Category: Structured Products and Derivatives

If Hedge Funds, Then Investment Banks

If Hedge Funds, Then Investment Banks

Posted on by David Merkel

I’m still flooded by my workload, so just one comment this evening.? The Wall Street Journal posts an article on overly favorable (and smoothed) returns at hedge funds through securities that are mismarked favorably.? It was no surprise to naked capitalism, and no surprise to me either (point 26).? I’ve been writing about this issue off and on for three years now, because economic processes are messy, and tend to generate messy returns, not smooth returns, particularly once the easy arbitrages are glutted with yield-seeking investors.? Also, I know what the temptation is to mismark illiquid bond positions when incentive payments may be riding on the result (which is why we took the marking out of our hands at a prior firm).

Having been an actuary in financial reporting for twelve years, I know what the pressure is when someone above you in the hierarchy asks if your reserve is wrong.? It is rarely asked when the reserves are too low.? Few managements are so farsighted.? It is always asked when income is too low, and adjusting reserves downward is so convenient.? And who will notice?? Few, I’m afraid, but most actuaries I know are highly ethical, and resist these pressures.

My target here not insurance companies, though, but the investment banks.? Actuaries have detailed rules for setting reserves.? We have societies and ethics codes.? Those who work at the investment banks are not typically CFAs, which is more of a buy-side thing, so there is no industrywide ethics code there.? Also, the value setting rules for many investment banking assets and liabilities are far more squishy than for insurance liabilities.? Finally, investment banks frequently hold the same instruments as the hedge funds, and get their pricing marks from the same sets of sources.? I suspect that the positions are similarly mismarked, and they are big enough to hide it, because derivative books are never unwound.

Well, almost never.? Buffett phrased it well in his 2005 Annual Report: (pp. 9-10)

Long ago, Mark Twain said: ?A man who tries to carry a cat home by its tail will learn a lesson that can be learned in no other way.? If Twain were around now, he might try winding up a derivatives business. After a few days, he would opt for cats.


We lost $104 million pre-tax last year in our continuing attempt to exit Gen Re?s derivative operation. Our aggregate losses since we began this endeavor total $404 million.


Originally we had 23,218 contracts outstanding. By the start of 2005 we were down to 2,890. You might expect that our losses would have been stemmed by this point, but the blood has kept flowing. Reducing our inventory to 741 contracts last year cost us the $104 million mentioned above.


Remember that the rationale for establishing this unit in 1990 was Gen Re?s wish to meet the needs of insurance clients. Yet one of the contracts we liquidated in 2005 had a term of 100 years! It?s difficult to imagine what ?need? such a contract could fulfill except, perhaps, the need of a compensation conscious trader to have a long-dated contract on his books. Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for ?imagination? when traders are estimating their value. Small wonder that traders promote them.

A business in which huge amounts of compensation flow from assumed numbers is obviously fraught with danger. When two traders execute a transaction that has several, sometimes esoteric, variables and a far-off settlement date, their respective firms must subsequently value these contracts whenever they calculate their earnings. A given contract may be valued at one price by Firm A and at another by Firm B.


You can bet that the valuation differences ? and I?m personally familiar with several that were huge ? tend to be tilted in a direction favoring higher earnings at each firm. It?s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.


I dwell on our experience in derivatives each year for two reasons. One is personal and unpleasant. The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re?s trading operation. Both Charlie and I knew at the time of the Gen Re purchase that it was a problem and told its management that we wanted to exit the business. It was my responsibility to make sure that happened. Rather than address the situation head on, however, I wasted several years while we attempted to sell the operation. That was a doomed endeavor because no realistic solution could have extricated us from the maze of liabilities that was going to exist for decades. Our obligations were
particularly worrisome because their potential to explode could not be measured. Moreover, if severe trouble occurred, we knew it was likely to correlate with problems elsewhere in financial markets.


So I failed in my attempt to exit painlessly, and in the meantime more trades were put on the books. Fault me for dithering. (Charlie calls it thumb-sucking.) When a problem exists, whether in personnel or in business operations, the time to act is now.


