Bernanke Shot First

The Fed minutes touched off a bear flattener, which tells me the market is decreasing the overall degree of easing and/or the time period the Fed will leave rates at the cycle low. This is emphasized by the 2-year, which sits at 4.14% after having fallen as low as 3.83% on 9/10. The current rate on the 2-year is only 60bps below the current target rate, suggesting that the total amount of Fed easing will probably only be another 75bps or so.

The minutes themselves had a little something for every one. There was upbeat news on the economy overall, but housing was viewed as a strong drag. I think the portions the market was focused on where statements like this:

With credit markets expected to largely recover over coming quarters, growth of real GDP was projected to firm in 2009 to a pace a bit above the rate of growth of its potential. Incoming data on consumer price inflation that were slightly to the low side of the previous forecast, in combination with the easing of pressures on resource utilization in the current forecast, led the staff to trim slightly its forecast for core PCE inflation. Headline PCE inflation, which was boosted by sizable increases in energy and food prices earlier in the year, was expected to slow in 2008 and 2009.

My take away is as follows:

• The Fed isn't going to keep cutting just because we have a credit crunch. They seem to view that problem as short-term.
• GDP growth is likely to be pretty slow in 2008, but accelerate in 2009. If that forecast remains in tact, the Fed isn't like to cut aggressively in 2008, less the 2009 bounce create inflation pressure.
• It sounds like they think food and energy prices will moderate just based on mean reversion. I didn't see any stronger justification for this view. I think the Fed wants this to be the case, since higher food and energy prices are threatening to solidify consumer expectations for higher inflation rates in the future. So their statements on moderating food and energy prices may be more purposeful talk than analysis.
• I think their view on housing continues to get worse. However, if you read between the lines here, I think there are people on the committee who don't want to cut rates so long as housing is an isolated area of economic weakness. I think the reasons for ignoring isolated weakness in housing is akin to reasons why they're ignoring isolated rising prices in food and energy.

My bearish view on intermediate term rates remains in tact. I still think the 10-year is rich at 4.65%. The 2-year is close to fair value if not slightly cheap.

Job Growth? This economy must be hotter than I thought!

Non-farm payrolls grew by 110,000 in September, which is probably a bit below the long-term job growth required to keep up with population growth, usually estimated to be about 150,000/mo. The big story is that August's figure was revised from -4,000 to +89,000. Again, neither increase is impressive, but against the backdrop of a very weak housing market, even decent job growth is most impressive.

Now this doesn't mean the economy is strengthening, particularly if you consider the decline in temporary employment. But it does mean it isn't quite as weak as we thought.

The take away is that the Fed can take a more modest approach to rate cuts, if they so desire. I think the odds of no move in October has risen substantially. Although if you take into account Donald Kohn's comments yesterday...

"We had been holding the federal funds rate at 5.25%, well above the expected rate of inflation, in part to compensate for what had been very narrow yield spreads and readily available credit."

To me that says that Kohn, and likely his colleagues, viewed 5.25% as restrictive with a goal of pushing credit spreads wider. It would seem that they've accomplished this goal, for the moment, and that would leave the door open for more cuts. We'll see.

Meanwhile, there was sure a lot of lawyering going on across the blogosphere. One of the reoccurring themes here on AI is that too many investors act like lawyers, arguing their case from a predetermined point of view, and seeking out facts that support that point of view. Good investors act more like detectives, starting with an open mind and letting the evidence lead them to a conclusion.

Nouriel Roubini and Barry Ritholtz's posts on yesterday's NFP release both smack of lawyering. Both harped on the large increase in teaching/education jobs, which is a legitimate albeit limited point. If changes in the school calendar made measuring teaching jobs difficult, then indeed July and August reports were understated. So the bad news we thought we were getting in those months really wasn't as bad as we thought. I note that neither blogger wrote one word about the education job issue after either the July or August report. (Here's Roubini and here's Ritholtz here and here.)

In both cases, I can't help but feel as though the writer is looking for bearish news to report. When August jobs was reported as negative, both sounded the alarm that a hard landing was coming. But when August was revised higher because of a legitimate discrepancy in the data both bloggers dismissed the revision as a mere data discrepancy. You can't have it both ways. The truth is that the job situation is better than we had thought.

And it isn't even as though this job report disproves the bearish case. Hardly! Employment is usually a lagging indicator first of all, and second of all the weak temporary employment numbers can't be ignored. And most importantly, we need faster job growth to keep up with population growth in the long-term. So if you have a bearish view, this data point won't necessarily coax you out of your cave.

But I think if you really want to make money in the investment game, drop your bearish (or bullish) view. And then examine the data with an open mind. Instead of imposing your own viewpoint, try instead to think along with the Fed. Read what they say, and then read between the lines of their statements. You'll find that your ability to forecast will improve dramatically.

Non-Residential ABS: No, no problem. Why?

A e-mailer asked me about non-residential ABS. This paper has been hit pretty hard, and I agree with the e-mailer who characterized the move as "odd and irrational." Anyway, here is a chart.


The blue line is auto-loans, the green is student loans, and the red is credit cards. All are AAA-rated, floating rate, and 2-years to maturity. The quote is in spread to LIBOR. The source is Merrill Lynch.

We can see that this paper has been trading right around LIBOR flat for years. The next graph goes back to 2000.
Notice no major move in this stuff in response to the 2001-2002 credit crunch. Or 9/11. Or even the 2005 downgrade of everything auto.

So why has this paper moved wider in this credit cycle but not the much worse 2001-2002 cycle?

The obvious theory is that the current period has more to do with consumer credit than 2001-2002. Back then corporate bond spreads moved dramatically wider as investors questioned the accuracy of financial reports. This time it has less to do with corporate health and more to do with poor credit standards in consumer lending.

And I think its logical to conclude that if consumer lending practices were getting sloppy in home loans, why not other loans? Put another way, if CDO demand was so strong as to encourage mortgage lenders to throw caution to the wind, the same effect should have encouraged other lenders to act the same way.

Interestingly, however, it appears this isn't what's happened. I did a little unscientific research into the composition of ABS CDOs in 2007 by looking back at all of the marketing materials I was sent in 2007. I found 10 deals (remember that basically all ABS CDO issuance dried up in June), none of which had a significant exposure to non-residential paper. A few had a bucket for "ABS CDOs" but didn't see any where that bucket was more than 10%.

Econometrics professors reading this blog, please forgive the sloppy statistics here, but I figure if out of 10 deals picked out of a hat, none of them had any non-resi ABS, then its likely that ABS CDO collateral overall was dominated by residential paper. Anyone who's seen hard stats on this, let me know.

Why would CDO collateral be primarily resi ABS? Wouldn't adding other types of consumer loans improve the correlation? Well I'd argue that auto loan, student loan, and credit card paper was too tight to interest CDO managers. Remember that a CDO needs wide spreads. He doesn't need to own a bucket of higher credit quality paper, because s/he figures credit losses can be managed within the structure. And as I've said before, both the managers and the ratings agencies grossly miss-estimated the correlation of residential loans.

A fair concern is that the default rate on all consumer loans is likely to rise. When HPA was very strong, consumers could get out of debt by doing a cash-out refi. We all saw the "consolidate your debts" commercials. Now that HPA's fire has gone out of the universe, the "debt consolidation" option is all but extinct.

So while my broad view is that most ABS has plenty of subordination to withstand a modestly higher default rate, there is a non-zero probability that we've all underestimated how much consumers were using their homes to bail themselves out. I'm personally involved in enough other sectors which have widened similarly which don't suffer from the possibility, however likely, that consumers will be even weaker than I currently think.

One option is FFELP student loan paper, which is U.S. Government guaranteed. I think the rate is about 5-10bps tighter than that student loan paper shown in the graph, but 5-10bps to eliminate credit risk ain't bad.

This is madness!

Spreads on everything except sub-prime stuff has been racing in. And its got me a little nervous that a true mania in credit might develop.

First the bad news: The ABX 2007-1 BBB- keeps hitting new lows...
Hard to hold out a lot of hope for Baa-rated sub-prime pools. I saw a pool offered by Goldman Sachs at a dollar price of $10 yesterday. It was originally rated Baa, now C. It was a 2006 vintage, so the loans are probably less than 2 years old. Just for fun I ran it through some modeling and found that if the current delinquency rate (15%) turns into a default rate, and the recovery is around 50% (generous), even at a $10 principal price you'd still wind up losing money. Bear in mind since the loans were probably less than 2 years old, there probably haven't been any resets yet! I didn't spend a lot of time on this particular piece so this is hardly complete analysis, but the point here is that there is a lot of shit out there that ain't coming back.

