Ever make your way as far into the interior as Coruscant?

I had the following debate today with an old muni master. Which would you rather own, assuming the same yield. Prince George's County MD, which is a wealthy Washington D.C. suburb, or New York City? Both came with BAB deals in the last two days, hence the debate. My friend took New York. I took Prince George's. Here's the low down on both.

• Population: New York 8.2 million, Prince George's 820,000
• Unemployment: New York 10.3%, Prince George's 7.5%
• Median Household Income: New York $38,293, Prince George's $55,526
• Case-Shiller Home Prices, last 12-mo: New York -10.35%, Prince George's (part of DC metro area) -9.78%
• Credit Rating: New York Aa3/AA, Prince George's Aa1/AAA

Here is the positives for New York over Prince George's. Obviously New York is a bigger economy with much more economic diversity. In addition, Prince George's bond issues have a fairly unusual "limited tax" stipulation. Typically a GO bond documents require the municipality to use their full and unlimited taxing power to repay bond holders. In a lot of cases, the property tax rate is determined by what is needed to fund debt service (as well as other government services). However, Prince George's has a limit of 2.4% of assessed value period.

Despite this, I like Prince George's better. First, much of the County's employment is based around the Federal government, which is the one part of the economy that is still growing. New York on the other hand is in the eye of the storm in terms of finance lay-offs. But more importantly to me, New York has a more complicated budget.

In reality, neither is likely to actually miss any bond payments. So the risk is a California-style budget battle, where the situation is unresolved for months and months causing spreads on bonds to widen dramatically. Isn't that much more likely to happen in the Big Apple? Prince George's just doesn't have a complicated enough budget to create this kind of problem. New York does. Hell, New York has gone through such budget battles multiple times in the past.

Anyway, food for thought among the muni guys in the audience.

Confident? What know you of confident?

Twice a month I'm amazed at how much the markets seem to care about Consumer Confidence. Two minutes before the survey was released, the Dow is at 9834. 2 minutes after its at 9758. Hey, I think the stock market feels over-bought too, but it doesn't have a damn thing to do with consumer confidence.

Here is a regression of the Conference Board's Consumer Confidence number vs. GDP. Here I've regressed the change in both as the variables. R^2 is paltry 0.053.


Now if you want to make the regression statistics look good, you can run it with the straight levels of both, as shown below.


This comes up with a reasonable 0.618 R^2. But hopefully anyone who actually passed Econometrics can see the flaw right away. There are four data points dominating the plot. And guess what? All four points are the most recent four points! Run the regression taking these out...

And you go right back to a plot with a very weak relationship, 0.049 R^2.

Its long been my view that I'd rather watch what consumers do than what they say. I can't remember how many times I've seen surveys of consumers asking things like do you plan on spending less this Christmas? Saving more for your children's college? These questions are like asking they people in your office if they are going to stick to their new diet. They'll all say yes, but will it actually happen?

Not that there isn't plenty to worry about when it comes to consumers. I'm getting tired of warning that consumers aren't even going to spend enough to create inflation. But forget about consumer confidence! It doesn't mean anything to anybody.

A Jedi can feel the Force flowing through him

Although there are some who continue to worry that the Fed's massive liquidity programs will ignite consumer inflation, I continue to view this as a very low risk. Consumers just aren't spending enough. But that isn't to say that the current level of money growth can't have serious consequences. Instead of excess liquidity flowing into consumer spending, it could flow into the capital markets, creating new distortions.

Today, as the 10-year Treasury is hitting 3.29% at the same time the Dow hitting new year-long highs, you have to ask, where is all this investment demand coming from? Is it a bubble? Maybe we don't have too many dollars chasing too few goods, but maybe we do have too many dollars chasing too few investments.

But here is an interesting caveat. The chart below shows mutual fund flows for the last three years. 2009 is YTD with no adjustment. Bonds are blue, stocks are yellow and "hybrid" funds are green.



In 2007, we had total flows of $223 billion, 41% of which went to equity funds. Then we have the panic year of 2008. Investors pull $226 billion from mutual funds, all most all of which comes from equities. It looks from this chart as though retail investors pulled money from stock funds and left the proceeds in cash, thus creating the much ballyhooed mountain of cash. But the month-by-month flows tell a different story.

Here we see fund flows month-by-month among bond fund types. For the first 9-months of 2008, there was a healthy $90 billion flow into bond funds in total. That's slightly ahead of the $108 billion pace of 2007. But in the last 3 months, investors pulled $63 billion from bond funds, adding to their cash hoard.

Now on to 2009. So far this year investors have added virtually nothing to equity funds. There is no mania there, at least not when it comes to retail mutual fund investors. Now there is significant variation month-by-month. In the first three months of 2009, investors withdrew $40 billion only to add $53 billion since. But even there, it doesn't look like a mania at all. Over the last 6 weeks, there have been $4 billion in net redemptions. Even the $53 in net purchases over the last 6-months seems paltry compared with the $233 billion in redemptions last year.

By contrast, take a look at bond funds. Fund investors have made net purchases to the tune of $253 billion so far this year. That is just about double the last two years of net purchases combined.

And unlike stocks, bond investors don't have any need to "catch up." If anything, mutual fund investors would seem to have come into 2009 over weighted in bonds. Not only did mutual fund investors redeem $233 billion in equity funds in 2008, those same funds plunged in market value during the year. If retail investors followed any kind of rebalancing discipline (no laughing back there anyone who deals with retail investors... I said "if"), there would be the need to redeem bond funds and buy stock funds. Right now the opposite is happening.

