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!

SMACKDOWN WEEK: Interlude

A couple commentors mentioned upcoming option ARM resets as a reason to be more bearish on housing. I wanted to make some quick comments about that.

First let me say that option ARM resets are a tricky thing. Most ARMs were underwritten in 2005 to early 2007. During 2005, 12-month LIBOR averaged 4%, during 2006 5.33% and in 1H 2007 it averaged 5.33% again. So the reset itself isn't a worry at all.

Its the recast that matters. The switch from the "Option" period to the full amortization period. The tricky part there is that most option ARMs have a 5-year "Option" period. That would mean that 2010 would be a big year for recasts, and 2011 even bigger. We wouldn't "burn out" on these things until mid 2012.

However, most option ARMs also have a provision where if the negative amortization gets to 15% (i.e., you owe 115% of the outstanding balance), it automatically reverts to the fully amortizing amount. Certainly if a borrower has managed to fall that far behind within the first couple years, the odds that that loan winds up in foreclosure is pretty high. Anyway, it throws off the theory that there is suddenly going to be a bunch of recasts in 2010 and 2011. Many of those loans are already recasting because of the neg-am element.

Here is how I see it. I track a large group of whole loan "prime" mortgage securitizations. My group is from 2006 and about half are Option ARMs, the rest are full amortization ARMs. Most are also limited documentation. So while the credit score said prime, everything else about the loan said "questionable." I created this grouping back in 2007 to track how seemingly good borrowers who took out bad loans performed. Its a pretty good gauge of how Option ARMs are doing.

The 90+ delinquency (which includes foreclosures) is currently 11.5% of the original balance for the whole group. The figure continues to climb month-by-month but the pace has slowed considerable. The last 5 months its increased by about 0.3% per month, vs. over 1%/mo. during most of 2008. So that's point 1, that the pace is clearly declining. Worth noting that the pools with mostly option ARMs are about 2.5 times the delinquency level of the full amortization loans.

Second, I track a similar group of sub-prime loans. That series has completely burned out, with the 90+ figure sitting at 17.5% for the last six-months. So basically what's going to happen in sub-prime has already happened.

Put these two together and you could conclude that the continuing rise in price foreclosures is just making up for the lack of rising sub-prime foreclosures. I don't know if the math of that exactly works, and I am sure that the sub-prime and prime loans were not typically in the same neighborhoods, but point is that a lack of new sub-prime foreclosures is at least something of an off-set.

If you drill down into some specific Option ARM deals, you find some very interesting info. Here are some stats on one of the deals in my list.

Pool Factor: 63.2% (meaning 36.8% has paid off)
# of Loans: 496
WALTV: 83.5% (so few loans are being forcibly recast)
90+ Delinq: 39.5%

Now here is what's interesting to me. 37% of this loan has paid off. Another 40% is not paying. That means the potential new problems are only 23% of the remaining principal. I pull several other deals with the same kind of circumstances. What we're seeing here is that the loans that never should have been made are already turning bad (the 40%). The loans that were made to actual good borrowers are paying off rapidly. What remains in between isn't a very large number.

That's the facts as I see them. I'd love to hear the other side. Just post a comment!

SMACKDOWN WEEK: Slimy? Mudhole? My home this is!

MORE BEARISH: CONSUMER SPENDING

MORE BULLISH: HOUSING

CONSUMER SPENDING

I'd like to start by describing my generic view of consumer decision making. People make decisions based on their own circumstances. So whether the Solos decide to buy Jaina and Jacen a new summer wardrobe or to keep the ragged stuff from last year is all about how the Solos are doing. The fact that unemployment is rising galaxy wide isn't an important factor in their decision making. Obviously if Han is worried about his job in particular, that would make a difference, but if he expects the smuggling market to remain strong, 5% overall unemployment or 7% or 10% isn't going to impact their decisions. Not by a large degree anyway.

I'll put this another way to illustrate the point. What if unemployment were especially low? Han could still lose income for one reason or another. People still lose their jobs in good times. So I argue that the Solo family's spending habits are a function of their specific income level and perceived stability. A poor macro picture in and of itself isn't relevant.