Meanwhile, asset-backed CP rates are improving dramatically. The following compares ABCP vs. 3-month LIBOR:

The ABCP rate is from the Fed's H15 release, and its only been tracked since 2006. But you can see that there was virtually no volatility in this rate until suddenly there was. This graph combined with the next graph on amount outstanding in ABCP:

ABCP outstanding looks a bit Beggar's Canyon back home eh? If you think about these two graphs together, my belief is that most of the bad actors in this space have been denied access to the CP market. So spreads are tighter on ABCP because the only issuers left are the stronger issuers. I'm hearing its mostly corporate guaranteed paper, i.e., a strong bank who has put a corporate guarantee on the SIV or whatever conduit has issued the CP. I think its important to realize that the concept of ABCP isn't a bad one. Hell, I think a lot of investors would prefer to have their CP backed directly by quality assets as opposed to being subject to corporate shenanigans. Currently the definition of "quality" has come into question, and the ABCP market is suffering for it, but in the long run, the ABCP market should be fine. That being said, I'm a little surprised its improved this much this fast. Its getting me just a little nervous

High yield corporate spreads have moved much tighter as well:

That's two years worth of data. Obviously this shows the big downward trend in spreads. I've said that I was constructive on high-yield, and I am still. But there is potential here for a mania phase to develop. Let me draw out a scenario...

1. High Yield spreads "correct" from unusually tight spreads in response to problems with sub-prime mortgage loans. (already happened)
2. HY spreads rapidly tighten back, not quite all the way to the previous tights, but maybe half way.
3. People start justifying the move by claiming that the HY market never had anything to do with sub-prime anyway. So, they'll claim, the widening of HY spreads was not fundamentally justified.
4. HY spreads keep tightening, blowing through all-time tight levels. This encourages more borrowers to come to market. LBO and covenant light deals re-emerge.
5. This causes the same problem we had in sub-prime: too many deals. Marginal borrowers are always the weakest borrowers, be it consumer or commercial loans.
6. Default levels rise significantly, and HY spreads gap out tremendously. See 2001.

According to Moody's, 32.7% of speculative-grade bonds default over a 10-year period. And the average corporate bond realizes 36% recovery after default. So a diversified portfolio of high-yield bonds has an expected loss rate of about 21% over 10-years. So to use simple math, if high-yield spreads fall to 210bps over Treasuries, the expected value of a high-yield portfolio is no better than a portfolio of Treasuries. Since obviously an investor in high-yield should expect some risk premium beyond just expected loss rates, there is some point above 210bps where value becomes very poor for high-yield.

So at 400+bps, there is value to high-yield. But be cautious. If a mania phase develops, don't fall for it. I'll be happy to unload my high-yield position at 300bps or so and watch the mania from the sidelines.

The Phantom Menace (update)

Last week I asked the readership to help me find good papers on the subject of a dollar decline. I thank everyone who sent me a suggested paper. Please continue to e-mail me interesting pieces at accruedint AT gmail.com.

Here are some of the highlights.

Paul Krugman "Will There be a Dollar Crisis?" Economic Policy July 2007.

Dr. Krugman has become more and more political, which is too bad from my perspective, since I think it has colored how people view his work. Say what you will about his politics, he has been one of the preeminent international economists for going on 3 decades.

Anyway, one of Krugman's strengths is his writing skill. I find his papers to be much more readable than most academics, without sacrificing weight. So this paper is a great read for anyone who isn't an economics PhD. Anyway, you can read his conclusions for yourself. I can't get past what seems like a core assumption of Krugman's in this piece.

Basically he says that there is a certain level of foreign indebtedness that's just plain unsustainable. Therefore the current account can't stay negative indefinitely. In order to correct this imbalance, the dollar must decline. None of these points are controversial.

If the dollar must decline, Krugman figures, why are investors still pouring money into U.S. assets? In other words, it sure looks like foreign investors in U.S. assets are buying investments with negative expected return. Krugman concludes that investors must be "myopic." Basically blindly buying U.S. assets while ignoring the fundamentals problem of our currency imbalance.

This sure sounds like a "the market is dumb" argument, and while Krugman himself cautions that second-guessing markets is dangerous, his "myopic" assumption is key to the idea that the dollar will suddenly fall. I learned a long time ago to beware the academic pedaling a model which is supposed to be smarter than the market. Now Paul Krugman isn't just any academic, but still, we must be cautious. And I don't have any particular reason to believe investors aren't myopic, but I also don't have any reasons why the are myopic. It seems just as likely that investors are reacting to something the models aren't modeling.

A couple other papers I found particularly valuable:

(Hat tip: Venkat) Jeffrey A. Frankel and Andrew K. Rose "Current Crashes in Emerging Markets: An Empirical Treatment" Board of Governors of the Federal Reserve System, International Finance Discussion Papers. January 1996.

Christopher Gust and Nathan Sheets "The Adjustment of Global External Imbalances: Does Partial Exchange Rate Pass-Through to Trade Prices Matter?" Board of Governors of the Federal Reserve System, International Finance Discussion Papers. January 2006.

FYI, there are many good papers from the Fed on this topic, which can be found here.

I'm continuing to focus on this area, so the conclusions here are hardly my last word.

Inflation statistics can deceive you, don't trust them

The Big Picture, authored by Barry Ritholtz is one of the most popular investment blogs going, and I often find Barry's work enlightening. But his obsession with "inflation ex-inflation" has got to stop. There are some good comments from Brad DeLong and KNZN on their respective blogs, but I feel compelled to chime in.

A central bank's job is to manage the money supply. Anything that has nothing to do with the money supply isn't the Fed's job. Keep that in mind.

Now let's assume that quantity demanded for a given good is expressed as a function of...

D = f (P, O, T, Y)

Where P is the price of the good, O is the price of other goods (compliments and substitutes), T is consumer tastes and preferences, and Y is nominal income. Note that Y is the only variable that would impact all goods in the same direction at the same time.

Thinking about the classic demand curve, changes in P cause movement along the demand curve, while O, T, and Y cause the demand curve to shift. Hopefully most of AI's readers took freshman microeconomics, and this all seems very elementary.

Now let's say that preference for some good, say corn, rises. Maybe Congress has increased the subsidy for ethanol, let's just say. Supply of corn is short-term inelastic, because it takes time to plant and harvest new corn crop. So the demand curve shifts outward, supply doesn't change much (if at all) and therefore the price of corn rises.

Now consumers of corn for food (as opposed to ethanol) will probably rotate into other food products, to the extent that corn has substitutes. So demand for wheat might expand, due to the O factor. And since wheat probably also has a fairly inelastic short-term supply curve, the price of wheat also rises.

So we have food prices rising, but having nothing to do with the money supply. Therefore reacting to this chain of events ain't the Fed's job. It makes no more sense to ask the farmer where to peg overnight bank loans than to ask the Fed to control agriculture prices.

Inflation comes from an increase in the money supply. If there is just more money floating around, this would manifest itself as a increase in Y. And remember that Y impacts all goods at the same time in the same direction. Perhaps not to the same extent, but at least in the same direction.

So let's say that in conjunction with the rising price of corn, the effective money supply has also expanded by 5%. Everyone has 5% more to spend, which causes all prices to rise by 5%. But corn and other food products actually rise by more than 5%, because of the shift in tastes. And somewhere some other price has to fall, or not rise as much, because the extra money being spent on food isn't getting spent someplace else.

Anyway, the Fed's problem is the 5% expansion in the money supply, not the increased demand for corn. Unfortunately, its difficult to peg exactly what the effective money supply is. And in real life, all goods face constantly shifting supply and demand curves. So the Fed faces a challenge in determining whether the money supply is increasing at a faster or slower rate than is desired.

In a perfect world, the Fed would look at a subset of goods for which O, T and the supply curve were all constant. It really wouldn't matter how representative those goods were, because the only thing that would cause the price to shift would be Y. The Fed could then determine if the change in price of this basket of goods was optimal knowing that the price change was due to changes in the money supply.

Of course, in real life, no such products exist. So the next best option is to strip out products which are known to have unstable supply and demand curves. This was originally the impetus for creating the "Core" CPI and PCE measures. Another way to handle this is to assume that the most volatile prices in a given period are being influenced by good-specific supply and demand factors and strip those out, whatever they might be. This is the idea behind the Dallas Fed's Trimmed Mean PCE and the Cleveland Fed's Median CPI estimate.