The second reason I regularly describe our problems in this area lies in the hope that our experiences may prove instructive for managers, auditors and regulators. In a sense, we are a canary in this business coal mine and should sing a song of warning as we expire. The number and value of derivative contracts outstanding in the world continues to mushroom and is now a multiple of what existed in 1998, the last time that financial chaos erupted.


Our experience should be particularly sobering because we were a better-than-average candidate to exit gracefully. Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner. Our accounting in the past was conventional and actually thought to be conservative. Additionally, we know of no bad behavior by anyone involved.


It could be a different story for others in the future. Imagine, if you will, one or more firms (troubles often spread) with positions that are many multiples of ours attempting to liquidate in chaotic markets and under extreme, and well-publicized, pressures. This is a scenario to which much attention should be given now rather than after the fact. The time to have considered ? and improved ? the reliability of New Orleans? levees was before Katrina.


When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those expressed in a country song, ?My wife ran away with my best friend, and I sure miss him a lot.?

I could go on about this, but it’s late.? There are other weaknesses in the system as well.? A good rule of thumb is that whenever there is a lack of natural counterparties, there will be pricing difficulties.

Closing comment: When I was at a Stable Value conference in 1994, I ran into some investment bankers and talked to them about this topic.? I asked them how they hedged their synthetic wrap exposures.? They said they didn’t hedge because it was riskless “free money.” I pointed out the scenario under which they could lose money, and asked how their auditor could sign off on the lack of the hedge.? Their comment went like this: “When we find an auditor capable of auditing our derivative books, we hire him and pay him ten times the salary.”

In a world like that, who knows what problems may lurk in the derivative books, because the auditors stand a better chance of figuring out the truth than the ratings agencies and regulators.

Tickers mentioned: BRK/A, BRK/B

Too Many Vultures, Too Much Liquidity

Too Many Vultures, Too Much Liquidity

Posted on by David Merkel

About a month ago, when the financial markets were more skittish, I saw a series of four articles on more interest in distressed debt investing (One, Two, Three, Four).? In this market, it didn’t surprise me much because we have too many smart people with too much money to invest.? It reminds me a bit of a RealMoney CC post that I made a year and a half ago:


 David Merkel
Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples. In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

We are still on the side of the demographic wave where net saving/investing is taking place, and that forces pension plan sponsors to find high-return areas to place additional monies.? Away from that, the current account deficit has to be recycled, and they aren’t buying US goods and services in size yet.? That’s why there will be vultures aplenty, outside of lower quality mortgages.? Even the debt market for new LBO debt is slowly perking up.? The banks pinned with the loan commitments may be able to get away with mere 5% losses.? Away from that, investment grade and junk grade corporate bonds are looking better as well.

Now, don’t take this as an “all clear.”? There are still significant problems to be digested, particularly in the residential real estate and mortgage markets.? CDOs still offer a bevy of credit issues.? There will be continued difficulties, and I don’t expect big returns.? But with so many willing to take risk at this point, I can’t see a big drop-off until they get whacked by worsening credit conditions.

So Where Are We Now — Normal?

So Where Are We Now — Normal?

Posted on by David Merkel

Maybe things have normalized.? After all:

  • Implied volatilities have fallen below long-run averages for equity indexes.
  • The equity market is within spitting distance of a new high.
  • The Fed is loosening (will they do more?)
  • The discount window is largely vacant.
  • Away from real estate, and real estate finance, things seem pretty chipper.
  • The yield curve is normalizing.
  • Inflation as measured by the government is low.
  • Long term interest rates are low, for investment grade borrowers.
  • Commercial paper problems are gone.
  • LBO debt difficulties will be solved soon, through a combination of losses to the banks, and canceled deals.

Or maybe not:

  • Inflation is rising globally.
  • The dollar is weak.
  • US inflation should start to rise as a result.
  • Housing prices are weak and getting weaker.? Default and delinquency statistics are rising.
  • The CDO [Collateralized Debt Obligation] problems are still not solved.
  • Defaults should begin to increase significantly on single-B and CCC-rated corporate debts in 2008.
  • The TED [Treasury-Eurodollar] spread is still in a panic-type range.