What's the conclusion for overall spending? Its that statistics like consumer confidence is over-rated. I've looked at the correlations, and consumer confidence is, at best, a coincident indicator. In other words, consumers don't lose confidence and then the economy weakens. The economy weakens and then consumers feel less confident. That tells you the confidence in and of itself has no bearing on economic activity. One doesn't cause the other.

I think Cash for Clunkers is an illustration of this point. Consumer confidence is still quite low, but give them a good enough deal on a car and they're ready to buy. Ready to take on a major financial commitment despite this purportedly weak sentiment. (Don't through me comments suggesting that I liked this program, I didn't. I'm just making a point.)

I have a similar view of the wealth effect, be it from financial assets or one's home. It all depends on an individual's situation. Let's zoom our targeting computer onto home values. There is a certain segment of the population that was using home equity to fund spending. Clearly that group will have to pare back spending. But there is a large segment of people for whom that peak value in homes is a meaningless number. I bought my house in 2001. It probably rose in value through 2006, then has fallen a solid 15 or 20% since. But none of that matters since I've never taken any equity out. I've just been sending my checks in every month.

I'll go even further and say that for most people, the biggest influence on how much money they choose to spend is how much money is currently in their checking account. The candy bar was called "Pay Day" because people celebrated Pay Day by buying stuff like candy bars! That is to say most people make decisions based on very short-term considerations. Not high-minded thoughts like "I've lost money in my 401(k) and I therefore need to save more if I'm going to retire in 29 years." For most regular Joe Americans, they can't (or choose not to) think that far ahead.

Point here is that if you take a consumer with a fairly stable job and good home equity, they aren't doing anything differently today than they did two years ago.

If I stopped here you might think I'm pretty bullish on consumer spending. In the short-run, I'm probably more bullish than a lot of people. But in the intermediate term, a number of factors are going to retard growth in consumption in a profound way.

Let's take my presumption above as truth, that most people make consumption decisions based primarily on how much cash they currently have access to. In the short-run, maybe that hasn't changed much. Like I said, if you didn't spend your home equity, it doesn't matter that your home value has declined a bit. That is, until you want to move. Then you need to come up with more cash to make your next down payment. I said that people might not change their current buying habits just because their 401(k)s declined, but eventually when they do to retire, they are going to have less money. For people closer to retirement, they are either going to have to save more aggressively or keep working, which is de facto savings.

Then there is the reality that consumer credit is going to be harder to come by. We know home equity loans are going to be more difficult just because of the lack of equity. But we also know that generally retail credit is not going to reach the same levels seen during the securitization boom. There just won't be enough capital to fund it at that same level. The reality is that these "0% financing for 12 months" deals were quasi-price reductions, but typically banks were involved in supplying the credit. I think those kinds of deals will be less prevalent. Not non-existent, but less common.

Taxes are another issue. I expect both federal and local tax rates to increase in the coming years. The feds might only target the rich, but locals will probably target more insidious increases, like sales tax or governmental fees. Clearly if we increase the price of everything by 1%, that's going to impact consumer spending.

Finally, I think we're going to enter a phase where unemployment is going to remain fairly high for an extended period. I don't think we'll stay at 10% for too long, but I think we'll still be above 7% at the end of 2010. Maybe even well into 2011. So even under my thought that consumers react to their own circumstances, more consumers are being impacted by "circumstances" than in past recessions. In fact, if more workers stay in the work force past normal retirement age, that increases the size of the work force and thus keeps unemployment high.

Bruce Kasman of J.P. Morgan back in April said he thought the economy was going to bounce into malaise. I think consumer spending will be similar. Consumers have some degree of pent-up demand for goods which will create a deceptive bounce in the next few months, but then we level out into a mediocre growth rate.

HOUSING

Somewhat paradoxically, my view of housing is pretty bullish, at least when contrasted with mainstream opinions.

First, you have to think about what caused the housing bubble/crash in the first place. I'm not talking about the deeper underlying causes, which we can debate, but the more proximate causes.

• Lending conditions become too easy, causing demand to increase
• Supply increases in response, both from new starts and rehabs
• Losses from sub-prime cause banks to pull back lending, demand falls
• Foreclosures rise, largely because of loans made to borrowers who could not afford regular payments and/or reset levels.
• Builders/rehabs still have a substantial supply over-hang. They can't destroy supply as demand falls, so prices fall.