If the Fed is going to pick an inflation measure to target, we want them to target something that in most closely aligned with shifts in money supply and shifts in money supply alone.

Its fair for someone to say that their household bills are rising at a faster rate than any of the core inflation measures. Some of the items that have been rising in price most lately have been repeat consumables, like gas and food. But the Fed isn't targeting cost-of-living. It can't. So if you want to blame the media for ignoring cost of living in reporting on "core" inflation measures, fine. But don't blame the Fed.

Its not their job.

He's a card player, gambler, scoundrel. You'd like him.

More than a few times when I've told someone what I do for a living, they've scoffed and called me a "professional gambler." And while I hope few people really think of Wall Street as nothing more than a giant casino, there is an inescapable link between investing and gambling. I have yet to find a trading desk where the betting action wasn't rampant. Hell, the most famous book about the bond market is titled "Liar's Poker" and features a story about John Meriwether playing a game of liar's poker for $1 million.

It isn't hard to see why a professional securities trader would have the same psychological profile as an avid gambler. You have to be decisive. You have to accept risk. You have to understand that luck will be a big part of your success or failure on any given bet.

I myself was very much into gambling on NFL games as far back as high school. While I never had a large amount of money on a game, and it was mostly just in the form of a pool among my friends, I learned a lot about investing and trading through gambling on football.

Focus on the primary factors, don't get distracted by secondary and tertiary elements. By this I mean, focus on which team is more talented than the other. Only if you think the talent level is very close should you start drilling down to stuff like matchups and weather conditions and minor injuries. Sometimes the secondary and tertiary factors can talk you out of making a good bet, or talk you into making a bad bet.

Same goes in investing. Focus on the fundamentals of a company. Only after you've completely analyzed the fundamentals should you drill down to things like technicals of the trading price or potential EPS surprises. The firm with better management and a better business model will win out most of the time, even if you completely miss-time the trade. Just as the more talented football team will win most of the time.

Filter out irrelevant information. All the time you hear about how this team has beaten that team 6 out of their last 9 matchups or some such. But in the NFL, non-division teams don't play each other every year. So 9 matchups might be over a 12 year period. Is there any relevance to the fact that the Raiders beat the Colts several times in the late 90's?

Similar crapola gets thrown out in the investment world. Back in 2000, I remember people claiming that technology stocks do well in recessions. So while every one saw the economy was slowing in late 2000, technology was supposedly a "defensive" way to play the recession. Mmmmm... didn't work out too well. The fact is that each recession plays out a little different, just like each boom plays out a little different. The economic fundamentals are never exactly the same. Just like the Colts are a very different team today vs. 1995, the economy is different today than the last time we had a recession.

Ignore the media as best you can. This is really a corollary to the first two points, because the media loves to focus of secondary factors and throw out meaningless statistics. Watch any NFL pregame show this Sunday. 80% of the talk will be focused on worthless banter about who wants it more or what stadium is tough to play in or which player is a great leader or who's mentally tough or who owns who or who is inspired by some personal problem or which coach is a genius or who's reeling from their last loss etc. etc. Remarkably little time is spent talking about who is more talented than who.

They'll also vastly overweight what just happened last week. If a good team starts 2-1 then loses in week 4, invariably there will be a story on ESPN about whether its time for that team to panic. Meanwhile if an average team starts 1-2 and wins in week 4, invariably ESPN will do a story about whether that team is a legitimate title contender. Especially if the average team beats a pretty good team. You just wait: this Sunday is week 4 and I promise you both stories will run on Sportscenter or one of ESPN's other NFL shows at some point this week.

The financial media is similarly obsessed with the recent past. Since the dollar has recently been dropping, there's also been a rash of stories in the press about how to play a falling dollar. Its possible articles like this have something to do with why retail investors are constantly getting whipsawed.

When someone like CNBC interviews a PM, they will invariably ask what stocks the PM likes "in today's market." Of course, CNBC means literally today's market. And yet if you listen carefully to the answer, the stocks and reasons often have little to do with today's market. Just the other day I was listening to Squawk Box and some PM said he liked pharma stocks because of demographic issues. Well that probably means the guy has been holding those stocks for years. Today's market? Very few PM's buy stocks or bonds based on where they think the market is going this week.

Forget about what's possible, concentrate on what's probable. Is it possible that the Rams will upset the Cowboys later today. Sure, its possible. Anything is possible. But if you go through the scenarios of what it would take for St. Louis to score that upset, you'll realize the odds are low.

Similar with investing. You can talk yourself out of good investments by over-weighting disaster scenarios. Investing and betting are both about probabilities.

When you lose, understand why you lost. Sometimes you are just unlucky. In fact, you'll wind up being unlucky a lot if you hang around either the investing or sports gambling game long enough.

So when you make a bet or a trade that doesn't work, first figure out if you were just unlucky. If whatever went against you was a possibility you considered, but estimated to be a low probability, maybe its just an example of things not breaking your way.

Remember that the point of examining your mistakes is to learn from them. So don't stop at small picture reasons why the trade didn't work. Often times the more specific your reasons the less applicable to other trades. Take Enron. You could conclude that it was just fraud. But that's not too applicable to other trades, because fraud is extremely hard to detect. Or you could conclude that you need to look harder at off-balance sheet funding. Better. But even better would be to watch out for aggressive management. The more aggressive managers are more likely to push hard for better quarterly numbers. The harder they push, the more tempting fraud becomes.

Don't get lured by the big spread. Whether its a team favored by 16 or an A-rated bond with a 250 spread, it can be tempting to conclude that the spread alone makes the bet worth it. That kind of thinking leads to lawyer analysis. Lawyers are charged with representing their client, and therefore they gather and/or interpret evidence which supports their client's position. The truth isn't a lawyer's problem. People all too often make betting decisions with a conclusion in mind at the beginning, then overweight evidence that supports their decision and ignore contradicting evidence. What a great way to lose money!

Remember the point is to make money, not to be a hero. People love to make bets that, if they pay out, make the better look like a genius. But usually these bets are highly risky. Like taking the 30-1 shot to win the Super Bowl or betting on an 11 point underdog to win outright. Or buying a deep out of the money option. Or buying a bond with a $50 price. If you want to make a bet like that, fine, but make sure you are doing it because you've completed an exhaustive analysis. Not because you want to be a hero.

By the way, I like the Bears laying 3 this weekend.

Fair disclosure: I have the Bears laying 3 this weekend.

So this is how democracy dies...

I've added a poll on what the Fed will do on 10/31 (right hand side under the Google ad). I'm curious as our collective opinion. I consider it your blog reader duty to vote.

This deal's getting worse all the time!

I was going to write a post about the Sallie Mae news, since LBO's have been a common topic on this blog in 2007. But as I started to write, I realized I didn't have anything to say that I haven't already said either here or here. I think the end-game here is a renegotiated price, and I think that's why the stock is considerably higher today.


On the liquidity front, things have improved greatly. Spreads on generic product have moved mildly tighter from the recent wides:

• Lehman High Yield Credit OAS now 400, was as wide as 465 on 9/10
• Lehman IG OAS now 132, was as wide as 143 on 9/17
• Lehman MBS OAS now 81, was as wide as 91 on 8/16

But all are much wider than recent tights:

• High Yield was as tight as 233 on 5/29
• IG was as tight as 82 on 5/29
• MBS was as tight as 47 on 4/9

But the move hasn't been indiscriminant. The ABX-07-1 BBB- index continues to hit new lows...

While the AA index has improved substantially...

Homebuilders continue to perform poorly (Centex's CDS)...


While mortgage market participants with strong access to liquidity are doing well (WaMu CDS)...


So this begs the question: if conditions remain as they are today, does the Fed need to cut further? Maybe. Remember that by my estimate, the Taylor rule still says policy is too tight, and I'm not alone in that view. So that would suggest that additional cuts are coming, and the liquidity crisis has nothing to do with anything. On the other hand, one cannot deny that the Fed choose to surprise the market with a 50bps cut for a reason. For the last 4 years or so, the Fed has always telegraphed its moves like a Notre Dame quarterback, then all of a sudden they decide to shock the market with a huge cut. This was obviously aimed at curbing the liquidity crunch. And to take that one step further, they probably choose to shock the market in the hopes that they could get away with fewer cuts in total.

So I think the odds of no move on Oct 31 are a bit higher than the 30% or so currently priced into funds futures. But then again, always in motion the futures are.

The Phantom Menace

The dollar's steep decline has gotten a lot of talk lately, and with it fear that an even worse decline is on the way. No less than Paul Krugman thinks we're headed for a Wile E. Coyote moment, when the erstwhile predator realizes he's run off the cliff and suddenly plunges Earthward.

