Search Results for “Unstable” – Page 8

Fifteen More Notes and Comments on the Current Crisis

Posted on 29 October 200820 June 2017 by David Merkel

1) Do Fannie and Freddie deserve some blame for the crisis that we now face? Yes, but not without blaming Congress and the Executive Branch for pushing homeownership far beyond the natural rate of ownership, which I wager is around 60% rather than the 72% that it touched for a brief time.

But here are some ways that F&F went out of their way to help create the current crisis:

F&F did push loan growth and growth of their retained portfolios in order to benefit their shareholders.
They bought significant amounts of Alt-A and other lower quality loans for their retained portfolio.
They aggressively lobbied to protect their position.
They argued for capital standards that were lower than would be needed in a crisis (so did many financial institutions)
They lowered underwriting standards in order to meet competition from private lenders. They could have given up business, delevered, and been stronger companies for when the crisis would hit.
They managed to their GAAP financials. A prudent financial institution manages to a stressed version of their most stringent capital constraint.

Finally, I would add that this was an area where Greenspan was right on policy, along with a few of the more conservative members of Congress. If you are going to have F&F at all, then use them contra-cyclically. When the mortgage markets are lending, F&F should sit on their hands, and let the market do its work. If F&F?s balance sheets weren?t impaired now, they could be doing some real good here, but because their credit quality is suspect, as well as the commitment to their solvency from the Federal Government, their cost of fresh capital is high, making mortgages more expensive than they otherwise would be.

Note the current rise in Fannie 30-year mortgage rates.? This series tends to peak out at 6.20% but I am expecting rates to exceed that and soon.

Personally, I don?t think the government should be in financial businesses. Government agencies tend to overlend, and lend to bad risks with insufficient compensation. Then again, I don?t think governments should be in the money business either; they abuse the privilege, stealing from us in the process.

2) Will contractual terms be honored by the courts? Some hedge funds will press for their rights. My guess is that they won?t win in this environment. The system has a tendency to fight individual rights in a crisis. But, there is no free lunch. To the extent that contractual rights are infringed, rates will rise when lending resumes to compensate for expropriation risk.

3) Get financing when you can, not when you have to. Others have pointed to this post, but it bears repeating.The banks ran for too long on capital bases that were too slender.Now they are paying the price.The only pseudo-equity capital available is that from government sources.

Now, there may be a competition for that capital from the government, and perversely, it might lead to banks using the capital to buy other institutions (PNC has already done it to Nat City), rather than make loans, and on net, I would expect that to result in still fewer loans being made than in the absence of a merger. So let the competition begin for who can gobble their cheap competitors with cheap government capital.

4) Away from that, the Fed is having a hard time controlling Fed funds since they started paying interest on reserves deposited at the Fed.

Though I have written on the changing balance sheet of the Fed [link] and its implications, Jim Hamilton of Econbrowser has a very good post on it as well. The only place where I think we differ is that I think this will eventually be inflationary to goods prices when the Fed is forced to stop sterilizing.

5) Now the Fed is in the business of short-term unsecured lending to corporations via buying CP. (I think this will help lead to the first real CP default since Penn Central.) Early indications are that CP funding costs are higher than before the crisis if CP is funded by the Fed.

6) Never buy something you don?t understand, unless you have a friend who is smart and trustworthy by your side to advise you. Many municipalities got bamboozled by investment banks in much the same way that homebuyers got swindled by those offering subprime loans. Through derivatives, they offered a way to lower the current costs of debt by having the municipality sell options against their position that would force costs higher under certain circumstances which seemed unlikely, but were more likely than not.

The same is true of many investment products created by Wall Street for retail investors.? Sell them something that offers a high yield with safety, subject to some options sold short that are unlikely to come into the money.? I see it often.? Don’t but complex structured products from your broker.? Odds are they are taking you for a ride.

7) Those who have read me for a long time know that I think GM and Ford are eventual zeroes for the equity, and the subordinated debt.? Even the senior debt will get whacked severely.? There is no value in corporations that have huge promises to their employees way out into the future, when competing against better capitalized and better run foreign competitors like Toyota and BMW.

So, don’t bother trying to rescue them.? Rather, let foreign competitors buy them out, if they want them.? That will be a good test as to whether there is value there or not.? Possible foreign buyers have worked under the assumption that the Big 3 cannot be bought.? If the US sends a message that they can be bought, would any of them be bought?? My answer is no, unless the US Government or the PBGC sweetens the pot.? Other notes:

Daimler thinks Chrysler is a zero. (no surprise here)
The Treasury should give up on lending to the automakers. (Much as other think they are critical.? If the plants are valuable, foreign capitalists will maintain them.)
The TARP may lend to auto financing arms, but that is probably a mistake as well.
We should not bail out the auto makers, regardless of how politically expedient is is.? Because of the employee benefit promises made, there is no way any US automaker can beat foreign competition.? It is time to let them fail, and let the unions take the rebuke that they royally deserve.
GM is not too big to fail.? Let them fail, and then expedite the bankruptcy process, so that senior debt becomes equity, the firm goes non-union, and the firm can compete globally for the first time in 40 years.