The housing problem is therefore no more complicated than a simple supply/demand imbalance. In fact, one could argue that the supply/demand imbalance wasn't even that large, but that the contagion was great because of the impact on the financial system.

So predicting an end to generalized home price declines is as simple as determining when supply is meeting demand.

Ask yourself, how did we know supply was not matching demand before? Because even as prices fell, demand didn't seem to pick up. We can see this in housing transactions. From March 2007 through January, existing home sales declined from 5.75 million units to 4.05 million units. Perhaps more telling is the fact that the figure only showed an increase in 5 out of 21 months. New home sales show a similar pattern although more severe. Units fell from a peak of 1.4 million units to a paltry 329,000.

Since that time we've shown pretty strong increases in both series. New home sales are up 17% off the bottom, existing up 6.7%. Both series have increased 4 out of the last 5 months.
Demand is meeting supply.

It doesn't really matter that total demand is much lower than in the past. Not in terms of home prices. If you are talking in terms of contribution to GDP or some such, then yes, overall activity isn't adding to GDP like it once did. But in terms of home prices continuing to decline, as long as supply meets demand, there isn't any reason to expect more declines.

I also consider the Case Shiller Index, which looks like its bottomed. I have long argued that that index is fraught with lags and other data problems. But if its lagging, then you'd say that housing might actually be better than indicated. Absent some catalyst to the negative, I don't see homes continuing to decline.

This isn't to say that home prices will start rising in spectacular fashion. I think demand is just now meeting supply because buyers think homes are cheap. If they were to rise above "cheap" then buyers would pull away. Plus all the problems consumers have that I mentioned above apply to housing. But inflation-level home price increases are perfectly reasonable.

The best argument for another leg down in home prices is accelerating prime foreclosures. I can't deny that prime foreclosures are high and rising. But I also think there is a substantial difference between a classic foreclosure and a bad loan foreclosure.

This downturn started when a set of loans, most of which never should have been underwriten (i.e. no doc loans), started going bad. A good percentage of these loans were de facto investment loans, even if they were supposedly underwritten with a residence pretense. For this and other reasons, these loans were not only bound to go bad, but they were bound to produce above-average losses for the lending bank. Think about a half-completed rehab gone bad. What can a bank do buy sell it as aggressively as they could?

Furthermore, these loans were concentrated in particular areas. If you wanted to do a flip, you did it in a "hot" neighborhood. So when they started going bad, all the banks were trying to sell houses in the same general areas within a given city. This is a factor that I think hasn't gotten enough attention. You have 10 houses on the same block for sale, each chasing the rest of them lower and lower trying to get the one buyer who wants to live there. Obviously this is a recipe for some ugly price changes.

I'm not here to say that all of the bad loans went to sub-prime borrowers. Look at any option-arm securitization and you'll see "prime" borrowers. The reality is that if someone took out a truly bad loan, one that the borrower never really could have afforded, then the loan must be at least two years old by now. By August 2007, the mortgage securitization market was already in shambles and the joke of the NINJA loan was already well known. I'd guess that July 2007 was about the last time you could get a classic no-doc mortgage. So in order to claim there is a wave of mortgage defaults coming, you have to explain to me why these people would default now instead of a year ago.

Now of course, we have unemployment rising and that certainly has an impact on foreclosure rates. But this is totally different than the bad loan foreclosures, in my mind. Unemployment-type delinquencies are more likely to be resolved through a modification. The borrower eventually finds a job and can resume payment. In addition, those foreclosures would be more spread out. Again, I think people underestimate the impact of concentrated foreclosures. If there is one foreclosure in your neighborhood, it doesn't destroy the value of all the other homes. Six or seven is a different story.

Next time on SMACKDOWN! Uh... I'll decide tomorrow!

SMACKDOWN WEEK: The Greedy Trade Federation

MORE BEARISH: Banking

MORE BULLISH: Brokerages

BANKS:
I get it. I really do. In February, the situation for banks looked as dire as the Jedi on Genonosis. Surrounded by hordes of battle droids, the capital markets shut off both for debt and equity, there was no apparant solution. Nationalization seemed like a legitimate option.

Turns out there was a ready-made clone army which was able to rescue the reminants of the Jedi attack force and bring the banking system bank from the brink. Who knew? Certainly not me. I thought the Stress Tests were, at best, a useful regulatory tool. Who knew they would inspire so much confidence? I don't know that Geithner himself can claim he really knew it would work so well.

