The Fed Vs. The ECB

The talk started last week in the media, only to be ramped up today with the equity market down and the economic news weaker. Look what the ECB (and a few others) are doing! They're out throwing gobs and gobs of liquidity at the markets in the hope that something beautiful will grow. The Fed, on the other hand, is performing more surgical strikes, trying to get at the root cause of the problem, the stagnation of the money markets. The pundits here are screaming up and down, "Why can't the Fed be more like the ECB?" My answer would be, "Why should they be?"

The ECB's policy of flooding the market with short-term liquidity is uninspired and, for all intents and purposes, ineffective. The ECB is like an army with only one weapon. It's not entirely their fault; the problem derives from the EU's inherent political weakness. Different growth rates and differing political agendas among the EU's member states makes the ECB's job (whatever it might be) difficult. Their policy is akin to city looking to solve its crime problem by calling in a carpet-bombing air strike. Sure, the crime problem is solved but no one is around to benefit. The problem with throwing liquidity at the situation is that it is not targeted at the areas in trouble, it has a diminishing marginal return, and the markets become dependent on its continual occurrence. The end goal is to create a smoothly functioning market, not a socialist welfare state for the banking system.

The Fed's goal seems to be to nudge the money markets back to normal function. They have made moves toward that end, being as minimalist as possible. Listening to some, you would think it is 1932 and that the New Deal needs to be recreated immediately. Take a look around, it is not that bad. Let the excesses wring themselves out of the market and let's see what happens.

Pardon the language, but the throwing of shit on the wall to see what sticks isn't the answer here. Smooth out the money markets, remove the excesses, and restore market confidence will go a long way to putting us back on track.

Merry Christmas and Happy New Year

I know it isn't PC, but Merry Christmas and Happy New Year!

The Fed Weighs In On Changes To Reg Z

I debated today whether to write about Goldman Sachs' remarkable quarter/year or about the Fed's proposed rule changes. On the former topic, for all those analysts out there that were blind to fact that credit markets were way overvalued for sometime, Goldman's results prove that at least one group out there knew what was coming, had the right controls in place and executed a successful strategy in very difficult markets.

Let's move on to the Fed, shall we? I have stated many times in this forum that the blame in this situation (if blame is the appropriate word) needs to be spread around to all parties involved, not just the mortgage originators/sellers. The Fed's pronouncements today don't really help out on that front. Deceptive and illegal practices should, without saying, be addressed by authorities. If these practices were so rampant, why was there no clamor to change/investigate them six months ago or a year ago? It has been tacit policy of every Administration over the past 60 years to increase the level home ownership in the United States. It has been the desire of most Americans to own a home for long before that. Over the years, home financing has become more creative and complex to accomodate more and more buyers. This market is no different than any other speculative market situation over the past 500 years. Loans were made to people and/or against properties that should not have been made. Due diligence had fallen by the wayside. When home values ceased rising, the whole scheme unwound.

Most of the attempts on the Federal level to remediate the current situation will, in my opinion, lengthen the time will take the market to resolve this mess. Loans need to default or restructure, homes need to foreclose, housing prices need to fall to a market clearing level, whatever that happens to be on a local basis. Some owners will revert to being renters, most likely people that shouldn't have been lent money to buy a house in the first place. Lenders will go out of business, or, more likely, be taken over by strong/opportunistic players.

The Fed's actions on Reg Z today, if implemented, will effectively shut down the sub prime mortgage market, at least until someone finds a way around the new rules. I don't think that should be the answer. For a price, people and companies should be allow to accept those risks, on both sides. Otherwise, what is being said is that this market shouldn't have existed in the first place. That's OK by me, but let's have the Fed, the Treasury, and Congress come out and state they were wrong to allow this to develop. That's not going to happen, nor should it as some, on both sides of the homeownership coin, benefitted from the existence of a sub prime mortgage market.

Do The Right Thing

Vikram Pandit made a bold move last week, particularly in light of short tenure on the job. Taking the approximately $50 billion of SIVs and placing them on Citi's balance sheet is the right thing to do. It recognizes the seriousness of the festering credibility issue that the credit markets find themselves. For months now, market experts have been chiding the US Government and the Fed to take some action, primarily in the form of a lower Fed Funds rate. The Fed has obliged with 100 bp (so far), with little effect on the problem at hand (as predicted in this and other learned forums). They have, however, propped up the stock market. The reason why a lower Fed Funds rate isn't helping the credit markets is that rates weren't too high to create tight lending conditions. Fear, uncertainty, and the re-realization of the existence of credit risk put the market into its present state, something that even a 1% Fed Funds rate would ameliorate significantly. The way to move forward is recognize the problem, and Mr. Pandit's move goes a long way for Citi. On balance sheet makes the SIV mess more quantifiable for the rest of the investing world, which, in turn, makes it easier for the investing world to evaluate the risk. This is what the market is all about, evaluating and taking risks, with the potential for being rewarded for that risk.

To borrow a line from Spike Lee, it is time for the rest of Street to do the right thing. Citi maybe the biggest single player, but there needs to be some follow through from other big players for this credit situation can come to a resolution.

As a final note, let us not forget that, in the aggregate, markets are generally positive as compared to the start of 2007. There are certainly market sectors that are down for the year, but all the major averages are higher. The rate cuts in the pipeline plus a presidential election will go a long way to helping out the market in 2008, unless we get more inflation numbers like we saw last week.

Here We Go Again...

The Fed shouldn't ease at this point. The equity market has become addicted to rate cuts. It is time to stop. The same pundits that are crying for a rate cut today are also saying that the real problem is in the money markets. They are correct on that count, that is where the real problem is. Seventy-five basis points worth of Fed Funds rate cuts haven't helped there; further cuts are unlikely to do anything on that front. If the Fed cuts rates back down to 1% and LIBOR trades at 3.5%, would these pundits consider that a success? At 250 bps spread, I would consider it a failure. The Fed need to deploy other weapons, specifically discount rate cuts combined with encouraging language to allow for use of the discount window. Here's a idea: Let the Fed cut the discount rate 75bp today and leave funds where they are. Then, we will see it that has an effect on the money markets. The Fed Funds cuts will have no effect, other than an artificial boost to stocks, leaving the markets in the same situation as we have been in since August. Lending needs to free up on the most basic level, overnight and short-term between banks, in order to open up markets and stimulate the economy on a more macro scale. This being said, I'm sure that Bernanke and Co. will not listen to me and go with the path of least resistance

Trust Your Government Redux

I think the best thing I can say about this plan to freeze rates for some mortgages is that, for the time being, Congress isn't sticking its head in this mess. It seems to be a huge leap, and a blind one at that, to thing that this will stabilize home prices. It remains to be seen whether this helps anyone. Many of these loans were on houses where the buyer's equity investment was zero to start. Freezing the rates on loans on properties where there is a negative equity situation may keep the payments manageable, but why as a borrower would you want to do so? The best thing would be A) restructure and refinance the loans to reflect reality and B) streamline the foreclosure process to allow property values to adjust to the appropriate (read: lower) level more quickly to the country and markets can move beyond this crisis. I understand the political expediencies behind this move, but, in the long term, the borrowers won't be helped. Using history as a guide, these homeowners will be stuck in their houses for an extended period, waiting for the time when their home equity will turn positive. Look at the late Eighties. If you bought a house in 1986, you would have had to wait until at least 1996, on a nationwide average, to get back to the 1986 (absolute, not inflation adjusted) level. People at the margin, the sub prime borrower in trouble, are just locking themselves into a situation they probably shouldn't have bought into in the first place. The Band-Aid approach is better. It hurts a lot to rip it off, but it's over with quickly.

Followed By the UK

In all fairness, the BOE has legitimate reasons for cutting rates.

Canada Caves First

The Bank of Canada (BoC) this morning cut its overnight rate 25 bps to 4.25%. This was in response not to a slowing economy (au contraire) or rising unemployment (it is at a 30+ year low), but rather to a hue and cry of Canada's manufacturing sector and the provincial premiers. The BoC used for cover the idea that future inflation will be lower; present inflation however is still pretty high. Canada was the first to cut rates to prop up exports, but they won't be the last. I don't blame them; Canada is acting in its national self-interest, ostensibly. However, the world, including many Americans, need to stop treating the United States and the rest of the world with a double standard. Let the rest of the world become more competitive rather than relying on the crutch of currency devaluation. Everyone and their brother is touting the success of the Brazilian economy. However, most of these touters either have too short of experience there or have chosen to ignore the fact that Brazil got to this point by devaluing its currency, which was one of the contributing factors to Argentina's bankruptcy. The Brazil real is still significantly weaker versus the US dollar than in was in 1999, even after the big run up this year.

I have said here many times that the risk of lower rates is higher inflation. If the reason for the Fed lowering rates was to prop up exports, I would be vehemently opposed to them. As it is now, I don't think a lower Fed Funds rate is justified, but at least a credible case can be made. Other countries, even those with independent central banks, lower rates all time in order to make exports competitive. My point is that these same countries shouldn't complain when a consequence of lower US rates is stronger US exports. However, no one people are as altruistic as Americans are. Maybe it is time to be more selective in our altruism.

