Structured Products and Derivatives – Page 39

The Boom-Bust Cycle, Applied to Many Markets

Posted on 7 February 2008 by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Players who are scared.
Players who have no choice.

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

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

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

Time to Begin Increasing Credit Risk Exposure

Posted on 31 January 2008 by David Merkel

Ugh, today was a busy day.? My views of the FOMC were validated as to what they would do and say, though I was wrong on the stock market direction on a 50 bp cut.? The bond market direction I got right.

Look at this post from Bespoke.? Ignore the percentage increase, and just look at the raw spread levels.? Better, add an additional 3%+ (for the average Treasury yield) to the current 685 spread, for a roughly 10% yield.? When you get to 10% yields, the odds tip in your favor on high yield.? That said, today’s crop of high yield corporate debt is lower rated than in the past.? Don’t go hog wild here, but begin to take a little more risk.? I was pretty minimal in terms of credit risk exposure for the last three years, owning only a? few bank loan funds, the last of which I traded out of in June 2007.

With fixed income investing, if I have a broad mandate, I start by asking a few simple questions:

For which of the following risks am I being adequately rewarded?? Illiquidity, Credit/Equity, Negative Convexity (residential mortgages), Duration, Sovereign, Complexity, Taint, Foreign Exchange…
What are my client’s tax needs?
How much volatility is my client willing to tolerate?
How unconventional can I be without losing him as a client?
What optical risks does he face from regulators and rating agencies, if any?

One of my rules of thumb is that if none of the other risks are offering adequate reward, then it is time to increase foreign bond positions.? That is where I have been for the past three years, and now it is time to adjust that position.? With respect to the list of risks:

Illiquidity: indeterminate, depends on the situation
Credit/Equity: begin adding, but keep some powder dry
Negative Convexity: attractive to add to prime RMBS positions at present.
Duration: Avoid.? Yield curve will widen, and absent another Great Depression, long yields will not fall much from here.
Sovereign Risks: Avoid.? You’re not getting paid for it here.
Complexity/Taint:? Selectively add to bonds that you have done due diligence on, that others don’t understand well, even if mark-to-market may go against you in the short run.
FX: Neutral.? Maintain core positions in the Swiss Franc and the Yen for now.? Be prepared to switch to high-yield currencies when conditions favor risk-taking.

That’s where I stand now.? The biggest changes are on credit risk and FX.? That’s a big shift for me.? If you remember an early post of mine, Yield = Poison, you will know that I am willing to have controversial views.? Also, for those that have read me here and at RealMoney.com, you will know that I don’t change my views often.? I’m not trying to catch small moves.? Instead, I want to average into troughs before they hit bottom.? If you wait for the bottom, there will not be enough liquidity to implement the change in view.

Living in the Shadow of the Great Depression

Posted on 24 January 2008 by David Merkel

Don’t we wipe the slate clean after two generations or so?? Or, as my old boss used to say, and he is looking smarter by the day, “We don’t repeat the mistakes of our parents; we repeat the mistakes of our grandparents.”? Our monetary policy is being guided by fear of repeating the Great Depression.? We may avoid that, and end? up with two lost decades, like Japan.? (it would fit the demographic trends…)? Or, maybe, the FOMC will ignore (or suppress the knowledge of) inflation, and bring us back to an era reminiscent of the 1970s.? Either way, we may face stagnation, but defaults are fewer in a 1970s scenario, though those on fixed incomes get hurt worse.

Don’t get me wrong.? I’m not blaming Bernanke and the current FOMC much; the blame really rests with Greenspan, and the political culture that can’t take recessions, so monetary policy must bail us out.? Consistently followed, it eventually leads us into a liquidity trap, or an inflationary era, or both.

Recessions are good for the economy; they clear away past imbalances.? We should have been accepting them to a greater degree over the past 25 years.? But now things are tougher, and most policy actions will lead to suboptimal results.? Personally, if the FOMC could resist the political pressure, leaving Fed funds on hold at 3.0-3.5% would produce an adequate result 2 years out, with some increase in inflation, but allowing the banks to reconcile their bad loans.

