Friday, November 28, 2008

We need? What about you need?

The Fed's new Term ABS Loan Facility (TALF) announced this week could be a significant step in improving credit availability. While many of the details of the program are not yet known, there is already several take aways.

First, this looks and smells a lot like a back-door way of reviving some of the TARP's original concept. Consider what we already know about the program. Eligible collateral for the TALF will basically include AAA-rated bonds within the major non-housing ABS sectors: auto loans, student loans, credit cards, and SBA loans. TALF loans will have a one-year term and will be non-recourse to the borrower. The facility appears to be oriented toward banks and insurance companies, but may actually be available to anyone. TALF loans "will no be subject to mark-to-market or re-margining" which is a critical part of the program.

Now put these criteria together and consider the effect. A bank may originate loans of the above types, then get funding from the Fed at an attractive rate. There is no need to worry about the funding being taken away suddenly because of changing haircuts, nor is there any worry about interim marks impacting economic results. The originator does have an incentive to make a good loan, since the Fed is going to require some haircut. But as long as the originator can make good loans, the eventual profit will be the differential between the lending rate and the Fed borrowing rate.
Let's look at a real life example. COMET 2008-A6 A6 is a credit card ABS issued in May. The original deal spread was +110bps over 1-month LIBOR with a 2.4 year average life. Currently bonds of this type are trading with a spread of around 600bps, which makes the dollar price of this bond around $89.
Analyzing asset-backed bonds gets complicated because bond holders get monthly principal and interest payments. But in simple terms, the bond is yielding LIBOR +600bps. If the Fed is willing to lend at LIBOR +50 or 100bps, banks will quickly gobble up high quality ABS paper. As a result, the yield spread on this kind of ABS will contract until its closer to the Fed's lending rate. If the COMET bond were to go from LIBOR +600 to LIBOR +300, the bond's price would appreciate by 5.5 points.
There would be two important knock-on effects. First, it would create a price floor for similar ABS which isn't pledged into a Fed facility, alleviating mark-to-market problems banks are currently facing. Second, it will allow for new origination in ABS, which will help rejuvenate consumer credit.
The primary beneficiary will be the ABS securities itself. Next would probably be the bigger holders of ABS paper, which include banks and P&C insurers. Companies involved in securitization will also benefit: credit card issuers like Capital One and student lenders like Sallie Mae. There is already talk that this program could be extended to Commercial MBS, which would benefit REITs tremendously.
Disclosure: Long certain ABS as well as Sallie Mae

Thursday, November 27, 2008

Accrued Interest Holiday Edition

Its time for a new tagline for the blog. So in proper geek fashion, I've created a poll. The options are...

Republic credits? Credits are no good out here. I need something more real.

More wealth than you can imagine

That was before the dark times... before deleveraging

Or suggest something else in the comments.

Wednesday, November 26, 2008

And NOW young monoline... you will die

Moody's has downgraded FSA and Assured Guaranty on Friday, claiming that with the future of municipal monoline insurance uncertain, it is unlikely that any stand-alone insurer could ever get a Aaa rating. I predicted the death of these insurers back in July when Moody's first put both on negative watch. For several months it appeared I was wrong, as either FSA or Assured wrapped approximately 22% of all new municipal issuance from August 1 to today. Assured's stock price rose from $11 to $17. They worked out a deal to re-insure CIFG's muni book. They agreed to purchase FSA. All in all it seemed like there were plenty of believers in municipal insurance.

But Moody's was the only doubter that mattered. Now municipal bond insurance is all but extinct.

Now I've outlined a good case for why municipal insurance should continue to live on. But forget about that. One can also make a case that FSA and/or Assured Guaranty shouldn't get a Aaa rating because of issues related to those companies specifically. But that's not what I want to talk about either.

What bothers me is Moody's assertion that demand for municipal bond insurance might decline and therefore no firm can get a Aaa rating.

Here is the problem with Moody's stance. It has nothing to do with their actual view of municipal insurance. Its painfully obvious that this is nothing more than CYA. Its like a referee doing a make-up call. They completely screwed up structured finance ratings from 2002-2007 or there abouts. And thus they have a lot of egg on their face in regards to FGIC, Ambac, MBIA, etc.

So now they want to act all tough and refuse to give Aaa ratings to monolines under any circumstances. Does this make any more sense than when they were giving out Aaa like business cards? Aren't they essentially making Assured Guaranty pay for the sins of FGIC?