Trust Your Government

I know the title isn't particularly descriptive, but let's hope Hank Paulson is really trying to do the right thing. The idea is good, getting all the lending-side parties together in order to speed up the process of potential mortgage restructurings. It is reasonable to assume that as long the process isn't co-opted by some other part of government (Congress would be a disaster), the best possible outcome can occur. Secretary Paulson is one of those "smart guys" from Goldman Sachs and knows what needs to be done. If, however, a wave of populist sentiment overtakes this process, the outcome would would devolve into something far worse than taking no action.

Certainly the banks and other financial players involved know what is involved in restructuring. That can't be said for most homeowners. Remember, many of these homeowners are now complaining they weren't informed of what could happen (Last word on this: the blogosphere is full of people with strong opinions on both sides, however if there was fraud involved in the mortgage creation, then prosecute the involved parties. Otherwise, admit you made a mistake, didn't read what you signed and live with the consequences). How are they supposed to negotiate in a restructuring? The information that is coming out so far is limited to freezing rate increases, but there has to be more to it. A rate freeze may help a few that can't make month to month payments and keep a few in their homes. However, it doesn't help the increasing negative equity situation caused by falling housing prices. I'll wait and see, but I'm optimistic that the Treasury does the right and necessary thing.

The Sound You Hear The Fed's Credibility Draining Away

It is truly amazing to see how much the media influences what is happening in the market these days. It would have been thought that the Fed would be immune, but it is beginning to look like that is case less and less. In the last two months, the Fed has cut the Fed Funds rate 75 basis points, the true (not the market rallying euphoria) effect has not been felt nor will it be for the next several months. The suggestion that another cut is coming in December has propelled equities much higher. This is exactly what the talking heads on TV have been espousing for weeks. Now they have convinced people who matter to go along with this idea, regardless of the longer term consequences. Perhaps they should listen to their guests who, almost uniformly, think that the economy will continue to plug along without cuts. The real problems now are in the credit market. Lowering Fed Funds in and of itself will not necessarily help the credit market. Seventy five basis points hasn't helped out the LIBOR situation much, a rate that actually means something in the real world. If the Fed wants to help there, cut the discount rate to below the Fed Funds and take other steps (maybe reserve requirements) to get lending going. Have the Fed apply some moral suasion (before they lose it) to all the players involved to grease the wheels. Otherwise, the market will just become addicted to continuous rate cuts and the US will end up like Japan.

The Fed still has a chance to do the right thing, but it is looking less promising.

Uncertainty Rules The Waves

In the this shouldn't continue category, the markets will continue to slowly implode until all the players disclose all the material information regarding their exposure to the credit markets. Just as nature abhors a vacuum, the market hates uncertainty. Uncertainty creates illiquidity, illiquidity creates risk aversion, and risk aversion creates the slow slide to valuation oblivion. It is really as simple as that. The Fed can cut rates until the cows come home, but it won't make a difference until the investors regain confidence in the markets. The sad part is that the economy is in pretty good shape, and the equity (and credit) markets should really be doing better. It is really amazing to me that there are a disproportionate amount of analysts looking at the Treasury market and predicting where Fed Funds should be. Those days are over. Risk aversion has push Treasury rates to unrealistically low levels, and the market watchers dip into their old playbook to have something to talk about. It can't be reiterated too many times: disclose and take your lumps. Let's all move forward.

More Fallout...

Many items related to the credit crunch/housing bubble have been written about and discussed ad nauseaum (including here), but surprising little has been mentioned about how to make money from it. Perhaps everyone has become too politically correct to discuss this, afraid of offending anyone, even those that made poor financial decisions. The reality is that opportunities abound in markets like this. Frankly, there more attractive investment options now than there were one year or even six months ago. Are the markets more inherently risky than six months ago? Probably not, but investors perceptions of the risk is much greater than then. These risks have manifested themselves in higher volatility measurements like the VIX index.

On TV, the answer on everyone's lips is twofold. Either buy tech stocks or invest internationally is the cry. Both strategies as a general rule have probably run their course. Where were these people a year ago, when both ideas were much more attractive than they are now on a valuation basis, especially international investing (I beat my brains out for years trying to get people to put there money in foreign currencies, to little avail). Certainly there have to be better options out there now than putting money into appreciated assets of perceived safety and immunity. It is understandable that Treasuries and other credit risk-free assets have benefited from a flight to quality, but the others may just be the next cycle in the fallout. It is time to look at other assets and overlooked areas for investment ideas.

The first thing I am not going to write is buy financials, but it stands to reason that the entire financial system isn't going away. Most of the sector has gotten beaten up badly. However, not being an equity analyst I'll leave those calls to them. The investment grade corporate bond market has not been a participant in this rally, however, with some notable exceptions, absolute yields haven't changed much either, pushing spreads back to '02 levels. High yield bonds and preferreds have done worse, mainly due to a fear-induced buyers strike. However, this is a baby with the bathwater situation. Here again, not everyone (and perhaps not anyone) is going out of business. It is time to start looking and locking in yields at the currently available levels. Remember, many corporate bonds today are trading at a discount, so a significant component to yield will be derived from price appreciation.

The other item I wish to touch on is real estate. All real estate is local, so you need to know well the market being considered. There may be significant price declines before stabilization. Also, real estate isn't very liquid and transaction and other costs are relatively high. However, here are two methods to keep in mind: foreclosures and bank sales. Foreclosures occur generally occur in a method not seen much any more, an open outcry auction usually handled by a county sheriff. It can be a cheap way of getting a hold of a property, but keep in mind that few properties ever make it foreclosure as both parties come to some agreement beforehand. Bank sales come about after a bank forecloses on a property it hold the mortgage on. They are usually "motivated sellers" as banks don't want to tie up capital in real estate. Contact banks for lists of property they may have for sale. The final item is tax liens. While this segment hasn't grown due to market fallout, by this time next year tax liens should be more plentiful as property owners fall behind on the taxes. A tax lien is created when someone is delinquent on their property taxes/other fees the owe to a governmental entity. The government wants its money, so it sells the right to collect that tax in the form of a lien to the highest bidder. Each state has its own method of doing this, so it is important to find out the rules well in advance. You may be able to foreclose on the lien and end up owning the property for practically nothing, but the real benefit here is the rate of interest you can charge the property owner. As it is a tax lien, your priority claim on the property comes right after the IRS. Again, the liquidity here is fairly low, so be prepared for the long term.

The Retail Fixed Income Professional's Lament

For those of you involved in the fixed income market, this will be no surprise. On the web, there are hundreds of posts like the one below. I decided to respond on behalf of all responsible members of the fixed income community.

Post:

Looking for some constructive suggestions.I am a fixed income investor. Whole Gamut (Broker CDs, Agency Paper, Corporates, US Treasuries, Mortgage-backed, etc)As any fixed income investor knows, the "spread" in these (mostly) over-the-counter investments can be as much as 3%on any given day. This is probably the last "full price commission" investment type out there.To me its really inconceivable that no one has yet sought to discount these "mark-ups" particularly since the fixed price wall fell on equity trades 30 yrs ago.I've thought about an "exchange" similar to a bulletin board where individuals could post what they have or want,kind of like an eBay of fixed income trading.To those unfamiliar with these mark-ups, it works kind of like this:Investor A owns a $50,000 Freddie Mac Bond with certain interest rate and maturity characteristics. This bond is given a CUSIP number which makes it "unique." This bond (like nearly all others) is held by Investor A's broker in "book entry" within his brokerage account.For whatever reason, Investor A would like to sell this bond. Looking at his statement, Investor A sees that the bond isworth (according to a computer pricing model called a "matrix") 99.25. Thus, Investor A's $50,000 bond is theoretically worth $49,625.Such matrix pricing is used for all sorts of reasons. The IRS accepts it. Margin maintenance is calculated from it.etc. etc.However.here is the rub.When Investor A calls his broker to sell it, his broker will say..."let me get you a bid"Invariably, the borker will get back to Investor A and tell him:The best I can get for you is (for example) 97.50, or $ 48,750.Now..multiply that my the billions of dollars of fixed income securities that trades each day.Where does this "difference" go? It goes to the trading desk of the brokerage firms.So my thought is, how to bypass the trading desk?If a bulletin board was established and Investor A finds Investor B, Investor A would instruct his broker to deliverthe security to Investor B once Investor B delivers the agreed payment amount.Now I'm sure the borkers who read this will flame me.....as this is pure herasy.But you know....it's about time someone told the emperor he's not wearing any clothes.

