Friday, May 16, 2008

Your overconfidence is your weakness

Apparently everything is doing just swimmingly. So much so that the Fed is going to hike rates later this year. Check out Fed Fund implied rates for the October meeting...

And for December...

So by December the odds of any rate cut are near zero, and there is a 60% chance of some kind of rate hike. Don't buy it. Instead buy the 2-year. Look, I think I'm a relatively optimistic guy, but the housing bust will take time to work through. In the mean time, consumer spending will be pinched and that will ultimately prove disinflationary. I know I got a violent reaction in the comments to yesterday's post on this subject, but I just can't buy that the money supply is expanding with banks universally pulling back on credit.

Meanwhile agricultural commodities continue to fall, which really belies the "oil is up because of the dollar" argument. Here is the chart...

While agriculture is still way up for the last 12-months and therefore should continue to pressure retail food prices for a while, this trend is a net positive for inflation expectations.

Anyway, former credit market pariah iStar Financial is coming with a new unsecured bond deal today. About a 30bps new issue concession, which isn't too bad all things considered. Swap spreads are crashing in, with 2-year swaps falling 6bps in the last 2 days, and hitting its lowest level since 4/7.

I continue to trade my personal money from the short side in stocks, if anyone cares.


Anonymous said...

You make a common error when you assume that the value or purchasing power of a currency is simply a funtion of its supply.

The demand for that currency is just as important. Economics 101: Price (purchasing power) is determined by the intersection of supply and demand.

Global demand for dollars is collapsing. Even if supply of dollars should go down it is likely that the purchasing power of the dollar will be much lower next year than this year.

Anonymous said...

good post...i usually find you a little over optimistic for my liking, but i think you have it right being long 2y Treasuries and short stocks. it seems to me that right now we have an overly optimistic institutional investor base, who haven't done their research on the scale of the problems facing the US today. the economic downturn will be long and painful and there will be many business and banking failures. money supply is not actually expanding, which like you say makes sense in a credit contraction.

so long treasuries, short stocks and selectively short credit seems the way to be. and definitely DON'T follow the crowd buying new bond issues like crazy these last two weeks...

Anonymous said...

Long foreign & muni bonds, short stocks except for international companies. Getting a little apprehensive about recoupling though...what are your thoughts on overseas equities?

Anonymous said...

You weren't asking me, but I'll give my 2 cents anyway. Many mid-sized solid companies that are household names in their own countries and steadily growing abroad are currently under-priced. A few have seen stocks bottoming out at P/E close to 10 as investors desperately liquidize assets. I'd recommend Nordic companies that have managed to establish themselves in Russia. Their home markets are small, while Russia's is large, so they can't help but continue expanding for the foreseeable future. But TANSTAAFL, these same companies are usually present in the Baltics too and that trio of countries are heading for recession.

Don't count on a rate cut by the ECB this summer. If the figures for the second quarter show sustained overall growth in Euroland while inflation hovers around 3% then it's unlikely that there will be any rate cut this year. I imagine Berlusconi will be howling but the rest of Europe could hardly care less about what he thinks.

Anonymous said...

AI - just because consumers in the *U.S.* may be retrenching (this is I think debatable) -- it does not follow that consumers world wide are retrenching.

Oil use in the U.S. has been more or less flat for the past couple years, according to the Dept of Energy. Yes, I know the talking heads on CNBC are saying consumers are cutting back due to higher gas prices -- but that's why they are on TV and not trading. The actual gasoline consumption numbers say usage is unchanged (its actually up by an insignificant amount).

Oil use in many other economies is SOARING. Many foreign governments fix the retail price of gasoline (China and India being two obvious examples). Consumers in those countries are not seeing higher crude prices pushed through -- plus their economies are growing like crazy.

Money supply elsewhere in the world is growing markedly -- and whether you admit it or not, inflation is a HUGE problem in the middle east, Asia and Europe. Theorize about housing all you want -- the inflation numbers are saying there is inflation.

Even here in the U.S.-- despite this housing deflation you keep harping on-- CPI is up 4% year over year. That's double the "comfort zone" cited by Bernanke, and the trend is up from last year when the housing debacle started. And CPI is such an understated measure that even the geniuses on CNBC are starting to mock it.