So it makes one wonder. If there is a bubble, isn't it more likely in bonds? If there is an asset class that is getting more than its fair share of the excess liquidity, it isn't stocks. Its debt.

Mortgage Bonds: Its a Trap!

On Wednesday Vanguard announced that their fixed income index funds would be switching from the Barclays Aggregate to the Barclays Float-Adjusted Aggregate. The difference? The new index will exclude the Agency and Agency Mortgage Bonds owned by the Federal Reserve.

So let's consider the consequences. First realize that mortgage borrowing rates are a function of MBS trading rates. If a bank originates a mortgage and then pools it into a MBS, the rate at which it can sell that security is going to determine the rate they will offer a buyer.

Second, realize that the Fed has purchased 71% of new Agency MBS issuance so far in 2009, and currently owns about 10% of all MBS outstanding. The Fed has been mostly buying the so-called "current coupon" which is the coupon which produces a price closest to par. Or put another way, the coupon which most newly originated MBS would carry. Currently that is 4.5%. (MBS only trade in 0.50% coupon increments, i.e., there is a 4%, 4.5%, 5%, etc. but effectively no such thing as a 4.75%).

Obviously the Fed wants to buy the current coupon because that's the one that influences current borrowing rates. But as a consequence, the Fed has become the overwhelming owner of the 4% and 4.5% coupons: 90% of the former and 80% of the later.

I was all for the Fed's Agency MBS purchase program when it was first announced, and clearly its been effective at lowering borrowing rates. Certainly its been the more effective QE effort when compared with Treasury purchases. Take a look at the long-term chart of MBS Libor OAS.

Now let's consider Vanguard. Vanguard's Total Bond Market Index fund is about $65 billion, and thus holds about $25 billion in MBS. 22% of the index is in 4% and 4.5% MBS, so Vanguard would have about $5 billion in these mortgage types.

So what's Vanguard going to have to do? Since the Fed owns about 10% of outstanding MBS overall, they'll have to sell $2.5 billion in MBS outright (almost all 4% and 4.5% coupons), buying corporates and Treasuries with the proceeds. Then they'll have to sell an additional $1.5 billion in 4's and 4.5's and reinvest in older, higher coupon MBS.

Who will the buyer be? Considering that the Fed owns 80% of those coupons already, it isn't like a deep investor base has developed for those bonds. Maybe Vanguard will wind up selling mostly to the Fed itself. But that just delays the spread widening that is eventually coming.

Notice on the chart above that the current coupon spread is at all-time tight levels. Makes sense given the current intervention. But that only has 6 more months to go. Vanguard's selling should be the start of what will be an extended period of MBS spread widening. On the chart, note that the last time rates were extremely low (2002-2003) Libor OAS was around +20. Currently we're -10.

And you have to expect the majority of the widening to hit low coupons, because that's what Vanguard/the Fed will either be selling or what they will stop buying. At that point mortgage rates will rise, not in a disastrous fashion, but probably at least 50bps. Then what? The borrower within a 4.5% pool will be way out of the money, which will not only prevent any kind of refinancing from ever happening, but also impair his/her mobility. In other words, those MBS will repay extremely slowly for investors.

Then investors are going to look at a 4.5% coupon 30-year mortgage and wonder why the hell you'd accept such a low coupon for so long.

And it isn't like the rise in MBS rates is going to help the macro economy. The decline in existing home sales the other day is very bothersome to those who thought the housing market had bottomed. More data points like that will change my mind.

Municipals: Your work here is finished

Here is a newsflash. The IRS isn't that bright. But there is a problem. I think they are cooking up a scheme that they think is going to increase tax revenue, but in reality is going to cost all of us more money without benefiting the tax coffers at all.


Its long been known that there is a certain contingency at the IRS and within Congress that wants to remove the tax-exception for municipal bonds. I've heard it time and time again from various sources. IRS hates munis. Here is their thinking. Municipal bonds are purchased mostly by the rich, who currently pay a 35% marginal tax rate. If there were no tax-exemption for municipals, the rich would be buying some other kind of bond, say a corporate bond, and paying 35% taxes on the income. So from the Federal government's perspective, they are missing out on 35% in taxes.


This 35% is basically a subsidy to state and local governments as well as many non-profits, particularly hospitals and colleges/universities. These issuers enjoy a lower interest rate on bond issues because the rich desire tax-exempt income. Let's put some numbers on this.

According to SIFMA, there are $2,726.8 billion in Municipal bonds outstanding. According to Merrill Lynch's Master Index, the average muni coupon is 4.69%. The Treasury department seems to think that if there were no tax exemption on munis, the average coupon would be 4.69%/0.65 (0.65 being the inverse of the 35% tax rate), or 7.22%. They would then tax you on the 7.22% coupon, adding up to $69 billion per year in tax revenue. Or so they seem to think. More on this in a moment.


Enter the Build America Bonds program. Under this program, municipalities can issue bonds with a taxable interest rate and receive a 35% subsidy on the rate. So for example, one of the first large BAB deal was for the University of Virginia. It sold with a coupon of 6.2% on a $250 million deal. Thus the Federal government will be writing a check to UVA for $5,425,000 every year until this thing matures in 2039.