Reply:

There are a lot of problems with what you suggest, some of which are listed here. Not the least of these problems is your premise that the matrix price for the bond on your account is accurate. They rarely ever are. Don't think of bond pricing like equities. There are roughly 8000 listed equities in the US; maybe half of them trade actively. There are literally millions of bond issues, some of which never trade. If you are really concerned about the bid, ask the broker to offer you the bond, or if not available, something similar. If they are not willing to do it or are unwilling or unable to provide you with a reasonable and understandable explanation, move your account to a firm that will do it. Then you can judge for yourself as to its accuracy. As a person that ran a fixed income trading desk dealing with individual investors at a major firm for many years, that is the information I was more than happy to provide as it showed our desk's professionalism and competitiveness. It is also what I advise my fixed income consulting clients. Finally, the trading desk makes its money on the bid-offer spread, but you are assuming that for bond you sell back to the trading desk, there is a ready buyer on the other side of the trade. That rarely happens, particularly when dealing with individual investors. The bid-offer spread should reflect the amount of risk in any given security. With what is going on in the credit markets, liquidity is lower and bid-offer spreads will be wider to reflect that increased risk as well as other risks.

A Rate Cut Too Far

Fortunately for us, the Fed is still independent enough to rise above the noise and chatter of the market pundits. In the last two months, the Fed has cut the target Fed Fund rate 75 basis points. The effect of these cuts has yet to be felt, and won't be until at least the end of the first quarter. Fed members have been out speaking publicly over the past week, preparing the market for a meeting that will not produce a rate cut. The equity market, and increasingly the money markets are becoming addicted to rate cuts. The wild market swings this past week prove it. However, the Fed must hold the line here and wait to see what happens.

There are several reasons for this; one I have already mentioned (effects yet to be felt). Second, the Fed doesn't want to use up all of its ammo now. It needs to save some to use later if necessary. Third, the Fed doesn't want to be int the same situation a few years from now as it is in now. A strong case can be made for the idea the current situation in the markets were at least exacerbated by Fed policy on rates earlier in this decade, when rates were left too low for too long. Fourth, and most important for the Fed as it is part of their mandate, is the level of inflation. If we are truly in a global economy, some of the global inflation is going to be imported to this country. Here again, there is a lot of market noise, particularly on the commodity front. You can't open your eyes or ears without seeing the price of gold or "black gold", which given the speculative pressures in the oil market, seems to be the inflation hedge of choice these days. However, price stability is the Fed's job and they know that continual rate cuts will eventually become problematic on the inflation front.

There are two problems in the market/economy today. One is housing. The housing market was in a bubble and is now being deflated. Too many houses and too much speculation needs to be worked out of the market. As much as everyone would not like to see people kicked out of their homes, many homeowners bought properties they couldn't afford. The media and politicians have focused on the cases of fraud that occurred in the mortgage market. The reality is that this is a small percentage of cases. A large percentage of defaults and foreclosures are in investment properties, which need to be viewed like any other investment that has declined in value. The rest were properties that were bought at the height of the market, sometimes using mortgage instruments that the buyers did not fully understand (sometimes they did). The housing situation is such that it would be in the best interest of all parties to try to restructure the mortgages to more realistic levels. Banks do not want to want to foreclose on a bunch of properties they can't easily sell and don't want to expose themselves to the public relations nightmare of kicking millions of people out of there homes. Homeowners don't want to have a mortgage default on their credit history. Both sides need to take their lumps and move on.

The other problem is the bubble being deflated in the credit markets; I have already written at length on this topic. The Fed can help here and have already tried. However, they need to specifically target the liquidity situation directly. Cut the discount rate, remove the stigma of doing so, and stop making it a penalty rate for now ( the Bank of England actually calls its rate at its emergency lending facility a "penalty rate"). This will free up liquidity in the front end of the fixed income market and will allow banks to lend more freely to the "real" economy. The Fed could also look at reserve requirements, but given the turmoil and uncertainty in the banking sector currently, I'm not sure this would help at this time (I'll leave that to the Fed to decide).

A Manic Market

Just a short comment today. Yesterday's rally and today's inaction, following what happened on Monday is just another sign of the uncertainty in the equity markets. The ironic thing is that base interest rates have remained benign. In the credit markets, bonds are getting brought to market, albeit at levels not seen in years. For example, Citi brought $4 billion 10yrs at +190, the widest spread ever for that issuer in that maturity. Yet, in absolute yield terms, it is only about 15 basis points higher that the last 10yr Citi brought in August. It is realities like this that show we are living through a manic market. Stocks will lurch from story to story and the bond market, especially anything with credit risk, will remain hostage to the uncertainty of valuations. Only in a crazy market do you see a Bear Stearns announce they are taking a charge equal to one-tenth of their market cap being viewed as a good thing. Well, at least they reduced their exposure; they claim they're net short sub prime now. I guess we should hope in doesn't rally...

PS. This blog went over 1000 hits today. Thank you!

A Different Comparison

To begin with, I apologize for my extra long hiatus. Save today, the financial markets have been taking a beating largely due to the unknowns in asset valuations held on the books of a variety of institutions. As referred to in a previous post, the sooner we get to accurate and full disclosure on the situation, the sooner that all the markets can return to normal function. It has been posited by many, including myself, that the current credit market problem has parallels in the LTCM crisis of 1998. Certainly from liquidity standpoint, there were segments of the market that suffered from a liquidity seizure this summer, although I would make the case that liquidity in general was worse in 1998, but the issue wasn't dragged out as long as it currently has been. Of course, the size and scope of the problem is much larger. That leads us to make a different comparison, one whose size is more in line with the dilemma.

The NASDAQ market index peaked in 2000 at a level over 5000. Back then, after an 80+% increase in prices in 1999, fear/greed coupled with the reality that companies with no revenue should have market capitalization greater than most of the Dow 30 came roaring back into the market and the bubble burst. The current market of SIVs, CDOs, ABCP, and every other acronym you can think of is no different than the NASDAQ was in 2000; just an overheated market where valuations (and value, for that matter) got way, way ahead of itself. The credit risk component was ignored and thrown out the window. Goldman announced today that they are net short this market. It wouldn't surprise me in the final review of all this that it was when Goldman went short and set up hedges in this market that the other market participants realized what was going on and tried to get out. The window, however, closed very quickly. Think of it like a game of musical chairs, where there are four chairs, one hundred players and one of the players controls the music.

There is one significant difference, which is why the NASDAQ comparison isn't made. When the price of Pets.com fell from $100 to 2 cents (or whatever) there was price transparency and the markets functioned well. In the current market for all the acronym products, there is not price transparency nor an agreement on what methodology should be used in determining value. Here's my suggestion on how to speed up the resolution of the problem (this won't happen, by the way). Get all the players, the top 50 say, to disclose in an unambiguous manner what they hold and how they are valuing it and let the chips fall where they may. This may create a sharp dislocation in the market, but it should go a long way toward transparency. The equity markets traded sideways for years until recently, but the bubble needed to burst and sound valuations needed to return to the market. Remember, the NASDAQ today at 2650 is still only half the level of March 2000.

P.S. In the giving credit where credit is due category, yesterday I had the privilege of attending a ceremony at the French consulate in New York where nine US WWII veterans, including my father, were inducted into the Legion of Honor for their service to France. It took a "regime change" in Paris and came 63 years after D-Day, but, still, the ceremony was moving and the words of President Sarkozy and his representatives were heartfelt and genuine.

Market Dislocations Create Opportunities

Whenever the bond market encounters these periods of dislocation, like it is currently experiencing, opportunities often present themselves. Given the state of the fixed income market, I'd like to highlight one segment that has been particularly hard hit. What area of fixed income has long stated maturities, relatively small institutional participation and is heavily weighted in bank/finance paper? The sector is preferreds.

Although there are now preferred funds and ETFs, preferreds are generally the bailiwick of individual investors. They're created to look like stock, and some have tax advantages like stocks, but they should be viewed and treated like fixed income instruments. A typical preferred will have a $25 par amount, pay quarterly, and is listed on the NYSE. Preferreds usually have a 30yr or longer maturity, with a par call feature that generally comes into play after five years. With the hybrid nature of their structure, preferreds are usually rated a notch below other debt instruments of a given company. Without going too much into arcane details, the majority of issuers are bank and finance companies, but there are also utilities, industrials, etc. The characteristics of the product make it more attractive and easier to understand for individuals. Except for the natural buyers listed above (funds and ETFs), institutions (hedge funds and the like) don't participate in the preferred market to the degree of other fixed income instruments. Let's just say it gets overlooked by that group of investors.

These factors (long maturity, low institutional participation, structure, nature of issuer) combine to create pricing anomalies in the preferred market. However, there is one counterintuitive element of preferreds that exaggerates the pricing anomalies; the fact that they are listed on the NYSE. Unlike most fixed income instruments, preferred trades either occur on an exchange or are reported to it on a timely basis, like a stock. Unlike a stock, a preferred issue doesn't have a specialist maintaining an orderly market. Dealers and customers are providing bid and offer prices on the floor via orders. If news comes out or the market is in turmoil, the bids on the floor get hit or pulled in rapid fashion, which can produce wild price swings. For example, (oversimplification for illustration purposes) if a preferred bid gets hit at 25, the next bid lower might 24. If the 24 bid is then hit, that is the equivalent of a 4 point move on a bond, given the $25 par value of the product. While the market will eventually step in and smooth out all the price discrepancies, that may take a considerable period of time (days, weeks, months) given the nature of the market problem.