I’m seeing more of my stocks get closer to the upper end of my rebalancing range.? I will begin reducing exposure if the market run persists.? I’m not crazy about the market here, but I am not making any aggressive moves.

Why I’m not Jumping at the Investment Banks at Present

Why I’m not Jumping at the Investment Banks at Present

Posted on by David Merkel

Three reasons:

  • There are still significant areas of concern that have not unwound yet — residential housing exposure will increase as housing prices fall further, including lawsuits which will eventually prove not meritorious, and CDO exposure.
  • It is my firm belief that their hedges hold in minor moves, but not major moves.? VAR modeling is fine for when the winds are calm, but not when they are gale force.? At gale force the Extreme Value Theory models kick in, and they are untested at present.? Berkshire Hathaway’s experience in unwinding GenRe’s swap book was telling; few things were marked conservatively.? That is probably true industrywide, partly because auditors are incapable of audit the swap books in all of their complexity, or they’d be working for the investment banks themselves.
  • New accounting regulations make earnings quality more opaque, and less comparable across time periods and companies.? This should result in lower multiples, akin to big commercial insurers.

That’s all.? Personally I think the investment banks will be a buy sometime in 2008, but I am waiting to see how the current leverage unwind affects them.

The Advantages of Being a Small Investor Amid Too Much Leverage

The Advantages of Being a Small Investor Amid Too Much Leverage

Posted on by David Merkel

Here’s a question from a reader a few weeks ago.

I consider myself to be a value investor and stick mainly to stocks
where I feel the asset to equity ratio is reasonable along with
consideration of other factors such as PE & share price to book value etc.
As a result, I am not panicking with the recent mkt downturn and expect
to hold most of my positions thru the major downturn when it happens.


Despite my resolve, I can’t help but feel uncomfortable with the recent
comments on subprime and liquidity etc. Again, I am a very inexperienced
amateur investor, but what I seem to be getting from the reports is that
there is so much leveraged investment in the markets these days that
even these mini downturns may force selling of stocks to cover leveraged
positions and could wash over the entire market. Reports of complete
funds being wiped out as a result of the necessity to cover leveraged
positions seem incredible to me. ?I personally feel leveraging should be
left to very skilled, specialized traders and will only consider it when
I have a portfolio of sufficient size that I would be able to use it as
insurance and in turn cover a position if required.

?

Having said all of this, I have several questions, if you would be so
kind as to consider.

?

Is there a way to assess the volume of leveraged positions relative to
the whole market and likelyhood to tip the whole market and the average
% the market will retreat based on the amount of leveraging in the
markets and the historical data on the effects?

?

Are there not rules that govern funds, in order to protect the investors
in the funds from complete liquidation due to leveraging by the managers
and at any rate doesn’t someone review the activities of the fund managers?

?

Is this leveraging in the marketplace so widespread and common now that
small investors like me are tilting at windmills if don’t participate?

?


I realize that these questions may be rather uninformed and somewhat
equivalent to “the meaning of life” scenerio, however I have been
reading your blog quite faithfully and with my limited understanding of
some of the technical jargon, find it very interesting.

Thanks for asking your question, and sorry I didn’t get to it earlier.? There are several things to write about here:

  • How serious are leverage problems in the market?
  • There are certain forms of leverage that are well measured, and some that are not.
  • Some institutions have leverage rules, and some don’t, sort of.
  • Am I at a disadvantage as a small investor, particularly if I stay unlevered?

Let’s go in order.? The leverage problems in the market today are significant, though none are urgent at present.? The furor over ABCP and SIVs and other bits of short-term lending have largely passed.? Good collateral got rolled over, bad collateral got picked up by stronger institutions.? That said, there are other important problems in the market that are not at a crisis point yet:

  • Falling residential real estate prices, and the effect on mortgage default, and the effect on those that hold mortgage securities.
  • Private Equity’s ability to repay debt on new acquisitions.
  • The willingness of the investment banks to takes losses on prior LBO lending commitments.
  • Losses in the CDO market, and who owns the certificates with the most exposure to loss.
  • Losses from high-yield lending to CCC, and single-B rated firms.
  • Are any significant financial institutions overexposed to the above items, such that they might be impaired?