The Treasury department seems to this this is no blood, because UVA was effectively getting a 35% subsidy anyway. Why not just pay them in cash? Ostensibly, the purpose of the BAB program was to open up demand for municipal securities beyond traditional buyers. If you remember back when the BAB program was enacted (February 17) the municipal bond market was in shambles. Demand from retail buyers, either direct or through mutual funds was non-existent. $14 billion had been withdrawn from muni mutual funds during the 4th quarter. The BAB program was supposed to help by enticing non-tax paying buyers, particularly pension funds and foreign banks, to buy muni bonds. That part of the program has worked brilliantly. BABs have become very popular among institutional investors. It has also constricted tax-exempt supply, which is a big part of why municipal bonds are so expensive currently.

But is there scum and villainy at play here? Are there those who want to see the BAB program made permanent and the tax-preference for municipals eliminated? Let's go back to the assumptions made by those who want to see munis die.

First there is an assumption that all municipal bond buyers are in the 35% tax bracket. But that is obviously false for a number of reasons. First, only about 1% of filers (or about 1 million returns) pay the maximum rate. Probably not enough to soak up the entire muni market. Its common for wealthy individuals who are no longer actively working to have very little traditional income, thus a relatively low tax rate. In fact, my wealthiest client has been stuck in AMT for several years. Some municipals are held by for-profit corporations, but this is overwhelmingly insurance companies who don't necessarily pay the maximum rate either. Insurance companies have notoriously variable tax rates, as they go through periods of higher or lower claims.

Evidence from trading history also suggests the marginal buyer of munis was at less than the 35% bracket. Here is a chart of the Muni/Treasury ratio since 2001.


You can see that during this period, municipals were never even close to yielding 65% of Treasuries, the theoretical break-even point. Somewhat closer is the Muni/AA Corporate ratio...
But even there, the ratio is usually in the mid-upper 70's. Only during a handful of periods (mostly when corporates got very tight, not when there was any change in tax policy) did that ratio fall into the low 70's.

So I think we can kill the first part of the theory, that the Treasury is suffering 35% in forgone tax revenue. Its probably more like 30%, somewhere between the 35% bracket and the 28% bracket. This is driven home all the more by fact that Build America Bonds are currently making up half of total municipal bond issuance. Currently municipalities can choose whether to sell bonds under BABs or to sell in the traditional tax-exempt market. As it is, almost all bonds issued longer than 15 years are going BABs. Why? Because the interest savings by going to the tax-exempt market is smaller than 35%. So municipalities are taking their 35% from the Feds!

Here is the first instance where I'll say this program is costing tax payers. If we want to subsidize local governments, its cheaper to just allow them to sell tax-exempt debt. Paying this direct subsidy is clearly costing federal tax payers.

Now let's say the conspiracy theorists are right, and the Treasury really wants to extend to BABs program permanently and eliminate the tax-exempt market. We've already seen that the 35% subsidy costs the Federal government. What about local governments? We all pay some sort of taxes to both the Feds and the locals. Does it really matter if we pay somewhat more to the Feds and somewhat less to our state/county/city/etc? It does if the municipality also winds up paying more!

If there were no municipal bond market, how would retail investors invest in the bond market? As any one who deals with individual investors knows, the answer is they will go where the yield is. Where will the yield be? Not in munis. It will be in corporate bonds, preferred stock, high-yield funds, etc.

Who will buy the municipals then? The same people who are buying the BABs! BABs have found ready buyers among those who traditionally had bought high-quality long-term corporate bonds. Once upon a time, these were buyers of AAA-rated names like AIG and General Electric. Obviously what was once thought of as a very safe, "sleep at night" bond is no longer considered as such. Many of those buyers have moved on to the BABs market, where you feel like you can sleep at night buying the State of Utah or the University of Texas bonds. You also have big mutual funds buying, figuring BABs are a good alternative to Treasuries for their long-term bond exposure.

On the surface this seems like no big deal. Municipalities sell the same bonds just to a different set of buyers. What's the difference?

It probably is no different if you are the University of Texas selling $300 million in bonds. Institutional buyers like that they can buy as much size as they want. But what if you are the City of Mos Eisley Speeder Parking Revenue Authority who wants to sell $10 million? Deals of that size happen all the time in tax-exempts. In the classic municipal market that was no problem because munis are often sold $20,000 at a time anyway. Retail buyers don't care about deal size. They care about name recognition. So the Mos Eisley Parking Authority sells bonds to the rich moisture farmers in the area who feel like they know and understand the parking revenues in Mos Eisley.

The big mutual funds, pensions, insurance companies, etc., don't "know" Mos Eisley. The only way they will bother to take a look at a smaller deal is if it offers much higher yields than similar (larger) deals. And if you are some lower-rated small issuer, like a hospital or private college, forget it. As an institutional buyer myself, if I'm going to really have to dig into a institution's financials and track it closely from quarter to quarter, like I would a Baa-rated hospital, I better be able to get large size to make it worth my while. So the local hospital who wants to sell $20 million in bonds to build an addition isn't going to attract institutional buyers at all, virtually at any price.

In the traditional tax-exempt market, a strong AA-rated revenue issuer, even if it were a small deal, would classically only be 10-15bps cheap to a state GO. If retail investors were taken out of the muni market and replaced by institutional investors, that gap is probably 50-75bps. Like I said, institutional buyers would have to be paid substantially to buy the small issue.

So let's do the comparison. On 9/16 the State of Utah just sold a 10-year BABs with a spread of 70bps vs. the 10-year Treasury. That came out to a 4.15% coupon. Thus the Federal government will be paying Utah 145bps of subsidy for a "net coupon" to the state of 2.70%. Conveniently, on the same day Utah also sold 9-year tax-exempt bonds at a yield of 2.68%. There is about 17bps in spread between 9-year and 10-year munis right now, so we can guess had Utah sold 10-year tax-exempts the yield would have been around 2.85%. 15bps of savings to the state by going with the BABs program.