Before putting any money into this, let me remind everyone that the current market condition is not something everyone should be involved in. It is certainly not for those of the faint of heart or for those who don't realize that an investment in most anything can lead to a loss (yes, there are people like that out there). As for the preferred market, it would be advisable to seek out the advice of someone who is very knowledgeable about this market in particular. Finally, the above discussion refers solely to the secondary market in preferreds, not new issues which has different market characteristics.

P.S. This will be my last entry this week. For those of you that live outside of New Jersey, Thursday and Friday is the state teachers convention. For those with kids, it is basically a holiday here.

Mark to Model=Best Guess

The current credit market situation would be laughable if it wasn't so serious. It is playing out like a bad daytime soap opera. The latest buzzword that is entering the everyday lexicon is mark-to-model.

All bond traders to some degree price securities using models, even one that trades a benchmark security like Treasuries. The simplest model would be a straight yield spread to Treasuries. As time marched on and increasing amounts of data could easily be processed, models became ever more complex. Synthetic benchmarks were used with increasing frequency, adding to the mix. It seemed that no amount of variables could stop some mathematical genius from developing a model to calculate the exact value of X. However, there are three variables that could never accurately be taken into account by the models. Those three variables are fear, greed, and liquidity.

Fear and greed are the two that create outsized moves in the market, either ends of the pendulum swing, as it were. Greed usually takes effect more slowly, building up to level of overvaluation. That is the point that the credit market reached in June over a buildup of several years. Then, fear took over, as investors sold and exited markets in an attempt to lock in what they had gained. Fear takes hold very quickly, like being hit over the head with a sledgehammer. It was at this point when traders were reporting "10,000 standard deviation" market moves. Finally, a second kind of fear kicked in, observed in the market as illiquidity. This is when the market players said "No mas" and brought the CP market, especially the asset backed CP market, to a standstill. With models used to calculate values starved of accurate input data, marking or pricing to model became a best guess scenario.

The faith that Wall Street and the investment community has placed in these models has been shaken. Almost daily now, new "best guesses" as to the carrying value (as it doesn't look like many of them have been sold or unwound) of these assets are released. It is one thing to interpolate the spread of a GE 6yr maturity bond, when the value of the GE 5yr and 10yr is known. However, in the current environment, it is near impossible to determine what value an asset has when the underlying securities have been repackaged four times and have uncertain cash flows going forward. To paraphrase last week's post, mark-to-market (or mark-to-worst case scenario) already.

Mark To Market, Already!

In July, I had a breakfast meeting with two gentlemen who are quite well versed in the bond market. They asked me whether the credit situation that was just coming to light would be prolonged and would it spread elsewhere. My answer was that this was the healthy move for the credit markets given how overvalued they had become. I went on to say that I didn't think that would spread to the rest of the economy and precipitate a recession (I'm not sure my colleagues agreed with me). Up until recently I agreed with that assessment. However, in making that assessment, I assumed (that word!) that the appropriate rules and laws of trading and valuation would apply. Now I'm now so sure.

The problem with my premise is that the valuation issues that began to come to light in summer are still lingering and perhaps they are getting worse. What I mean by getting worse is story out today on Merrill Lynch that they acted in concert with hedge funds to hide or defer losses. If this is true, it is almost a certainty that that type of activity occurred elsewhere. This is a major trust issue. Let's face it, financial firms don't have vast amounts of real assets backing up their market capitalization. When trust is eliminated from the equation, value and the ability to do business dries up. There are many examples; E.F. Hutton comes to mind about a firm where the market lost confidence. It cannot be emphasized enough that all the players need to determine their exposures, value them as conservatively as possible (there were many times in my career when I marked bonds to distressed levels, even zero, if I couldn't determine the value by usual means.) or get them off the books. There is a market clearing value for everything. You would get the impression when reading/listening to the popular press that these SIV assets are worthless. That is because when it is discussed, the exposure level is mentioned implicitly as an all-or-nothing value; either a SIV is worth face value or it is worth nothing, like a coin flip. The reality is that the value is somewhere in between. It's time for the banks, brokerages, and other involved parties to move to those levels come clean about the losses and move on. Otherwise, the markets face continuing levels of volatility, slowly deteriorating week by week, trading lower on rumor and innuendo.

The Deficit

Given my background, I get a lot of questions on the the dollar's value. Many of them are related to the trade deficit. Here is the bottom line. The US has been shipping dollars out of the country in mass quantities to pay for imports for years. The US is a large country with a history of steady growth. The dollars come back to this country to take advantage of those growth opportunities. Lately, there have been growth opportunities elsewhere as well, in sufficient amounts that some of that investment goes to other countries, lessening demand for dollars. Hence, the "price" goes down. This make goods here cheaper and if all things were equal (which rarely occurs in trade), consumers will demand more, which they have. US exports are increasing at 3 times the rate of imports, and would be increasing faster if the single largest US import, oil, wasn't being driven higher by speculators (I know, I know, the supply figures were lower. It shouldn't be a real surprise that companies don't want to buy oil here when they think it will be cheaper later on. Supply number measure oil in storage, not what's being produced. In addition, gasoline prices have lagged oil, squeezing margins. Here again, it shouldn't be a surprise that less in being produced and capacity utilization is down.). As long as inflation remains under control, we shouldn't be overly concerned about a weaker dollar. Our trading partners, however, that have made a living off of a stronger dollar, have much more to be worried about. But that story is for another time.

So ends the micro- and macro-economic lesson.

The Fed Did the Right Thing

Not because they agreed with I posted yesterday, but because they told investors, as much as they can, what they are going to do going forward. They have rightly adjusted expectations while giving themselves flexibility.

Caveat Emptor

This is another in the series of pre-Fed postings, while we wait for some discussionable (is that a word?) news.

Last night, while cleaning up, I was flipping around the channels and I came across Jim Cramer and his Mad Money show. He was pounding the table, in a less-than-usual animated fashion, on Brazil, and specifically Banco Bradesco (BBD). He rattled off a whole host of reasons why you should buy Brazil, all of them valid. He stressed buying the ADRs, rather than the local (ordinary) shares, also sound advice, for the most part. He even admonished himself for a Brazilian pick earlier in the year, Bradesco vs. Itau.

What Cramer neglected is the history of investing in Brazil. Investors with little experience in Brazil and elsewhere in emerging markets don't realize how fast money can exit these markets. To be fair, I don't know what Mr. Cramer's experience is relative to Brazil. I do, however, know mine. I know that a good chunk of the gain is currency-related (Yes, ADRs have currency risk. You are buying a dollar-denominated proxy for the local shares. Even if the underlying shares don't move in price, the ADR value will fluctuate with change in value of the US dollar relative to the local currency) The BRL is up a ton this year vs. the USD; that probably won't happen again, at least to the same degree. It wasn't that long ago that the BRL was devalued in order to bail out the economy. This, among other things, helped push Argentina over the edge into bankruptcy, as they are large trading partners. Finally, Brazil is one of the most opaque markets in the world. The rules of normal business practice and laws to protect investors are nowhere near the level of transparency that you would find in a developed market. Locals control much of the business and information flow in Brazil, and that isn't going to change anytime soon. The bottom line here is also the title line: Caveat Emptor.

For The Record...

As is now customary, I will go on the the record about what I think the Fed will do tomorrow. So far, I'm 0-for-1, for those of you keeping score. The Fed will cut both rates 25bps, really for no other reason than they have primed the market with that feeling. Fifty basis points looks aggressive here, especially give equity prices, but, in fairness, I said that last time. Postponing a cut until December is inconsistent with Fed actions in general. Rarely does the Fed do one and done. What will be most important about tomorrow's announcement will be what they say going forward. The Fed needs to throw something to currency market, to at least keep the decline of the dollar steady. What would work would be a statement to the effect that the Fed is going to gauge the effectiveness of recent cuts on the economy, markets, etc. They can get away with this because it is generally accepted that it takes some time for these moves to filter through the economy. Then they throw in the boilerplate language about standing ready to act if necessary, yada, yada, yada, to keep equities from selling off 10%.

With one more meeting this year, the Fed is in a tough spot. They don't have as much room to maneuver. Next year, being an election year, the Fed will be more hesitant to act. There is no incumbent up for re-election, so it does give them more flexibility. They may not need to do much more anytime soon. However, the Fed need to telegraph its thoughts now that it can't solve the subprime crisis or bail out homeowners that bought more than they could afford by themselves; market-based solutions are what is needed in both cases. Otherwise, it will be a tough '08.

The Next CEO of Merrill Lynch Is...