Now, some of the leverage is well measured, and some is not. We really don’t know with derivatives what the total exposure is, and whether the investment banks have been clean with their counterparty management.? (That said, so far it looks like it is working.? There may be a Wall Street rule, that if someone is near the edge, find a way to kick them over the edge, so that you can foreclose with more collateral.)

We also don’t know about lending to or from hedge funds, and hedge fund-of-funds. ?? Non-bank lenders, we know about what they securitize publicly, and that’s most of it, but the rest, we don’t know.? Foreign lenders to the US — the Treasury collects some data on them, but the detail is lacking.

All of these are areas where reporting requirements are limited to non-existent.? Regulated domestic finance — we know a lot about that, and that’s a large part of the system; the open question there, is how much the regulated part of the system has lent to the non-regulated part of the system.? Difficult to tell, but given the slackness of bank exams over the past five years, it could be significant, but I doubt perilous to the system as a whole.

Banks, S&Ls, Mutual funds, Insurance companies, and margin accounts have leverage rules. ? Many non-regulated entities face leverage rules from the ratings agencies, which limit their ability to borrow and securitize.? Still other face limits on leverage from those who lend to them, in the form of debt covenants.? Almost everyone is limited in some way, but in a bull market, those limits often get compromised as a group.? The limits are not as wide as would be optimal for financial system stability.

So, there are some protections for those who lend to hedge funds and hedge fund of funds, but little protection to those who invest in them.? Hey, if you’re a big institution, and invest here, you are your only protector; no one is coming to rescue you in a crisis.

But onto the last question:? Am I at a disadvantage as a small investor, particularly if I stay unlevered??? You have many advantages as a small investor.? One? of the largest advantages is that no one can force you to be hyper-aggressive, except you yourself. If you are reasonable in your return goals, you can safely achieve better than your average levered competitor through a crisis.? An unlevered investor can’t be forced by anyone to take on or liquidate a position.? Levered investors, or those with return requirements from outside parties, do not fully control their own trades.

Second advantage: you can be more picky.? You can avoid trouble areas in entire if you want.? Many institutional investors face diversification or tracking error requirements, which force them to in vest some in areas that they don’t like.? As an example, I was one of the few investors that I knew that didn’t take some losses from the tech bubble popping.

Third advantage: you don’t have to take risk if you don’t want to.? If the market is too frothy, and shorting is not for you, just reduce exposure, and wait for a better entry point.? (Warning: that entry point may not come.)

A disciplined private investor may not have the same level of knowledge as the institutions, but he can have a longer time horizon, and play the out of favor ideas that might threaten job security of those who work inside institutional investors.? With that, I would advise you to take use your advantages, and invest accordingly.? Keep it up with the value investing!

For those with access to RealMoney, I advise reading these longish articles if you want more background on how I think here:

Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders? Hands, Part 1
Get to Know the Holders? Hands, Part 2

Watching the Maple Leaves Rise as Fall Approaches, or, Maybe I’m Just Looney

Watching the Maple Leaves Rise as Fall Approaches, or, Maybe I’m Just Looney

Posted on by David Merkel

What a day.? We’ve had too many “What a days” lately, and its late.? Over at RealMoney today, I posted this:


 David Merkel
Watching the Maple Leaves Rise as Fall Approaches
9/20/2007 12:49 PM EDT

It brings a lump to my throat, but the Canadian dollar briefly traded over parity to the U.S. dollar today. My guess is that it decisively moves above the U.S. dollar, and stays there for a while. Why not? Their economy is in better shape.Oh, and to echo one of Doug’s points, watch the 10-year swap yield. Nothing correlates better with the prime 30-year mortgage rate. It’s up 13 basis points since the FOMC move.