Consider this. Let's say that a new municipal insurer is created and that insurer acquires all the municipal policies from Ambac. Now let's say that the new insurer has enough capital such that if it immediately went into run off, it could pay all realistic potential premiums with a significant cushion. What is "realistic" and "significant" in the previous sentence would need to be defined, but there is no reason why Moody's can't come up with those numbers.

Why can't such a firm be rated Aaa?

Notice how in the above scenario, the firm's ability to generate new revenue isn't relevant. The firm's ability to raise new capital isn't relevant. Its simply does the firm right now have adequate capital to pay its liabilities. Why is that concept so unreasonable?

For Moody's to claim they cannot rate on this basis is a total cop out, because this is exactly how all securitized deals are rated. A securitization is always a closed loop. The ratings have to be based on available capital versus expected losses. Obviously mistakes were made in rating securitized deals in recent years. But for Moody's to claim they cannot rate on such a basis is complete bullshit. Do we need to alter our models? Absolutely. But Moody's cannot on one hand claim to be a competent ratings agency and on the other hand claim they can't estimate muni losses versus available capital.

Municipal insurance benefited both investors and municipalities. Now it will die, all because Moody's doesn't have the courage to rate insurers based on dollars and cents. Instead they are rating based on public relations.

And by the way, why the hell has AGO's stock price risen since this news? They are toast, and I'm short.

Tuesday, November 25, 2008

My God, they aren't kidding!

The Fed will be buying up to $600 billion in debt and MBS backed by Fannie Mae and Freddie Mac. Yeah, that'll move the market. Today we had Agency debt 30-40bps tighter, swaps about 15bps tighter, and MBS about 35bps tighter.

Here is the quick take from that. I love agency and MBS debt for long-term holders, but I'd probably wait for this to settle out before buying anything. This week is classically a poor liquidity week, and we're living in a poor liquidity market. So every event is going to result in outsized moves. You are smarter to buy on the second round, not the first.

Also this should be effective in lowering mortgage rates. Already I'm hearing borrowing rates should be down around 5.5% after today's move. But given where the 10-year Treasury is, mortgage borrowing rates should be able to drop down below 5%. That would help a lot in creating a refi-wave as well as improving housing affordability.

Meanwhile, Goldman priced their FDIC insured deal today at 3-year +220. Immediately traded down to +200. Morgan Stanley, J.P. Morgan, Citigroup, and Bank of America should all be coming with similar deals either this week or next. As I predicted, this came cheap to Agencies by about 20bps.

Will the liquidity be decent in these FDIC deals? I don't see why not. Will it be as good as Agencies? Not at first. Various funds that have "government" mandates may not be able to buy this paper without some sort of approval from council or a board. That may take a few months, but eventually I think actual "full faith" paper (FDIC) will trade tighter than "implicitly" backed (Fannie/Freddie) paper.

It is entirely possible that the Treasury eventually puts a full faith backing on the GSEs, which would negate the above statement. So I'd say at even spread, I like the FDIC paper. If GSE paper is wider, I prefer the GSE.

Friday, November 21, 2008

Goldman Sachs: General, count me in

The FDIC announced their final rules on the so-called Temporary Liquidity Guarantee Program, or TLGP (Pronounced "Teelgup"). This is the program that was designed to allow banks to issue FDIC insured debt, ensuring that they'd be able to roll over any debt coming due in the coming months.

The key change in the final rules is that the guarantee will now be timely principal and interest. Under the original rules it would be possible for an investment in a failed bank to get tied up in bankruptcy court, and while the FDIC would eventually pay you, there was no assurance as to exactly when.

Already Goldman Sachs says they will be bringing FDIC insured debt as early as Monday, and I'd expect an avalanche of banks to come with new issues in the next few weeks.

This debt will now carry a full faith and credit guarantee for as long as three years (6/30/12 to be exact). Note that similar debt has been issued in Europe, most notably Barclays who did the first deal in the U.K. That deal was priced at swaps +25. I expect U.S. debt to come wider. To me, its got to trade in context of Agency bonds, which are more like swaps +50, Treasuries +165.

There are three interesting wrinkles here. First, the FDIC bank debt will be explicitly guaranteed, while Fannie and Freddie are not. However, I'm hearing the FDIC stuff will have a 20% risk weighting for banks. That's equal to Agencies currently, but there has been talk that the Agencies will be reduced to 10%.