Since there is a Fed meeting this week that has meaning and given the dearth of other news in the financial world (Riding on a plane with Warren Buffett on his trip to China does not qualify as breaking financial news, sorry CNBC), all eyes are focused on Stan O'Neal's departure from Merrill. Whether or not you think his exit is justified, his leaving has become a foregone conclusion now that he went behind the board's back, the same board that put him into that job over other, some would say, more qualified candidates. Merrill seems to go through these gut-wrenching fits every five years or so. They get into trouble when they stray too far away from what they do best, catering to the needs of private clients. That certainly what has happened here with these massive credit market exposure writedowns. It happened back in '98 after another fixed income blow up, Russia. Then, they exited a fixed income sector that I traded at a large competitor. I had one of the best months of my career, picking up Merrill's inventory on the cheap and having one less major competitor to deal with. For Merrill, this cycle is nothing new. What's different is that this time it goes all the way to the top. Stan O'Neal never enjoyed the unquestioned support of the 15,000 financial advisors as previous CEOs did. He wasn't one of them.

Who's next? Page C1 of today's Wall Street Journal has the pictures of the likely candidates: John Thain; Greg Fleming; Bob McCann; and Larry Fink. I'm going to shoot all of their candidacies down, knowing full well by the time I finish writing this one of them may have already accepted the job, and make my own suggestion. John Thain already was president of Goldman; why would he want the Merrill job? Besides, Thain wants Chuck Prince's job. Fleming knows the markets, but as far as the Merrill FAs are concerned, he's just another Stan O'Neal. He didn't come from their ranks and would not be acceptable to the FAs. Bob McCann would fit that description as far as Merrill's brokers are concerned, but he know little about that troubles the firm currently faces. Still, McCann would be the safe choice by placating the salesforce. That leaves Larry Fink. He certainly is the best all around candidate, but he has it pretty good over there at BlackRock. I'm not sure he wants to leave to take the Merrill job. It is also questionable how much of an outsider, which seems to be the consensus as to whom would be best for Merrill, Fink is , as Merrill owns 49% of BlackRock.

Having said all that, and not trying to be too self-serving, but I would like to put forth yours truly for the Merrill CEO position. I am definitely an outsider, certainly have the fixed income experience, and am very knowledgeable as to the workings of a large retail brokerage firm. So, if anyone on the Merrill board is reading this, except Stan O'Neal and Bob McCann of course, feel free to contact me at your convenience.

Foresight is 20/20

http://www.bloomberg.com/apps/news?pid=email_en&refer=rates&sid=axTqfaTiLf4I

Just a quick note on a Friday. The above link is to a Bloomberg article on Argentine debt. Surprise, surprise that the value of these securities are in question. This is an "I told you so". All I can say is caveat emptor. There can't much sympathy for those that bought these securities and the accompanying warrants given the bankruptcy, the lengthy restructuring, the hardball tactics, the opacity of the structures' valuations, the limited convertibility of the currency, and the headlong rush into the arms of the likes of Hugo Chavez. Well, greed can be blinding. Have a good weekend.

The Demise of the Bond Trader

The big losses being racked up by the banks and brokers these days can be directly attributable to one thing: the demise of the bond trader. More specifically, it is the demise of the art of bond trading in favor of the science of bond trading. Since the advent of widespread use of computers on Wall Street for valuation purposes, the art of bond trading has been pushed into slow but steady decline. Twenty years ago, the most sophisticated piece of equipment on a bond trader's desk was a Lane or Monroe bond calculator. It was the explosive growth of repackaged MBS pass-thrus (CMOs) that created the need for more sophisticated methods of determining value. Back then, the real prestige item for Wall Street firms was a Cray Supercomputer (do they even exist anymore?), used in calculating all the cash flows and other variables that went into structuring a CMO. The rest is history. There have been hiccups along the way, most notably in 1993-4 when the mortgage prepayment models didn't adapt to the changing interest rate/product environment and in 1998, when genius failed, as the book was so aptly titled, to account for reduced liquidity. It turns out, or perhaps more correctly, will turn out that 1998 was just a warmup for 2007. When the art of trading finally pushed back against the science, liquidity ran for the hills.

I'm no Luddite. My writing this blog should prove that. Nor am I suggesting that the world go back to writing prices and spreads down on little pieces of paper taped all over the desk. The problem comes about when a mathematical model completely supplants common sense. Management, for the most part, loved this because a model provides a definitive answer. Management could then take the model-derived answer and show it to the CEO, Board of Directors, major investors, regulators, etc. and say "See, here is our exposure, here is our risk, and here is what we've done to mitigate it. You may rest assured, now." As is publicly known now, and privately talked about for awhile, the inputs that were used to generate these model-derived values, particularly with regard to liquidity, were faulty to say the least. The models, generally very complex mathematical formulas taking into account a whole host of variables, are developed by some of the finest technical minds in the world, but have little practical market experience. Many are PhDs in the "hard" sciences, Physics and the like. Most of the people that use the models are not finest technical minds in the world, but have some or much practical market experience. Therein lies the disconnect. The consumers of information, always looking for better and faster ways to make money (a good thing, by the way), have become so reliant on the neat answers that models provide them that they ignored common sense and forgotten how to trade and the risks of trading.

If there is one lesson learned by all of this, it should be that the decision makers and risk takers need to get in touch with their trading roots and apply good old-fashioned common sense to the model equation. Securities that are packaged and repackaged and repackaged and repackaged again deserve more scrutiny, on all levels including rating, then they have received in the past. Values need to reflect all the risks, including the risk that the value may not be able to be determined. Maybe then, the trader's "bid out" would have happened sooner, sparing many the problems of the past few months. Probably not, but it is a wishful thought. The good news is that some happy medium will develop, new methods will arise, and the bond market will go on its merry way.

Back to August

Merrill Lynch announces a much larger than expected loss, coupled with weak home sales numbers and the pundits are coming out of the woodwork, falling all over themselves to demand that the Fed cuts rate 50bps next week. An analyst on CNBC went further this morning, saying that Hank Paulson's involvement in the creation of the SIV buying facility (designated M-LEC, or designated by me as BOSTONS-Buyers Of SIVs That Others Nevertheless Spurned) was really his way of begging the Fed to cut rates. Not surprisingly, Fed Funds futures are now leaning toward a 50 bp move. What is ironic about this is that the same people who were up in arms about the government (including the Fed) not acting fast enough are still up in arms or at least suspicious, about the government trying to help. Even with videotape and YouTube, TV has a short memory.

The bottom line here is that there are assets on the books of many firms that still have the valuation problems. At this point, that should have been worked out. When a valuation problem occurs, it is imperative to mark an asset to an appropriate level. Sometimes it is difficult what that level might be. At the end of the day, something is only worth what someone will pay for it. Too many times in my career did I come across the theoretical values guys out there, saying a security is worth X because the model says so. This Merrill announcement, and probably more to come from others, tells us that the model devotees are still holding sway. The value of Google stock is readily quantifiable, but the value of SIV-123abc isn't. When in doubt, mark it to a conservative level. When there is no real bid for an asset, the mark should represent the worse case scenario if that asset had to be sold. Clearly, the owners of these assets haven't gotten to that level yet. They are hoping the market bails them out, which is why they set up the M-LEC as a transitional facility until previous liquid market condition return. Then, M-LEC is a home run as it was able to pick up cheap assets.

In the end, it is the role of capitalism to punish entities that get valuation wrong. There is still a way to go, but the system will work and, in the end, economic growth will continue.

The Case For Sound Advice

'Sell all your mutual funds and stop being ripped off'.



Here is the link to this article http://www.marketwatch.com/news/story/sell-all-your-mutual-funds/story.aspx?guid=%7B4B8CD1AC%2DE5B4%2D46E0%2D9C24%2D03B45347A67F%7D

Basically, the author says that the fees they charge are not justified by returns. He also goes into a rehash of the mutual fund scandals of a few years back. He suggest index funds (ironically, offered by mutual funds) and ETFs. With these investments, the embedded fees are low (not including commissions charged at the point of sale). The case could be made that in these index-type investments, you get what you pay for. Owning an S & P 500 index fund maybe great for low expenses, but does it fit with your goals?

The point here is to get a hold of some sound advice. Work with an advisor and develop an investment policy statement, outlining your goals and objectives while taking into account your risk tolerances. Planners and advisors charge for the value of their information. If they do a good job, as defined by your investment policy statement, they should be compensated a fair amount. Mutual funds may be part of this mix, in some cases they may be the only way to get involved in certain sectors. However, take the time to understand the all the costs and loads involved.

Finally, mutual funds may be the best way to execute an investment policy. For example, if your total investable funds are only $50,000, you probably can't get financial planner for a reasonable fee (many have minimums). Putting together a diversified portfolio of investments may not be possible without use of mutual funds. Be mindful of the costs. If professional help is not practical, draw up your own honest and common sense-filled investment policy statement, delineating what you are trying to do and what you are willing to do (how much risk are you willing to take on) to get there. Stick with it, refer to it, and update it from time to time as needs goals, and risk tolerances change.

The Patron Saint of Bond Traders

Just a picture from the shrine of the patron saint of bond traders, Santoliquido.