Now let's take a high quality but small issuer who has to sell bonds 75bps wider than the state of Utah. Had they sold on the same day as Utah they would have had a spread of 145bps for a coupon of 4.90%. The subsidy would be 171bps for a net coupon of 3.18%. So earlier I assumed that same issuer could normally come in the tax-exempt market 15bps wider than Utah, or 3.00%. So if the tax-exemption were taken away and thus retail weren't around to buy up smaller deals, the smaller issuer would pay 18bps in higher interest that it would otherwise.

Now let's think about the wealth transfer here. Small issuer pays more in interest. Federal government pays small issuer, but not enough to make up for the extra interest cost. Federal tax payers pay more. Local government pays more in aggregate, which of course eventually hits local tax payers. Who wins in all this?

Govt. to Banks: With each passing moment you make yourself more my servant!

The idea of the government mandating pay packages is stomach churning. It has nothing to do with the relative wisdom of any given compensation scheme. I completely agree with the idea that the way bonuses were structured in a lot of cases created an incentive for employees to shoot for the moon. If you tell me I might make $5 million in a single year, and the only way I can make that money is by putting on very risky trades (with the bank's money), what am I likely to do? If I lose I might get fired but I can always find another job. If I win, I get $5 million to put in the bank. The next year I will try the same risky trades and if they don't work next year guess what? I still have my $5 million!

But even if the idea of more sensible compensation packages is a good one, we all know the government is going to muck it up. Let's say that in 2010, regulators come up with a very reasonable and logical set of pay rules, which allow those that really do perform to become insanely wealthy while being properly incented to maintain reasonable risk levels. But what happens in 2011 when there is a new congress? Or in 2013 when there is a new President? Will the standard of "reasonable risk" and "reasonable compensation" be a moving target? You bet your light sabre that it will.

All that being said, let me throw out a different spin on all this talk about compensation limits. Now stay on target with this, because I'm going to make a pretty wide arc here to get to my final destination.

The other day I wrote about Too Big To Fail. I argue that the way to solve Too Big To Fail is not to mandate that banks take less risk. There is no way to build regulations today that will imagine all the possible ways banks might take risk in the future. Remember that the current bank regulations were designed to curb risks by forcing banks to put more capital up against riskier assets. The problem was that "risky" was defined by credit rating. So why did banks buy up every Super Senior CDO they could find? Because it was AAA-rated! They could pledge minimal capital! (or none if they set it up as a SIV!!!)

I therefore warn against future attempts to reduce bank's risk through regulation. Eventually banks will figure a way around the regulation and get as risky as they want to be anyway.

As I said the other day, the key isn't to make banks less risky, but to make the banking system less risky. I don't want to see us regulate away risk and at the same time regulate away financial innovation. In fact, I'd love to see a competitive market for banking, where some banks choose to take more risk and some choose to take less and we see who ultimately prevails. Wouldn't we rather live in a world where creative and successful risk taking is rewarded? If the government dictates risk, then it will be those that are creative at getting around the rules who are rewarded.

The only way such a system can exist is if no one bank, or even not a group of banks, pose a substantial systemic risk. This is the opposite of what we have now, banks that are so interconnected that the failure of Lehman Brothers almost touches off a Great Depression. I mentioned some remedies the other day, such as creating a central counter-party for over-the-counter derivatives.

But part of the solution has to be to make banks smaller. In order to create such a system, there has to be an incentive for banks to remain smaller. Currently there is an incentive to get bigger. Bigger banks like J.P. Morgan or Wells Fargo can brag about their earnings/geographic diversity and thus access the capital market cheaper. Some argue that banks have a direct incentive to get bigger in order to reach Too Big To Fail status! I don't know that bank managers think along these lines, but its clear that bond investors feel this way. Why else would a moribund bank like Citigroup have easier access to capital than a more conservative bank like M&T Bank? We all know Citi is (or at least was) functionally insolvent. Only their Too Big To Fail size saves them.

Alternatively, what if we actually created an incentive for banks to remain smaller? For example, say there was a government backstop for prime brokerage accounts, similar to what I described the other day. But let's say it was structured like the FDIC insurance on deposit accounts, where PB accounts above a certain size enjoy no guarantee. Hedge funds would have to diversify their holdings across many prime brokers creating a natural limit on how large any one prime broker could get, at least in terms of using PB as a funding vehicle.

When Lehman failed, many fund assets became tied up in bankruptcy. Many more were withdrawn from other firms (Goldman, Morgan Stanley) for fear that they could face the same fate. It becomes a all risk, no reward situation. If I keep my money at Morgan Stanley and they survive, I get no reward. If they fail, I wind up with my account frozen. So every one withdraws. According to various sources, Morgan Stanley lost 1/3 of their prime brokerage accounts in the week following Lehman's failure. That alone might have been enough to sink Morgan Stanley if it hadn't been for Fed liquidity programs. So even if Morgan Stanley had been a innocent by-stander, they might have failed on contagion alone.

As tax payers who wind up on the hook for the failure of these firms, we have to see how this is entirely untenable. We can't have a world were Firm A pays for the sins of Firm B. Even if Firm A isn't entirely innocent, its still an idiotic policy to even make such a situation remotely possible.

If there were some insurance for prime brokerage, this wouldn't happen. Because of the government backing, no given investment fund would have to panic about the financial condition of any one of their trading partners as long as they were adequately diverse in their prime brokerage relationships. Meanwhile if a PB failed, the contagion ramifications would be limited.