8 ) Greg Mankiw asks if we have learned enough.? My view is no, we have learned little, and what Bernanke thinks he learned regarding the Great Depression is wrong.? This is not a crisis of confidence and liquidity, it is primarily a crisis of solvency, which drains liquidity.? High levels of total leverage make a financial system inherently unstable, and the only way to cure it is through expedited bankruptcy procedures.? As it is now, Bernanke and Paulson are trying to save the financial system by wagering the credit of the USA.? (My opinion is that our nation is great enough that we whould risk another Great Depression rather than give up our liberties to the Government.)

9) A young friend e-mailed me from LIthuania (where she has a semester abroad), and asked me how serious the current economic situation is.? My response:

To give you the quick summary, we may be headed into Great Depression 2.? Or, as I sometimes call it, the Not-so-great Depression.

A Depression is a severe recession where the solvency of the banks is compromised.? Debt levels of financial companies, consumers and our Government have gotten to levels where repayment of debts in full is difficult if not impossible.? The system is overleveraged, and funded by leveraged institutions that could fail if they aren’t paid back.? There is kind of a “domino effect” here, where failures can cascade.

That’s why the Government has stepped in, encouraging financial institutions to shift their debts over to the Government.? That will work for a while, but eventually parties will become reluctant to lend to our Government as it becomes a bottomless pit of promises.? Then inflation of the currency will begin.

This is an ugly situation, one that is the product of sloppy monetary policy, poor regulation of financial companies (for two decades), poor risk controls, overlending by government institutions, and a cultural failure where we borrowed too much and saved too little.

I wish I could be more chipper here, but this is ugly, and what the government is doing is not likely to solve the problems at hand.

10) Slow moves tend to persist, sharp moves tend to mean-revert.? Don’t put much confidence in today’s sharp move up.? Strong one-day upside moves are characteristic of bear markets.

11) My post last night neglected one item.? Stable value funds have more flexibility than many other financial entities.? Be wary if the credited rate drops a lot.? Better to withdraw funds in that scenario, because it implies that the market value of assets is significantly less than the book value.

12) Be ready for a surprise in the GDP data, as I highlighted last quarter.? The implicit deflator for Gross Domestic Product will be extra high in the third quarter because of the fall in energy prices.? Just as it pushed “real” GDP higher in the second quarter, it will exact its pound of flesh in the third quarter.

13) My pal Cody is red hot, and though he is less measured than I am, I agree with much of what he says.? We need to vote out Republicans and Democrats.? We need new options.? Personally, I think we need to radically change the Constitution, and move to have a parliment, where the head of state is the head of the majority party.? That will create government that is closer to the consensus.? Eliminate the Presidency — it is too dangerous of an institution.

As Cody put it today: 2. Real headline today: ?White House Encourages Money-Hoarding Banks to Start Lending? ? I thought profit-motive was what was supposed to encourage banks to lend. And only profits make stocks go up, so why would shareholders want the banks to start lending if the bankers don?t think it?ll be profitable?

I can’t agree more, and the Treasury is pushing on a string if they are trying to force the banks that they have financed to lend.

14) Commercial Real Estate is the shoe yet to fall, yet the CMBS market has anticipated much of the decline.? Are the Fed and Treasury ready for this?? They weren’t ready for residential housing declines.

15) The foolishness that exists today regarding the government buying stakes in financial companies has now transferred itself to policymakers who think the equity market is now cheap, so invest the Social Security surplus in the equity market.? Problems:

We have always avoided Socialism like this in the past.
How can a bureaucrat with no profit motive figure out whether out whether this is a good decision or not?? Or, how will the bureaucracy extract maximum value for the taxpayers?
Is the market really cheap now, or, only seemingly so.? The time to invest is during a baby bust, not a baby boom as it is now.

As with so many of these decisions, the answer will only be clear in hindsight.

A Maximum of One Year of Interest Lost

Posted on 28 October 2008 by David Merkel

A reader asked if I had an update to my piece Unstable Value Funds? Yes, I do.

Have we survived the demise of Fannie and Freddie, Ambac and MBIA? It seems that way, but I would not be certain. These credits were crammed into stable value funds. How do you feel about life insurers? The stock prices of those that issue GICs have fallen significantly. Credit spreads have widened significantly.

Should you worry here?? My view is yes.? Any significant negative impact on the GSEs, Financial Guarantors or Life Insurers could affect the solvency of stable value funds to the tune of one year’s worth of interest.

This is similar to the way that I view money market funds.? It is possible that they could lose a year’s worth of interest.? Beyond that, I don’t see likely losses, unless the stable value fund had an unusual investment policy.

Blame Game

Posted on 10 October 200810 October 2008 by David Merkel

Some people don’t like the concept of blame.? They view it as useless because it wastes time in looking for a solution.? I will tell you differently.? Blame is useful because it identifies offenders, which is the first step in eliminating the problem.? The trouble is that few have the stomach to get rid of the offenders.

So, as I traveled home from prayer meeting with my children last night, we listened to a radio show discussing the current credit crisis.? This was a good discussion, unlike many that I hear.? But the discussion (on NPR) eventually focused on “who should we blame?”? Okay, here is my incomplete version of who we should blame:

1) The Federal Reserve, especially Alan Greenspan.? For the past 20 years, we couldn’t let the economy have a severe, much less a moderate recession.? Rates were reduced before significant pain was felt by those who had borrowed too much.? The 1% Fed funds rate in 2003 was the pinnacle of that effort.? It created the ultimate bubble; there is nothing left to reflate in 2008 from easy monetary policy.