While you and some other LOUD Wall Street types are busy crying for Congress to bail you and some irresponsible "home owners" out of losing positions -- the facts are that the housing disaster is rather concentrated. A small minority of people who got in way over their heads are predictably in trouble-- as are the foolish bond holders who lent them money.

The sky is NOT falling and the housing situation is nothing like what it was in the great depression. You are all a bunch of cry babies. 95% of the country is paying their bills and cutting back on splurges -- same thing we have to do in every recession. We are not whining for Congress (aka taxpayers) to bail us out.

Wall Street's business model has become dependent on absolutely unhealthy levels of lending -- it needs to cut back. No amount of Fed Funds cuts or stupid taxpayer bailouts will make 100% LTV securitization profitable.

I still haven't heard you (or any other deflation advocate) give any kind of explanation why the 15% per year housing price appreciation was not wildly inflationary... so I can't place much faith in your current notion that 10% house price depreciation is somehow now deflationary. You are trying to have it both ways, and it doesnt make any sense.

The Greenspan/Bernanke monetary experiment has proven to be a complete disaster. Greenspan is spending his retirement defending his unsound policies against criticism from all over the world, while Bernanke can't seem to figure out if the sky is falling or not. Paul Volcker has called Bernanke's actions barely legal, and setting foolish precedent in the long term.

I know you and I disagree on the whether there is a liquidity problem (you) or an insolvency problem (me). I have very patiently explained my views, but all I have heard from you is that a bunch of over-leveraged portfolio managers are in over their heads, and somehow this means the Fed must bail them out at the expense of anyone with savings...

The U.S. national debt is at all time highs. Consumer borrowing is at all time highs. Home equity (percent of homes paid for as opposed to borrowed) is at all time lows...

How can you possibly argue that what we need is more debt?

Anonymous said...

Wait, you went through this long tirade about how money supply is not expanding or contracting -- but now you want to argue that this non-event is deflationary?

Given the absolutely massive (unmanageable?) levels of debt in the government and at the consumer -- you had better be wrong about deflation (I think you are).

If you truly believe deflation is taking hold -- you really should move to another country. A massive debtor nation like the U.S. would not survive any measurable levels of deflation.

So AI -- are you moving or do you not believe your own deflation theory?

Anonymous said...

AI, love reading your posts.

Looks like we have a battle of deflation in asset prices caused by deleveraging vs. inflation of COLA caused by "flattening of the world".

Accrued Interest said...


I don't remember arguing for a bailout, with the exception of Bear Stearns. I have argued that I thought there would be a bailout of home owners. So I base my decisions on what I see happening and not what I want to see happen.

Now I believe you have argued that the Fed's actions to date constitute a bailout. I wouldn't characterize it that way, because in my view, all the Fed has done is expand the discount window. I don't think the mere existence of the discount windown constitutes a bailout. But that's mostly a debate over the definition of a bailout. I think you'd say the Fed shouldn't be expanding liquidity in the way they are period, so whether or not we call it a "bailout" isn't the point.

What I'd like to hear your response to is my contention that we have both a real economy problem and a liquidity problem. Both. You are trying to characterize my arguments as though I deny the former in favor of the later, as if they are mutually exclusive. That's a point of view I just don't understand at all. Your case that the Fed shouldn't be doing what they are doing is perfectly legitimate and you've argued it well. I just happen to disagree. But your point that liquidity isn't (or wasn't more accurately) part of the problem doesn't make sense to me. In other words, arguing that we have a solvency problem doesn't negate the liquidity problem, but you seem to think it does.

Accrued Interest said...

And I don't think we're headed for deflation. I just think there are dysinflationary forces at work here.

Also for the record, I'm worried about inflation expectations taking hold. Very worried. I just think the more likely thing is that consumers are going to be more worried about the price of their house falling than paying more for gas.

But my confidence in that view is maybe 70/30. The 30% view though would cause the Fed to aggressively hike rates in the near term, which would undoubtedly put us in a prolonged and/or double dip recession, depending on the timing of things.

That kind of leaves you negative on stocks either way. Because either the consumer remains crimped for a while and doesn't spend as much, or growth is retarded by tight monetary policy. Both are not so hot for profit growth.

Anonymous said...


OT questions:

What is Fed's exit strategy for the $350B lending to banks?

What will be the bond traders response if news that these "Triple-A" assets are pretty much "junk"?