This is exactly why we have FDIC insurance, by the way. So that when First National Bank of Alderaan fails (due to no remaining customers!) customers of First National Bank of Tatooine don't panic.

Anyway, its just one idea. The point here is that we need to make more progress on this Too Big to Fail problem. I advocate a two-pronged approach. Limit the contagion, and create incentives for banks to remain smaller.

So now we're back to compensation. I told you it would take a while. Anyway, what if compensation was only restricted once a financial institution reached a certain size? We'd make it any financial firm, from investment manager to bank to insurance company. If you want to make the big bucks, go to a non-TBTF bank!

Anyway, that's not something I'd actually advocate if I were Libertarian Dictator of the World. I'd probably mandate no restrictions at all. If anything I'd give voting shareholders an easier way of mandating a better compensation scheme. But compared to what the government is actually going to do, I think this idea is a pretty good one.

Size matters... a lot

As part of our on-going discussion of what's better today vs. a year ago, there is a question of what have we "fixed?" In other words, among problems within our financial markets that caused the crisis, have any of these been addressed?

To me, the most disturbing is the problem of Too Big To Fail (TBTF). I'm an ardent believer in free markets, but its obvious that certain institutions (ahem, Lehman) became so intertwined with other institutions that we couldn't afford to let them fail. The demise of one firm would cause the failure of others, feeding a generalized panic and thus making the panic a self-fulfilling prophesy.

If you want to minimize the government's involved in the financial system, we have to find a way to address this Too Big To Fail problem. Have we made progress? Hardly. Here are the top 15 financial institutions within the Russell 3000 a year ago, ranked by assets. (Note I had Bloomberg produce the previous Fiscal Year assets so its possible the dates don't match up institution by institution, but it should be close enough. Asset figures in $billions.

1. Citigroup: 2,187
2. Bank of America: 1,716
3. J.P. Morgan Chase: 1,562
4. Goldman Sachs: 1,120
5. AIG: 1,048
6. Morgan Stanley: 1,045
7. Merrill Lynch: 1,020
8. Wachovia: 812
9. Wells Fargo: 575
10. MetLife: 559
11. Lehman Brothers: 504
12. Prudential Financial: 486
13. Hartford Financial: 360
14. U.S. Bancorp: 238
15. Bank of New York Mellon: 198

That's a total of $13.4 trillion in assets. Note I excluded Fannie Mae and Freddie Mac from this list. While they certainly lived in the Too Big to Fail world, they were also a totally different situation compared with other firms.

I then calculated these 15 firms' assets as a percentage of all assets for the whole group.

61%.

This wouldn't be total U.S. financial assets, because I used a list of public companies as the universe. Still, should be instructive.

Alright, what about today? Here is the top 15 right now. Here I've removed AIG as they are technically still in these indices.

1. J.P. Morgan Chase: 2,175
2. Citigroup: 1,938
3. Bank of America: 1,818
4. Wells Fargo: 1,310
5. Goldman Sachs: 885
6. Morgan Stanley: 659
7. MetLife: 502
8. Prudential Financial: 445
9. PNC Financial: 291
10. Hartford Financial: 288
11. U.S. Bancorp: 266
12. Bank of New York Mellon: 238
13. SunTrust Banks: 189
14. State Street: 174
15. SLM Corp: 169

That's $11.3 trillion, a significant drop off from a year ago. But as a percentage of all assets, that's still 56% of all assets. Is that progress on the TBTF front? Hardly.

I suppose its fair to say that we aren't going to get the size of these institutions smaller over night. But not all of these firms are smaller. I'd argue J.P. Morgan, Bank of America, and Wells Fargo are more TBTF now than last summer because of subsequent mergers.

Another point is that it isn't all about size either. Look at the 2008 list. Lehman only had $500 billion in assets, but it wasn't the asset level that made their failure so catastrophic. It was the fact that Lehman was a counter-party to so many derivative transactions. It was that Lehman was a prime broker to so many hedge funds. It was that Lehman's credit was owned by so many money market funds.

Let's say Lehman had failed just as it did, but all its prime brokerage accounts remained in tact and all its derivatives contracts remained in force. In other words, let's just say that the government back stopped both those elements of Lehman's business. What would the consequences have been?

Basically that would have worked very similarly to FDIC insurance on deposits. I was with a group of friends this spring, one of which was a customer of a local Baltimore bank. I commented that I didn't think that bank would survive the next 6 months. (It has survived so far, but its still circling the drain.) Anyway, the woman asked if she should withdraw her money. I said it doesn't really matter since she didn't have over $250,000 with the bank. Worst that happens is that there is some red-tape around getting your money back. I don't know if she closed her account or not, but its fair to say that the FDIC insurance creates a distinct lack of urgency.

As a free-market capitalist, and assuming a world without government intervention is unrealistic, wouldn't a FDIC-style insurance pool for prime brokerage/derivatives make a lot more sense than putting the government in a position of buying equity in banks?

A galaxy far, far away...

Every one is going to be doing these "One Year Later" pieces. I'm not going to give you a retrospective on what the government could have done. I've made my position well known. I'm also not so arrogant as to claim that I know how much things would have been different. If we had bailed out Lehman, then would we have bailed out Wachovia? Or AIG? Would Wachovia have failed if not for Lehman? What about WaMu? Or Merrill? If Lehman had managed to survive, could Merrill (Or Morgan Stanley, or anyone else) have been the one to trip us into the crisis? Who knows. Its entirely speculative. The only thing that's inside that cave is what you bring with you.

