considerably wider spreads than the cash bonds. It’s not as if the cash bond owners are dumb; they are probably a better reflection of the true expectation of default losses, because they cannot be traded as easily. Once the notional amount of CDS trading versus cash bonds gets up to a certain multiple, the technicals of the CDS trading decouple from the underlying economics of the bond, whether the bond stays current or defaults. In a default, often the need to buy a bond to deliver pushes the price of a defaulted bond above its intrinsic value. Since so many purchased insurance versus the true need for insurance, this is no surprise.. it’s not much different than overcapacity in the insurance industry.

4) If you want a quick summary of the troubles in the residential mortgage market, look no further than the The Lehman Brothers Short Swaption Volatility Index. The panic level for short term options on swaps is above where it was for LTCM, and the credit troubles of 2002. What a take-off in seven months, huh?

LBSOX

5) Found a bunch of neat charts on the mortgage mess over at the WSJ website.

6) I have always disliked the concept of core inflation. Now that food and fuel are the main drivers of inflation, can we quietly bury the concept? As I have pointed out before, it doesn’t do well at predicting the unadjusted CPI. Oh, and here’s a fresh post from Naked Capitalism on the topic of understating inflation. Makes my article at RealMoney on understating inflation look positively tame.

7) The rating agencies play games, but so do the companies that are rated. MBIA doesn’t want to be downgraded by Fitch, so they ask that their rating be withdrawn. Well, tough. Fitch won’t give up that easily. Personally, I like it when the rating agencies fight back.

8 ) Jim Cramer asks if Bank of America will abandon Countrywide, and concludes that they will abandon the bid. Personally, I think it would be wise to abandon the bid, but large companies like Bank of America sometimes don’t move rapidly enough. At this point, it would be cheaper to buy another smaller mortgage company, and then grow it rapidly when the housing market bounces back in 2010.

9) Writing for RealMoney 2004-2006, I wasted a certain amount of space talking about home equity loans, and how they would be another big problem for the banking system. Well, we are there now. No surprise; shouldn’t we have expected second liens to have come under stress, when first liens are so stressed?

10) In crises, hedge funds and mortgage REITs financed by short-term repo financing are unstable. No surprise that we are seeing an uptick in failures.

11) As I have stated before, I am not surprised that there is more talk of abandoning currency pegs to the US dollar. That said, it is a getting dragged kicking and screaming type of phenomenon. Countries get used to pegs, because it makes life easy for policymakers. But when inflation or deflation gets to be odious, eventually they make the move. Much of the world pegged to the US dollar is importing our inflationary monetary policy.

12) Finally, something that leaves me a little sad, people using their 401(k)s to stay current on their mortgages. You can see that they love their homes, as they are giving up an asset that is protected in bankruptcy, to fund an asset that is not protected (in most states). Personally, I would give up the home, and go rent, and save my pension money, but to each his own here.

“The Unwind”

“The Unwind”

Posted on by David Merkel

I invest like a moderate bull and I reason like a moderate bear.? Why?? In general, in free economies, the equity markets favor the bulls over long periods of time.? So, I stay invested in equities in almost all markets, and let my other risk reduction techniques do my work, rather than making large changes in asset allocation.? That said, I appreciate the risks that the markets have been throwing off lately, and I am somewhat worried.

I have been a bear on residential housing and residential housing finance for the last four years.? I expected that those that took a lot of credit risk — subprime, Alt-A mezzanine and subordinates, would get hurt.? What has surprised me, though, is the degree to which AAA whole loan collateral and agency loan collateral has been hurt.? I failed to see the amount of leverage being employed there.? I looked at that area and said, “You can lever this stuff 10x, and you probably won’t get hurt if you are smart.”? Fine if 10x is the limit, but you had players at over 30x, and now you have that paper being tossed back into the market, depressing prices, and raising yields.? This raises the risk of a self-reinforcing move that will only end when unlevered and lightly levered buyers soak up the high yielding safe assets that couldn’t find a home elsewhere.

Any asset can be overlevered. ? A house, a home loan, a corporation… there is some level of debt that will kill the owner of a given asset.? High quality mortgage paper got overlevered, and even though current market prices are attractive to unlevered buyers, there is the short-term risk that more players will be forced to delever.? So when is the right time to buy?