2) Congress and the Presidency — they encouraged undue leverage in a variety of ways:

a) Fannie, Freddie, the FHLB, and more: Everyone has gotta live in a single family home.? Gotta do that.? Thomas Jefferson’s ideal was that we should encumber future generations so that marginal buyers could live in houses beyond their means.? They compromised lending standards more and more, along with private lenders as the boom went on.

b) The SEC: in a fiat currency world, controlling the currency means controlling leverage of financial institutions.? The SEC waived leverage restrictions on the investment banks in 2004, leading to a boom, and a bust. Big bust.? Ginormous bust — how many large standalone investment banks are left?

c) Particularly the Democrats in Congress defended the GSEs as their own pet project.? I am not bashing the CRA here; I am bashing the goal of having everyone live in a house beyond their means.

d) We offered a tax deduction on mortgage interest, and a limited exemption on capital gains from selling a home.? There is no good reason for these measures.

e) And, the Republicans in Congress who favored deregulation in areas for which it was foolish to deregulate.? Much as I favor deregulation, you can’t do it if you have fiat money (unbacked paper money).? In that case you must restrain the growth of credit.

f) The Bush Jr. Administration — they did not enforce regulations over financial institutions the way that the law would demand on a fair reading.? Again, I’m not crazy about regulation, but unless you have a gold standard, or something like it, you have to regulate the issuance of credit.

g) Their unfunded programs with promises to the future; the states and Federal Government always promise today, and don’t fund it.? Hucksters.

3) Lenders steered borrowers to bad loans.? There was often implicit fraud, and in some cases, fraud.? The lenders paid their staff to do it.

4) Borrowers were lazy and greedy.? What? You’re going to enter into a transaction many times your income or net worth, and you haven’t engaged helpers or friends to advise you?? Regardless of the housing price mania, you should have gone slower, and done more homework.? Caveat emptor — you neglected that.

5) Appraisers were slaves of the lenders who wanted to originate and sell.

6) Those that originated MBS did not check the creditworthiness adequately.? They just sold it away.? Investment banks did not care where a profit was coming from in the short run.

7) Servicers did not demand a high price for their services, making it hard for them to service anything but solvent borrowers.

8) Realtors steered people into buying more than they could rationally afford; I’m not saying they did that on purpose, but their nature was to sell to get the highest commissions.

9) Mortgage insurers and financial guarantee insurers — because of the laxness of accounting rules, they were able to offer guarantees significantly in excess of what they could pay in the deepest crisis.

10) Hedge funds, investment banks and their investors — they demanded returns that were higher than what was sustainable.? They entered into businesses that would not survive difficult times.

11) Regulators let themselves be compromised by those following the profit motive.? Many hoped to make money after joining private industry later.

12) America.? We let ourselves become short-term as a culture, encouraging short-term prosperity, regardless of the cost.

13) Neomercantilists — they lent us money, because they wanted they export sectors to grow for political reasons.? This made our interest rates too low, encouraging overinvestment and overconsumption.

14) Average people who voted in Congress, and demanded perpetual prosperity — face it, we elect those that govern us, and there is the tendency in America to love the representative that brings home the pork, while hating Congress as a whole.? Also, we need to bear with recessions, and let them do their work, and not force our government to deal with them.

15) Auditors that did a cursory job auditing financial entities.? As the boom went on, standards got lower.

16) Academics who encouraged a naive view of diversification, and their followers who believe in uncorrelated returns.? In a bad economy, everything is correlated, and your statistics from a good economy don’t matter.

17) Pension and other funds that believed the academics.? It is amazing what institutional investors will fund, given the mistaken idea that correlation coefficients are stable.? Capitalistic economies are unstable by nature!? Why should we expect certain strategies to workallo the time?

18) Governmental entities that happily expanded government programs as the boom went on.? Now they are talking about increased taxes, rather than eliminating programs that are of marginal value to society.? Governments should not rely on increased taxes from capital gains, or real estate tax assessments.

19) Those that twitted “doom-and-gloomers,” and investors who only cared if markets went up.? It is hard to write about what could go wrong in the markets.? Many call you a wet blanket, spoiling their fun, and alleging that you are a short, or some sort of misanthrope.? The system is biased in favor of happy talk.? Just watch CNBC.

20) Me, and others who warned about the current crisis. Perhaps we weren’t clear enough.? Maybe our financial interests made us look like we were talking our books.? I know that I spent a lot of time on these issues, but in the short run, I was still an investor, trying to make money in the markets, hoping that what I feared would not occur.? Now I am getting my just desserts.

This is an incomplete list.? I invite you to add others to the list in your comments.

In Defense of the Rating Agencies — III

Posted on 23 August 200824 August 2008 by David Merkel

After writing parts one and two of what I thought would not be a series, I have another part to write.? It started with this piece from FT Alphaville, which made the point that I have made, markets may not need the ratings, but regulators do.? (That said, small investors are often, but not always, better of with the summary advice that bond rates give.? Institutional investors do more complete due diligence.)? The piece suggests that CDS spreads are better and more rapid indicators of change in credit quality than bond ratings.? Another opinion piece at the FT suggests that regulators should not use ratings from rating agencies, but does not suggest a replacement idea, aside from some weak market-based concepts.