I do think its very interesting to consider how much things have changed, or not, since last September. So I'd like to begin a discussion on what's better, worse, or no different since before the Fannie/Freddie bailout on September 7. I'm going to start with a few points, and wait for others to come in via comments or e-mail (accruedint at gmail.com). In each case, I want one or two sentences (per point) as well as numerical evidence to back you up.

Here are a few:

• US GDP 2Q 2008: +1.5%. 2Q 2009: -1.0%
• Consumer credit: 8/31/08: $2,576 billion, 7/31/09: $2,472 billion (-4%)
• Goldman Sachs 5yr CDS: 9/5/08 +160, now +120
• Home Equity Loan ABS issuance: 2008: $4 billion. YTD 2009: $0
• CMBS issuance: 2008: $27 billion, YTD 2009: $0
• Fannie Mae 30-year commitment rate: 9/5/08 5.887%, now 4.692%
• Bank's loss reserve as pct of total loans and leases: 2Q 2008: 1.81%, 2Q 2009: 2.77% (from FDIC quarterly banking profile)
• Bank's equity capital as pct of total assets: 2Q 2008: 10.16%. 2Q 2009: 10.69%.

So there are just a few to get us started. I'll continue to post additional ideas of both my own and others as the week progresses. Thanks in advance for your comments.

SMACKDOWN WEEK: Chut chut, Watto

I am of two minds when it comes to commercial real estate, so I'm going to write this a little differently than the other SMACKDOWN pieces. I'm going to go over some commonly held (if not majority) views on CRE and then talk about where I come out.


1. Commercial real estate is only beginning to become a problem.
Agree. While I've argued the worst for residential real estate is behind us, and while I also think the economy is at least bottoming, the worst for commercial real estate is yet to come. I look at it this way. Imagine a retail development. Doesn't matter if its a mall or an outdoor space. Assume that the space has many lessees, some larger chains, some local retailers, a restaurant or two, etc.


Consider the progression of this recession. Retail sales didn't start falling in earnest until August 2008. Ex-autos, the retail sales figure peaked at $310 billion in July, fell to $280 billion by December (9.7% decline). It now stands at $284 billion, a 1.3% increase. So net-net we're down about 8.4%.


An 8% decline in sales may or may not sink a given retailer, and it certainly wouldn't cause someone to close up shop right away. Say you leased space to operate a Cantina. You see your sales decline over a 6-month period by 8%. This Cantina is your blood sweat and tears. You aren't just going to close up shop at the first sign of red ink. It would take a little time for you to conclude you aren't making adequate profits.


Same goes for bigger retailers. Say there is a Gap within this retail development. Gap isn't going out of business, but maybe this is one of their underperforming locations. Again, they aren't going to close it after one underperforming month. But maybe once they get through Christmas, they take a look at their best and worst locations, this one gets cut.


Office buildings aren't that different. Firms make layoffs but that might not immediately mean they take less office space. Especially a medium-sized business. Say you employed 150 people in some professional services business. Say its an advertising agency. Revenue starts dropping off last summer, but you probably don't get around to laying anyone off until October or maybe even later. And the first dozen or so layoffs would just create more space for those that are left. Only after large scale layoffs (or closing the business entirely) would you need less office space.

So its obvious that problems in commercial real estate are likely ahead of us, not behind us, even if the economy has already bottomed.


2. Commercial real estate prices are going to drop more than residential prices have.
Agree with this too. Its hard to get real good data on how far commercial real estate prices have fallen. Of course, commercial real estate is a more diverse set of assets than residential. A hotel is very different from an industrial park. Plus assets don't trade as often. But we can get some idea by looking at REITs. Right now the Wilshire REIT index is down 57% from its peak, and at one point was down as much as 78%. Residential obvious never got this bad, especially not nationwide.


3. Losses on commercial real estate lending will be worse than residential.
Don't agree entirely. The lending standards were never similar. Here I have two bond deals. One was a large CMBS deal from late 2006, one was a B/C residential deal. Two things to notice.


First, the CMBS.

The total delinquencies in the CMBS deal are tiny, only 3%. Next see that the subordination to the senior most part of the deal was originally 30%. That means that losses have to top 30% before the senior bonds start taking losses.


Now look at the B/C resi.

This deal is getting worse all the time!

Delinquencies at 54%, while the originally subordination was only 20%. So the deal was originally set up to take 10% less losses than the CMBS deal.


This gets to an important point. Everyone knew commercial real estate property values could decline when the loans were underwritten. Loans were underwritten accordingly. Residential was underwritten as though home price declines wasn't possible. That's why a residential deal full of sub-prime borrowers could actually have less subordination than a commercial deal.


You also have to consider the lack of innovation in commercial real estate. There wasn't the equivalent of a NINJA loan or Option ARM loan in CRE. On top of all this, residential loans were very commonly repackaged into ABS CDOs. While there were some CRE CDOs, it was a tiny fraction of the total structure squared market. Most of the more infamous RMBS securities, the ones that are sinking Ambac and sunk Merrill Lynch were these repackaged RMBS. Not the more pass-through like CMBS.


4. Commercial real estate will be worse than residential.
So this last point becomes difficult to say, because it depends on your point of view.