What To Do, What To Do....?

The stock market goes up, then it goes down, then it goes up, and then it goes down. The main concept that needs to be remembered in this environment is the difference between being a trader and an investor. Although many of my friends are employed as traders, when it comes to their personal financial situation, they are investors, either voluntarily or by corporate mandate (you know who you are). While this is a great time to be a trader (if you know what you are doing, of course) as traders love volatility (the way to make money as a trader is to buy at one price and sell at a higher price in a relatively short period of time), it is an unsettling time to be an investor. With the amount of financial information and commentary available to people, a filter needs to be put in place to regulate what is really important. Here a just a few things to keep in mind, regardless of your situation. First, what is your time horizon for any given investment? If you are 43 and the money is in an IRA, you really shouldn't be concerned about day-to-day, week-to-week, or month-to-month moves, as long as you are comfortable with your investment plan. If it is money being used to buy a house in three months, that is a different story. Second, what is your risk tolerance? Some people are very comfortable to be invested 100% in equities and real estate. Others don't want to put there money in an FDIC-insured CD. Only you know your risk tolerance. A good financial advisor should be able to define and quantify that for you. Finally, what percentage is in what? Even you are the most conservative investor, you might 5% of your money in a hedge fund with massive sub-prime exposure. At the margin, this is your most risky asset. Are you prepared to lose it? Are you prepared for that investment to take ten years to rebound? Again, only you can answer that question.

While you are watching CNBC and the market is moving up and down, keep in mind who you are, what you are invested in, and what your time horizon is. These periods of volatility are good times to review strategies with your advisor to determine if you investments are properly positioned for your needs.

It's The United States, Stupid

Well, it finally happened. CNBC, specifically Mark Haines, admitted this morning that they change their views more than daily depending on their guests' opinion. Today, amongst all the positive earnings from US industrial multi-nationals, they had a series of guests bashing the US economy. Guess what, the US economy is weak, led by housing. Foreign economies are showing signs of strength, but it is not the monolithic picture that it is made out to be. The worst guest of all, an American no less working for Credit Suisse in London, made a self proclaimed unpopular statement that the US is no longer the center of the universe, that it is the middle class of emerging markets driving the world economy. It is sad that CNBC puts people like this on without presenting a balanced view or asking the guest hard questions (they do, when it suits the host's personal agenda, on both sides of the spectrum).

There is only one question that needed to be asked of this analyst. Here it is: What created the conditions that allowed a middle class to form in these emerging markets, or the developed markets, for that matter? It's the United States, stupid. Is there really anyone sane out there that thinks the world's economic situation (or political) would be better off if the US hadn't acted the way it did over the past 60 years? Before I get 1000 posts, yes the US made mistakes along the way. The worldwide benefits of a global economy are starting to be realized, particularly since the fall of the Soviet Union. Emerging economies, sources of raw materials and cheap labor, starting from low bases are of course experiencing faster growth. The US created the conditions that allowed for this growth. The US continues to grow rapidly. There is no other country on Earth that approaches the size of the US that is as dynamic as it is here. Sure there is emerging market growth now, but what happens when these markets mature? Will they foster a spirit of openness and free trade? Will they resolve their massive domestic problems? When Brazil runs out of trees to cut down and iron ore to dig up, will the masses go back to accepting the massive wealth disparities that have and continue to exist there? When China runs out of cheap labor, brought on more quickly by a "one child" policy, will they retreat into another Cultural Revolution? Will Russians continue live with (or not) a declining life span and turn further back toward dictatorship? If the world is relying on any or all of these scenarios to take the place of the US in world leadership, it would be overly optimistic, to say the least.

As for the commentating world fretting about US domestic demand, that story plays well somewhere, however not CNBC's audience. If the US economy makes up 20% of the world's economy, then Caterpillar, Honeywell, etc. should be selling 80% of their products elsewhere. They can, thanks to the conditions created by the United States.

Just Walk Away...

It took longer than expected, but finally an article appeared about people walking away from real estate as their equity turned negative (Wall Street Journal, page D1). The story chronicles two people that got caught up in the real estate price frenzy, only now to consider defaulting in their mortgages and/or filing for bankruptcy. In many ways, it parallels the situation that occurred in the US in the late Eighties and early Nineties. In many ways, it doesn't. Before the various governments here start bailing everyone out, a few points need to be kept in mind.

The first is that, in many cases and certainly in the high growth bubble real estate, is that many of the "walkers" today are not owner-occupiers, but rather investors that got overextended. Fifteen, twenty years ago most people got in trouble were in their own homes, caught up in an extended downward move in real estate prices, exacerbated by over building. The market eventually worked its way out of that (helped in areas like Florida by Hurricane Andrew) but it took time. These days, with information flows much faster, the up and down cycles are shortening. There is a concern that these foreclosures and bankruptcies will force the renters in these investment properties out on the street. If the governments want to step in with moral suasion here (not legislation), go right ahead. Banks should be convinced kicking these people out on the street isn't in their best interest. At least they are receiving income while the market adjusts to new levels.

The second point is that all the new mortgage options coupled with reduced/ignored credit quality/issues has helped facilitate the problem. While the popular press has focused on the 89 year old homeowner duped into taking out the mortgage they didn't want or need, the reality is that most people, investors or homeowners, overextended into houses and mortgages they could not afford. If there is fraud involved, by all means go after them. If not, the parties involved need to take their lumps. Again, here is case where the moral suasion of government should be used to renegotiate the terms between mortgagor and mortgagee. Like the other credit issues in the market, there has to be an accounting and a reckoning of the risks taken, on both sides.

Score One For The President

Everyone knows, courtesy of Bill Murray, that the Dalai Lama is a big hitter, but the fuss being generated worldwide over the ceremony today is over the top. The Dalai Lama is being awarded the highest US civilian honor, the Congressional Gold Medal. The ruckus in Beijing over this is nothing short of ridiculous. The Chinese are starting to believe all the press written about themselves if they were under the delusion that the could order (yes, order) or threaten (yes, threaten) President Bush into not attending the ceremony.

Let's, for the moment, forget that the leaders of this Congress (the ones with single digit approval ratings) are giving the Dalai Lama this honor specifically to irk the Chinese and embarrass the President (why do you think it is happening during their five-year party congress?), this Dalai Lama isn't even advocating a separate state for Tibet, much to the consternation of many Tibetans. Why are the Chinese so upset? First, it take the focus away from their show. There isn't any real concern on their part about a Tibetan separatist movement or the US support of it. Second, and more important, it is the Chinese tit for tat regarding the US (and others now) constantly berating them about the value of the Yuan. Finally, as mentioned above, they think that because of their size everyone is going to back down. They go Mattel to apologize to them, unbelievably, why not the US government.

Fortunately, President Bush isn't going down that road. Instead, he took the high road, saying the honor is for the Lama's religious works and gave those who tried to back him into a corner nowhere to hide. On CNBC, the buzz was what this might to do US-Chinese trade relations. The answer is nothing. The Chinese aren't going down that road with the US. Without the 8-12% growth provided by exporting here, the Chinese government wouldn't last very long.

It Was Twenty Years Ago...Fri-day

Nothing to do with Sgt. Pepper or the Beatles, but Friday is the 20th anniversary of the '87 market crash. Back then, market professionals were huddled around their Quotron and Bunker-Ramo machines frantically hitting the Enter key to see how much the Dow dropped. The long bond traded up with 5 different handles as investors ran for cover. The NYSE's new electronic system, which could handle all of 95 messages per second, was quickly overwhelmed, not that it mattered as almost all trades were done by pencil and paper. The tape was hours behind. The specialist system was strained severely, but didn't break or collapse.

Over the past few weeks, the equity markets, ex NASDAQ, have traded to new highs. The last few days, reality has set in as stocks have weakened. The battle out there still continues over who is right on the economy, the stock or bond market. The answer depends on who you ask and when you ask it. For a couple of weeks, since the brokerage firms reported earnings, the market seems to have forgotten about housing/mortgage/sub-prime situation as those brokerage numbers came in at or above expectations. The euphoria has ended with the reality of the banks' earnings. It may change later this week as more tech earnings come out.

The real answer is that, ex housing, things are looking pretty good in the US. There is a lot of excesses that need to be worked out in that space. Individual companies may or may not do well in this environment. Certainly banks are having issues. Banks and brokerages make up most of the liquidity in fixed income markets. Other entities like hedge funds that might normally step in here are restrained by tighter credit, valuation problems, and redemption events. The real, meaning not Wall Street, economy must be kept in focus through the noise.

SMLEC

That isn't one of the easier acronyms to pronounce. Usually the financial geniuses come up with better names that roll off the tongue like REMIC, Iboxx, or ToPrs, the more complex the structure, the easier it is to pronounce. For example, the raison d'etre for SMLEC (or M-LEC if you read the Wall Street Journal) is to create a orderly (aka not free-falling, not unpriced) market for SIVs and SIVs-lite, which, as can be surmised, is easy to pronounce, yet all the kings horses and all the quants on Wall Street can't get a handle on their value. My thinking is that this came up so suddenly, that the marketing teams didn't have time to produce something catchier.