My own long-term view on exchange rates is that they are reflective of economic events, as opposed to being economic events in and of themselves. That's a bit of a simplification, to be sure, but consider what currency really is. Its just a means of exchange. We know that currency tends to decline in value over time, a process economists call "inflation." Why does currency movement have to be more complicated? In other words, if the dollar buys fewer ears of corn or fewer yen, what's the difference?

Classically, currency movement either reflects relative inflation in two countries (purchasing power parity) or relative real interest rates in two countries (i.e., that the country with higher rates will attract investment and therefore its currency will rise.) Given this, I wasn't initially concerned when the dollar declined over the last couple weeks. Given that multiple Fed cuts were being priced in by U.S. markets, its logical that:

A) Inflation would be on the rise in the U.S., diminishing the value of the dollar and

B) Interest rates were falling, causing foreign investment to be more attractive.

So a declining dollar seems to be the logical extension of what the Fed was doing. Not surprising at all.

However, there is a growing contingent of economists who believe a more severe dollar decline is likely, to the point where I don't feel comfortable merely dismissing the currency market as no big deal.

So I've embarked on a reading mission, where I'm going to be looking for any and all quality papers I can find explaining why the dollar is vulnerable (or not) to see if my classical explanation requires a bit more depth.

In order for me to be convinced that I should join the bearish dollar crowd, here are the questions I need answered:

1. If the trade deficit is "unsustainable" at current levels, why has the U.S. been able to run a deficit more or less constantly for the last 30 years?
2. Same question on foreign debt loads. They have been high for a very long time. Why are conditions today so different?
3. If the answer to either #1 is that the deficit is historically large, then why is deficit of 6% of GDP a drastically bigger problem than 3 years of 2% deficits?
4. Can the notion of Bretton Woods II be disproved? Or more to the point, what would cause China, Japan, and others to allow the U.S. currency to depreciate? Particularly in a sudden fashion?
5. If we assume that a declining dollar coincided with inflation, this would likely cause the Fed to hike interest rates. Why wouldn't this attract foreign investment and thus strengthen the dollar?
6. If the theory for a dollar decline is portfolio diversification on the part of central banks, why would these central banks choose to diversify suddenly?
7. If the theory of a savings glut is accurate, then a dollar decline supposes that the glut of savings must travel elsewhere. But if there was someplace to travel, we wouldn't have a savings glut (or as some describe, an investment drought) in the first place. What's going to change in the short run?

I'm riffing a bit with these questions, so I'm sure I'm forgetting something. And many of these are related. But these are the questions I'm embarking to either confirm or deny. I'd appreciate links to any pertinent papers readers know of. Please e-mail me at accruedint (at) gmail.com.

Update: Here.

You fixed us all pretty good

I've written several times about the CDO market. Let me begin by saying that I think that the CDO market is a net positive for the economy. Used properly, CDOs can be an effective means of spreading risk around in the economy.

However, the CDO market has played a central role in creating the sub-prime housing quagmire we are currently muddling through. Indeed, I believe the CDO market has a lot to do with the housing bubble itself. Let me talk a little about how the CDO market contributed to the sub-prime problem, as well as some ideas of how we can retain the good elements of the CDO market without the bad.

CDOs basically take a pool of risky credits and divide the credit risk up among different investors. Investors who want less credit risk buy the portions of the deal which get first priority on principal payments. Those who want more potential income choose riskier tranches. For a primer on CDOs, click here. Suffice to say that the concept of a CDO is based on the time tested idea that a diversified pool of risky assets tends to have a relatively predictable return pattern.

So what went wrong? It isn't that diversification of credit risk doesn't work. In my opinion, its more like something akin to the extrapolation problem in regression.

Let's say you are studying the effect of caffeine intake on focus. You get together 500 people, with 25% each drinking 0, 1, 2, and 3 cups of coffee over a 1 hour period. Then you ask each to take a series of tests to measure focus. For the sake of argument, let's say your results look something like this:

I'm completely making this up for an example, so these results look far too clean, but stay on target. I'm getting to my point. Anyway, the blue dots represent the range of results at each level of coffee intake and the red line is the median observation. We see that although each additional cup of coffee does improve focus, the marginal impact of that 3rd cup is pretty limited. So I'm sure those who do any amount of econometric work look at this chart and see a nice quadratic. And of course, that's no coincidence, since I used a quadratic equation to make the chart:

5 + 6C - C^2 + Err

Where C is the number of cups and Err is a random error term.

So let's say you divine that equation from your data. Even if your equation perfectly explains what happens to the average person who ingests 0-3 cups of coffee, the applications of the equation are still limited. For example, it tells you nothing about what happens if you drink 4 cups of coffee. Or if you take more than 1 hour to drink your coffee. Or the effect if you drink 4 cups every day for a year. Before I turn us back to the bond market, let me point out that this is freshman statistics stuff. CFA Level 1 stuff. Anyone who doesn't understand this should be banned from using Excel's regression function.

Now let's look at the sub-prime mortgage market. Remember that CDOs work by owning higher risk securities, then spreading the idiosyncratic (i.e., single security) risk out among many assets. So CDO managers are happy to own higher credit risk securities, so long as they believe they can effectively spread the risk out. Ergo, a CDO manager trying to create an ABS deal would be looking for higher risk/higher yielding residential mortgage deals. Managers started finding that the higher yielding items were pools issued by underwriters viewed as having weaker credit standards. Maybe these pools had a higher percentage of 100% (or higher) LTV and/or stated income loans. But as far as the CDO manager was concerned, that wasn't a problem, because that risk could be spread out in a very large portfolio of bonds.

How did s/he know how much in high LTV or low doc loans was prudent? Well, CDOs always assume some level of defaults will occur, and usually they can perform quite well at default levels a fair bit higher than the assumed level. But what they cannot withstand is a large number of defaults occurring over a short period of time. More on that in a minute. Anyway, if you want to avoid a large number of defaults all at once, you need credits with a low correlation. Fortunately (!?!) correlation was right up the alley of the quant wizards running CDO portfolios. Armed with reams of historical data, they calculated the delinquency correlation of high LTV, low doc, low FICO,etc. etc. loans with each other. What they found was the delinquency correlation was relatively low. So if you had one high LTV, low doc HELOC in Oregon, and another in Virginia, the odds of both defaulting was calculated to be quite low.

The ratings agencies took the same approach. Default probability and correlation are the keystones to CDO ratings. Not surprisingly, the ratings agency quants and the CDO manager quants used the same data and came to the same conclusions. ABS portfolios had fairly low calculated correlation. As far as ratings go, a low correlation suggested that a portfolio's realized default level would be more likely to fall within a small band, and less likely that a large number of defaults would occur in a single year. A quick note on the ratings agencies: notice they don't need to be biased to agree with the CDO managers on the approach. While I think conflict of interest is a major problem at the ratings agencies, I think the problem with the CDO market is deeper.

OK so we've all built highly complicated Monte Carlo simulations with carefully calculated correlation statistics. Meanwhile some of the most creative people on Wall Street were getting involved with the CDO market.They began to pepper the ratings agencies with new ideas, usually with the goal of decreasing the subordination (i.e., increasing the equity's leverage). The ratings agencies basically said "If you can make it pass our tests, you'll get your rating." So CDO managers began monkeying with things like IC and OC tests, PIK toggles, and other fun things. If the test could trigger at higher default rates and allow the deal to perform adequately, that would allow for less actual subordination while still getting the ratings desired. In turn, this meant that if everything went well, the equity return would be much greater.

Some readers will be happy to hear that in the overwhelming majority of cases, CDO managers retained some or all of the CDO equity. So when they strove to take on more leverage, they believed they were displaying confidence in their own models and managers. Most were actually putting their money where their model was.

Demand for higher-rated CDO tranches was very strong. Banks could buy insurance on AAA-rated CDO tranches from someone like MBIA at a price slightly less than the LIBOR spread offered on the CDO. The result would be something rated AAA with insurance on top of that at a net spread of, say, 5bps. Someone who can borrow through LIBOR, like a strong bank or someone with a CP program, could basically earn that 5bps for free. Hence the rise of the ABCP programs.

So demand for CDOs was hot and the CDO managers and investment banks were making great fees on creating them. The managers and the investment banks worked together to make sure adequate bonds were issued in order to feed the CDO machine. That meant investment banks were bidding aggressively to underwrite various types of bonds popular in CDOs, including sub-prime mortgage deals. Indirectly, this probably lead to the investment banks proving attractive warehouse lines to sub-prime mortgage originators, or even acquiring mortgage lenders outright. And remember, the CDO manager wants higher risk/higher yielding paper, so the most popular loans were going to be the more risky loans.