Market based measures of creditworthiness are more rapid, no doubt.? Markets are faster than any qualitative analysis process.? But regulators need methods to control the amount of risk that regulated financial entities take.? They can do it in three ways:

Let the companies tell you how much risk they think they are taking.
Let market movements tell you how much risk they are taking.
Let the rating agencies tell you how much risk they are taking.
Create your own internal rating agency to determine how much risk they are taking.

The first option is ridiculous.? There is too much self-interest on the part of financial companies to under-report the amount of risk they are taking.? The fourth option underestimates what it costs to rate credit risk.? The NAIC SVO tried to be a rating agency, and failed because the job was too big for how it was funded.

Option two sounds plausible, but it is unstable, and subject to gaming.? Any risk-based capital system that uses short-term price, yield, or yield spread movements, will make the management of portfolios less stable.? As prices rise, capital requirements will fall, and perhaps companies will then buy more, exacerbating the rise.? As prices fall, capital requirements will rise, and perhaps companies will then sell more, exacerbating the fall.

Market-based systems are not fit for use by regulators, because ratings are supposed to be like fundamental investors, and think through the intermediate-term.? Ratings should not be like stock prices — up-down-down-up.? A market based approach to ratings is akin to having momentum investors dictating regulatory policy.

Have the rating agencies made mistakes?? Yes. Big ones.? But ratings are opinions, and smart investors regard them as such.? Regulators should be more careful, and not allow investment in new asset classes, until the asset class has matured, and its prospects are more clearly known.

With that, I lay the blame at the door of the regulators.? You could have barred investment in novel asset classes but you didn’t.? The rating agencies did their best, and made mistakes partially driven by their need for more revenue, but you relied on them, when you could have barred investment in new areas.

In summary, I still don’t see a proposal that meets my five 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.

And because of that, I think that solutions to the rating agency problems will fail.

Crude Oil: What Goes Up, Must Come Down?

Posted on 16 August 2008 by David Merkel

It was only two months ago when I wrote my surprisingly well-received post, Ten Notes on Crude Oil: The Fixation. It was surprising to me because I’m not an expert on energy issues. I’m just a good generalist portfolio manager who knows a little about a lot. So, I have to be careful what I say, and candidly say that I’m not sure, when that’s the case.

Here’s a graph of the price of crude over the last year.? Over the last two months, it was up fast in month one, and down faster in month two.? What a ride!

One Year Chart of the front month future of WTI Crude Oil

As prices rose in late June, President Bush called for lifting the restrictions on offshore drilling in the US.? If opening up ANWR was tough, this would be tougher, as there is a visceral feeling against drilling in states with significant coastal populations, even if the rigs can’t be seen from shore.

Another hurdle would be the lack of equipment capable of doing the drilling in the short run.? Think of all the industries with relatively tight capacity constraints that would be stimulated if the ban were lifted.? Drill-ships and rigs, specialty steel, coal, industrial gases… and more.? It would be quite a project.

As crude oil rose over $130/barrel, the exchanges moved to put limits on oil contracts.? Two weeks before the peak, credit conditions were leading shorts to cover positions.? Refiners began to let their crude inventories fall because it was getting more expensive to finance them.? So, as the market approached the price peak, there were a wide number of financing issues pushing the market around.

One week after the price peak, the demise of SemGroup made the headlines.? They were reportedly short the crude oil market, and were forced buyers covering near the peak.? Capitalistic markets are unstable, and that is mostly good thing, because it motivates market players to respond to the need.? At any significant peak/valley, some player that was taking significant chances gets uncovered as a fool who took big risks without a sound capital base, exacerbating the peak, and, the decline, though the fool doesn’t get to benefit.

As the price peak passed, this article posited why we would see oil down below $100.? The summary answer is demand destruction and supply encouragement.? High prices are the solution — users don’t buy as much, and suppliers see reason to produce more.? As for demand destruction, it is well underway in the US, but in places where prices are subsidized, or are artificially high due to taxes, the process is slower.

Every market has momentum players.? Momentum is a really simple strategy; do what the majority are doing.? That exacerbates the swings in the market, but given the needs of hedgers, whether they are producers or users, momentum tends to occur anyway for reasons of fear.

No surprise that high oil prices lead to conservation efforts on the part of corporations, as well as individuals.? High prices solve themselves.

One month after the recent peak, journalists point out the recent price peak.? Hindsight is 20/20, gentlemen.? I understand the need to explain what is going on, but I have more respect for those that take a position before the reversal, when it is painful to do so.

Crude oil is inelastically supplied and demanded, so it it should be no surprise that the price is volatile.? Small changes in expectations can produce big results, as is posited in this article on queueing theory.

I am not a peak oil “true believer.”? I believe that it is more likely than not.? As a result, I offer some time to the other side, because we can learn from them.? How much of the recent price spike is supply and demand, and how much? is speculation?? Hard to disaggregate, because speculation is normal to capitalistic markets.

Buffett: my guess is that he is accumulating a large stake in ConocoPhilips.? I could be wrong here; badly wrong, as he could be selling off.? But COP is cheap, has a large refining capacity, as well as significant E&P efforts around the globe.

Finally, a book review.? I was going to do reviews of two books on opposite sides of the peak oil question, but the book on the negative side was never sent to me.?