The fear is that the FOMC will drop rates to Japan-like levels in order to avoid a Great Depression-style scenario, and create the Japan scenario as a result.? My guess is that we would get more inflation than Japan, and not be able to do that.? We are a debtor nation, versus Japan as a creditor nation; that makes a difference.

Patience is a virtue, individually and corporately.? We are better off waiting and allowing monetary policy to work, rather than overdoing it, and setting up our next crisis.

As For A Financial Guarantor Bailout

The last time financial guarantors went broke in a major way was during the Great Depression.? The financial guarantor stocks have rallied massively in the last few days, and I think those rallies are mistaken.? There is much hope for a bailout of the insurers.

The insurers may indeed get bailed out, if the NY Commissioner can convince those that would get hurt to pony up equity, much as many of them are already hurting at present, but that equity would significantly dilute existing shareholders of the holding companies of the guarantors.? I would not be a buyer of the guarantors here; I would sell.

Unstable Value Funds?

Posted on 18 January 2008 by David Merkel

		David Merkel
		Things That Go “Bump” in the Night
		1/17/2008 1:45 PM EST

One piece that I wrote three years ago for RealMoney has relevance today in a new way. Stable Value Funds often invest in AAA securities (some are solely invested in AAA securities), and some funds will have above-average exposure to securities credit-wrapped by the financial guarantors, and possibly, to some asset-backed securities that were rated AAA at issue, but don’t deserve that rating now. For those who have exposure to stable value funds through their defined contribution plans, it might be wise to check what exposures your funds have to the guarantors, and to AAA structured securities that are trading significantly below amortized cost. The summary statistic to ask for (not that they will give it to you) is the market-to-book ratio of the fund. If it gets lower than 97%-98%, I would avoid the fund.

Now for the good news: If a stable value fund breaks, the total loss is likely to be small, like that of a busted money market fund. The one exception would be if a stable value fund manager tried to meet withdrawals while facing a run on the fund, and ratio of the market value of the assets to the book value of the assets kept falling.

In such an event, better for the fund manager to stop withdrawals early and announce a new NAV that counts in the loss.

I don’t know of any stable value funds that are in trouble, so take this with a grain of salt. Most stable value funds are managed conservatively, so any testing will likely reveal that most of them are fine. There may be a few that aren’t fine, though, so a little testing is in order.

If you do find a need to move, money market and high quality bond funds are an excellent substitute for stable value funds. Be aware that you might have to leave funds in a non-competing fund option for 90 days to get there. In this market, the risks there could be as great as the losses on the stable value fund, so think out the full decision before making any change.

Position: none

That was my post at RealMoney today.? I wrote it with some degree of uncertainty, because stable value funds have a defense mechanism.? They can lower the crediting rate to amortize away the difference between book value and market value, and in a crisis, many will not argue with the credited rate reductions.? They are just happy to preserve capital.

Do I think this is a big problem?? No.? Do I think that no one is talking about this?? Yes.? The thing is, a lot of things can be hidden by the various wrap agreements that stable value funds employ.? If I were a stable value fund, I would not want to publish my market value to book value ratio.? If it’s above one, the fund will attract inflows, diluting existing investors.? If it’s below one, net outflows will increase, threatening a run on the fund.

Just be aware here, because if you can’t get a feel for the underlying economics of your stable value fund, you should probably seek another investment in the present environment.

Thirteen Notes on the Nexus of Woe: Financials and Real Estate

Posted on 17 January 2008 by David Merkel

1) Let’s start on a positive note: Doug Kass says it is time to buy the financials.? I may never be as successful or clever as Mr. Kass, but I think he is early by one year or so.? And this is from someone who is technically overweight financials — I own six insurers, two high-quality mortgage REITs, and two European banks.? When it comes time to own financials, I may have a portfolio with 50% financial stocks, and I will pare back the insurers.