Anyway, given how far we've come, I get why a Bank of America can rally from $2.5 to $17. Is $17 too high? Maybe, but that's not the point here. The point is, some kind of huge rally in bank stocks fits with how much things have improved.

The "systemically important" banks (i.e. the Stress Test 18 not including GMAC) have now managed to raise about $53 billion in new equity capital through stock sales. Many have increased their capital position further through earnings retention, asset sles, etc. That is all fantasic news, especially since as a tax payer, I'm a shareholder in all of these firms.

But the story doesn't end there. There is almost universal agreement that the situation at large banks is much improved. It isn't just about new capital raised or even access to capital. Its also because large banks have gotten much more aggressive about recognizing and/or provisioning for losses. I picked five of the largest true banks: J.P. Morgan, Citigroup, Bank of America, Wells Fargo, and PNC. Over the last year, loss reserves at these banks have increased by $20 billion, from a total of $20 billion to $40 billion. According to the FDIC, there is currently $193 billion in total loss reserves among all FDIC insured institutions, up from $121 billion one year ago.

Let's do the math. Loss reserves in the overall system was $121 billion one year ago, $20 of which was our five large banks. Loss reserves then increased to $193 billion, $40 of which was the Big Five. So other than those five, loss reserves increased by about 51%, whereas loss reserves increased by 100% at the Big Five.

Do you think that loan losses have increased at the largest bonds at double the rate of all other banks? Think about that while you read on.

Loan loss reserve as a percentage of loans tells a similar story. The Big Five have loan loss reserves equal to 3.9% of total loans. I estimate that all other banks have only 2.3%. In fact, I estimate that while the Big Five account for 13.6% of all loans, they actually account for 21.1% of all loan loss reserves.

Are big bank's loan portfolios really that much worse? Maybe they are somewhat worse, but what seems more likely to me is that big banks are further along in terms of recognizing potential problem loans. And this makes sense. What does a typical regional bank loan portfolio look like? Local loans right? Small businesses, local developers, etc. I was driving through a small town a few weeks ago and pointed to an empty building that looked like it was once a convenience store or small resturant. I said the loan for that building didn't come from J.P. Morgan or Wells Fargo. It came from someone like First Community Bank of Mos Eisley.

All banks like to think they have above average loan portfolios. And why not? I'm sure they all think they have loan officiers with extremely high midi-chlorian counts. Otherwise the bank wouldn't have hired them. I'm also sure when management asks the loan officers about certain loans, they are given an optimistic picture. Afterall, the credit officer has his own ego and reputation. But we know in reality that not all banks can be above average, and even some of the above average banks are going to suffer greater losses than they expected.

One final thought on large banks vs. small banks. The big banks took large losses in securities early in this cycle. Stuff like CMBS, leveraged loans, etc. Most of that stuff needed to be marked to market, and thus the loss on these should already be recognized. In the case of CMBS and other securities, there have been substantial improvements from the worst levels, actually adding to bank profits. Small banks didn't get into as many problems with securities, which is to their credit, but it also means that their losses are yet to come.

BROKERAGES
On to where I'm more bullish: regional brokerages. Sure I think Goldman Sachs and Morgan Stanley will make their money. In fact, the IPO and bond underwriting business looks much better now than it did six months ago, which will clearly benefit the big boys.

But I also think we're ushering in an era of diminished liquidity, which will benefit regional brokerages disproportionately over large brokers. Back in the good old days of 2006, if I wanted to sell 2 million Pepsi bonds, I'd just call 3 or 4 dealers and collect competitive bids. Dealers were happy to committ their capital. Today not so much. Today if you want best execution on a bond you need to work a little harder, actually find an end account that wants to buy the bond.

In a world where capital commitment was the name of the game, Goldman Sachs had a severe advantage over someone like Stephens. The former had all the capital in the world. The later had to watch their pennies. So what did Stephens' salemen do? They spent their time developing relationships with end accounts. When a bond came for the bid, the Goldman salesman just called his desk. The Stephens salesman called his accounts.