As for the pro-peak oil book, Profit from the Peak: The End of Oil and the Greatest Investment Event of the Century, my disappointment was that it was not written by an expert in the industry.? He posits that not only are we at peak oil, but we are at peak energy.? We are at or close to the peak in many forms of energy: coal, uranium, natural gas, etc.

This is a bold claim, an one that I think will be partially falsified, as men make efforts to expand energy with the incentives that come from high energy prices.

Full disclosure: long COP, also anyone entering Amazon.com through a link on my site, and buying anything, ends up giving me a commission.? No increase of cost to you.? It is my version of the tip jar.

Now, That Was Fast!

Posted on 6 June 2008 by David Merkel

From the RealMoney Columnist conversation yesterday:

		David Merkel
		Stealing a March; Next Comes the Pile-On
		6/5/2008 3:37 PM EDT

So yesterday Moody’s places MBIA and Ambac on Negative Watch. S&P grabs the ball and downgrades them, leaving them on negative outlook. I pointed out a while ago that the dike had been breached, and it was only a matter of time until the downgrades came.

And, as I pointed out yesterday, there will be new entrants to the market. Not only will Berky be there, with Assured Guaranty and Dexia, but Macquarie Group joins the party as well.

Even if Ambac and MBIA (the holding companies) survive, the business that used to be profitable for them will be occupied by others. I’ll throw this out as my next prediction in this space: they both go into conservation, and in runoff, claimants get paid off, senior debtholders get nicked, subordinated debtholders lose a lot, and the equity is a zonk.

Position: none

		David Merkel
		This Is a Great Country
		6/5/2008 3:41 PM EDT

One last note: the stocks rally after the downgrade. Probably short covering and other derivative-related activity, but you have to admit it is amazing for the stock to go up when the franchise gets destroyed.

Position: none

-=-=-=-=-=-=–==–==-=–=-=-==–=

Okay, after yesterday’s piece, there was a fast, opportunistic reaction by S&P. Moody’s action gave them cover to downgrade, and S&P took the ball and ran with it. Now that action gives Moody’s the cover to downgrade freely. There is no longer any reason for them to stay at Aaa. There is no money in it, and their reputation can only take further his from here. Rating agencies are like wolf packs — there is safety in the pack. Don’t be an outsider.

From one of my old RealMoney pieces (12/1/2004): Many of the conflict-of-interest problems still exist today. One more example: Could the ratings agencies downgrade MBIA (MBI:NYSE) or Ambac (ABK:NYSE) even if they wanted to? MBIA and Ambac rely on their Aaa/AAA ratings to the degree that they would have a difficult time operating without the rating. Much of the bond market relies on enhancement from MBIA and Ambac. The loss of a Aaa/AAA rating would be a jolt to the guaranteed bonds.

In addition, MBIA and Ambac structure their risks according to models provided by the ratings agencies. It is the models of the ratings agencies that tell the guarantors how much equity must stand in front of the debt that is being guaranteed. The ratings agencies are an inherent part of the business model of the financial guarantors. MBIA and Ambac can’t get along without them.

The ratings agencies derive so much income from these major financial guarantors that their own financial well-being would be affected by a downgrade. I’m not saying that either should be rated less than Aaa/AAA, but there is a cliff here, and I am wary of investing near cliffs.

Well, we came to the cliff, and S&P shoved MBIA and Ambac to the edge. Now Moody’s can push them over the edge. It should come soon. As with the rating agencies actions on the other financial guarantors, once a guarantor is pushed below AAA, the rating no longer matters as much. There are dedicated “AAA only” investors that care about this, and they will be forced sellers now, or, they will modify their investment guidelines. 🙁

Now, as I have mentioned before, stable value funds will have their difficulties here. Some have positioned themselves as “AAA only” funds, and that led to large holdings of MBIA- and Ambac-guaranteed debt. What they do now is beyond me. I suspect they try to modify their investment guidelines. 🙁

Well, at this point, we have to contemplate life without the old guarantors. They will shrink and disappear, while new guarantors, who are all currently skeptical of doing much more than Municipal bond insurance, will grow, and make it impossible for the old guarantors to return, because they are much better capitalized. Once you lose your AAA as a guarantor, you will rarely get it back.

One Dozen Notes on Our Crazy Credit Markets

Posted on 13 March 200813 March 2008 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?

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.

One Dozen Thoughts on Bonds, Financials and Financial Markets

Posted on 26 February 200826 February 2008 by David Merkel

1) The blog was out of commission most of Saturday and Sunday, for anyone who was wondering what happened. From my hosting provider:

We experienced a service interruption affecting the Netfirms corporate websites and some of our customer hosted websites and e-mail services.

During scheduled power maintenance at our Data Centre on Saturday Feb. 23 at approximately 10:30 AM ET, the building’s backup generator system unexpectedly failed, impacting network connectivity. This affected several Internet and Hosting Providers, including Netfirms.

Ouch. Reliability is down to two nines at best for 2008. What a freak mishap.

2) Thanks to Bill Rempel for his comments on my PEG ratio piece. I did not have access to backtesting software, but now I do. I didn’t realize how much was available for free out on the web. He comes up with an interesting result, worthy of further investigation. My main result was that PEG ratio hurdles are consistent with a DDM framework within certain moderate values of P/E and discount rates. Thanks also to Josh Stern for his comments.