I hear the monolines are decoupled from the market. What is the likely bond market reaction if Ambac & MBIA are downgraded?

Thank you for posting your thoughts.

Accrued Interest said...

On Ambac and MBIA, my view is that the market has discounted their downgrade already, especially ABK. I'm basing this on the fact that the market hasn't really reacted to recent negative news for both companies. I think it looks pretty likely that at least Moody's is nearing some action.

The thing about these companies is that there isn't much chance they'd run out of cash in the very near term. So from a cash-flow view, the risk that other financial institutions would have to eat what ABK or MBI have insured is low, in the near term. Obviously a downgrade may result in new capital needs, but the market seems to think that capital is available if need be. Right or wrong, I'd take that as the market's view.

On the "exit" strategy... if I'm reading your question correctly, I don't think they need one. Interest in the TSLF is basically nada, and use of the discount window has been waning. So I think the plan is just provide liquidity for as long as its needed.

Anonymous said...

AI -

If your business is economically viable long term (without direct or indirect subsidies), and the market "unfairly" demands that you convert all your assets to cash immediately -- that is a run on a bank. That is a case where a lender of last resort (Fed or whomever) should step in. Shutting down that sort of business makes so sense economically, and hurts everyone in the long run. That would be a "liquidity" problem.

On the other hand, if your business is not economically viable (by itself without subsidies) -- then it is NOT a liquidity problem.

Bear, and many other "portfolios" on Wall Street, are questionable entities at best. Clearly, 30-1 leverage is just asking for trouble at some point -- it leaves you zero margin for error. If your organization is run by or operated by humans... well to err is human. Anyone who allowed their company to get levered 30-1 is not a good business manager. Period. Amen. End of discussion.

If your business model depends on making (and securitizing) loans to persons of questionable credit worthiness; and you lend 100% LTV to those people; and the collateral you are lending against is priced way way way above its long term trend; and you make the loan on short term rates when short term rates are at generational lows (suggesting they have no where to go but up).... Well that is just plain stupid. No, that isn't 20/20 hindsight -- dozens of journalism majors who never set foot in an MBA class anticipated the problem. Anyone qualified to run a bank or Wall Street firm has no excuse.

Some fellow blogger is going to try to argue that Bear wasn't insolvent. Well, Bear management went to the Fed because they were ready to declare bankruptcy. And Jamie Dimon, even with a Fed gun to his head, refused to buy Bear unless the Fed carved out $30 billion of trash. The people running Bear thought it had a problem, the market thought it had a problem, the Fed thought it had a problem, JPM thought it had a problem -- only a bunch of blogger who haven't seen the details of Bear's books think it was OK.

When a bank legitimately has a problem -- that isn't a "bank run" that the Fed is designed to avoid.

It should be mentioned that Bear is not alone. Think of the people that are throwing money at over levered Wall Street houses... basically foreign central banks and foreign sovereign funds... Or more generally -- players not motivated by profits. Non economic players.

Warren Buffet is sitting on tons of cash, and Wall Street is selling for half price. If this was a "bank run", its hard to figure out why a smart long term investor like him wouldn't be snapping it up.

You talk about a liquidity problem, but you neglect to mention there are lots of players like Annaly Capital, Pimco, Blackrock, etc that are HUGE mortgage players and they aren't having trouble getting funding. They are well run firms,:their liability's maturity closely resembles those of their assets and they are "reasonably" leveraged. Even though they have longer term financing than the clowns on Wall Street, they have lower leverage.

Wall Street has serious problems. There is a disturbing level of cronyism. A good CEO would never allow 30-1 leverage on volatile securities. Funding multi-year assets with overnight debt is insane -- it means you have a huge curve flattening trade on top of your 30-1 levered portfolio. And the basic "business model", if you can call it that, amounts to securitizing garbage and pretending like it is off balance sheet.

If you look at the major banks and Wall St houses, many of them have now "lost" more money in the past year than they supposedly "made" in the previous 10 years... in short, their business model does not actually make money.

I really worry about the long term future of the United States when the government steps in and uses taxpayer monies to prop up loosing businesses. This is socialism. Yes, lending banks money at 2% (Fed Funds) and borrowing it back from them at the 10yr rate is a taxpayer subsidy -- no matter what silly spin the Fed tries to put on it.