Looking at slope of the yield curves 10-years to 2-years, the Treasury curve has widened 20 bp and the swap curve 23 bp. If all Bernanke is trying to do is calm the short-term lending markets, that’s fine, but the long-term markets are getting hit.

Even in the short-term markets, things aren’t that great. We’re past the CP rollover problem, but the TED [Treasury-Eurodollar] spread is 135 bp now, and that ain’t calm.

I’m not a bear here, but there are significant risks that we haven’t eliminated yet… most of them stemming from the need for residential real estate to reprice down 10%-20% in real terms. Hey, wait. Hmm… what if the FOMC doesn’t really care about inflation anymore? They could concoct a rise in the price level of 20% or so, which would presumably flow through to housing, bailing out fixed-rate borrowers with too little margin (ignore for a moment that floating and new financing rates will rise also).

Okay, don’t ignore it. It will be difficult to inflate our way out of the problem. Even as the dollar declines, it will cause our trading partners to decide whether they want to slow their export machines by letting their currencies rise or buying more eventually depreciating dollar assets.

I would still encourage readers to be cautious with real-estate-related assets and those who finance them. Beyond that, just be wary of firms that need financing over the next two years. It may not be available on desirable terms.

Position: none, but who is not affected by this?

Interesting Times

We are within a half percent of taking out the all time low (1992) on the Dollar Index [DXY].? Since the move by the FOMC the ten-year Treasury has moved up 21 basis points.? That’s not stimulative.? Then again, maybe the FOMC wants to address the short term lending crisis, but could care less about stimulating the economy as a whole.? If this is their goal, let’s stand up and applaud their technique, but perhaps not their goals.

All that said life has returned to the investment grade bond market, and may be returning to the junk market, and maybe even the LBO debt market, if the banks will take enough of a loss to get things moving.? What I am finding attractive currently in fixed income right now is prime residential mortgage paper (this is rare — I usually hate RMBS).? Implied volatilities in are high, just look at the MOVE index, but they will eventually come down, at which point, the prices of mortgage bonds should improve (on a hedged basis).

Beyond that, I like foreign bonds, but am uncertain as to what currencies to go for; I still like the Canadian dollar, yen and the Swiss franc, but beyond that, I don’t know.? Aside from that, keep it short and high quality, because the long end isn’t acting well, and the junk credit stress is starting to arrive.

Away from that, I also still like inflation protected bonds, but they have run pretty hard since April.? TIPS overshot on the FOMC announcement, and have undershot since.? What a whipsaw.

So where would that leave me if I were a bond manager?? Foreign, mortgages, inflation-protected, and short duration high quality.? Sometimes the game is about capital preservation, and nothing more.

The Longer View, Part 4

The Longer View, Part 4

Posted on by David Merkel

In my continuing series where I try to look beyond the current furor of the markets, here are a number of interesting items I have run into on the web:

 

1) Asset Allocation

 

  • Many people who want to stress the importance of their asset allocation services will tell you that asset allocation is responsible for 90% of all returns, so ignore other issues.? An article on the web reminded me of this debate.? The correct answer to the question, as pointed out by this paper, is that asset allocation explains 90% of the variability of the returns of a given fund across time, but only explains only 40% of the variability of a fund versus other funds.? Security selection matters.
  • Two interesting papers on asset class correlation.? Main upshots: historical correlations are not fully reliable, because risky assets tend to trade similarly in a crisis.? Value tends to march to its own drummer more than other equity styles in a crisis.? The effects on correlation in crises vary by crisis; no two are alike.? Natural resources and globa bonds tend to be good diversifiers.
  • In bull markets, risky asset classes all tend to do well.? Vice-versa in the bear markets.? My reason for this correlation is that you have institutional asset buyers all focusing on asset classes that were previously under-recognized, and are now investing in them, which raises the correlation level, not because the economics have changed, but becuase the buyers have very similar objectives.
  • There are a few good states, but by and large, public pensions are a morass.? Most are underfunded, and rely on future taxation increases to support them.? When a public system realizes that it is behind, the temptation is to take more investment risk by purchasing alternative asset classes that might give higher returns.? This will end badly, as I have commented before… I suspect that some state pension plans are the dumping grounds for a lot of overpriced risk that Wall Street could not offload elsewhere.