3) I posted a set of questions on Technical Analysis over at RealMoney, and invited the technicians to comment.

		David Merkel
		Professionals are Overrated on Fundamental Analysis
		2/21/2008 5:19 PM EST

I’m not here to spit at technicians. I have used my own version of technical analysis in bond trading; it can work if done right. But the same thing is true of fundamental investors, including professionals. There are very few professional investors that are capable of delivering above average returns over a long period of time. Part of it is that there are a lot of clever people in the game, and that raises the bar.

But I have known many good amateur investors that do nothing but fundamental analysis, and beat the pros. Why? 1) They can take positions in companies that are too small for the big guys to consider. 2) They can buy and hold. There is no pressure to kick out a position that is temporarily underperforming. With so many quantitative investors managing money to short time horizons, it is a real advantage to be able to invest to longer horizons amid the short-term volatility. 3) They can buy shares in companies that have been trashed, without the “looks that colleagues give you” when you propose a name that is down over 50% in the past year, even though the fundamentals haven’t deteriorated that much. 4) Individual investors avoid the “groupthink” of many professionals. 5) Individual investors can incorporate momentum into their investing without “getting funny looks from colleagues.” (A bow in the direction of technical analysis.)

When I first came to RM 4.4 years ago, I asked a question of the technicians, and, I received no response. I do have two questions for the technicians on the site, not meant to provoke a fundy/technician argument, but just to get opinions on how they view technical analysis. If one of the technicians wants to take me up on this, I’ll post the questions — hey, maybe RM would want to do a 360 on them if we get enough participation. Let me know.

Position: none

		David Merkel
		The Two Questions on Technical Analysis
		2/22/2008 12:15 AM EST

I received some e-mails from readers asking me to post the questions that I mentioned in the CC after the close of business yesterday. Again, I’m not trying to start an argument between fundies and techies. I just want to hear the opinions of the technicians. Anyway, here goes: 1) Is there one overarching theory of technical analysis that all of the popular methods are applications of, or are there many differing forms of technical analysis that compete against each other for validity (and hopefully, profits)? If there is one overarching method, who has expressed it best? (What book do I buy to learn the theory?)

2) In quantitative investing circles, it is well known (and Eddy has written about it recently for us) that momentum works in the short run, and is often one of the most powerful return anomalies in the market. Is being a good technician just another way of trying to decide when to jump onto assets with positive price momentum for short periods of time? Can I equate technical analysis with buying momentum?

To any of you that answer, I thank you. If we get enough answers, maybe the editors will want to do a 360.

Position: none

I kinda thought this might happen, but I received zero public responses. I did receive one thoughtful private response, but I was asked to keep it private. Suffice it to say that some in TA think there is a difference between TA and chart-reading.

As for me, though I have sometimes been critical of TA, and sometimes less than cautious in my words, my guesses at the two questions are: 1) There is no common underlying theory to all TA, there are a variety of competing theories. 2) Most chart-readers are momentum players, as are most growth investors. Some TA practitioners do try to profit from turning points, but they seem to be a minority.

I’m not saying TA doesn’t work, because I have my own variations on it that I have applied mainly to bond investing. But I’m not sure how one would test if TA in general does or doesn’t work, because there may not be a commonly accepted definition of what TA would say on any specific situation.

4) One more note from RM today:

		David Merkel
		Just in Case
		2/25/2008 4:20 PM EST

Um, after reading this article at the Financial Times, I thought it would be a good idea for me to point readers to my article that explained the 2005 Correlation Crisis. Odds are getting higher that we get a repeat. What would trigger the crisis? A rapid decline in creditworthiness for a minority of companies whose debts are referenced in the relevant credit indexes, while the rest of the companies have little decline in creditworthiness. One or two surprise defaults would really be gruesome.

Just something to watch out for, as if we don’t have enough going wrong in our debt markets now. I bumped into some my old RM articles and CC comments from 2005, and the problems that I described then are happening now.

Position: none, and there are times when I would prefer not being right. This is one of them. Few win in a bust.

There are situations that are micro-stable and macro-unstable, and await some force to come along and give it a push, knocking it out of its zone of micro-stability, and into a new regime of instability. When you write about situations like that before the fact, it is quite possible that you can end up wrong for a long time. I wrote for several years as RM about overleveraging credit, mis-hedging, yield-seeking, over-investment in residential real estate (May 2005), subprime lending (November 2006), quantitative strategies gone awry, etc. The important thing is not to put a time on the prediction because it gives a false message to readers. One can see the bubble forming, but figuring out when cash flow will be insufficient to keep the bubble financed is desperately hard.

5) This brings up another point. It’s not enough to know that an investment will eventually yield a certain outcome, for example, that a distressed tranche of an ABS deal will eventually pay off at par. One also has to understand whether an investor can handle the financing risks before receiving the eventual payoff. Will your prime broker continue to finance you on favorable terms? Will your regulator force you to put up more capital against the position? Will your investors hang around for the eventual payoff, or will they desert you, and turn you into a forced seller? Can your performance survive an asset that might be a dud for some time?

This is why the price path to the eventual payoff matters. It shakes out the weak holders, and moves assets that should be financed by equity onto strong balance sheets. It’s also a reason to be careful with your own balance sheet during boom times, and in the beginning and middle of financial crises — don’t overextend your positions, because you can’t tell how long or deep the crisis might be.