None of the major banks/sell side firms were big 20-30 years ago. The ones that were big are now gone, and life went on. Its ridiculous to say the U.S. won't survive if we don't prop up poorly run companies.

Let them fail. Call it tough love if you want, but for the long term good of the country, poorly run businesses MUST be allowed to fail.

Our society won't make it if we preserve the stupid at all costs, especially at the expense of the prudent.

If Wall Street is going to be successful, we must have meritocracy instead of cronyism.

Its not a liquidity problem if your business is a money losing disaster. That's called insolvency. The fed should have let them fail

Accrued Interest said...


Maybe I'm just dense, but I think I finally get where you and I differ. I'd argue two things:

1) Bear Stearns was not bailed out. Their bond holders and other liability holders were. No CEO is going to operate their business hoping to be taken out at $2/share.

2) The system couldn't afford to have Bear go down. It didn't have anything to do with leverage, it had to do with massive counter-party risk. That's the problem I'd love to see solved, the cross-counterparty risk problem. We cannot have these massive derivates changing hands with old highly leveraged brokerages standing in between. That's insane. These instruments need to be standardized and exchange-traded. Then problems at any one brokerage wouldn't bring down the whole system.

It infuriates me, as a tax payer, to know that I'm taking some of the risk that rightfully belongs to J.P. Morgan. But as a student of economics generally and of the Depression specifically, I believe it is the right move.

Anonymous said...

AI, thank you for you reply. Your knowledge is priceless for a young and learning investor.

"I'm basing this on the fact that the market hasn't really reacted to recent negative news for both companies. I think it looks pretty likely that at least Moody's is nearing some action."

Back to monolines, this is where I just don't get it. If the market already discounted the downgrade, then why not just do it and have some credibility and trust back to the market. All these "game playing" with ratings and level 3 just cause me to think Wall Street is trying to scam me. Am I wrong to think that way or should I just follow the market forces. Resistance is futile? I used to work for Enron and this smell like Enron.

Accrued Interest said...

One more thought on Bear Stearns:

We may never really know if Bear Stearns would have survived in the absense of the bank run. But to say there was no bank run is just not the case. They suffered massive prime brokerage withdrawals. Now we'll never know if BSC would have eventually suffered enough losses to take them under anyway, but the proximate cause of their near bankruptcy was a bank run. I think that's settled fact.

We are all saying we'd like to return to capitalism. In a real capitalist world, ABC Brokerage could decide to have 100-1 leverage and XYZ Brokerage could have 5-1 leverage. If ABC is being foolish, they go under. If ABC somehow hedges and manages that leverage, they make tons of money. That's capitalism. That's the world I wish we lived in.

But in the real world, ABC is intertwined with the whole financial system, and therefore if ABC goes down it will cause losses at firms that were otherwise properly managing their risks. That's unacceptable, and hence the real life ABC was bailed out.

Like I say, the way to get closer to the capitalist ideal is to eliminate the counter-party risk. If the top 20 banks and brokerages all funded a CDS exchange, then the bankruptcy of any one wouldn't sink our system. We could have just let BSC go.

Accrued Interest said...

Now on the monolines...

Its clear that Ambac's rating in particular is BS, at least to me. The struggle, which I wrote about here...

... is that neither company is likely to run out of cash any time soon. So if having a AAA rating wasn't so important for their business, this would be a minor story.

So if we agree that they are "unlikely" to run out of cash. How unlikely? 1%? 5%? 10%? How "unlikely" does it have to be before we'd call it AAA?

I mean, I wouldn't call them AAA, but it doesn't matter what I think does it?

Getting back to the "capitalist" theme... in a perfect world, if I didn't think Ambac was worth a AAA rating, then I just wouldn't buy their securities or I'd demand more yield to do so. In a perfect world, credit ratings would be sort of like star ratings for a resturant. You are perfectly allowed to hate a 4-star place and love a 2-star place. Just like you could argue that some BBB company is less risky than some AAA company. You are welcome to that opinion.

Unfortunately in banking, AAA is the law. It impacts capital ratios in a way that doesn't please me. It puts way too much weight on a subjective measure of credit risk.

Celal Birader said...

I just can't buy that the money supply is expanding with banks universally pulling back on credit.

Bank credit is still going up according to THIS .

Accrued Interest said...

Fair enough, although I'd point out that there has been a lot of bringing SIV's onto balance sheets which had influenced these figures.