2) What of the Financial Guarantors?? Forget that I said I would flip the 14% MBIA surplus note, I did not expect that it would do so badly so quickly.?? The rating agencies are all concerned to potentially downgrade MBIA, Ambac, and others.? Downgrades are death, and rating agencies would only consider such measures if they knew that other companies would step in to continue their AAA franchise if they kick the losers over the edge.? Berky, by entering the financial guarantee space, has signed a death warrant for at least one of MBIA and Ambac, and who knows, Berky might buy the loser.

3)? Away from that, PartnerRe, one of my favorite companies, has written off its entire stake in Channel Re, which provided reinsurance to MBIA.? Leave it to that classy company to write off the whole thing, which implies bad things for MBIA as it relies on reinsurance from Channel Re, which it also partially owns.

4) Though this is a test of the financial guarantors, it is also a test of the rating agencies, which are in damage control mode now.? My view is the Moody’s and S&P will survive the ordeal, and come back fighting.

5) For a lot of nifty graphs on the subprime lending crisis, look at this article from the BBC.

6) Now, a lot of the subprime crisis is really a stated income crisis.? Think about it: income is such a standard metric for loan repayment.? If one lets borrowers or agents fuddle with income, should we be surprised that loan quality declines?

7)? Even the black humor of the credit crunch in residential real estate points out how much more residential real estate might fall in price, and with it the values of companies that rely on residential real estate.

8) The boom/bust nature of Capitalism can not be repealed.? As an example, at the very time that you want banks to want to lend more to support the real estate market, they insist on larger down payments.

9) At my last employer, and at RealMoney, I would often say that the biggest crater to come in residential housing was in home equity loans.? JP Morgan is a good example of this.? Should this be surprising?? I noted from 2004-2007 how much of the ABS market had gone to home equity loans, and felt it was unsustainable.? Now we are facing the music.

10) Now consider credit cards.? Even cards on the high end are reporting deteriorating loan statistics.? Unlike past history, many people are paying on their cards to maintain access to credit, and letting their home loans slide.? Worrisome to me, and to the real estate markets as well.

11) Even auto loans are getting dodgy in this environment. ? No surprise, given that lending quality and consumer credit behavior have both declined.

12) Commercial rents may seem to rise in some areas, but there are tricks that owners use to occlude the economics in play.

13) Now for long term worries, consider what will happen to the real estate market as the baby boomers age.? Houses in colder areas will get sold, and houses in warmer areas will be bought.? This article does not take into account reverse mortgages, which will also be prominent.? Aside from that, the idea that baby boomers will be able to cash out of their homes to fund retirement will be hooey, unless we let wealthy foreigners buy into the US.? There will not be enough buyers for all of the houses to be sold without immigrants buying them.

I’m Not Afraid Of Derivatives

Posted on 10 January 2008 by David Merkel

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

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

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

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

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

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

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

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

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

Fifteen Points on Credit Where Credit Ain’t Due

Posted on 8 January 20088 January 2008 by David Merkel

I’ve wanted to do a post on credit for a while, but I’ve just had too many things to think about. Well, here goes:

1) From the “We Keep Him in a Bubble” file there is James Glassman with his prediction that Spring 2008 would bring the end of the housing troubles. Why does this guy still get air time? Why wasn’t Dow 36,000 enough? There are too many vacant homes to reconcile, there is no way for Spring 2008 to be it….

2) For an excellent summary of where we are in housing, Calculated Risk has this review piece.

3) Not all defaults are subprime. They are happening with Option ARMs, and even prime loans where they had to get Private Mortgage Insurance.

4) Is the subprime mortgage bust bigger or smaller, or similar to the size of the the S&L crisis? I’ll go with bigger. I don’t buy DeKaser’s smaller argument because securitization has provided more credit to small and medium sized businesses. I do think Portfolio.com is on the right track by looking at the amount of the housing price rise that has happened.

5) Personally, I find it delicious that the banks get stuck footing the bill in particularly bad foreclosure situations. So much for structural complexity in lending.