I have agonized on this one, because the problem is short-term financing.? Repo financing from brokers that have their own balance sheet worries.? (Note: some are talking about mark-to-market accounting — yes, that has a small effect here, but not as large as the financing issue.)? Repo financing is short-term collateralized lending.? 97% of the value of the agency loan collateral gets loaned, with 100% of the agency loan collateral as security.? If collateral prices move down, more margin must be posted. This is an unforgiving situation.? If you can’t meet the margin call (demand for more funds to support a losing position), your collateral will be liquidated.? (There also issues in how one hedges, but that is for another time.)

When to buy?? Most repo funding is short — a day to a week.? Some extends over 30-90 days, and Annaly uses 1-3 year repo financing (where do you get that?).? My sense is this: wait for two weeks after you hear of any major fund liquidation, and commit half a position.? After another two weeks, commit the other half, if no further liquidations have been heard.

At my last firm, I would talk with my boss about “The Unwind.”? All of the areas of the credit market where ordinary prudence was being ignored, and in the short run, leverage was increasing, because is paid to do so in a rising market.? Eventually, asset cash flow would prove insufficient to finance the interest costs, and then “The Unwind” would happen.? Leverage would have to come out of the system, both from explicit loans and from derivative contracts.

We are in “The Unwind” now.? Leverage is coming out, even in asset classes that I did not anticipate.? “The Unwind” will end when players with strong balance sheets hold most of the previously overlevered assets.

What Should the Spread on a Corporate Bond Be?

What Should the Spread on a Corporate Bond Be?

Posted on by David Merkel

Suppose we had seven guys in the room, an economist, a guy from a ratings agency, an actuary, a guy who does capital structure arbitrage, a derivatives trader, A CDO manager, and a guy who does nonlinear dynamic modeling, and we asked them what the spread on a corporate bond should be.

  • The economist might say whatever spread it trades at at any given moment is the right spread; no one can foretell the future.
  • The guy from the ratings agency would scratch his head, tell you spreads aren’t his job, but then volunteers that spreads are correlated with bond credit ratings on average.
  • The actuary might say that you estimate the default loss rate over the life of the bond, and the required incremental yield that the marginal holder of the bond needs to fund the incremental capital employed. Add those two spreads together, and that is what the spread should be.
  • The capital structure arb would say that he would view the bondholders as short a put from the equityholders, estimate the value of that option using the stock price, equity option implied volatility, and capital structure, and would back into the spread using that data. Higher implied volatility, higher leverage, and lower stock prices lead to higher spreads.
  • The derivatives trader would say, “Look, I sit next to the cash trader. After adjusting for a deliverability option, if cash is sufficiently cheap to to the credit default swap spread, we buy the bond and receive protection through CDS. Vice-versa if the cash bond is sufficiently rich. In general, the bond spread should be near the CDS spread.”
  • The CDO manager would say that it depends on the amount of leverage he and his competitors can employ in buying bonds for his deals, and how dearly he can sell his equity and subordinate tranches.
  • The guy into nonlinear dynamics says, “This is not a good question. There are multiple players in the market with differing goals, funding structures, and regulatory constraints. All of my friends here have the right answer under certain conditions… but at any given point in the market, each has differing levels of influence.”

After we tell the guy into nonlinear dynamics that he didn’t answer the question, he says, “Fine. Look at the high yield market today. Why were spreads so low nine months ago, and so high now? Did likely default costs have something to do with it? Yes, a sophisticated actuarial model would have looked at the quality of originations and seasoning, and would conclude that default costs would rise. But spreads have moved out far more than that. Have costs of holding high yield debt risen? Capital charges have risen as more downgrades have happened, and as anticipated. That’s still not enough. The loss of the bid for high yield bonds from CDOs is significant, but that is still not enough. As the credit cycle turns down, who is willing to make a bid? Who has the spare capital, and the guts to say, ‘This is the right time.’ Even if it will turn out all right in the end (the actuarial argument), I could lose my job, or get a lower bonus if I don’t time my purchases right. Hey, Actuary, do you want to increase your allocation to high yield at these levels?”