Finally, there will be extensive supply of the FDIC stuff over the next month or so, whereas the Agencies have done very little term issuance. So given the market's poor liquidity, I'd expect the new FDIC issues to have a new issue concession, and therefore price wider than Agencies.

Thursday, November 20, 2008

Update on 30-year Swaps

On October 21, I wrote that 30-year swap spreads, which were hovering around zero at the time, was a another sign that lack of liquidity was creating some non-sensical prices.

Now that same spread is -59. Yes, if you want to receive fixed and pay floating for the next 30-years, your fixed payment will be... drum roll... 2.85%.

Initially this was all about hedging of range notes. But there is more to it now. Many long-duration managers, particularly hedge funds and insurance companies, are holding highly illiquid corporate bonds, but they need to maintain that long duration. So say you own a 7-year Comcast bond, but you really want 30-year duration. Its easy enough. You pay fixed on a 7-year swap and receive fixed on a 30-year swap.

More likely a lot of managers are just receiving fixed on the 30-year as an overall portfolio extension trade. This doesn't require any cash commitment assuming the swap has a zero PV at origination. For a manager with a highly illiquid portfolio, that's probably real attractive right now.

3.44% for 30-years? Where do I sign up!?!?

Okay, someone is obviously short the long-bond and can't find a buyer, because not only did it rise 5 points during the regular session, it rose another 4 points after 4PM. Up 9+ points on the day. The yield is a paltry 3.44%

As a tax payer, I demand the Treasury immediately offer to sell as many bonds as the market will bear at this level. I also demand that the Treasury sell any maturity of T-Bills at 0.01% in unlimited quantities. If the public wants to just donate their money to the Treasury, I insist the Treasury take it.

Wednesday, November 19, 2008

CMBS: This is no cave...

If you are like many of our readers, you are a bond guy and are well aware that CMBS (commercial mortgage-backed securities) are in an absolute free-fall. If you aren't a bond guy, let me be the first to tell you that the CMBS market is in an absolute free-fall. Here is the chart on the Barclays INVESTMENT GRADE CMBS index month-to-date.

Yes... that -19.61 number? That's a percentage return vs. Treasuries. The whole index down 20% month-to-date. Ugh.

The story is no better for AAA-only bonds. Check out the AAA CMBX spread (higher spread = bad).

Readers may remember that I said AAA CMBX should tighten based on fundamental risk if the credit crisis was improving. That's way back when this index was around 220. Now 550. So I'll go ahead and say the credit crisis isn't improving.

Anyway, this sparked an interesting debate among two colleagues of mine. I argued that if I had to blindly buy a CMBS deal full of hotel projects or retail projects, knowing nothing else about the deal, I'd buy the hotels. Its purely academic, because I actually wouldn't buy either. But its an interesting debate, and I think its one that would extend to REIT stocks as well.

Here's my thinking. I believe that the liquidity crisis is passing, but that we're entering into a severe recession. Economic activity of all types are going to contract, so the question is who is better prepared for such a contraction?

Classically hotels have been viewed as more economically sensitive compared with retail. In a recession, business cut back on travel and consumers cut vacations. But they still keep shopping, even if at a reduced rate. Add in the fact that during the most recent recession, hotels were hit particularly hard, as 9/11 curtailed travel even more than a normal recession.

My conclusion is that the hotel sector might actually outperform the retail sector.

Post your thoughts, and remember death is not an option. You have to go to bed with one of these uglies, which one do you choose? I'm also posting a new poll on the same subject.

Tuesday, November 18, 2008

The New Order

Much has been made of the November 15 deadline for many hedge fund clients to submit redemption requests. While we wait to see what the eventual impact of this will be, let's consider how the changing nature of leverage has altered the the bond market. Bear in mind that fixed income arbitrage was among the most popular hedge fund strategies. In addition, it was a core strategy for many dealer prop desks as well as the foundation of the CDO market. The decline of leverage may permanently alter the nature of fixed income spreads.

Fixed income arbitrage is, at its core, fairly simple. Start with a bond that yields x% (over and above some hedge in some cases), assume one can borrow y% of the par amount at a cost of z%. If the math of all that works out to a reasonable IRR on the residual, the arbitrage works.