But for all the quantitative minds contributing to the CDO market, they seemed to forget Statistics 101. You see, the historical statistics on mortgage delinquencies were computed during a time when loans with over 100% LTV or stated income were rare. The rarity of the loans implied that those loans were only approved because there was a legitimate special situation suggesting the risk inherent in the loan was reasonable. The CDO quants extrapolated this data out, and concluded that no doc, high LTV, etc. were all good risks.

But history turned out to be no guide. Things were different this time. Stated income loans went from a rarity to commonplace. According to Bear Stearns, about half of the sub-prime loans made for home purchases in 2006 were either low or no doc loans. Half. That should have screamed out to everyone in the ABS business that gigantic amounts of fraud was being perpetrated. That half of all sub-prime borrowers had a legitimate reason for not fully documenting their income defies common sense.

Obviously if many borrowers who never should have been financed were getting loans, this caused the demand curve for housing to shift outward. Indeed, there is anecdotal evidence that many were using no doc loans for speculation purposes. Which obviously only fueled the already hot real estate market.

Notice that we don't need to make an assumption about HPA or interest rates to see that these borrowers were highly likely to default. If a banks are underwriting loans that are entirely fraudulent, no amount of HPA or falling rates are going to prevent a much higher default rate. Even if most of the fraudulent borrowers intended to pay off the loan, most fraudulent borrowers are going to be toast. That's just logical.

So it should have been obvious that the default rate on these loans was going to be very high. In fact, there is extensive evidence from other credit-types that when issuance becomes very high, default rates subsequently spike. One could imagine that the quality of potential borrowers never actually improves, so when more loans are being made, the marginal borrower is a weak one.

Anyway, so not only should the ratings agencies have seen that default rates on sub-prime MBS would rise, they should also have seen that the correlation would rise as well. For the same reason. If default rates are related to issuance levels, then when issuance is high, correlation is also high. The loans in Oregon and Virginia became more highly correlated because they were both underwritten with weak credit standards.

And the ratings agencies should have been in the perfect position to see this. They have the world's best databases on historical default rates. They should have used knowledge from other asset classes and applied it to the sub-prime MBS market. We've seen time and time again that huge increases in issuance result in greater defaults. From commercial real estate to manufactured housing to high-yield corporate bonds. Perhaps this is where the conflict of interest reared its ugly head. Maybe they willfully ignored this problem.

So how to improve the CDO market?

• Assume dynamic correlation. Don't just run a bland Monte Carlo. We have the computing power vary the default rate, recovery rate and the correlation within the simulation. Do it.
• Use all information available, not just asset-specific. The financial markets are always inventing new structures, but certain basic principles remain. The ratings agencies know this, and should apply it.
• Ratings should be based on subordination only. A structure relying entirely on subordination for its rating is less reliant on the models working than one that relies on coverage tests and excess spread. By this I mean, if there is 10% of the debt structure junior to my tranche, I know the deal can take about 10% in losses before I'm hit. But if there are a slew of IC/OC tests and other complexities, then that becomes muddled. Then it becomes a matter of how fast the losses come in, which means that the speed of losses needs to be correctly modeled. We need more humility in our modeling!
• Deals should pay sequentially. CDO managers hate this idea, because paying down their most senior tranches also means paying down your lest expensive debt. But here again, a simple sequential pay structure makes gaming the models far more difficult.

I think these simple reforms can restore credibility to the CDO market, which will turn CDOs from a great threat to a powerful ally. We don't want to live in a world where only banks can make mortgage loans. Securitization is a good thing. But we need some culpability. Otherwise it will be a long time before we have a viable sub-prime market again. A long time.

You just watch yourself... We're leveraged men.

Liquidationists... You might want to hide your eyes, because what I'm about to say might be a bit disturbing.

The bond market needs liquidity in order to efficiently price securities. Specifically, it needs leveraged investors to have access to leverage.

Wait, wait. Don't fire up that outraged comment just yet. Hear me out.

Let's imagine a world where there are four investors and three asset classes. The three asset classes are...

• High quality bonds, which we'll just call "Quality" from now on.
• Low quality type A, which we'll just call "Type A."
• Low quality type B, which we'll call "Type B."
  

These three bonds types are perfectly correlated within each class, such that all Type A bonds move exactly the same. They have no fundamental correlation with each other, however. Therefore a credit event in one type doesn't necessarily have any impact on the other types, at least not directly.

The four investors have specific "preferred habitats." This is a term used in several academic works on the bond market. All it means is that investors tend to be involved in certain types of bonds (or certain maturities of bonds) because of their investment objectives. The relative value between the investor's preferred habitat and other types of bonds does not enter into their investment decision. In our case, we will assume that each investor only has expertise in certain bonds, and therefore will not venture into the classes where they have no expertise. I think in the short-term, this matches reality.

• The first we'll call "Mutual Fund." This is a non-leveraged investor, who invests in all three asset types. Mutual Fund's demand for bonds is a function of flows from outside investors. Therefore Mutual Fund's short-term demand curve is perfectly inelastic. By this I mean, it doesn't matter how cheap bonds get (or how rich) Mutual Fund can only invest what it has.
• The second we'll call "BSAM," just to make up an acronym. BSAM is invested equally in Quality and Type A assets and is maximum leveraged at 10x.
• The third we'll call "NLY." NLY invests in Quality assets only. They are currently 10x leveraged, but could be as much as 15x based on current lending conditions.
• The fourth we'll call "Alpha." Alpha invests in equally Type A and Type B assets and is 5x leveraged. They could go up to 8x.

OK. So now let's say there is an exogenous shock to Type A assets, causing them to lose 10% of their value. Nothing has fundamentally changed about any of the other assets.

So BSAM immediately becomes subject to margin calls. 50% of their assets are now down 10%, so to put it in dollar terms, they've suffered $5 in losses for every $100 in assets. Of course, they only had $10 in equity to begin with, so now they're down to $5 in equity. In order to get them back to 10x leverage, they have to sell half their assets. Because liquidity in Type A is poor, most of the sales are in Quality.

Alpha has suffered as well, but they had much more equity. They lost $5 for every $100 in assets, but they had $20 in equity. In order to get down to 8x leverage (the max allowed) they only need to sell $2.50 per $100. Again, since Type A is illiquid, Alpha sells Type B bonds.

So now we have selling in both Quality and Type B assets, but the question is, who is going to buy?

Let's put this in a supply and demand context. The supply of Quality and Type B has shifted outward. Note it isn't a move along the supply curve, because there has been no change in the price of either.

The demand curve is completely flat for Type B assets. Mutual Fund is the only potential buyer, and they have no assets with which to purchase bonds.

What about Quality assets? We know that NLY has some room to add, so there is potential demand there. Unfortunately, NLY's ability to add bonds is no where near the supply BSAM is dumping. NLY has $8.33 in equity for every $100 in assets. They could add about $25 in assets by levering up to 15x. But BSAM needs to sell $50 in bonds.

So in both cases there aren't enough investors capable of buying the bonds that are for sale. So there is no clearing price. At all. I guess the hard core mark to market crowd would write it all down to zero, but that's another topic.

In real life, Wall Street would serve as market maker, so the bonds would clear. But the prices would all be lower. But now it becomes self-feeding. Prices on Quality and Type B fall because of the technical of BSAM liquidating. That puts pressure on Alpha and NLY's leverage levels. Both then continue to sell more assets, and the Street soaks them up, but at still lower prices. Now the Street is over-leveraged themselves, and stops extending their repo lines. Now everyone is in trouble.

Notice that it took one heavily leveraged buyer to take a relatively modest loss to touch off a serious liquidity crunch. The other players had much more responsible leverage, and yet they got caught up in the liquidity crunch all the same.

OK. Now let's say that the Fed wants to try to deal with this. What the system needs is more cash to absorb the forced selling. Once that is absorbed, the extra cash can be taken away. What should they do?

• Extend loans to banks and brokerages. This gives them cash to continue making markets. It also prevents them from pulling credit lines away from investors with performing assets. The Fed actually did this by opening up discount window borrowing as well as allowing Citi and Bank of America to lend money to its brokerage unit through its bank unit.
• Force short-term rates down. This increases carry for banks and brokerages, which increases the profitability of market making. It also discourages investors from leaving money in cash, which over the intermediate term should increase demand for higher-quality bonds. Again, this helps absorb the overhang of bonds for sale.