Just so no one trips over themselves, SIV stands for Structured Investment Vehicle and SMLEC means Single-Master Liquidity Enhancement Conduit. Personally, my choice would be BOSTONS-Buyer Of SIVs That Others Nevertheless Spurned. It is a little more accurate and definitely more descriptive. On the face of it, if this "buyer of last resort" helps liquidity in the front end of the market, it will be a success. The Wall Street Journal seemed to be somewhat in a snit that the Treasury was involved in this in some way. As long as they aren't putting up tax money to finance it, this is the kind of action they should be doing to get markets moving.

The other concern is that is just another way for the big banks to keep this stuff off balance sheet. This maybe true, but these items are already off balance sheet. I seriously doubt that J.P Morgan and B of A are going to create a fund for the sole purpose of bailing out Citi, the most heavily involved bank. It must kept in mind that this is a work in process. It also must be remembered that this isn't the RTC, the entity set up to restructure S & L's and their assets/liabilities. The very existence of this fund maybe enough to stabilize this market, without much of the fund being used. The should help the cream rise to the top, leaving SMLEC to unwind the rest, at a tidy profit for its investors.

$29 Billion

Yesterday, the Commerce Department released the trade deficit figures for August. Even though the number came in better than estimates at $57.6 billion, it is still a huge outflow that must be offset by capital account inflows. However, there are many positives to look at here. It could be much worse, given all negatives floating around. The most serious long-term negative is the increasing protectionist sentiment in Congress. They seem to be most insistent on pushing the US back to the economic glory days of the Jimmy Carter era, or worse by foisting upon us a Herbert Hoover-era, Smoot-Hawley-like, Depression-creating tariff. It shouldn't be surprising that Congress has an approval rating approaching the single digits. Maybe they should stick to censuring the current Turkish government for the ninety-year-old actions of the Ottoman Empire, but that is the subject of another post.

Which brings me to $29 billion. The figure represents the total value of petroleum products that the US imported in August. I'm no mathematics expert, but that works out to about $1 billion a day. That number also works out to almost exactly one-half of the trade deficit number. Given that the price of oil has moved higher at a fairly regular pace over the past few years, that deficit number has grown. None of that part of the deficit is with China; they make up a large part of the other half. The biggest single recipient, surprisingly or not, is Canada, which explains the 30-year high in the C$. The rest of it goes to the usual suspects in no particular order: Saudi Arabia; Mexico; Venezuela; etc. Every time the price of oil goes up, the deficit will get worse, despite all of the Chinese-bashing tariff that can be put in place. The weaker dollar contributes too (even though commodities are priced in dollars, as the dollar weakens, producers adjust their prices accordingly to make up for the reduced purchasing power), although it is far less significant and is probably more than offset by increasing exports.

It is this side, the energy side, of the trade deficit that is the real problem. It is the one that needs to be addressed, not the politically expedient goods side that gets all the attention. Of course there are problems with the goods deficit that need to be addressed, but the discussions need to be limited to the high value goods that can be profitably competitive with area of the world that have unlimited supply of cheap labor. Let them make the cheap stuff (And don't apologize to them when they are in error, call them out on it. This means you, Mattel). As stated in previous posts in this forum, $80 dollar a barrel oil opens up many opportunities for alternatives in the US that weren't feasible at $30/barrel. Conservation, cleaner coal, oil shale, solar, the list goes on and on. The US government should embrace this opportunity and lead the nation into the post-imported oil epoch.

Another Follow-Up

Long-time readers here know that several posts on the blog have been devoted to the relative price movements between oil and gasoline. Oil has skyrocketed while gasoline hasn't moved this year. This relationship is beginning to manifest itself in lower earnings for domestic suppliers and refiners. If the cost of raw materials (crude oil) goes up and the finished product (gasoline) stays the same, margins get squeezed. Yesterday in the Wall Street Journal there was an article on whether the next move for oil is $100 or $50. While this is obviously important, it is really the price of the finished product (gasoline) that really matters.

Here's why I think oil should be capped around this level (barring some external shock). First is slower US growth. While the rest of the world seems to be doing well, the US still makes up a large percentage of the world economy. Second, with oil sustained around the $80 level, more supply will come on line. This takes time however. The longer the price stays up here, the greater the chance for increased supply. While the Saudis will want to push the price down to a level where they can keep this additional supply off the market as their cost is below $10/barrel, it won't get to that level soon. The good thing is that much of this new supply will be domestically produced. Similar to oil sands of Alberta, the Western US has huge reserves of oil, although much of it is trapped inside of shale. At $80/barrel, this can be produced profitably and without the externally generated political risks. The third point is that at these price levels, substitutes, primarily ethanol, are attractive and coming on line in an increasing rate. If the government lifted the 52 cent/gallon tariff on imported ethanol, its price would come down and use increase. The last point, plus the expansion of domestic refineries (finally), will help keep gasoline prices down.

In The Short Memory Department (Redux)

Well, look at the stock market now. For example, on Aug 15, Goldman Sachs' shares could have been had for roughly $165/share; yesterday the stock closed above $239/share. I pick Goldman for two reasons. The first is that being a financial powerhouse, it was in the center of the credit market maelstrom. The second is that as a well-run organization, Goldman has weathered the storm. A 75 point move, or 45%, in less than two months is nothing short of spectacular. Critics would state that Goldman was down almost that much before the credit market crisis, which is true. Most financial firms were down, and many have not come back. It is not worth listing them; you know who they are. The same critics would also say that Goldman is really a hedge fund, not a Merrill Lynch or Lehman. That may also be true, and they may take on more risk than their competitors. Goldman also seems to manage it much better than their competitors. At 9+ times earnings, it is certainly not out of line with these same competitors.

The bottom line here is a theme that has been stressed many times here, don't panic in times of crisis. During these times, there are always winners and losers. If you are a long-term investor, this kind of event is going to happen periodically. If it works, stick with your plan and adjust it if necessary. Try to rise above the noise. Step back from the constant stream of financial information if it helps you focus on what is important.

Little Montenegro down on the Adriatic Sea

To begin with, anyone that guesses what book the title of this post came from gets extra credit. The EU's finance ministers warned Montenegro not to unilaterally "Euro-ize" as it is incompatible with EU law. In order to adopt the Euro, countries must meet certain financial criteria, although the EU has bent the rules before. When Montenegro split from Serbia last year and became independent, using the Euro was the most effecient and expedient thing to do rather than create its own currency. In fairness, the warning was less directed at Montenegro than at EU member states that may try to backdoor their way into using the Euro without meeting the criteria.

On the other hand, it would be thought that the EU would happy, nay thrilled, to have some legitimate entity wanted to use their currency. Until now, only rogue states (Saddam Hussein, Iran, Venezuela, etc.) looking to thumb their nose at the US and criminals (the 500 Euro note, being highest value, widely circulated paper currency in the world) looking for portability of assets were only ones voluntarily adopting the Euro.

For all of Europe's talk about becoming the world's next reserve currency, this is just another point, along with an underdeveloped bond market, showing they have a way to go. If Montenegro wants to use someone else's currency, they should try the US dollar. They would be welcomed with open arms.

reader update

Yesterday, this blog received it 500th hit, which may not seem like much but it puts it in the top 2% of blogs worldwide. I've had readers from as far away as Europe and Asia, but the vast majority have been from the US. For those of you that are regular readers, thank you. Finally, for those of you that think I'm getting rich off of this, Google tells me that this blog has generated $3.80 in ad revenue over the past two months. They don't pay out until it reaches $100. I always thought Google was overvalued, but maybe I was wrong. With all of this blog ad cash they are sitting on, perhaps the stock deserves to be at $600/share.

Told You So...

Instant analysis. This is a textbook example of why not to look at these month to month headline numbers. A minus-4 to a plus 89? You don't want to know what that difference is on a percentage basis (In fact, it can't be calculated). The trend over 2007 of about 100k job gains per month is probably weak enough to give the Fed cover to cut 25 bps on Halloween, especially with the dollar moving higher. On the other hand, they might go back to worrying about inflation and take a wait and see attitude. I'm inclined to think the former, as the Fed doesn't want to appear as being too indecisive, given their last statement, lurching from number to number. Have a good weekend.

Another Month, Another Employment Number

Here we go again. Just by observing some anecdotal, very unscientific evidence, the 100k gain in jobs the consensus is looking for seems to be too high (I have a lot of time these days to conduct these surveys). Add in the announced job cuts and factor in that new home construction has fallen off the map, the number should be weak. Yet, who knows? Those of you who know me or have been regular readers (I got a page hit from Qatar yesterday, goin' global) know my feelings on the employment numbers. In a nutshell, in and of themselves, employment numbers are next to nonsense. We are relying on the 50 state bureaucracies, plus assorted commonwealths, territories, and districts, to provide timely and accurate information to be complied by another bureaucracy. Any number where the revision gets as much attention as the headline has to suspect. In the aggregate, looking over months of data, employment figures become useful in spotting trends.