Actuary: “The ratings agencies have told us we only have limited room to do that. Besides, our CIO is a ‘fraidy cat; he wants his bonus in 2008. But in theory it would make sense to do so; we have a long liability structure. We should do it, but there are institutional constraints that fight the correct long-term decision.”

Nonlinear Dynamics Guy: “Okay, then, who does want to take more credit risk here?”

Derivatives Trader: “We are always net flat.”

CDO manager: “Can’t kick a deal out the door.”

Capital Structure Arb: “We’re doing a little more here, but our credit lines aren’t big. Some friends of mine that run credit hedge funds are finding that they can’t lever up as much during the crisis.”

The economist and the guy from the rating agency give blank stares. The Nonlinear Dynamics Guy says, “Look, high yield buyers took too much risk in the past, and now their ability to buy is impaired by increasing capital charges, and unwillingness to resist momentum. Now levered buyers of high yield credit have been killed, and there is excess supply at current levels. Rationality will return when unlevered and lightly levered buyers, or buyers with long liability structures (looks at the actuary) hold their nose, and step up and buy with real money, not short term debt.”

The actuary nods, and makes a mental note to discuss the idea with the CIO of the life insurance company. The economist and ratings agency guy both shrug. The CDO manager asks how long it will be before he can do his next deal. No one answers. The derivatives trader says “Whatever, I make my money in all markets” and the capital structure arb smiles and nods.

Nonlinear Dynamics Guy [NDG] says to the latter two, “Good for you. But what if your financing gets pulled? Many places are finding they can’t borrow as easily as they used to.” The two of them blink, grimace, and say “Our lines won’t get pulled.” Nonlinear Dynamics Guy says, “Have it your way. I hope you all do well.” At that the actuary smiles, and asks if NDG would be willing to speak at the next Society of Actuaries meeting. NDG hands him his card, and says, “Let’s talk about it later. Who knows, by the time of your meeting, things could be very different.”

On Information Cascades and Lemmings

On Information Cascades and Lemmings

Posted on by David Merkel

I’ve never been comfortable with the concept of rationality in economics, at least, if rationality is defined as maximizing or minimizing a certain function, largely because maximizing and minimizing take effort, and people avoid effort (it is a bad not a good).? So when I read jive about information cascades, I roll my eyes.? Don’t get me wrong, I like Dr. Schiller; he’s a clever guy.? What is meant by information cascades is a sudden acknowledgment of things that were obvious, but ignored, because economic actors decided to follow the crowd.

Now, in the equity markets, momentum players can make money, but they have to cut their losses, and not stay at the game too long on any individual stock that is falling.? Houses are far less liquid than stocks, so the threshold to act is that much higher, plus for those that have mortgages, the leverage magnifies the pain when prices fall.? Thus people delay acting, and when they act, because a pain threshold has been crossed, they act all at once.

Is this an “information cascade?”? I think not.? It is more akin to “gunning the stops” in an equity market.? As prices fall, more people decide to sell to preserve some value, and prices go down more than anticipated.? It is not so much a question of information, but fear that drives the trade.

Information takes a different form.? Those who analyze their borrowings such that they know that it is unlikely that they will ever be forced to sell have genuine information.? They have sized their borrowings appropriately.? They are relying on the table model of stability, rather than the bicycle model (stable so long as you keep moving).

We don’t get dramatic moves in markets from information cascades, but from levered borrowers that are forced to sell for one reason or another.? These are borrowers that lacked information.? They became “informed” because of price moves that they did not anticipate.

Ten Items — Saturday Evening Hodgepodge

Ten Items — Saturday Evening Hodgepodge

Posted on by David Merkel

There are times where I feel the intellectual well is dry, and I come to my keyboard and say, “What do I write tonight?” This is not one of those times. I have too many things to write about, and not enough time. I’ll see how much I can say that is worth reading.