6) I agree with Caroline Baum; I don’t think that the FOMC is pushing on a string. The monetary aggregates are moving up, and nominal GDP will as well… it just takes time. The yield curve has enough slope to benefit banks that don’t face a lot of credit problems… and the yield curve will steepen further from here, particularly if the expected nadir of Fed funds drops below 2%. Now, will real GDP begin to pick up steam? Not sure, the real question is how much inflation the Fed is willing to accept in the short run as they try to reflate.

7) Now, inflation seems to be rising globally. At this point in the cycle, the FOMC is ahead of almost all major central banks in loosening policy. I think that is baked into the US dollar at present, so unless the FOMC gets even more ahead, the US Dollar should tread water here. Eventually inflation elsewhere will get imported into the US. It’s just a matter of time. That’s why I like TIPS here; eventually the level of inflation passing through the CPI will be reflected in implied inflation rates.

8 ) Okay, MBIA will split in 5 years? That is probably enough time to strike deals with most everyone that they wrote coverage for structured products, assuming the losses are not so severe that the entire holding company is imperiled. If it’s five years away, splitting is a possibility, but then are the rating agencies willing to wait that long? S&P showed that they are willing to wait today. Moody’s will probably go along, but for how long?

9) I found it interesting that AQR Capital has not been doing well in 2008. When quant funds did badly in the latter half of 2007, I suffered along with them. At present, I am certainly not suffering, but it seems that the quants are. I wonder what is different now? I suspect that there is too much money chasing the anomalies that the quant funds target, and we reached the end of the positive self-reinforcing cycle around mid-year 2007; since then, we have been in a negative self-reinforcing cycle, with clients pulling money, and the ability to carry positions shrinking.

10) Now some graphs tell a story. Sometimes the story is distorted. This graph of the spread on Fannie Mae MBS is an example. Not all of the spread is due to the creditworthiness of Fannie Mae. Those spreads have widened 30 basis points or so over the past six months for Fannie’s on-the-run 5-year corporate bond, versus 50 basis points on the graph that I referenced. So what’s the difference? Increased market volatility makes residential MBS buyers more skittish, and they demand a higher yield for bearing the negative optionality inherent in RMBS. Fannie and Freddie are facing harder times from the guarantees that they have written, and the credit difficulties at the mortgage insurers, but it would be difficult to imagine the US Government allowing Fannie or Freddie to default on senior obligations.

That’s another reason why I like agency-backed RMBS here. You’re getting paid a decent spread to bear the risks involved.

11) I would be cautious about using prics from CMBX, ABX, etc., to make judgments about the cash bonds that they reference. It is relatively difficult to borrow and short small ABS and CMBS tranches. It is comparatively easy to buy protection on the indexes, the only question is what level does it take to induce another market participant to sell protection to you. When there is a lot of pressure to short, prices overshoot on the downside, and stay well below where the cash bonds would trade.

12) One last point, this one coming via one of our dedicated readers passing on this blurb from David Rosenberg at Merrill Lynch:

A client sent this to us last week

It was a New York Times article by Louis Uchitelle in December 1990 on the housing and credit crunch. In the article, there is a quote that goes like this ? ?This is different from the experience of the Great Depression, but something related to the 1930?s is beginning to happen?. Guess who it was that said that (answer is at the bottom of the Tidbits).

Answer to question above

?Ben Bernanke, a Princeton University Economist? (and future Fed chairman, but who knew that then?).

My take: it is a very unusual time to have a man as Fed Chairman who is a wonk about the Great Depression. That makes him far more likely to ease. The real question is what the FOMC will do if economic weakness persists, and inflation continues to creep up. I know that they want to save the day, and then remove all policy accomodation, but that’s a pretty difficult trick to achieve. In this scenario, I don’t think the gambit will work; we will likely end up with a higher rate of price inflation.

In Some Ways, The Municipal Bond Market Was Asking For It

Posted on 16 February 200817 February 2008 by David Merkel

What do municipalities want from their bond market? Low long-term financing rates. In and of itself, that’s not a bad goal to pursue. The question is how you do it.

What prompted this post was an article from The Bond Buyer (via Google cache). The need for short-dated tax-free muni bonds drives hedge funds (typically) to buy long munis and sell short term debt to finance the bonds, which tax-free money market funds buy. For more on Variable Rate Demand Structures, look here. (Thanks, Accrued Interest. The article was prescient to the current troubles.) The Wall Street Journal also anticipated the current troubles in this article. The hedge funds could only take the pain for so long. As perceived risks rose with the sagging prospects of the financial guarantors, fewer market players wanted to buy the short term debt, because the collateral underlying the short term debt no long had high enough ratings. That led to the hedge funds having to collapse their balance sheets, selling the long munis, and repaying the short term debts, taking losses in the process.

Now, many of the same difficulties apply to auction rate bonds (another article from Accrued Interest), no matter who the obligor (entity that must pay on the bond) is. As I commented recently:

Part of the difficulty here is that auction rate structures are unstable. They can handle 30 mph winds, but not 60 mph winds. Auction rate structures deliver low rates when things are calm, but can be toxic when short term liquidity dries up. A sophisticated borrower like the NY Port Authority should have known that going in. Small borrowers are another matter, their investment banks should have explained the risks.