These arbitrage accounts were the marginal buyers in the fixed income markets. As long as the arbitrage remained attractive, yields (or yield spreads) would remain within a narrow band. When an investor wanted to sell a bond, even if there was no long-term buyer at the ready, arbitragers would step in and provide liquidity. In this way, leveraged buyers were ensuring that the market remained efficient. Spreads would only meaningfully widen when credit risk increased.

We know it went too far. CDO^2 and SIVs were the most obscene examples. But even reasonable arbitrage strategies, like TOBs and CLOs became too large as a group. They stopped just being the marginal buyer and became the whole market.

That marginal buyer is gone, and isn't likely to come back any time in the foreseeable future. Admittedly, it isn't as though leverage is being pushed to zero in the fixed income markets, but haircuts (i.e., the amount of margin that must be posted) are now such that levered buyers cannot force efficiency. Take something simple like Fannie Mae 5-year bullet bonds. Should have a very small spread versus Treasuries given the government backing of the GSEs, but instead the spread is currently around 1.45%. It seems like an arbitrage.

But in order for an actual arbitrager to realize a decent IRR on the trade, it probably needs to be leveraged 20x or so. Now maybe one can actually get that amount of leverage versus Agency collateral, but what happens if the trade initially goes against you? The potential margin calls would kill you. Its a difficult arbitrage to actually realize.

The consequences for investors are far reaching. First, bonds will be permanently less liquid. Dealers will be going away from making money via bond arbitrage and go back to making money on transaction flow. In order for that to be viable, the bid/ask spread is going to have to stay much wider than in 2006. Odds are good that trading volumes will also remain much lower than was the case in 2006.

Second, yield spreads will probably remain more volatile than in years past. This is because real money buyers, like mutual funds and banks, will become the marginal buyer of bonds. The technicals of real money demand will suddenly become much more important in determining short-term spread movements.

Third, new debt issues will need to have a greater concession to secondary trading in order to get sold. Take a look at Thursday's 30-year Treasury auction to see what I mean. Primary dealers aren't able to keep Treasury auctions orderly in a world where Treasuries in general are in hot demand. The result? The 30-year Treasury priced about 2.5% lower in price than where it was trading the previous day. By Friday morning, it had regained all that it had lost. The same thing will happen to new issue corporate, municipal, and even agency bonds of large size.

In the short term, what should investors consider in bonds? If banks, mutual funds, and other long-term investors are going to be the new marginal buyers, buy what they are going to want. That is high quality, high yielding bonds. This means longer-term or bonds with option risk, such as callable agencies, municipals, and agency mortgage-backed securities.

Finally, if liquidity is going to remain challenging, buy bonds you are comfortable owning for the long-term. If you do buy a corporate bond, assume that it will cost you 3-5% of the bond's value to sell at short notice.

Friday, November 14, 2008

Told you about the long bond...

30-year Treasury up 2 1/2 points this morning. Told ya so. Wouldn't be surprised to see it get down to 4.15% but there is resistance there.

Meanwhile, Assured Guaranty, the insurer I pronounced dead a few months ago, is buying FSA. Might be more accurate to say Dexia is dumping FSA. More on this as I get more info on the transaction. Anyone who is hearing anything about this should e-mail me: accruedint AT

Thursday, November 13, 2008

30-year auction: They're just not in demand anymore

The 30-year auction was... something less than good. You don't need to hear any of the auction statistics (which can be deceiving, don't trust them). Just look at the trading action. See if you can guess when the auction was held...

The subsequent large rally in stocks didn't help and left the 30-year down 3 points on the day. For most of the day the 10-year held in until stocks really got going, and is now down more than a point.

I'm positive you'll see a bunch of media yakers claim that this is evidence that no one wants U.S. bonds. Bullshit. If that's true why is the 2-year threatening to break 1%?

The reality is that even the U.S. Treasury isn't immune from the deleveraging contagion. The Treasury used to be able to count on primary dealers to take down all their bonds. Dealers are crunched for capital. Plus what capital they have isn't getting committed to low margin business like inventorying Treasuries.

Look for this Treasury supply to get digested over the next 5 trading days, and the 30-year will be right back in the 4.15% area.

Asset-backed securities and the future of consumer lending

So... no buying of mortgages from banks in the TARP. What are they doing?