1) Jimmy Rogers (I?ve met him once ? a nice guy) tends toward the sensational. There is a grain of truth in what he says, but the demographic situation in China is worse than that in Japan, which is why they Communist leadership there is considering eliminating the one-child policy:

I gave a talk last October, which included a lot on the effects of demographics on the global economy:

http://alephblog.com/society-of-actuaries-presentation/ (pages 15-23) (non-PDF versions have my lecture notes)

Now, eliminating the one-child policy won?t do that much, because most non-religious women in China don?t want to have kids. In developed societies, once women don?t want children or marriage, no level of economic incentive succeeds in changing their minds.

This isn?t meant to be social commentary. The point is that there is a global demographic shift of massive proportions happening where there will be huge social pressures on retirement/eldercare systems, because the ratio of workers to retirees will fall globally. China will be affected more than most, and the US less than most (if we can straighten out Medicare).

The economic effect will feel a little stagflationary, with wage rates improving in nominal terms, taxes rising to cover transfer payments, and assets being sold (to whom?) to fund retirements and healthcare. There need not be a crisis, like a war over resources, in all of this, but it won?t be an easy next 30 years. One thing for certain, when you look at labor, capital, and resources at present, the scarcest of all is resources. Again, resource price inflation. At present, capital is scarcer than labor, but that will flip in the next 30 years.

2) A few e-mailers asked for more data on how I view monetary aggregates. On monetary aggregates, my view of it is a little different than most, and I take a little heat for it. Ideally, the lower level monetary aggregates indicate a higher degree of liquidity; greater ease and shorter time of achieving transactions. The other way to view it is how sticky the liability structure is for the banks. Demand deposits, not sticky. Savings accounts, stickier. Money market funds, stickier still. CDs, even stickier.

As the Fed changes monetary policy, there are tradeoffs. Willingness of the public to hold cash, versus opportunity at the banks to make money from borrowing short and lending longer, versus banking regulators trying to assure solvency.

That’s why I look at the full spectrum of monetary measures. They tell a greater story as a group.

3) No such thing as a bad asset, only a bad price? No such thing as a bad asset, only a mis-financed asset? Both can be true. What we are experiencing today in many markets is that many assets were financed with too much debt and too little equity. In the process, because of the over-leverage allowed for high returns on equity to be generated from low returns on assets, the buyers of risky assets overpaid for their interests.

This has taken many forms, whether it was Subprime ABS, CDOs, SIVs, Tender Option Bonds, the correlation trade, etc. Also the borrow short, lend long inherent in Auction Rate Securities, TOBs, and other speculations that make wondeful sense occasionally, but players stay too long.

Rationality comes back to these markets when “real money buyers” appear (pension plans, insurance companies, wealthy dudes with nose for value), and these non-traditional buyers soak up the excess supply of investments that are out of favor, and do it with equity, at prices that make the unlevered return look pretty sweet. This is how excess leverage gets purged from the system, and how pricing normalizes, with losses delivered to the overlevered.

4) As I said in my post last night, there is value in the tax-free muni market for non-traditional buyers. Is this the bottom? Probably not, but who can tell? Smart buyers will put a portion of a full position on now, and add if things get worse. Don’t put a full position on yet. I eschew heroism in trading, in favor of a risk-controlled style, where one makes more on average, but protects the downside. It is possible that the drop in prices will bring out more sellers, but I think that there will be more buyers in the next week. That said, the leveraged buyers need to get purged out of the muni markets.

5) In late 2004, I wrote a piece called Default Cycle Will Turn Nasty in 2007. Later I added the following comment:


 David Merkel
A Low Quality Post by David
3/27/2006 3:54 PM EST

Interesting to note on Barry’s blog that he has noted that the “low quality” trade has been so stunning over the past three years. I thought Richard Bernstein at Merrill and I were the only ones who cared about this stuff. But now for the bad news: the trade won’t be over until high yield spreads start blowing out, and presently, they show no sign of doing that. Why? There haven’t been many defaults, for one reason. The few defaults have been for the most part in auto parts and airlines. There’s no systemic panic.

Beyond that, there’s a lot of capital to finance speculative ventures, and to catch bad ones when they fall. That means that marginal ideas are getting forgiveness as they get refinanced.

The demand for yield is huge, which drives the offering of protection in the credit default swap market. Fund of funds encourage hedge funds to seek steady income, which makes them tend to be insurers against default risk, rather than speculators on possible default.