Now Goldman is less willing to committ capital. Now the Goldman trader might not be willing to bid at all, or maybe bid something silly cheap. Whereas the Stephens salesforce is doing exactly what they always did, call their accounts. Those firms are better suited to thrive in the new, lower liquidity world, where its less about capital and prop trading and more about relationships and finding sources of liquidity.

SMACKDOWN WEEK: Episode II

Its time for another SMACKDOWN week. This time we'll be looking at areas of the market and the economy where there seem to be extreme views and/or those where there has been an extreme run of late. In each piece, I'll contrast an area where I'm more bullish with one where I'm more bearish. I suppose you'd say these will be areas where I'm more bullish/bearish than average, but in truth with so many extreme views out there, its tough to say how meaningful average views are these days. Hell, if we contrasted my view with the average blogger, my expectation that the sun will most likely rise tomorrow would seem like naive optimism.

I'll start with one area I won't be covering. The stock market itself. I suppose if you asked me whether I think stocks will be higher or lower two years from now, I'd say probably higher. But my confidence in that view is pretty low. Lately I've found more success trading on my short-term view, trying to make small gains add up over time, than trading on a long-term macro view.

I would also say that while I expect the market to be higher in two years, we could also see some very scary swings in between. I think the factors that kept volatility low in the past, namely leveraged investors who were willing to take on small arbitrage opportunities, is gone and isn't coming back. The result will be larger swings in all sorts of markets from bonds to stocks to commodities. No one leans against small moves, and therefore the small moves become big moves.

Anyway, here are some of the topics I plan to cover. If you have other ideas, please e-mail me. I won't promise I'll write about it (because I might not have a strong opinion) but the feedback is nice.

• Commercial real estate
• Banks
• Consumers spending
• Inflation
• Housing
• Commodities
• Municipals
• The dollar and foreign participation in U.S. markets

Finally, I know I haven't been posting and or e-mailing people back much. I'm sorry, just been really busy. I've always focused this blog on writing more quality than quantity. If you'd like to subscribe by e-mail, there is a link on the right-hand side of the page. This will save you the trouble of checking the site so often.

Consumption: A person of some importance I believe

Is anyone else bothered by the following: In the opening minutes of A New Hope, C3-PO warns R2-D2 that "There will be no escape for the Princess this time." Then presumably less than 24 hours later when Luke stumbles accross the hologram of Leia begging for help from Obi-Wan, C3-PO seems to not know who she is:

LUKE: Who is she? She's beautiful.

THREEPIO: I'm afraid I'm not quite sure, sir.

LEIA: Help me, Obi-Wan Kenobi...

THREEPIO: I think she was a passenger on our last voyage. A person of some importance, sir -- I believe.

Maybe this is what you get for seeing a movie 498 times...

Anyway back to economics. Merrill Lynch is out with a intriguing analysis in their latest Credit Market Strategist. "The Myth of the Overleveraged Consumer." Before you dismiss this as blindly bullish bullshit from the Bull, let me tell you that the report isn't terribly rosy in its conclusion. But it does cause one to really think about what drives consumption in the U.S.

First, they estimate that the top 10% of Americans in terms of disposable income account for 42% of consumption. The 40-90 income percentile ("the middle class") accounts for 46%, leaving just 12% for the 0-40 percentile.

Combine this with the balance sheet of these various income categories:

Merrill's headline says it. The middle class is over-leveraged, not The Consumer. What we see is that the over-leverage of the middle class impacts 46% of spending even though its about 60% of the population.

The differential is even more stark when you look at wealth lost as a percentage of assets. Because the middle class' net worth is mostly their home, the crisis has hit them harder:

We think of the wealthy as being hit hard because of how poorly financial assets have performed, but stocks have rebounded at least somewhat. Homes have not. Add to that the fact that the wealthy tend to have a cushion of assets to support spending should they experience a temporary loss of income. So the highly paid commissioned salesman might not cut back much if his/her income is down for a year. S/he might just spend some savings. The middle class doesn't have that luxury.

The point is that the wealthy can keep spending at approximately the same rate, and if they represent 42% of consumption in normal times, then maybe consumption won't fall as much as we feared. Of course, we can't just dismiss the middle class' position. I stand by my idea that consumers overall can't spend at the same rate and will have to continue balance sheet repair.

But this does make you question certain popular trades. Like selling luxury brand companies for "trade down" stocks. If the wealthy are spending but the middle class is cutting back, who gets hurt more? Wal Mart or Tiffany? Toll Brothers or Ryland?