6) Americans are the most overhoused people in the world. No one else gets as much space, or stores as much stuff, broadly speaking. This book review of “House Lust,” will take you through the whole matter, in probably too much detail. (And yes, my house is large also, but I have ten people here… Americans can be unusual in other ways too; as a culture, we are more optimistic about children.)
7) From Calculated Risk, a tale of why lenders tend to forbear with marginal borrowers that are having difficulties with their current loans. One thing they don’t mention, the Residential MBS market does not have special servicers like the Commercial MBS does. When a loan gets into trouble, the CMBS special servicer gets paid adequately, but the ordinary RMBS servicer does not, particularly when lots of loans are in trouble. It is a weakness in the RMBS system.

8 ) As the TED spread declines, market players begin to relax about liquidity. But what of solvency? As losses are realized by banks, some will have to shore up their capital positions, and to do that, they will have to ratchet back lending.

9) How similar is the US today to Japan back in the early ’90s? There are some similarities, given the property bubbles in both places, and the interest rates that get lower and lower, but there are differences — a healthier banking system in the US, and a more market-oriented economy here as well. A depression is possible in the US, but I would not assume it at present.

10) Is the US consumer spent-up? Could be. Consider this article on auto loans as well. Personally, I am surprised at the degree to which lenders will make consumer loans with inadequate security, but that is just a normal aspect of American life today. For now.

11) What of corporate bonds? It certainly seems like junk bonds will be seeing more defaults in 2008. (Here also.) This shouldn’t surprise us, because the credit quality was low and the volume of high yield bond issues was high 2004-2006. It takes a little while for bad debt to season, and we should see the results in 2008.

12) When I did my “Fed model” I used BBB corporate yields as my comparison to earnings yields on equities. Given the backup in credit spreads, my Fed model is not nearly as favorable as those using Treasuries. But those looking only at credit spreads get the wrong result also. With Treasury yields so low, most high quality bonds are not attractive now.

13) On the bleak side, I tend to agree with Naked Capitalism and the FT that there is a transfer of power going on in the world, away from the US, and toward China and the Middle East. Power follows capital flows, and they are funding the US at present. They will own more and more of US businesses over time. They increasingly won’t be satisfied by owning our debts.

14) I found this piece from Credit Slips to be educational. There are certain types of income that can’t be garnished; nonetheless, garnishing happens. The only way to protect yourself is to fight back, and that article highlights how it is done.

15) Finally, credit at its most basic level. Credit is trust; trust that repayment plus interest will occur. Who do you trust? Personally, I found the discussion following Barry’s post to be depressing, because so many commenters were cynical. here was my comment:

Capitalism is based on trust. Without trust, capitalism will slowly cease to exist. Yes, there will be barter-type transactions, but any complex long-term transaction or relationship is based on trust. Any multi-party transaction requires trust, because multiple parties can gang up on the weak one.

Even representative government requires trust. Now, that trust is often abused, but who wants to get rid of representative government?

There is a lot more trust within our society than most of us imagine. Woe betide us if trust drops to a minimum level.

Estragon (thank you) agreed with me at the end, but it is fascinating to consider the implications of a society where trust is declining. Ultimately, it means that credit will be declining.

Depression, Stagflation, and Confusion

Posted on 26 December 2007 by David Merkel

I’m not sure what to title this piece as I begin writing, because my views are a little fuzzy, and by writing about them, I hope to sharpen them.? That’s not true of me most of the time, but it is true of me now.

Let’s start with a good article from Dr. Jeff.? It’s a good article because it is well-thought out, and pokes at an insipid phrase “behind the curve.”? In one sense, I don’t have an opinion on whether the FOMC is behind the curve or not.? My opinions have been:

The Fed should not try to reflate dud assets, and the loans behind them, because it won’t work.
The Fed will lower Fed funds rates by more than they want to because they are committed to reflating dud assets, and the loans behind them.
The Fed is letting the banks do the heavy lifting on the extension of credit, because they view their credit extension actions as temporary, and thus they don’t do any permanent injections of liquidity.? (There are some hints that the banks may be beginning to pull back, but the recent reduction in the TED spread augurs against that.)
Instead, they try novel solutions such as the TAF.? They will provide an amount of temporary liquidity indefinitely for a larger array of collateral types, such as would be acceptable at the discount window.
We will get additional consumer price inflation from this.
We will continue to see additional asset deflation because of the overhang of vacant homes; the market has not cleared yet.? Commercial real estate is next.? Consider this fine post from the excellent blog Calculated Risk.
The Fed will eventually have to choose whether it is going to reflate assets, or control price inflation.? Given Dr. Bernanke’s previous statements on the matter, wrongly ascribing to him the name “Helicopter Ben,” he is determined not to have another Depression occur on his watch.? I think that is his most strongly held belief, and if he feels there is a modest risk of a Depression, he will keep policy loose.
None of this means that you should exit the equity markets; stick to a normal asset allocation policy.? Go light on financials, and keep your bonds short.? Underweight the US dollar.
I have not argued for a recession yet, at least if one accepts the measurement of inflation that the government uses.

Now, there continue to be bad portents in many short-term lending markets.? Take for example, this article on the BlackRock Cash Strategies Fund.? In a situation where some money market funds and short-term income funds are under stress, the FOMC is unlikely to stop loosening over the intermediate term.

Clearly there are bad debts to be worked through, and the only way that they get worked out is through equity injections.? Think of the bailing out of money market funds and SIVs (not the Super-SIV, which I said was unlikely to work), or the Sovereign Wealth Fund investments in some of the investment banks.

Now, one of my readers asked me to opine on this article by Peter Schiff, and this response from Michael Shedlock.? Look, I’m not calling for a depression, or stagflation, at least not yet.? At RealMoney, my favored term was “stagflation-lite.”? Some modest rise in inflation while the economy grows slowly in real terms (as the government measures it).?? A few comments on the two articles:

?First, international capital flows from recycling the current account deficit provide more stimulus to the US economy than the FOMC at present.? Will they stop one day?? Only when the US dollar is considerably lower than now, and they buy more US goods and services than we buy from them.
Second, the Federal Reserve can gain more powers than it currently has.? If this situation gets worse, I would expect Congress to modify their charter to allow them to buy assets that it previously could not buy, to end the asset deflation directly, at a cost of more price inflation, and spreading the lending losses to all who hold longer-term dollar-denominated assets.? If not Congress, there are executive orders in the Federal Register already for these actions.
Third, in a crisis, the FOMC would happily run with a wide yield curve — they will put depositary institution solvency ahead of purchasing power.
Fourth, the Fed can force credit into the economy, but not at prices they would like, or on terms that are attractive.? In a crisis, though, anything could happen.
Fifth, I don’t see a crisis happening.? It is in the interests of foreign creditors to stabilize the US, until they come to view the US as a “lost cause.”? Not impossible, but unlikely.? The flexible nature of the US economy, with its relatively high levels of freedom, make the US a destination for capital and trade.? The world needs the flexible US, less than it used to, but it still needs the US.

One final note off of the excellent blog Naked Capitalism.? They note, as I have, that the FOMC hasn’t been increasing the monetary base.? From RealMoney:

		David Merkel
		The Fed Has Shifted the Way it Conducts Monetary Policy
		12/21/2007 11:56 AM EST

Good post over at Barry’s blog on monetary policy. Understanding monetary policy isn’t hard, but you have to look at the full picture, including the presently missing M3. I have a proxy for M3 — it’s total bank liabilities from the H8 report –> ALNLTLLB Index for those with a BB terminal. It’s a very good proxy, though not perfect. Over the last years, it has run at an annualized 9.4%. MZM has grown around 12.8%. The monetary base has grown around 3%, and oddly, has not been spiking up the way it usually does in December to facilitate year-end retail.

The Fed is getting weird. At least, weird compared to the Greenspan era. They seem to be using regulatory policy to allow the banks to extend more credit, while leaving the monetary base almost unchanged. This is not a stable policy idea, particularly in an environment where banks are getting more skittish about lending to each other, and to consumers/homebuyers.