The bond market thinks it is going to be weak, judging by the recent move in rates, all but assuring future cuts. The equity market isn't so sure. After taking the major averages, ex NASDAQ, back to their recent highs, the rally stalled. A weak number probably means further Fed rate cuts, especially since this is the last monthly number before the next meeting. It also means slower growth, at least domestically, capping further earnings gains. What a conundrum!

How, in general, should you play these numbers? Investors should basically ignore them, using them only to determine the direction of long-term trends. Trying to trade the bond market based on the hot number of the month, whatever it is, will most likely give you whiplash. Let the professionals lose money in the half-hour after the number (although it is a zero-sum game, somebody wins). If a number (or revision) prints that few expect, there will be wild swings in prices, exacerbated by the lower, albeit increasing, levels of liquidity in the fixed income market. The hour after a big number can be irrational. Trader's years can be made or broken during that time. By the time the equity market opens at 9:30, instant analysis has been completed and the direction for the rest of the day can usually be figured out, unless there is another big number tomorrow. Happy employment Friday to all, and to all a good night.

The Dollar's Falling, The Dollar's Falling!!!

If I had a dollar for every time since 1980 I read or was told about how it was all over for the US dollar, I could permanently retire with all those greenbacks, despite their fluctuating value. Given its current level, you would have to be blind and deaf to not be aware of the demise of the currency. Today, there is a piece on page C1 of the Wall Street Journal regarding this topic. The columnist tries to inject as fear and doom and gloom as possible right off the bat with the title, “Why the Dollar Won’t Regain Its Past Strength”. He quotes professors from Harvard and Berkeley and trots out some model they developed saying the dollar has 20% more to go. If that is case, then I suggest you call your broker immediately and buy some short-term, non-dollar government bonds. They make it sound like it is a no-brainer, and, who really knows, maybe it is. It can’t hurt to have that kind of exposure and diversification in a portfolio generally.

There have been several posts in this forum regarding this subject. The biggest risk to a weak dollar is inflation. If inflation gets too high, we have problem, and so does most of the rest of the world. There are benefits to a weaker dollar, which are detailed in previous posts. If I had to bet on the US adapting to a weak dollar or the rest of the world having to adjust to stronger dollar, I think everyone knows where I stand. Already, the Europeans are screaming for currency relief.

The other points of the piece are somewhat dubious. The rest of world catching up in productivity isn’t a real surprise as they chuck their electric typewriters for PCs. There doesn’t seem to be any lack of demand for US Treasuries, judging by where they are trading. Finally, the point regarding EM spreads doesn’t mention the supply and demand issues in that market, and it remains to be seen whether EM doesn’t suffer the fate as the rest of the credit market.

Finally, after an informal and unscientific poll of traders, I have yet to find anyone that read this “required” reading on Wall Street desks.

Remain Calm, All Is Well

That was Kevin Bacon's character's line from Animal House just before he was stampeded by the crowd into a two-dimensional figure. It was also the general point this blog was trying to make during the market's nadir in August. Certainly the equity market has taken it to heart. If you had been out of touch for the last three months and looked at the current level of the stock averages, you would think that the market just went into the summer doldrums and was just now beginning to emerge. Technicians will tell you that the stock market is a leading indicator of economic performance. Based on that, we can expect a sharp economic downturn, followed by an almost as sharp economic boom. It seems hard to believe that the housing market in general is going to turn around quickly, given the nature of the market (the transaction costs and time involved are radically different) and the amount of excesses that need to be worked out, although some depressed local markets, Florida for example, could be helped by the weak dollar bringing in foreign buyers. Likewise, the fixed income markets sustained significant damage in the recent turmoil. Banks are starting to disclose the effects of the past three months, taking their lumps and hoping that liquidity flows back in. Like in the housing market, it is hard to believe that appropriate valuations now exist for all these credit and structured products that no one had a clue on a month ago (the only real appropriate valuation is what someone is willing to pay for x or y, not what some model says it is worth). It will take some time for the bond crowd build up their appetite for risk again.

The bottom line is that in this instance, hindsight will be 20/20. If the economy goes into a general (one not limited to housing and related sectors) recession, then the bond guys were right. If not, then the equity guys were right. As a life-long bond guy, I'm inclined to believe the equity guys. The events that occurred in the bond markets over the past few months were strange, to say the least, pushed forward by a blind ignorance of credit risk and the resulting liquidity risk, and aided by the absence of key players during the usual summer slowdown.

Follow Up

No one guessed what those two lines on the graph are. One is the USD/CAD relationship and the other is the USD/BRL relationship. Notice, as the quant guys would say, how they have a high degree of R-squared.

Let Someone Else Worry About The Dollar

As stated many times in this forum, the biggest risk to a weak US dollar is the resulting inflation. It's the Fed's job to figure that out. Let's say that doesn't happen. So, what's the problem? The mass media will tell you about how expensive to go to Europe on vacation. There are three ways to solve that: don't go; economize; or be prepared to spend more. Is this really a problem. Of course not! Here's a better idea, go on vacation in the United States. The money stays here, helps employ people here, and you don't have to go through the hassle of getting a passport, a real problem these days. Foreign tourists, spurred on by a weak dollar, are coming here in droves despite all the complaints about security, visas, etc. They are spending money too, buying things here that are cheaper even without the currency adjustment. If you need immediate evidence of this, take a look inside any book jacket and see the difference between the US and Canadian price. Hop in your car and drive up to the Woodbury Common Outlets north of New York City and watch the busloads of Asian tourists disembarking on shopping junkets (For further proof, the local airport there is gearing up to accept international charter flights specifically for this purpose).

Some of the above is tongue-in-cheek, but in all seriousness, let someone else worry about the dollar. For decades, the world benefited from a strong dollar, exporting anything and everything to the US. These countries decry the low US savings rate despite the fact it is the main driver of their export-based economies. Export growth is triple the rate of import growth. This is occurring without a strong national policy championing exports as exists in other countries. There is even serious talk of exporting ethanol from the US now until domestic distribution infrastructure catches up with supply increases. (As an aside, the price of ethanol has dropped 40% from its peak. This will help the inflation numbers going forward, not so much on the energy side but on the food side as production costs, farmers a big users of ethanol, and supplies balance out).

These foreign countries should push to spur domestic demand rather than rely on weak currencies to bail them out. The US dollar is weaker than it was, but there isn't anyone seriously stating that it is undervalued at this point. In fact, against dollar-pegged currencies, like China, it has a ways to go.

Have a happy Fourth Quarter, 2007.

O Canada

The Canadian and US dollars are trading at parity, bringing full circle a cycle that lasted almost 31 years. Back in 1977, I won a $100 (US) bet with a Canadian on whether the C$ would see $1.1o or parity first (Guess what side I picked; if I had only invested that money in Microsoft, Intel, Google, etc.). Now that we are back to this level, I'd like to propose something quasi-radical, a US-Canadian dollar currency union.

Let's not make any mistake here. The reason the C$ has strengthened is the commodity boom. Canada is one of the largest exporters on raw commodities in the world. While they have always been a major commodity exporter, it is the mix of exports that has propelled it higher. Eighty dollar-a-barrel oil makes hard to produce Canadian oil profitable generating huge royalties for provinces involved and the national government, monies that weren't generated exporting wheat and nickel (Maybe diamonds. Watching Ice Road Truckers has led me to believe that companies must be making large profits, given the costs involved in production). These royalties have allowed Canada to post a record budget surplus, reducing the debt-to-GDP ratio by more than half over the past 11 years (Of course, if the US spent as little on defense as Canada, which spends somewhere around the amount that New York State spends, every citizen here would be getting a dividend check from the federal government).

Canada is a boom and bust economy. Currency union would force them to invest, in the good times , in businesses and technologies that would see them through the resource bust times. Historically, Canada has allowed the C$ to depreciate to be more export competitive. People seem to have forgotten that it was just over five years ago that the C$ traded at $1.60. Oil has been the great equalizer this time around, but I don't think Canadians want to go down the road Middle Eastern sheikdoms. Eventually, the oil party will end, either in lower prices, increasing use of substitutes, or a combination of both. It would help the US as well, as new legislation here would help reinforce monetary discipline, either through a merged or overriding central bank and create some fiscal discipline as well, as budget deficits would have to be restrained. I would even go farther as to invite other countries that have adopted the dollar around the world to at least have some observer status in the new central bank.

Parity just makes the mechanics easier, as well as making the explanation easier to all involved parties. It is a long-term positive for both countries.

PS: One line in the previous post shows the US$ fall vs. the C$ this year. Can you guess the other line?

A Little Friday Fun

Just a little Friday fun to close out a long week. Can anyone guess what the graph above represents? A hint: it is currency related. While there will be no prizes awarded for correct answers, you will have the satisfaction of doing a job well-done.