 

2) Insurance

 

 

3) Investment Abuse of the Elderly

 

It’s all too common, I’m afraid.? Senior citizens get convinced to buy inappropriate investments.? Even the SEC is looking into it.? This applies to annuities as well, mainly deferred annuities, which I generally do not recommend, particularly for seniors.? The comment that a CEO doesn’t fully understand his own annuity products is telling.

 

Now fixed immediate annuities are another thing, and I recommend them highly as a bond substitute for those in retirement, particularly for seniors who are healthy.

 

The only real cure for these deceptive practices is to watch out for the seniors that you care for, and tell them to be skeptics, and to run all major investment decisions by you, or another trusted soul for a second opinion.

 

4) Accounting

 

  • I am against the elimination of the IFRS to GAAP reconciliation for foreign firms.? What is FASB’s main goal in life — to destroy comparability of financial statements?? We may lose more foreign firms listed in the US, which I won’t like, but a consistent accounting basis is critical for smaller investors.
  • Congress moves from one ditch to the other.? This time it’s sale of subprime loans.? Too many modifications, and sale treatment is at risk, so Congress tries to soften the blow for the housing market.? Let auditors be auditors, and if you want the accounting rules changed, then let Congress do the job of the FASB, so that they can be blamed for their incompetence at a complex task.
  • As I’ve said before, I don’t like SFAS 159.? It will lead to more distortions in financial statements, because managements will tend to err in favor of higher asset and lower liability values, where they have the freedom to set assumptions.

 

5) Volatility

 

  • Earn 40%/year from naked put selling?? Possible, but with a lot of tail risk.? I remember how a lot of naked put sellers got smashed back in October 1987.? That said, it looks like you can make up the loss with persistence, that is, until too many people do it.
  • Here’s an interesting graph of the various VIX phases over the past 20 years.? Interesting how the phases are multiyear in nature.? Makes me think higher implied volatility is coming.
  • I don’t think a VIX replicating ETF would be a good idea; I’m not sure it would work.? If we want to have a volatility ETF, maybe it would be better to use variance swaps or a fund that buys long delta-neutral straddles, and rebalances when the absolute value of delta gets too high.

 

That’s all for now.? More coming in the next part of this series.

Fifteen Notes on the State of the Markets

Fifteen Notes on the State of the Markets

Posted on by David Merkel

1)? Start with the pessimists:


2)? Move to the optimists:

3) Hedge funds are getting outflows at present (and here), and August performance was pretty bad (and here — look at? “Splutter”).? I began toting up a list of notable losers, but it got too big.? One positive note, many of the large quant funds bounced back from their mid-August stress.

4)? When muni bonds get interesting, you know it’s a weird environment.? It starts with the fundamental mismatch of muni bonds.? Muni issuers want to lock in long term financing, but most investors want to invest shorter.? Along come some trusts that buy long bonds and sell short-dated participations against them, and hedge the curve risk with Treasuries.? When credit stress got high, long munis were sold because they could be, and long Treasuries rallied, which was the opposite of what was needed for a hedge.? (Note: hedging with Treasuries can work in normal markets, but fails utterly in panics, as happened in 1998.)? When the selling was done, in many cases high quality muni yields were high than Treasuries even before adjusting for taxes.? That didn’t last long, but munis are still a good deal here.

5) Large caps are outperforming small caps.? Foreign exposure that large caps have here is a plus.

6) Not all emerging markets are created equal.? Some are more likely to have trouble because they are reliant on foreign financing. (Latvia, Iceland, Bulgaria, Turkey, Romania)? Others are more likely to have trouble if the US economy slows down, because they export to us. (Mexico, Israel, Jordan, Thailand, Taiwan, Peru)? I would be more concerned about the first group.

7) Are global banks cheap?? Yes on an earnings basis, probably not on a book basis.? We need to see some writedowns here before the group gets interesting.