SMACKDOWN WEEK: I see a city in the clouds

MORE BEARISH: Municipals

MORE BULLISH: Foreign ownership of Treasuries

Municipals

There are a number of problems with municipals today. First let's get to the least often discussed: munis aren't cheap. On an absolute yield basis: (10-year muni rates according to MMA):




Now we know that general interest rates are low, but even on a percentage-of-Treasury basis, munis are at best fair value. From 2001-2007, the average 10-year muni/Treasury ratio was 86.9%. Currently its 90.2%. Hardly screaming value.


What about muni credit quality? My concern is two fold. First, municipalities are not very nimble. One of the big positives among corporate securities (stocks and bonds) has been their ability to rapidly cut costs in the face of falling demand. IBM can lay off thousands at a moment's notice. Anadarko can shut down oil rigs. Boeing can shutter plants.

But municipalities the proverbial Bantha trying to turn around in quicksand. A governor can't just unilaterally say the State needs to shut down certain programs. A mayor can't unilaterally shorten work hours. A county council president can't lay off unionized public employees. They literally don't have the power to do so, at least in the overwhelming majority of cases. They just can't react quickly to a changing revenue environment. Expense management is therefore a major challenge.

How bloated is state and local government spending? I'd generally say that local government spends what it has. So when revenues rise, no one in the state legislature says "Hey, let's save this for the next recession," unless mandated by law to do so. They spend it! What looks better to constituents? A nice new park or a larger "rainy day fund?" Politicians will pretty much always pick the nice new park.

Revenue is also going to be a continued challenge. There are four major areas of revenue collection for state and local governments. Residential property taxes, corporate property taxes, income taxes and sales taxes.

I'd argue that all four will either decline or at best be flat in 2009-2010. I'm going to assume, as is very common among state and local governments, that we're talking about a June-June fiscal year. So the 2008-2009 revenue figures would be based on economic activity during that period. Basically as the recession was really gearing up. Since June 2008:

• Nationwide home prices down 15.4% (Case Shiller Composite 20)
• Retail Sales down 9% (Census Bureau)
• Non-farm payrolls down 4.5%

So even if all four bottom out here (if you care, I think home prices will but the other two won't), all are starting from a weaker start. For example, if state sales tax started the 2008-2009 period at 100, its now 91 (i.e., a 9% decline). If the decline was evenly distributed during the year, the average collection would have been at a 95.5 level during the year. But for 2009-2010 we're starting at 91. Sales tax collection could bottom here and still collections for 2009-2010 would be down 4.7%. The same principal applies to property and income taxes.

Commercial real estate is likely to get worse before it gets better. That's a subject for another SMACKDOWN but suffice to say that commercial property taxes aren't going to be a source of revenue increases for municipalities for some time.

So we're likely to see continued budget problems in 2009-2010 and I'd think 2010-2011. Will there be large numbers of municipal defaults? Probably not. Large municipalities will figure out a way to pay off bond holders. In general, municipalities don't have the option of choosing to pay other expenses but not pay bond holders. A state legislature can't say they'd simply rather pay public employees than debt service. It isn't an option.

In addition, many local municipalities have their tax rates determined by their budget, not the other way around. In other words, property tax rates are not voted on by the local government, but in fact a plug for whatever rate makes the budget balance, debt service included.

So I think what you are going to see in 99% of situations is cuts in governmental services (sometimes severe) but not cuts in what's owed to bond holders. There will be exceptions, probably far more exceptions than in years past. The history of municipal bond defaults is extremely light, and we could well wind up with more defaults over the next 24 months than we had over the previous 24 years. It won't be a disaster, but it will be pretty bad.

BULLISH: Foreign participation in the Treasury market.

I recently made a case that I thought the dollar would keep declining. What I didn't say is that I thought there would be a dollar crisis, precipitated by our ballooning debt.

First let's look at current foreign participation. The following chart shows TIC data for Treasuries (net purchases) month-by-month (in blue) and 12-month rolling averages (red).

Can't see any crisis here. The rolling average is basically in the same range its been since 2004.

Could a crisis develop? Sure, but I don't understand how the U.S. gets into a currency crisis and there is some other currency that is A) large enough to take the huge net flow the U.S. currently absorbs and B) not impacted by the U.S. crisis.

In other words, let's look back at CDS trading among sovereigns. Here are the levels on 12/31/2007, according to Bloomberg (all in bps, higher means more risk).

• Japan: 8.5
• U.K.: 8.9
• Germany: 6.9
• France: 9.7
• U.S.: 8.4

And at the end of 2008 (note this wasn't the peak, but it was an easy single point to compare all of them)

• Japan: 44.2
• U.K.: 106.9
• Germany: 45.9
• France: 54.1
• U.S.: 67.4

What does this tell us? Confidence in the U.S. declined substantially during 2008, but it also declined in all our largest "competitors" for foreign flows. If things really are that bad here in the U.S., things are probably pretty bad elsewhere as well.

We're also probably past the peak for Treasury borrowing. Not in terms of absolute debt but in terms of the need to sell new securities. Hopefully there will be no "second stimulus," and the TARP funding won't need to be increased. But assuming both those things, I think the marginal supply of Treasury bonds should be declining, thus reducing the fear of a simple supply overwhelming demand.

Over time, I'm sure emerging nations would love to create a new reserve currency. But as things stand, there is no way a new currency wouldn't have a U.S. dollar component. There was talk of Brazil, China and Russia using more SDR's from the IMF in place of dollar assets. But such a move strikes me as entirely political, meant to look like a move toward independence in the eyes of each country's populace. In reality SDR's derive their value from... Ewok tom-tom roll... the U.S. dollar, pound sterling, euro and yen!