This has the odor of trying to be too clever, by not making permanent changes, trying to manage the credit troubles through temporary moves, and not permanently shifting policy through adding to the monetary base, which would encourage more price inflation. But more credit through the banks will encourage price inflation as well, and looking at the TED spread, it seems the markets have given only modest credit to the Fed’s temporary credit injections.

I am dubious that this will work, but I give the Fed credit for original thinking. Greenspan would have flooded us with liquidity by now. We haven’t had a permanent injection of liquidity in seven months, and that is a long time in historical terms. Even in tightening cycles we tend to get permanent injections more frequently than that.

Anyway, this is just another facet of how I view the Fed. Watch what they do, not what they say.

Position: noneThe Naked Capitalism piece extensively quotes John Hussman.? I think John’s observations are correct here, but I would not be so bearish on the stock market.

After all of this disjointed writing, where does that leave me? Puzzled, and mostly neutral on my equity allocations.? My observations could be wrong here.? I’m skeptical of the efficacy of Fed actions, and of the willingness of foreigners to extend credit indefinitely, but they are trying hard? to reflate dud assets (and the loans behind them) now.? That excess liquidity will find its way to healthy assets, and I think I own some of those.

In Defense of the Rating Agencies — II

Posted on 25 December 2007 by David Merkel

It is easy to take pot shots at the rating agencies.? Barron’s did it this weekend.? What is hard is coming up with a systematic proposal for reform that will do more good than harm, as I pointed out on my last piece on this topic.?? Ordinarily, I like the opinions of Jonathan Laing, but not this time.? In my opinion, Barron’s failed the test of coming up with a systematic solution that recognizes market realities.

From my last article, I will repeat the market realities:

There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves.? The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.? The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
Somewhere in the financial system there has to be room for parties that offer opinions who don?t have to worry about being sued if their opinions are wrong.
Ratings can be short-term, or long-term, but not both.? The worst of all worlds is when the ratings agencies shift time horizons.

From the Barron’s article:

MAKE NO MISTAKE: THE LATEST debacle dwarfs the rating contretemps earlier in the millennium. In all, $650 billion of 2006 subprime mortgages were securitized in the past year. Moody’s officials point out that only 15% or so of the dollar amount of that rated debt — counting all tranches — has gone bad, requiring downgrades. But the ripple effect of those downgrades has wreaked havoc throughout the global credit markets.

Having been a mortgage and corporate bond manager back then, I’m not sure I agree.? The ABS, CMBS and whole loan RMBS markets are about the same size as the corporate bond markets.? The degree of stress on the system was higher back in 2002.? To give one bit of proof, look at the VIX, which is highly correlated with corporate credit spreads. ? Why was the VIX in the 40s then, and around 19 now?? What’s worse, the banks were in good shape back then, and there are more questions about the banks now.? Most of the current problems exist in exotic parts of the bond market; average retail investors don’t have much exposure to the problems there, but only less-experienced institutional investors.

The Barron’s article suggests five areas for reform:

1. The SEC must encourage more competition by approving more rating agencies.? Rating fees would drop and diversity of opinion would lead to more accurate and timely ratings.

I’m all in favor of more rating agencies.? I don’t think rating fees would drop, though.? Remember, ratings are needed for regulatory purposes.? Will Basel II, and NAIC and other regulators sign off on new regulators?? I think that process will be slow.? Diversity of opinion is tough, unless a ratings agency is willing to be paid only by buyers, and that model is untested at best.

Regarding John Coffee, Jr. in the article:

Industry expert and Columbia Law School professor John Coffee Jr. has suggested an elegant solution to bolster rating-agency quality control, both to Barron’s and in recent congressional testimony. He wants the SEC to require raters that have been granted official status to disclose in a central database the historical default rates of all classes of financial products that they’ve rated. Regulators and investors would thus have an effective means of assessing the raters’ rigor.

Furthermore, Coffee argues, the SEC should discipline miscreant agencies by temporarily yanking their registration in areas where their ratings have been notably wrong.

And after that,

2. All rating agencies should be required to disclose default rates on all classes of securities that they’ve rated.? Agencies with bad results should have their SEC approvals yanked temporarily.