On the same day they pulled the rug from under our banking system, Treasury announced they would be "exploring" programs to improve liquidity in the AAA-rated asset-backed security (ABS) market. Although securitization has in many ways been a big part of the problem, revival of the ABS market would make a big difference.

Remember the covered bond idea? Its a structure used extensively in Europe where a bank pledges a pool of mortgage loans to "cover" a piece of debt. In theory, the bank enjoys a lower interest rate on such debt because it is both a general obligation of the bank as well as "covered" by the mortgage loans.

In July, the Treasury proposed covered bonds as an alternative to the traditional securitization markets. It never really got going in large part because the corporate bond market continued to deteriorate, and thus was not receptive to new products. But the idea was sensible enough. Covered bonds better align the bank's incentives with the investor, because the bank remains on the hook for the debt no matter what. This is in contrast to a straight securitization, the bank off loads all the risk to investors.

From a macro-economic perspective, a vibrant covered bond market would have allowed banks to lend knowing there was a ready source of cash. Banks will not lend until they are confident in their sources of cash. If the covered bond idea is dead, for now anyway, perhaps the ABS market can pick up the slack.

Historically, ABS have typically been backed by consumer loans, including credit cards, auto loans, home equity, and student loans. ABS were typically structured with a senior/subordinate credit enhancement, meaning that certain tranches of the deal would take losses first and only once those tranches were wiped out would other tranches take a hit.

Of course, there have been numerous problems with the ratings agencies allowing too little in subordination in certain deals. But there is nothing inherently wrong with the senior/sub concept. In fact, if its kept as a simple sequential loss structure, analyzing the credit of an ABS deal becomes relatively straight forward: its just losses versus available subordination. Sounds a hell of a lot more transparent than trying to decode a bank's balance sheet!

So what if the ABS market could be revived? Lenders who could not access the unsecured debt markets could access the ABS markets, raising loanable funds. If the lender also kept a sizeable residual on the deal, the result would be similar to the covered bond idea.

Many companies would benefit directly from an improved ABS market. Credit card issuers, such as American Express, Citigroup, and Capital One. Student lenders such as Sallie Mae. Even the autos would benefit, although obviously the GM and Ford situation is much deeper, Toyota and Honda would also benefit.

It wouldn't solve all our problems. I still wish they were buying mortgage assets. But this is better than nothing.

Wednesday, November 12, 2008

AI to Paulson: A Jedi must have the deepest commitment

Hank... Hank... you've got to be kidding me. Its clear to you that buying illiquid mortgages "is not the most effective" way to use the TARP. Seriously. Can some one please let Secretary Paulson know that mortgages are, in fact, the crux of the problem. Why do we have a problem with banks lending to each other? Because no one trusts anyone else's balance sheet. Because the mark-to-market price of mortgage assets just keeps falling.

Let's talk about the reality here. This doesn't represent a shift in strategy by Paulson. Banks have forced his hand.

There was whispers for a week or two that banks didn't want to participate in the TARP asset purchases. As individuals, they can't see the incentive. Its a classic free-rider problem. All banks would benefit if all banks participated, but each bank looking at its own situation individually isn't incented. Or more accurately, it isn't clear whether a bank would benefit individually or not, and given all the strings attached to participation in the TARP, banks are passing.

So where does this leave us? Worse. Undoubtedly worse.

We'll still get through this, but now you have to figure that home prices will bottom well in advance of the general economy. Why? Consider a possible progression:

1) Home prices bottom. Put whatever time frame on this that you'd like. I actually think it could happen sooner than many expect, but I digress.

2) Home lending is relatively robust for borrowers with good credit (It must be, or home prices wouldn't have bottomed!), but this is solely because the GSEs are there to securitize these loans. If the government is actively supporting the ABS markets, then credit card, auto and student lending markets will be performing OK as well.

3) But actual bank capital will remain challenged. By the time home prices bottom, banks will have taken more losses on foreclosures and commercial loans. And beyond the TARP, most banks will not have been able to raise significant outside equity capital.

4) So commercial lending will become very rare indeed until such time as banks have rebuilt their capital base. Therefore new business formation, acquisitions, capital projects, all will become difficult if not impossible.

What kind of economy does that leave us with? A long recession that's what. Recessions are caused by misallocated economic resources. Some businesses need to downsize or be eliminated, and those resources need to be allocated elsewhere. The recession is the pain that occurs in between.