Merrill's piece closes with a warning. All the government programs will eventually come at a cost: rising taxes on the wealthy. Now we find out if that code is worth the price we paid.

Muni Insurance: A passenger on our last voyage

MBIA is down $1, which is about 20% on a downgrade by J.P. Morgan. This after surging to almost $7 in recent days on reports that the company might be able to foist some of their MBS exposure back to the originating banks.


The interesting question to me (since I wouldn't actually touch MBIA's stock with a 10-foot Gaffi Stick) is whether there is any possible business left for MBIA even if the optimistic view of their legal battles comes to fruition. As we all know, MBIA is attempting to separate their muni and structured finance businesses in an attempt to someday write new muni insurance contracts. But is that still a viable business?


Before we answer that, we need to look back at what muni insurance was all about. There is a myth out there that muni insurance was used primarily by weaker credits as a means of lowering their interest expense. That's not really true. I did some digging through old MBIA investor presentations (funny to hear them boast about "penetration" into the structured finance business) and found this chart from 2006:





There's nothing magic about 2006, I just wanted a period which was clearly before structured finance risk started becoming a problem to show what muni underwriting was like during the "good times." We see 28% of the total par outstanding was in GO munis. I did some rough calculations and it comes out to something like 44% of muni underwriting was in GO's. Notice also what you see very little of: healthcare, housing, industrial development (zero). In other words, the riskier segments of the muni market are clearly under-represented.


The point is to say that muni insurance was not typically used as a true credit enhancement, at least not in terms of avoiding default. By now you've heard the stellar record of GO bonds, which almost never default. So who needs the insurance?


I argue that the need for muni insurance is borne more out of information asymmetry than actual credit enhancement. By this I mean, investors in municipal bonds often struggle to get complete and up-to-date information about a given municipality. Take for example a random school district in Pennsylvania: Glendale School District. Go to their website and try to find their financials. I couldn't find them. So if you had bonds for the Glendale School District, how would you follow their financial performance? You could potentially get someone from the Superintendent's office to send you reports, but odds are they would only be produced annually and with a long delay before the report is available.


Imagine if a corporation wanted to sell bonds, but refused to report regular reports. Would the bond be sellable?


Muni insurance filled this gap. The insurer could demand certain information and/or legal language in the bond deal that investors could not. Especially not individual investors. In that way, muni insurance was a little like title insurance on a home. No one expects to use it, it very rarely comes into play, but in the event that something truly crazy happens, like the Orange County scandal, investors are covered. The insurer deals with it.


So I'd say that municipal bond insurance served a certain public purpose. Allowing local municipalities to sell bonds at attractive rates.


And yet, I still think muni insurance is a dying business. Why? Because in a way, MBIA/FGIC/XLCA/Ambac's problems are very similar to Fannie Mae and Freddie Mac's. The for-profit nature of the firm got in the way of realizing the public purpose. Now obviously MBIA was never a "public" entity in the way Fannie/Freddie were, but I think the point stands. Investors aren't going to trust insurance the way they used to ever again.


Still, the need for resolving this information availability problem remains. I ultimately think the better solution is for states to form their own credit enhancement programs. This could be accomplished through a bond bank, which is common in Indiana and California. It would have to be altered from some of the existing bond bank programs, where the underlying credit was only whatever municipalities participated in the specific issue. In the old days, a California Communities bond issue might only be backed by 2 or 3 local California towns, but would also carry Ambac insurance. That used to be fine, but now its obviously not going to work. California could alter their bond bank program such that a surplus account is created to make up any losses on individual loans, which would allow for a better overall rating on their program.


Another possibility is some sort of state intercept program. This would be where the state agrees to backstop local municipal school district deals. There are such programs in force in Texas, for example. The problem here is that such programs are usually only available for school district bonds, not for other local government needs. So if Pflugerville School District needs a new roof on the high school, that can be done through the Texas Public School Fund. But if the town of Pflugerville needs a new roof on City Hall, there is no state help.