I know some of you are just busting at the seams to write a comment along the lines of "Let 'em suffer! Why should the Fed bail these people out?!" But who's getting bailed out here? In my example, BSAM saw 50% of its capital wiped out, and the Fed's actions aren't changing that. The Fed has merely made it possible to sell those bonds at some price. In fact, under the scenario I developed, all three leveraged players wound up getting hurt to varying degrees.

I contend that if the Fed cuts rates down 75-100bps for a few months, then rapidly reverses course, the impact on inflation will be minimal. And the bond market is able work through this deleveraging process without too many innocent bystanders getting hurt.

Look at the size of that thing!

50bps. I'm very surprised. There was plenty of chatter leading into today that 50bps was possible, but I figured if they had wanted to do 50bps, they would have made an inter-meeting cut.

I've talked a lot about the moral hazard issue, and I've made my opinion clear: I think its a non-issue. At least assuming they don't cut back down to 1%. Anyone who got an IO at a teaser rate in 2005-2006 is facing a serious reset regardless, so I really don't see where moral hazard comes into it. Do you think that John Doe home buyer took out that ARM thinking "Gee, if this goes against me, the Fed will cut rates again!" I don't.

Anyway, the markets obviously loved the news. I read the strong reaction from both high-yield and the stock markets as relief that the Fed is on top of things. But the bond market did give an indication about the risks of cuts as well. Both the 10-year and the 30-year bond actually rose in yield (fell in price) today. Why? Because inflation uncertainty just increased.

I'd like to see the Fed follow the 1998 playbook. Cut 75-100bps to prevent the liquidity crisis from expanding. Let banks get back into a position to make new loans to good borrowers, be that individuals or corporations. Don't cut so much that the bad banks don't feel the pain, because we need the bad loans wrung out. Then when the market has made clear that its strong enough to walk on its own, start hiking again.

In this scenario, I suspect the Fed will be forced to hike to a rate higher than 5.25%. This is what happened in 1999. After the Fed cut 3 times in 1998, it took all those cuts back and then some in 1999, and rate product had a terrible year. That's my outlook for the next 2-6 quarters. Fed cuts some more, but it doesn't help long rates, as investors remain weary of inflation. Then the Fed is forced to start hiking again within 2-3 quarters, eventually getting to 5.50% or beyond. The 10-year probably has 100bps or more of yield upside under such a scenario.

Hence why I like being short duration here. I know its contrarian to get short when the Fed is cutting. The old "don't fight the Fed" cliche. But the market is currently priced in a prolonged easing cycle. If it doesn't come to fruition, rates will wind up substantially higher.

A low risk way to play this is in the agency MBS market. MBS are basically short calls on long-term rates. In other words, MBS are kind of like the old covered call strategy, which tends to work best when the market is mildly negative. Besides, agency MBS are likely to benefit greatly from improving liquidity. I wouldn't touch non-agency MBS period.

You might be able to play in TIPs here too. I'd think TIPs would catch a bid here, as inflation worries rise. Unfortunately, I think the problem in TIPs is oil. Since TIPs are based on total CPI, its possible that core inflation rises because the Fed is supplying too much money, and yet oil prices come off their all-time highs, resulting in total CPI which isn't any higher. So I'd avoid TIPs, especially if you are a long-term investor.

I'm constructive on high-yield, but only because I think its fairly valued. If you are a long-term investor and understand that high-yield is susceptible to widening significantly in the short-term, then think about adding a small allocation. But I'd do it for the income, not assuming tightening.

The Fed is taking an awful risk here. This had better work.

That bad huh?

Sometimes a picture is worth a 1,000 words. So here is a virtual collage of what a liquidity crunch looks like...

First, the rate on 3-month T-Bills vs. 3-month LIBOR measured in spread. Read this as the amount of extra yield in 3-month LIBOR vs. Treasuries.


Next, Fed Funds target vs. 1-week LIBOR. Both are interbank rates, but one is manipulated and one isn't. I contend that the spike in 1-week LIBOR indicates how banks without access to Fed Funds could borrow. Notice this has normalized a bit.

Finally, the private reverse repo rate with Treasury collateral vs. Government Agency MBS as collateral. Effectively no credit risk in either. Why 60bps more to borrow using the later over the former?

What makes this a liquidity crunch rather than a credit repricing? The fact that there is little/no credit differential in the rates quoted here. And yet the spreads have moved dramatically.

It is pointless to resist

A fair amount of virtual ink has been spilled debating whether the Fed will cut on Tuesday. Most of it has centered around the sub-prime mess and consequent liquidity crunch. I've argued in this space that the Fed would work to provide liquidity to the bond market, and in fact they have, by lowering the discount rate and expanding availability of discount window borrowing.

Anyway, there are many who still believe the Fed shouldn't cut on Tuesday. I've seen many solid arguments for this case. Some revolving around inflation, which is an argument I find appealing, but ultimately incorrect. Others are focused on moral hazard, which is a case I understand and am to which I'm sympathetic, but still I find unconvincing.

But the case was strong for a Fed cut before the liquidity problem really got going. But don't listen to me, ask John Taylor, devisor of the well-known Taylor rule. As with many ingenious ideas, the Taylor rule is a very simple model. It postulates that monetary policy is basically a function of two things: GDP growth and inflation. That's not much of a stretch. Then you assume that the proper Fed funds level is a function of the difference between GDP growth and potential GDP as well as the difference between current inflation and target inflation. The classic Taylor rule calculation assigns a coefficient to these two gaps and adds them together. Subsequent economists have concocted any number of alterations. Discussion of a few can be found here. Anyway the classic formula is as follows:

R + B1(y - Y) + B2(p - P)

Where B1 and B2 are constants, y is actual GDP growth, Y is potential GDP, p is actual inflation, P is target inflation and R is the base rate. You might think of R as the intercept.

The Taylor rule has done a pretty good job explaining Fed activity in the past, although its ability to predict Fed activity into the future is mixed. Some use this fact to damn the model's usefulness, but I disagree. The fact is that in order to use the Taylor rule into the future, you have to predict the model's inputs. In other words, to predict what the Fed might do 4 quarters from now, you also need to predict GDP and inflation 4 quarters from now. Not too easy. Frankly the data is too damn variable, even the revisions to CPI and GDP can be quite large. But if you want an idea about how tight/easy monetary policy is right now, the Taylor rule is a great guide. If you have a good idea of how tight policy is now, you can make a reasonable forecast as to where the Fed is most likely headed.

Anyway, let's look at the GDP gap.

Note that the estimation of potential is my own. I think that any estimate of potential GDP would be considerably higher than that 1.9% year-over-year growth the economy turned in last quarter.

For inflation, I use the Cleveland Fed's Median CPI measure. My research shows that this is most accurate for use in the Taylor rule. And I assume the Fed's target is 2%. That's broadly consistent with recent Fedspeek.

Inflation remains above the target, but the trend is obviously lower.

By my estimation, the Fed should cut rates down to the 3.75% area based on current data. Will this happen? Historically, this model is pretty accurate in guessing whether the Fed would hike or cut, but not much accuracy on the degree. Again, I think this has a lot to do with the variability of the data. But it also has to do with how Fed activity today impacts the future. If I think current conditions warrant 3.75%, it may be that the Fed cuts to 4.50% and that alone causes inflation or growth to tick up. So instead of putting a lot of weight in the estimated level, I interpret the 3.75% signal as indicating a strong likely hood of more than one Fed cut.

So you can agree or disagree with my case, but anyone in the "Fed Cut = Sub-Prime Bail Out" camp should realize that there is a very reasonable and classic macro economic argument for several Fed cuts right now. I think the liquidity crunch merely closes the blast doors on a September cut.

A certain point of view

Yesterday's post set off a flurry of comments, most of which were telling me how wrong I was. But fortunately it was all very reasoned, and I'd like to thank every one who posted a comment for contributing to the blog.

I wanted to reiterate that I don't find anything wrong with being bearish. While I'm not terribly bearish right now, I do think the odds of recession are fair, and perhaps the stock market hasn't pricing that in properly. I honestly don't spend a lot of time thinking about whether the stock market is fairly valued or not. I do spend a lot of time on credit spreads, and those tend to correlate with stocks, but that's honestly about it. For what its worth, the money I've allocated to stocks stays invested at all times, and I rebalance regularly, regardless of my market view. I have some trading strategies I employ for my own money, involving all kinds of cute things like technicals and leverage and short selling, but its all bond related. I'm not a stock guy. I just know that stocks usually go up, and I like those odds.