Disclosing default rates is already done, and sophisticated investors know these facts; this is a non-issue.? Yanking the registration is killing a fly with a sledgehammer.? It would hurt the regulators more than anyone else.? Further, what does he mean by “miscreant” or “notably wrong?”? The rating agencies are like the market.? The market as a whole gets it wrong every now and then.? Think of tech stocks in early 2000, or housing stocks in early 2006.? To insist on perfection of rating agencies is to say that there will be no rating agencies.

From the article:? One investor-subscription-based rating service, Egan-Jones, has been trying fruitlessly to win official agency status for more than a decade. In that time, the Philadelphia concern has been miles ahead of the established agencies in downgrading the likes of Enron and WorldCom and more recently the mortgage and bond insurers, mortgage originators and investment banks caught up in the subprime-mortgage crisis.

“It’s tremendously liberating to just work for investors and not worry about angering the issuer community,” partner Sean Egan tells Barron’s. “Not only have we been able to give investors earlier warnings of corporate frauds and other negative credit situations, but in many cases we’ve led the industry on upward credit revisions of worthy recipients.”

I like Egan-Jones, so it is with pleasure that I mention that they have achieved NRSRO [nationally recognized statistical rating organization] status.? That said, their model that I am most fmailiar with only applies to corporate credit.? Could they have prevented the difficulties in structured credit that are the main problem now?

3. Agencies must be encouraged to make their money from investor subscriptions rather than fees from issuers, to ensure more impartial ratings.

If this were realistic, it would have happened already.? The rating agencies would like nothing more than to receive fees from only buyers, but that would not provide enough to take care of the rating agencies, and provide for a profit.? They don’t want the conflicts of interest either, but if it is conflicts of interest versus death, you know what they will choose.

4. Agencies no longer should have exclusive access to nonpublic information, to even out the playing field.

Sounds good, but the regulators want the rating agencies to have the nonpublic information.? They don’t want a level paying field.? As regulators, if they are ceding their territory to the rating agencies, then they want he rating agencies to be able to demand what they could demand.? Regulators by nature have access to nonpublic information.

5. Agencies must say “no” to Wall Street when asked to rate exotic types of debt instruments that lack historically relevant performance data.

Were GICs [Guaranteed Investment Contracts] exotic back in 1989-1992?? No.? Did the rating agencies get it wrong?? Yes.? History would have said that GICs almost never default.? As I have stated before, a market must fail before it matures.? After failure, a market takes account of differences previously unnoticed, and begins to prospectively price for risk.

Look, the regulators can bar asset classes.? Let them do that.? The rating agencies offer opinions.? If the regulators don’t trust the ratings, let them bar those assets from investment.? The ratings agencies aren’t regulators, and they should not be put into that role, because they are profit-seeking companies. Don’t blame the rating agencies for the failure of the regulators, because they ceded their statutory role to the rating agencies.? But if the regulators bar assets, expect the banks to complain, because they can’t earn the money that they want to, while other institutions take advantage of the market inefficiency

Look, sophisticated investors don’t rely on the rating agencies.? They employ analysts that do independent due diligence.? Only rubes rely on ratings, and sophisticated investors did not trust the rating agencies on subprime.? My proof?? Look how little exposure the insurance industry had to subprime mortgages.? Teensy at best.

There will always be differences in loss exposure between structured securities and corporate bonds at equivalent ratings.? Structured securities by their nature will have tiny losses for long periods of time, and then large losses, relative to corporate bonds.? The credit cyclicality is even bigger than that of corporate bonds.

Let’s get one thing straight here.? The rating agencies will make mistakes.? They will likely make mistakes on a correlated basis, because they compete against one another, and buyers won’t pay enough to support the ratings.

Barron’s can argue for change, but unless buyers would be willing to pay for a new system, it is all wishful thinking.? Watch the behavior of the users of credit ratings.? If they are unwilling to pay up, the current system will persist, regardless of what naysayers might argue.

Investment Bank Counterparty Risks are Probably Modest

Posted on 22 December 2007 by David Merkel

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

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

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

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