But resource reallocation takes capital. And if banks won't lend, its going to take a long time indeed for that reallocation to occur.

Friday, November 07, 2008

Investigation is implied in our mandate

In the post from Thursday, I argued that the current recession is the result of classic over investment, in this case in housing. This brings up the very important question of why we had an over investment in housing. (I'm posting a new poll on this subject, but first, you read.)

The potential suspects I'm going to consider are: the GSEs, the Fed's low interest rate policy in 2002-2003, and the rise of structured finance, especially CDOs.

First, one suspect I'm immediately tossing out. Lack of government regulation on lending. There is a perfectly legitimate argument that regulation was too lax. But I'd rather investigate why banks were so willing to underwrite so many sketchy mortgages. Because if there was some perverse incentive to lend money recklessly, then no regulatory scheme would have prevented it. Had mortgage regulations been more stringent, the lending would have flowed someplace else anyway.

Blaming the GSEs is complicated, because the GSEs have been around a very long time. It is undeniably true that without the GSEs there wouldn't have been as much supply of available funds for loans. But in my opinion, the GSEs incremental impact on loanable funds didn't wildly change from 2001-2007. In fact, the evidence is that the GSE's market share declined during this period, as other types of securitization gained in popularity. More on that later.

1% Fed Funds in 2003
This is a popular argument, that ultra low rates lead to ultra easy liquidity. Plus ultra low government bond yields lead investors to aggressively seek out higher yielding investments.

There is something to this, but to me it doesn't explain why availability of mortgage capital actually accelerated in 2004-2006 as interest rates were rising.

Structured Finance
I argued, over a year ago, that CDOs were the primary culprit in causing the sub-prime problem. Consider: why were mortgage brokers willing to underwrite every loan they saw? Because they knew they could sell the loan. Who was the buyer? Structured finance.

On the lower end of the credit spectrum, structured finance created the leverage. On the top end of the credit spectrum, banks levered their positions through SIVs. All that liquidity flowed right into mortgages, and thus into houses.

Now, you could argue that 1% Fed Funds helped to create demand for structured finance. Sure. There is plenty of inter-related issues here. But in my opinion, without CDOs, the Fed's interest rate policies wouldn't have caused the housing bubble we're seeing now. I'd also argue that low volatility, not low interest rates, were the primary reason why structured finance flourished. The Fed can't really be blamed for creating a low volatility environment, after all, that's their job.

If readers have other potential suspects, go ahead and post a comment.

Thursday, November 06, 2008

I'm taking an awful risk here... this had better work...

Is the TARP working? Are rate cuts working? Stimulus package? Is the TSLF working? What about the GSE conservatorship? Is that going to work? What about my lucky rabbits foot?

Pundits love to debate whether any given program will "work" or not. But in these debates, the participants tend to talk past each other. Take the capital injections made through the TARP. One side can argue that this scheme is "working" because of falling LIBOR and CDS spreads on banks. The other side can claim that this program does nothing to address the root problem (foreclosures) and will not allow the U.S. to avoid recession.

Of course, they're both right. And hence this is a boring and frankly unproductive debate.

Most of the programs and plans currently enacted (my rabbit's foot aside) are aimed not at preventing a recession. That ship has sailed. To see what I mean, think about the basics of the business cycle.

Recessions tend to be the result of some misallocation of resources within the economy. Since reallocating resources takes time, there is an inevitable period where the economy operates at less than full capacity. The greater the adjustment needed, the deeper and longer the recession.

In the period leading up to this recession, we had a overinvestment in housing. Even if nothing else had happened, the adjustment in housing probably would have resulted in a recession. Loans were made that shouldn't have been made. Houses were built that shouldn't have been built. We need to clear the excess investment (houses).

However, we also had a financial economy which had become reliant on low volatility and continuous access to liquidity. After the failure of Bear Stearns, Wall Street was forced to decrease their leverage positions. Continuously falling marks, especially on housing assets, only increased their need for additional equity. This added to the already painful economic adjustment underway.

The came September. The rapid failure of the GSEs, Lehman, AIG, Washington Mutual and Wachovia changed everything. The urgency for firms to deleverage was dialed up to 11. In addition, common forms of debt financing, including securitization, have completely dried up. Most firms can fund their activities using other forms of financing, but it will be expensive and potentially painful to make the transition.