8) I’ve talked about SFAS 159 before, and you know I think it is a bad accounting rule.? This article from my friend Peter Eavis helps to point out some of the ways that it allows too much freedom to managements to revalue assets up.? What I would watch in financial companies is any significant increase in their need for financing, which could point out real illiquidity, even though the balance sheet might look strong; this one is tough because financials are opaque, and the cash flow statement is not so useful.? Poring over the SFAS 159 disclosures will be required as well.

9) As I have suggested, pension plans will probably end up with a decent amount of the hit from subprime lending, through their hedge fund-of-funds.

10) Hedge funds do better if the managers went to schools that had high average SAT scores?? I would not have guessed that.? Many of the best investors I have known were clever people who went to average schools.

11) My but bond trading has changed.? When I was a corporates manager, hedge funds weren’t a factor in trading.? Now they are 30% of the market.? Wow.? Surprises me that volatility isn’t higher.

12) Rich Bernstein of Merrill (bright guy) is getting his day in the sun.? His call for outperformance of quality assets seems to be happening.? Now the question is whether the cost of capital is going up globally or not.? If so, he says to avoid: “1) China, 2) emerging market infrastructure, 3) small stocks, 4) indebted U.S. consumers, 5) financial companies, 6) commodities and energy companies.“? Personally, I think the cost of capital is rising for companies rated BBB and below, which brings it back to the quality trade.

13) Econocator asks if markets have priced in a recession, and he says no. My problem with the analysis is that we would need 10-year Treasury yields in the 2.5% area to fully price it in by his measure, and that makes no sense, outside of a depression, and then, nothing is priced in.

14) Morningstar moves into options research.? Could be interesting, though Value line has had a similar publication, and I’m not sure that the market for publications like this is big enough.? They make a good point that most people use options wrong, and get the short end of the stick.

15) Oil is amazing, but wheat is through the roof.? I’ve seen articles about bread prices rising.? Fortunately, the cost of grain is a small part of the cost of foods that rely on grain.

With that, I bid you good night.

Eight Notes on Residential Real Estate

Eight Notes on Residential Real Estate

Posted on by David Merkel

For those wanting a road map of where I am likely to post over the next few days, tonight is mortgages and real estate, tomorrow is speculation, and Friday should involve longer dated topics. For those that commented on the blog redesign, I want to say that I appreciated your comments, particularly the critical ones. In the next two months, I’ll be doing a minor redesign to fix some of the flaws that I introduced in the process. I’m not perfectly happy with the result, and it can be improved. Trivia: I co-edited the best high school yearbook in the nation back in 1979, so I do have some eye for design. It’s more of a question of the computer implementation.

Onto real estate:

1) After a bubble bursts, it’s amazing the details that come out on the ethical lapses that transpired. With Countrywide, people were steered into loans that were worse than what they might have qualified for there or elsewhere. Now, they should have shopped around; I always do that on mortgage loans. That Countrywide is still facing problems after the Bank of America infusion might not be too surprising; companies that cut corners with their customers are more likely to be aggressive in their accounting practices. After the post-bailout bounce, the convertible preferred that Countrywide got is now under the $18 strike price.

CFC price chart

2) Can the mortgage crisis swallow a town?? Yes.? I know this personally, as some friends of mine on the Eastern Shore of Maryland are finding out right now.? They are not in one of the best areas, and demand has dropped off a cliff.? Entire neighborhoods near them are in bad shape, making everything else less salable.? They need to sell their home for medical reasons, and they can’t do it without taking a loss, which would impoverish them.

3) The internals of the housing market are now such that no one is arguing over the troubles faced.? Consider:

4) But won’t the President and Congress bail out strapped homeowners?? Tough task.? Current proposals are just dust on the scales, and doing anything big would be a budget-buster.? I agree with Accrued Interest; a bailout is bad policy.? I suspect one will happen anyway.? Washington, DC specializes in bad policy, if it wins votes.

5)? After a bubble bursts the second order effects can be quite significant.? Consider:

6) Now, I wonder if Merrill Lynch will have any significant hits from subprime.? I would expect it, but who can tell for sure?