There is a real difference between being bearish because some asset class is currently somewhat over valued and expecting a financial apocalypse. The former is looking for a correction, which are fairly common. The later is looking for something that has very rarely or possibly never happened before.

And here is the problem with forecasting something that hasn't happened before. You don't know when to conclude that it isn't going to happen. Take consumer debt loads. By some measures, consumer debt is extremely high. This leads some to conclude that a day of reckoning is forth coming. But the problem is that consumer debt has been high for a long time. By at least one measure consumer debt has outpaced GDP by a full 1% over the last 20 years. So if one held that consumer debt was too high, you could have held that opinion for the last decade. And yet until just now, there hadn't been any problems with consumer debt. If you had stayed out of the stock market from 1997 to 2007 you would have missed out on a 92% return. This despite a
historically bad bear market in 2000-2002. And even today, the jury is still out on how badly this will impact the stock market. So far its been very little.

As some commenters pointed out, bears also need to know when to get back in, which is very difficult. Say you had been bearish on stocks because you felt they were "irrationally exuberant" in December 1996 (Greenspan coined the phrase in a speech on 12/5/96). From 12/5/96 to 3/31/00 the S&P 500 advanced 111%, or about 25% annualized. But you stick with your theory, its just getting more irrational, you think. Then things start turning your way. From 3/31/00 to 9/30/02, stocks fall 44%. Do you re-enter the market? Well the S&P was at 744 on 12/5/96 when you decided to go bearish. It hit a low of 777 on 10/9/02. But still above the level where you determined things were "irrationally exuberant." Can anyone reading this honestly say they would have known to exit their short then? Of course, we know the rest of the story. Stocks are up 15% annualized in the nearly 5 years since 9/30/02.

Several commenters advanced something to the effect that periods of financial innovation end badly. Let me give you an example. In the 1980's part of the stock market boom was the burgeoning LBO market, which was made possible by the growing junk bond market. The junk bond market as we know it today was basically invented by Drexel Burnham and Michael Milken. Prior to this "innovation" junk bonds were almost exclusively fallen angels.

As readers undoubtedly know, in 1989, Milken was indicted on various securities law violations. Drexel would declare bankruptcy in 1990. Drexel had dominated the market making in high-yield debt, and therefore their exit ushered in a period of horrible liquidity in junk bonds. It would have been very easy to conclude that the popularity of junk bonds was just a fad, and that we would soon return to the previous norm of junk bonds being mostly fallen angels.

Meanwhile, junk performed very poorly. From September 1988 (when the SEC first sued Drexel) to February 1990 (bankruptcy) junk bond prices fell more than 12%, based on the Merrill Lynch High Yield Master. (Total return was still positive at 1.6%). The S&P 500 was up more than 26% during this period. For the rest of 1990, junk continued to fall, losing another 12% price wise, and falling about 1.7% in total return.

Whatever happened to the junk market anyway? Oh yeah, its still going strong. In calendar 1991 the high-yield market returned 39% and hasn't really looked back since. See, the innovation was a good one. Was Milken and Boesky and those guys all crooks? Sure. Did it end badly for them? Hell yeah. Would you have been wise to avoid stocks (or high-yield bonds) even had you predicted their downfall? Only if you timed it just right.

What's in the bear's cave? Only what you take with you

For as long as I can remember (and probably longer than that), there has been a sizable bearish contingent in the investment community at large. And I'm not talking about people expecting a run-of-the-mill recession or a normal correction in some over valued asset class. I'm talking about a major recession/massive market repricing to correct a (perceived) deep imbalance.

Anyone who peruses popular blogs, online forums, etc., will find no shortage of ultra-bears. Even here at Accrued Interest, there have been many commenters in this category. Over the years I've read dozens of well-written, well-reasoned arguments for ultra-bearish scenarios. Since starting this blog I've read a few well-reasoned ultra-bearish arguments online or in the comments. Of course, I've seen many more poorly argued cases, but I digress. I'm fascinated by the ultra-bear phenomenon. Particularly since I can't remember the last time I talked to a professionally money manager who was seriously bearish. In other words, you talk to people all the time who are mildly bearish about some asset class or sector, but usually they're talking about anemic earnings growth or spreads reverting to long-run averages. Rarely do you hear a professional money manager make a claim like the S&P 500 will be lower in 5 years, or Treasury rates will rise to 10%, or anything along that line.

This is not to say pros are always right. The tech bust of 2000-2002 is a great example. A lot of money managers were negative on technology, but no body seriously expected the S&P 500 to lose 50% of its value peak to trough. I wasn't surprised when Pets.com went bankrupt, but I was personally long stocks the whole time.

So anyway, why do ultra-bearish scenarios hold such sway over such a large number of people? Why do financial market disaster stories capture the imagination of so many? And at the same time, why do professional money managers seem to never think things will go badly? Here are my thoughts.

The financial markets always seem like a house of cards. We've seen time and time again stories of companies suddenly falling apart: Penn Central, Barings, Drexel, Enron, Worldcom, the S&L's, etc. Countrywide's flirtation with insolvency recently was a great example as well. In many cases, the company seems to go bankrupt either because of scandal or some complicated
structural issue that can be hard to understand. Again using Countrywide as an example, what percentage of college education people who read about Countrywide's problems in the paper actually understood the issue of securitization? Few. One can't help but feel like something fairly small can bring down the whole system.

And there are a lot problems in our economy that don't seem so small. The budget deficit. Foreign holding of Treasury debt. Terrorism. The negative savings rate. The Republicans. The trade deficit. The housing market. Energy prices. The Democrats. The War. Gold prices. Consumer debt levels. I'm sure I could go on.

Unfortunately, politicians and the media tend to use sound bytes to explain these problems and their potential consequences. And its often the case that the quicker, easier, more seductive conclusion is the bearish one. Take foreign holding of Treasuries. Currently about half of U.S. Treasuries are held by foreigners. A commonly quoted Fed paper claims that long-term Treasury rates would be 150bps higher if not for foreign holdings. The easy conclusion is that interest rates are vulnerable. And if real rates rise by 150bps, we know that a deep recession can't be far behind.

But when you start questioning the underlying assumptions behind a bearish conclusion, you realize this odds of this scenario are remote. Why would China decide to dump Treasuries, when doing so would decimate the value of their reserves? Why would they want to cripple U.S. consumers, which is the lifeblood of their export-driven economy? Besides, as long as the U.S. has a trade deficit, the dollars have to be reinvested in U.S. assets. China (or anyone else) simply can't just pull out of the U.S. market. Its nonsensical. By the way, the fear that foreigners would pull out of U.S. markets has been around for at least 30 years, going back to the petro dollar investors of the 1970's. But to hear the media tell it, the phenomenon is some how new.

I find another problem with the ultra-bearish argument is it tends to ignore economic dynamism. The U.S. economic is incredibly adaptable, and financial markets are even more so. The economy is more able to deal with events, such as 9/11, than ever before. And while obviously such things can cause pain in the financial markets, it doesn't threaten the whole system. Even events which have called into question the viability of certain types of investments, from the collapse of Drexel to the Russian default to the current CDO debacle, the financial markets are able to deal with it. There is still a high yield market, a emerging debt market, and there will still be a CDO market in the future.

It is also a fact that more forces are working to keep the financial system going than working to tear it down. For that matter, there are more forces working to keep a given company alive than drive it under. So that tells you that when you bet on the financial system being driven into chaos, you have to bet that external forces like the Fed or the government will be ineffective. Historically the Fed's reflation efforts have been quite effective at least in terms of limiting the broader economic impact of financial market stress. See 1987, 1991, 1998, and 2001. Have there been recessions? Of course. Will we be telling our grandkids about the horrors of the 1991 recession? Probably not.

I've already hinted at why professional money managers are rarely all that bearish. Anyone who has been managing money for a reasonable amount of time has seen periods of severely overblown fears. In almost all cases, its turned out to be little more than a blip on the long-term radar. In fact, if timed right, every bear market in almost every risky asset has turned out to
be a excellent buying opportunity.

So professionally, controlling your fear and keeping your cash invested has almost always turned out to be a good career move. Whereas sitting on large amounts of cash waiting for financial Armageddon has turned a lot of money managers into insurance salespeople.