So now we need to adjust to a large number of foreclosures, a deleveraging financial system, and a rapidly changing funding structure. That is a recipe for a deep and long recession.

There is nothing the Fed or anyone else can do to prevent this process from occurring.

But the Fed and Treasury can help to ease the transition. Programs like the commercial paper funding facility can help firms that relied on asset-backed commercial paper to transition to other secured funding. Offering FDIC insurance on new bank debt allows banks to roll-over maturing debt, buying them time to deleverage through normal cash flow.

But these programs cannot, will not, and I content were never intended to "fix" the financial system. We will get through this, but we need more time.

As an investor, if you continue to think in terms of "solutions" from the government, you are missing the point. Even putting my libertarian ideology aside, the government cannot "solve" a misallocation of resources. The best thing it can do is provide liquidity to make the transition as painless as possible.

So in thinking about whether some scheme is going to "work" or not, think in terms of avoiding unnecessary economic adjustments. Think in terms of easing the transition. Don't think in terms of avoiding a recession or reversing the steep losses in the stock market. Nothing can stop that now.

Monday, November 03, 2008


Volatility in stocks is unusually low today. I keep expecting CNBC to run one of their classic BREAKING NEWS headlines along the bottom of the screen:


Deflation: A new threat

Does the rate cut matter? We know that 1% fed funds isn't making mortgage rates lower, or spurring banks to lend. So what's the point? Is the Fed pushing on a string? Are they out of bullets?

I think too much of the commentary has been focused on the impact of fed funds on the stock market and/or the lending markets near term. There has also been way too much debate on whether the Fed's actions will "work" or "not work" in terms of averting a recession. The Fed isn't trying to revive the stock market nor is it trying to avert a recession. Those that continue to think in these terms will continue to misunderstand the market for the next two years.

The Fed is currently focused on deflation. They may not have made direct mention of this in their recent post-meeting press release, but deflation is the Fed's ultimate concern. Right now we have a weak economy which is headed for a recession. Nothing can stop that now. The tail risk here is another Great Depression. And what would bring about another Depression?

Here's what Milton Friedman has to say. "I think there is universal agreement within the economics profession that the decline - the sharp decline in the quantity of money played a very major role in producing the Great Depression."

Friedman believed very strongly that a proper reaction by the Fed in 1930 would have prevented the Depression. The deleveraging of our economy will result in a contraction in the money supply, all else being equal. In the recent past, the rapid expansion of credit has created huge amounts of spending power. This spending power is now being removed much faster than it was created. On top of that, the massive loss of consumer wealth, both from housing and from equity markets, will force individuals to increase their savings rate to fund large ticket purchases and long-term financial needs. A contraction in the money supply will result in deflation.

So what does Ben Bernanke think of the Fed's culpability in causing the Depression? At Milton Friedman's 90th birthday, Bernanke said, "Regarding the Great Depression. You're right, we [the Fed] did it. We're very sorry. But thanks to you, we won't do it again." That's all you need to know when thinking about the Fed's playbook for the next year or two. Bernanke will fight deflation with everything he's got. The only lower bound on fed funds will be zero. Here is a quote from Bernanke in 2002. "As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken."

He goes on to say that currency only has value because it has a limited supply. If the problem is that the currency is overvalued (i.e., the currency buys too many goods), the solution is simple: increase the supply. From the same speech: "But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."

We may have a long way to go before we are literally printing money. But the fact that Bernanke would even mention such a thing shos the kind of resolve the Fed has in fighting deflation.

So what's the trade? First, you need to revise your thinking about the impact of ballooning government debt on the economy. Normally deficit spending results is both inflationary and negative for the dollar. In this case, the government debt is mostly going to offset a rapid decline in private leverage. Thus the increase in debt will not necessarily cause inflation or a devaluation of the dollar, but rather alleviate the deflationary impact of deleveraging.

Second, forget the idea that there is some natural lower bound on interest rates. It is easy to look at 2-year Treasury notes at 1.5% and scoff that rates simply can't go lower. But depending on how effective the Fed is in fighting deflation, rates could keep falling from here.

Finally, the odds are good that the Fed will succeed in preventing sustained deflation, simply because they have such powerful tools at their disposal. But the more unconventional means they employ to fight deflation, the more difficult it will be to control the outcome. In other words, an aggressive fight against deflation may eventually result in more volatile prices in the future.