7)? Was it such a good idea for the US government to promote home ownership so vigorously?? I have generally said no, and Caroline Baum questions the wisdom of the policy as well.

8) Finally, we keep them in a bubble to make sure that their theories on how the economy works do not get contaminated by data.? I’m partly kidding here, but the Fed is very optimistic that any spillover from residential real estate to the general economy will be light.? I think the effect will be moderate; it will definitely hurt, but not destroy the US economy.

Tickers mentioned: BAC CFC GS MER

The Road from Here to Stagflation

The Road from Here to Stagflation

Posted on by David Merkel

Cramer again.? This time I disagree more, because he is talking about the Fed.? He has five views of the Fed that he hates.? Let me take them in order:

1) The Fed doesn’t matter — It depends.? In the short run, when the Fed loosens, healthy assets get stimulated, but damaged assets don’t.? In the intermediate run, companies get financing from healthy financials to reconcile dud assets that were misfinanced, but the process takes time, maybe a year or two.


2) The Fed is pushing on a string — Initially, it will look like that is true.? It almost always does. Things that are viewed as problems now will not be helped by the initial effects of Fed policy.

3) The economy won’t react to the Fed, no matter what — Cramer is right to dis this one.? The Fed will revive nominal growth after a year or two.? The hard question is how much comes from inflation, and how much comes from real growth.

4) The dollar collapses because of cuts — Here I disagree with Cramer.? The dollar will decline.? Interest rates are a more powerful factor than GDP growth in exchange rates, because financial transactions are larger than trade in goods by an order of magnitude.

5) The Fed doesn’t want to do anything and doesn’t have to do anything — Well, true on its face, but the Fed is a political creature.? It responds to market signals, and it has signaled that it wants to “solve this problem.”? Cramer is correct here.? The Fed will act; the only question is how much.

But ask yourself a different question. How could the Fed break the logjam in the commercial paper market, particularly ABCP?? I clipped a lot of articles on this.? There is a lot of CP maturing (maybe $140 billion) in the next week or so.? It is not the banks that are so much at risk, though some will have to collapse conduits and bring asset back onto their balance sheets, lowering capital ratios. ? The non-banks are the ones getting smashed, and the banks may have modest exposure to their woes.? Information Arbitrage has it right when he says that this is a case of misfinancing assets.? (Hey, maybe the Fed could directly monetize ABCP by buying it instead of Treasury notes.? No, no, please don’t… 🙁 )

Now, how much will the FOMC cut rates?? Unusually modest for PIMCO, they call for 1% by 2008.? (They never met a rate cut that they didn’t like.)? Fed Governor Plosser suggests that they have other tools they can use, without cutting the Fed funds rate. The ever-smart Jim Griffin concludes that the main risk to the Fed at present is inaction, and I agree.? At a time like this, the FOMC must do something notable, or the political heat cranks up.? Then again, we can look at the Treasury bond market as a whole, and easily conclude that at least 1% of loosening is in the foreseeable future.? As Caroline Baum puts it, “The fact that the funds rate is hovering so far above the rest of the yield curve is the most obvious sign that policy is tight. Yet Fed officials seem determined to see evidence of it in the real economy before they relent.”

Four quick notes before I end:

  1. Remember that Fed funds futures are typically only good for predicting the next meeting, and nothing beyond that.
  2. There’s still a lot of subprime debt to be reconciled in money market funds.
  3. Central banks are supposed to help with illiquidity but not insolvency.? At the edges, this is not so clear.? Illiquidity can lead to insolvency if bank capital levels are inadequate.
  4. An excellent summary article on all of this from the Bank of International Settlements, the central bankers’ central bank.

My summary: the FOMC will cut in September, and because monetary policy works slowly, they will be politically forced into more cuts than they would like, until signs of rising inflation cuts off the cuts sometime in 2008-9.? The yield curve will be much wider then, and then the hard choices faced in the 1970s will reappear, along with the s-word: stagflation.? I hesitate to use the word, because it is so sensationalistic, but I feel that we are headed there, slowly but surely.

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