I'd say that as an industry, the mistake professional money managers usually make is when we start reaching. Particularly in the bond market, where there can be so many complicated structures. Every honest bond manager will tell you that there was some point in their career where they put some money into something that they didn't fully understand. Maybe they thought they understood it, only realizing too late why the yield looked so good. In fact, if you are ever in the position of hiring a bond manager of any sort, ask about their biggest mistakes in trading. If you don't get a straight answer, don't hire them. Anyway, I'd be willing to bet that most of the worst "reach" trades people have made have happened when spreads were unusually tight. In other words, typically at the end of a bull market in spreads.

My simple advice to those who subscribe to an ultra-bearish forecast: think hard about the consequences of a dynamic economy. Its very possible that we go through the worst housing market since the Depression over the next 5 years, but Countrywide still finds a way to stay in business. Or that AAA-rated subprime pools still make investors whole. Because the market just has a way of working these things out. Betting against the economy recovering isn't my idea of courage. For a pro its more like suicide.

With our combined strength we can put an end to this destructive conflict

Let's think for a moment of the concept of a mutual insurance company, and to make my analogy, let's strip it down to something very simple.

Let's say that 5 otherwise unaffiliated hospitals decide to get together to form a mutual insurance company. The newly formed company would insure each hospital against malpractice liability. To make life easy, let's assume each hospital is the same size with the same basic patient mix. In other words, each has about the same potential liability. At least on paper.

Anyway, so each hospital makes an equity contribution to the insurance company, which we'll call Spread Out Our Malpractice Exposure, or SooMe. This money is invested. They form a board by each nominating one person, then the board hires a CEO and hires the staff necessary to run an insurance operation. They also buy a reinsurance policy for liability over some pre-determined limit.

In forming SooMe, the hospitals avoid being at the mercy of outside insurers. And if they collectively keep their malpractice losses low, the investment income from their portfolio could eventually be paid out in dividends. In other words, the hospitals directly benefit from improving their performance. This is as opposed to buying outside insurance, where the insurer would be the only beneficiary from reduced liability.

On the other hand, the owners of SooMe are taking risk on each other. And while the board of SooMe might create certain risk standards or what have you, SooMe would never be able to control its members fully. For example, its possible that some hospitals have better hiring practices than others. Or that one hospital starts accepting more high-risk patients than others. These things would be difficult to control fully. So in forming SooMe, each hospital would have to be comfortable with assuming a portion of the risk of the other hospitals. This probably means becoming quite familiar with the management of each hospital as well as the policies and procedures each has currently in place.

They need to buy the reinsurance policy to protect against the possibility, however likely, that their collective liability swells beyond what they've contributed. In bond parlance, SooMe is in a subordinate position and the reinsurer is in a senior position. Only once SooMe's assets have been drained would the reinsurance kick in. (OK I know it's a bit more complicated than that, but stay with me.)

So notice that the whole thing happens without any tricky off-balance sheet maneuvers. No accounting gimmicks. Nothing nefarious. Just a group of self-motivated agents coming together for mutual benefit.

Now, let's say, as yesterday's post describes, a group of banks got together to form a new company called LoanCo. And LoanCo buys a set of loans from each bank. Wouldn't that be awfully similar to the mutual insurance company described above? The banks have risks they'd like to limit. They aren't actually eliminating risk, because they are putting up the cash to form
LoanCo in the first place.

Notice that the banks would have to recognize the losses on the loans sold to LoanCo. Why? Because the other owners of LoanCo wouldn't be willing to overpay for the debt acquired. They'd have to come up with some means of determining market value. Could they agree to inflate the value of all loans sold to LoanCo? They could in theory, but this wouldn't be to any one's advantage. Assume there were 5 banks forming LoanCo, and all 5 sold $10 billion par value in loans to LoanCo. Say that the loans should be worth 90 cents on the dollar, but they are actually sold at par. So from any one bank's perspective, I've sold my $10 billion in loans to LoanCo $1 billion above market value. But at the same time, LoanCo has over paid for the other $40 billion in loans by $4 billion. So I own 20% of a company overvalued by $5 billion. I'm no better off.

So I think that if LoanCo was formed by a group of banks mutually coming together out of their own volition, I see no problem. In fact, I think its brilliant. And the transfer of risk involved in such a maneuver would not be markedly different than other very prevalent risk diversifying strategies, such as self-insurance.

However, if the Fed forces them to come together, or if any other governmental force is involved, then my whole argument is thrown into the pit of Carkoon. I think many of the comments posted on DealJournal roundly criticizing the idea are apt, if the Fed got involved.

And as to the comment by the Ghost of Ken Lay ("Sounds like something I want to do"), remember that the Enron stuff was truly a closed system. Enron formed these off-balance sheet partnerships and Enron was de facto the only owner. So Enron could stuff losses in whatever pocket it wanted, because no one was watching. If a group of banks get together, they check and balance each other. I'm certain that Jamie Dimon won't eat losses just to help out Chuck Prince.

There's something familiar about this place...

Alright, I know imitation is the sincerest form of flattery, but I want whoever is reading this blog from CreditSights to show themselves. I'm seen the domain in my logs, so you cannot hide forever. Today they released a report titled "Distressed CPDOs: We're Doomed."

Mmmm... sounds familiar...

But hey, I don't mind if CreditSights wants to borrow my titles, just send me a free subscription.

And then the loans just float away... with the rest of the garbage

Creativity is generally viewed as a positive trait. But at this moment in time and in the world of finance, creative financing solutions have become synonymous with shell games. Its unfortunate, because creativity in finance has brought us so many important innovations, most I'm sure were derided in their early stages. But anyway, I digress.

The top banks who underwrote bridge loans to finance recent LBO transactions find themselves in a tough position. A prison of their own creation, to be sure, but it may require a little creativity to find their way out.

So let's look at where they stand and make a few not-so-bold assumptions:

1. Banks like J.P. Morgan, Citigroup, Bank of America and others made large loans to private equity in order to facility LBO transactions. The assumption was that these loans would be paid off quickly from proceeds of either a permanent loan package or a public bond offering. The terms of the bridge loan, therefore, were borrower friendly.
2. Now that the high-yield market has sold off tremendously, the borrowers may choose (or be forced to) keep the bridge loan outstanding for considerably longer than first assumed.
3. The banks would certainly not agree to the terms of the bridge loan if negotiating a permanent loan today. Considering the rate alone, the Lehman High Yield Index OAS has risen 207bps off its recent low in May. So its likely that the banks would want something on the order of 150-200bps in additional yield if negotiating these loans today.
4. The spread duration of a 10-year loan is about 7. So that implies that the theoretical market value of a 10-year loan declines by around 10% if market spreads increase by 150bps. Obviously the loans were made with various terms and at various levels, but its safe to say that loans agreed upon between January and May 2007 have probably decreased in market value by at least 5-10%.
5. The banks are willing to take some amount of the credit risk in these companies, but would like very much to reduce the concentrations. With the CDO market basically shut down for the moment, they will have to find some other buyer.

So if we accept all of above, all of which is either simple fact or a easy assumption, what are the bank's options.

Well, first they could offer to pay the break up fee. Usually in a LBO, either the buyer or the seller can walk away from the deal, but must pay a 1% or so fee to the other party. If the private equity buyer was game, the bank could offer to pay the break up fee. Its a good deal for the bank, because the banks probably know that the real value of the loans has declined by considerably more than 1%. We know that banks involved with TXU have offered to do just this.

I'm skeptical that this will actually happen, because I think the private equity firm can get a better deal by negotiating down the price of the acquisition, as discussed here.

Now here is a creative solution, which I've got to say is absolutely brilliant. I'm sure the odds of this actually happening are incredibly low, but its brilliant none-the-less. OK here is the idea.

Banks know they can't get away from the economic loss taken on these poorly negotiated loans. But they still want to mitigate the concentration risk of having such large loans to a small number of borrowers. Why not just solve each other's problems? Create a new company with all these various banks contributing equity capital. Then the new company buys the loans from the bank. The banks, as a group, have exactly the same economic risk as before, but individually they have spread out their credit risk. As Deal Journal points out, this is very similar to a CDO transaction in most respects.

The downside is that the banks basically eat the market loss on the loans up front. But not only do they wind up with more diversification, its also possible that they'd be able to someday sell some or all of this new company they created. At the very least, they wind up retaining some of the upside should the loans eventually be sellable to a 3rd party.

Now, I'm sure the comment section is going to light up with complaints that this is some kind of accounting shenanigans. That's a legitimate concern. But this wouldn't seem to excuse the banks from taking a FMV loss, nor would it ultimately be much different than a normal loan syndication, other than the huge size of the thing.

Creative? Yes. Shell game? Maybe on the books, but not in real economics. Good idea? Absolutely.