I think the reality is that the U.S. is going to have to raise taxes to pay down our debt. I think there will be significant political pressure here to do something about the deficit, as I think Americans don't like the idea of ballooning debt. Healthcare reform may or may not happen, but either way, its going to just mean more or less of a tax hike. That's going to create significant problems in terms of consumer spending, but would improve the whole foreign Treasury participation problem.

SMACKDOWN WEEK: They just aren't in demand anymore

SMACKDOWN WEEK continues! I know its been more than a week, but SMACKDOWN Fortnight doesn't have the name ring.

MORE BULLISH: INFLATION

MORE BEARISH: THE DOLLAR

This one is a little strange, because what exactly does bullish on inflation mean? What I mean is that inflation will remain low, probably below the Fed's so-called "comfort zone" for at least a year. I don't know whether you want to call it bullish or bearish since my view poses a significant risk of dangerous deflation.

Anyway, you can see my basic argument against inflation from the last SMACKDOWN. Instead of rehashing all that, I thought it would be more interesting to talk about what might push inflation the wrong way. Specifically, what I'm looking at to indicate that inflation is starting to become a problem.

First, let's talk about what we mean by inflation. I'm talking about consumer inflation that rises significantly above the Fed's comfort level of 1-2% on Core PCE. I don't want to get into the whole inflation vs. cost of living debate yet again. Suffice to say I'm concerned with monetary inflation, not increases in prices of particular goods categories.

So you ask yourself, where does inflation come from?

Ultimately it has to come from consumers spending money. In the too many dollars chasing too few goods equation, someone has to be chasing. As I've written before, if Ben Bernanke just went out and doubled the money supply, but no one actually spent the money, there is no "dollars chasing" only "dollars."

The chart below shows Core PCE deflator vs. the year-over-year change in consumer expenditures. The chart covers every monthly observation (of the 12-month change) since 1969.

Not surprisingly there is a strong correlation here: 0.82. I've drawn a fitted trend line just to illustrate the point.

Notice there are exactly 8 observations where consumption growth is negative. Its the last 8 months! To be fair, I'm doing year-over-year numbers to take out some of the month-by-month noise, but the point stands. We're entering the first outright decline in consumer spending in 40 years.

There are those that talk about the Fed creating another bubble by keeping money easy. That risk exists for sure. But the bubble can only form in a place where money is flowing. Where is money flowing? To a large degree, its into "savings."

Could there be a bubble in savings? Perhaps. Some think that the excess liquidity is flowing into risk assets, stoking another bubble. But this "savings" isn't flowing into brokerage accounts so much as its flowing into money markets and paying down debt. 4Q 2008 and 1Q 2009 marked the only outright declines in household indebtedness since 1952! Can there be a bubble in debt repayment?

Our current situation and current policies shouldn't result in inflation if the easy money is removed in time. I think there is a much greater risk of premature tightening of policy and thus creation of a double dip recession. But more likely we'll see a very tepid recovery (maybe after an inventory bounce), a recovery not strong enough to stoke inflation.

What worries me is Fed independence. The re-appointment of Ben Bernanke is a huge positive on that front. Obama could have set a new precedent, than the Fed Chair was basically like any cabinet position and every new president gets a new Fed Chief. That would have obviously made the position much more political. But there... off in the distance... you can hear those ominous french horns of fate playing, like Luke looking out onto the twin sunsets...

Recently Ron Paul (who I'm normally 100% behind) said he would get a vote on new requirements for audits of the Fed. Even he says that Congress doesn't want to interfere with monetary policy, but we all know its a slippery slope. Maybe today's Congress understands that monetary policy should be apolitical and only wants audits after a considerable lag. Tomorrow those lags are smaller. Then the timing of the audits suddenly coincides with FOMC meetings. Then the FOMC needs to seek "advice and consent..."

MORE BEARISH: THE DOLLAR

Be forewarned that I am not a currency trader. I don't have a strong opinion about any particular USD/EUR or JPY level as "right." I am steeped in basic macroeconomics: a currency's value should reflect two basic fundamentals. Relative inflation and relative investment opportunity. The later should reflect both overall economic growth as well as prevailing interest rates.

So we look at the U.S. versus the rest of the world on those three points: relative inflation, relative interest rates, and relative growth. Worth noting that all these things are inter-related, and that the direction of each from here will be more important than the current level.
On interest rates, and normally its assumed short-term interest rates matter most, so here are two-year government rates around the world.

You can see that the U.S. is among the lowest worldwide. To the extent that this is reflective of Fed policy, its obviously dollar negative.

Next I have GDP forecasts for 2010.

The U.S. shows up pretty well on this list. Basically among industrialized nations, the U.S. is expected to grow the fastest in 2010. So that's somewhat of a dollar positive. However, I believe the main reason why the U.S. is expected to grow faster than the Euro zone is because of more accommodate monetary policy here in the U.S. In other words, we may get more growth, but we'll also get more inflation.

That's not contrary to what I wrote above. I expect the Fed's accommodation to successfully create inflation in the 1% area. Compare this to the Eurozone, where Trichet and company are much more hawkish. I doubt they get to 1%, and I really think deflation is a strong possibility. I think Trichet is making a policy mistake, but regardless it will help the Euro strength. Japan's problems with inflation are well-documented and thus well-priced into the currency markets.
Anyway, so growth may be a positive for the dollar, but interest rates and inflation are negatives, and I think all that adds up to a weaker dollar.

A related topic is, of course, foreign support for the U.S. bond market. A foreign withdrawal from the bond market could precipitate a dollar collapse. That is something I will address in my next post!