I would like to see these kinds of programs expanded without the help of the Federal government. One of the problems that always worries me about municipal finance, and its lack of transparency, is that good fiscal management can't always been differentiated from budgetary shell games, especially on the local level. Again, this is an area where the muni insurers were a benefit since they could enforce certain standards better than individual investors could. I could see a state-level insurance pool filling this role, making sure local issuers keep to some standard of good fiscal management. But if it rises all the way up to the Federal level, there will be too much distance between the issuer and the guarantor.

Radian: What are you still doing here?

Radian reported a profit this quarter mostly on the back of insurance claims recinded due to misrepresentations. AIG is up big on the news, as are other insurers. It might explain MBIA's big move to the upside yesterday.

Here's something a bit odd, though. Why are all the other banks up on this news? It isn't like foreclosures are down. In fact, what Radian is saying is that they've managed to avoid paying banks the insurance they were otherwise due. How is this good?

Isn't Radian just transfering losses from their own books onto other banks? Won't the other MI's follow suit? Even the more conservative banks, e.g., J.P. Morgan or Wells Fargo have exposure to potentially "misrepresented" loans through their recent acquisitions. I suppose banks would rather Radian (and the other MIs) survive in some form. But even then, I'd have to say this is at best, a mixed event for banks. Not a clear positive.

The other day I wrote a fairly positive view of the housing market, but I reiterate, banks remain very vulnerable. I think the systemically important banks will survive, but I think there are lots more failures to come. Feels like the market is losing sight of this.

The Choosen One

Today's comments by Nouriel Roubini that there might be "light at the of the tunnel" are really only notable because of who is saying it. Roubini is one of several star economists/analysts that have come out of the recent crisis. Meredith Whitney and Nassim Taleb are two others that come quickly to mind.

Its funny how short the media's (and the investing public's) memory is. Both seem to want to find the analyst who has it all figured out. As though someone actually has the proverbial crystal ball. Every cycle the media finds the people who called the big move correctly. Today its Roubini and Whitney. But 10 years ago it was Henry Blodget and Mary Meeker.

Think about what made someone like Mary Meeker a star. She basically got one big call right: that not only the internet was going to change the world, but that it was also going to capture the imagination of investors. Whether or not you could say she called the formation dot.com bubble, she certainly had a good vision on what was driving the moment.

But when that moment passed, did the Mary Meeker's of the world see it coming? Not really. I mean, we know Blodget poked fun at some of his own calls in those infamous e-mails, but I would argue that most of the star dot.com analysts believed in the internet, even if they didn't believe in all the specific companies involved.

Now bear in mind, there is a feedback loop here. You make a bold call, it works, you get interviewed on TV, you get a huge pay raise, every one calls you a genius. Its heady stuff. Check out Henry Blodget's rapid rise on his Wikipedia page sometime. When you parlay a great call on Amazon.com into your dream job, isn't there some psychological impact there? On some level, wouldn't you start to think to yourself, "Gee, when I tell every one to buy, all sorts of rewards come my way. All the guys saying 'sell' are looking for work."

These analysts understood what was going on in the market and in the economy at a specific moment in time. They were smart people, to be sure, but they didn't have some sort of transcendent understanding of markets. They just had a better feel for that market, that mentality, than anyone else.

I don't see how someone like Meredith Whitney is all that different. She had a better view on banking than most, and she deserves all the credit for that. But let's not pretend like she is the next guru who truly understands banking above all others. Every story about her is prefaced by saying that she "predicted" the financial crisis. But really, does she know more about banking than people like Richard Bove? That guy apparently liked Washington Mutual stock in May 2008, according to one story I pulled up off a web search. Is he an idiot and Whitney a genius? It isn't all that simple is it?

My problem is that investors aren't really served by this deification of people who have gotten the short-term calls right. Professional traders will tell you they make about as many bad trades as good, you just try to set it up such that your good trades pay off more than your bad trades lose. But the media doesn't teach this lesson. Instead, they implicitly tell you that Nouriel Roubini has it figured out. That if only you had listened to him, your 401k wouldn't have dropped by half. Hell, CNBC often teases their interviews with stuff like, "Coming up, the analyst who called the banking crisis! See where she says the market is going now!"

It isn't about finding smart people. The guys on the CDO-squared desk were smart too. The guys who dove into the dot.com bubble were smart too. Alan Greenspan was a smart guy, and he seemed to have as good a grip on markets as anyone... until he didn't.

Take an analyst's good call for what it is. A good call. Nothing more.