I know that I wrote “Default Cycle Will Turn Nasty in 2007;” I take my calls seriously, because I have money on the line, and many of you do too. I think the low quality trade, absent a market blow-up, won’t outperform by a lot in 2006, but will still outperform. Something needs to happen to make credit spreads not look like a free lunch.

My best guess of what will do that is the seasoning of aggressive corporate bond issuance in 2004 and 2005. Bad credit be revealed for what it is, and even the stocks of low quality companies that eventually survive will get marked down for a time, as strong balance sheets get rewarded once again.

Position: none

Then later, in early 2007, I wrote: I was wrong on underperformance of junk bonds. Tight levels got even tighter, with an absence of significant defaults. Junk bonds led the bond market in 2006. In 2007, I don’t expect a repeat, but I do expect defaults to start rising by the end of 2007, leading to a widening in spreads and some underperformance of junk bonds. The real fun will come in 2008-2009. Corporate credit cycles last four to seven years, and the last bear phase was 2000-2002. We’re due for a correction here.

Well, I got it close to right. Timing is tough.

6) Would you pay a high enough price to buy a short-dated TIPS with a negative real yield? Yes you might, if you were hedging against nominal Treasuries, with the CPI running ahead at 4%, and short-dated (5 years and in) nominal bonds at 2 1/2% and lower. As it is, the market seems to be hesitating at going negative, but in my opinion it will, until the concern of the FOMC changes to price inflation.

7) Wilbur Ross didn’t get rich by being dumb. He didn’t buy stakes in MBIA or Ambac, but in one of the two healthy firms, Assured Guaranty. Better to take a stake in the healthy firm in a tough market; they will survive, and write the business that their impaired competitors can’t. This just puts more pressure on MBIA and Ambac, and provides a lower cost muni insurance competitor to Berky.

8 ) MBIA and Ambac are playing for time, and I don’t mean that in a bad way. They are willing to shrink their balance sheets, and write little if any structured business, pay principal and interest in dribs and drabs, and pray that S&P and Moody’s give them the time to do this, and keep the AAA/Aaa intact. It could be three years, and stronger players (FSA, BHAC, AGO) will absorb their non-structured markets. But it could work. If I were Bill Ackman, I would take off half my positions here. Just a rule of thumb for me, when I am managing institutional assets and I become uncertain as to whether I should buy or sell, I do half, and then wait for more data.

Remember, many P&C insurers have been technically insolvent (in hindsight) during the bear phase of the underwriting cycle. They survived by writing better business when their balance sheet was in worse shape than commonly believed. The financial guarantors have a unique ability to wait out losses.

9) There have been all sorts of articles asking whether XXX institution is “too big to fail?” Well, let me “flip it” (sending my pal Cody a nickel for his trademark 😉 ) and ask, “Is the US too big to fail?” There’s a reason for my madness here. “Too big to fail” means that the government will bail out an entity to avoid a systemic crisis. Nice, maybe, but that means the government raises taxes to do so (nah) or issues debt that the Fed monetizes, leading to price inflation. Either way, the loss gets spread over the whole country.

What would a failure of the US look like? The Great Depression springs to mind. Present day Japan does not. They are not growing, but they aren’t in bad shape. Another failure would be an era like the 1970s, but more intense. That’s not impossible, if the Treasury Fed were to rescue a major GSE via monetary policy.

10) I have had an excellent 4Q07 earnings season. As of the end of February, I am still in the plus column for my equity portfolio. But, into every life a little rain must fall… after the close on Friday. 🙁 Deerfield Capital reported lousy GAAP earnings, and I expect the price to fall on Monday. Now, to their credit:

  • They reduced leverage proactively, and sold Alt-A assets before Thornburg blew.
  • They moved to a more conservative balance sheet. It is usually a good sign when a company sells its bad assets in a crisis.

I would expect the dividend to fall to around 30 cents per quarter. I should have more to say after the earnings call. They are becoming a little Annaly with a CDO manager on board (might not be worth much until 2010).

I may be a buyer on Monday. Depends on the market action.

That’s all for this evening. Good night, and here’s to a more profitable week next week.

Full disclosure: long DFR

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