Yes, the explanations are all there in the documents, but a good advisor explains things in layman?s terms. That said, it is usually the shortsightedness of local governments wanting low rates and long term funding at the same time that really causes this. You can have one or the other, but not both with certainty.

Or, as I commented at RealMoney:

		David Merkel
		Failed Muni Auctions are not the End of the World
		2/14/2008 2:50 PM EST

Most of the municipalities with the failed auctions are creditworthy entities that don’t need bond insurance. Bond insurance is “thought insurance.” The bond manager doesn’t have to think about the credit if he knows the guarantor is good. If the guarantor is not good, then the bond manager has to get an analyst to look at the underlying creditor. That takes work and thought, and both of those hurt. Daniel Dicker is on the right track when he says the municipalities are racing refinance. Well, good. Auction rate structures are stable under most conditions, but under moderate stress, like the lack of confidence in the guarantor, they break. I would like to add, though that auction rate structures are kind of a cheat. Why?

1) The municipality gets to finance short, which usually reduces interest costs, but loses the guarantee of fixed-rate finance. 2) This is driven by investors who want tax-free money market funds. Most municipalities don’t want to issue the equivalent of commercial paper. They want long term financing. 3) The auction rate structure seems to give the best of both worlds: long term financing at short rates, without having to formally issue a floater. 4) For minor hiccups, an interested investment bank might take down bonds, but in a crisis, they run faster than the other parties from a failed auction.

The municipalities could have issued fixed or floating-rate debt over the same term, but they didn’t because it was more expensive. Well, now they will have to bear that expense, and yes, as Daniel points out, that will make the muni yield curve steepen.

Pain to municipalities, which will mean higher taxes for debt service. Fewer auction rate securities to tax free money market funds. It’s a crisis, but not a big crisis.

Position: none
Let me put it another way. No one complained when hedge funds levered up the long end of the muni market, allowing municipalities to finance more cheaply than they should have been able to. But now that the leverage is collapsing, and municipalities that did not prudently lock in their rates, but speculated on short rates are getting hurt, should it be a major crisis? I think not. Personally, I think the wave of auction failures will give way to refinancing long, and a new group of speculators buying auction rate securities at higher yields than the prior short-term equilibrium yield.

Eight Thought on Our Fragile Debt Markets

Posted on 14 February 2008 by David Merkel

It’s early morning now, after two days on the road.? It is good to be home, and it will be good to get back to “regular work” once the workday begins.? A few thoughts:

1) Here are two Fortune articles where Colin Barr quotes me regarding Buffett’s offer to reinsure the muni liabilities of the financial guarantors.? He correctly quotes my ambivalent view.? I am not willing to take Ackman’s side here, nor that of the guarantors and rating agencies.? This is one of those situations where I don’t think anyone truly knows the whole picture.? My thoughts are limited to Buffett’s offer.? He’ a bright guy, and he is hoping that one of the guarantors is desperate enough to take him up on his offer.

2) Personally, I found this note from the WSJ economics blog worrisome.? Ben Bernanke is probably a lot smarter than me, but I can’t see amelioration in the residential real estate markets in 2008.? We still have increases in delinquency and defaults at present.? Vacancy is increasing. Inventory is increasing.? The market is not close to clearing yet.

3) I like the “quants.”? Are they a big force in the stock market?? Yes.? But they are an aspect of Ben Graham’s dictum that in the short run the stock market is a voting machine, but in the long run it is a weighing machine.? “Dark pools” sound worrisome, but to long-term investors they are a modest worry at best.? Traders should be concerned, but that is part of the perpetual war between traders and market makers/specialists.

4) There are two aspects to the concept of the rise in housing prices.? One is the scarcity of desirable land near where people want to live.? The second is that financing terms got too loose.? Marginal Revolution says there is/was no housing bubble.? They are focusing on the first issue, and downplaying the second issue.? My view is that there are legitimate reasons for housing prices to rise, but we built more homes than were needed, and offered financing terms to buyers that were way too generous.? To me, that is a bubble, and we are still working through it.

5) Auction-rate securities have always seemed to me to be micro-stable, but subject to macro-instability.? What do I mean?? Small fluctuations get absorbed by the investment banks, but large ones don’t.? As an old boss of mine used to say, “liquidity is a ‘fraidy cat.”? It’s around for minor jolts, but disappears in a crisis.

6) Muni bond insurance is thought insurance.? Most municipal bonds are small.? What credit analyst wants waste time analyzing a small municipality?? With a AAA guaranty, the bonds get bought in a flash, and they are liquid (so long as the guarantor continues to be viewed positively).? So, I still view municipal guarantees as having value.? Not everyone else does.

7)? Intuitively, I can feel the dispute regarding the recycling of the current account deficit.? The two sides boil down to:

When are they going to stop buying depreciating assets?
What choice do they have?? They have to do something with all the dollars that they hold.

It’s a struggle.? In the short run, supporting the US Dollar makes a lot of sense, but the build-up of continual imbalances is tough.? Why should we buy into a depreciating currency in order to support our exporters?

8 ) Privatize your gains, socialize your losses.? It’s a dishonest way to live, but many press their advantage in such an area. Personally, I think that losses need to be realized by aggressive institutions.? They took the risk, let them realize the (negative) reward.

That’s all for the morning.? Trade well, and be wary of things that work in the short run, but are long run unstable.