The Backwater's Backwater

For years, those of us that are fixed income professionals had to endure playing second banana (at best) to those in the equity market, no matter how more important or smarter we are (Ha!). We were always the backwater of the investment world. Within the backwater is its own backwater, commercial paper (many of you thought I was going to say retail). There is kind of a Revenge of the Nerds poetic justice in all of this turmoil. Imaging the mighty stock and bond markets being led around by the nose by the commercial paper market. Twenty years ago, this couldn't have happened. However, this isn't your father's CP market. Way back when, the CP market consisted of a bunch of A1/P1 rated companies like GE and GMAC (then part of a triple-A rated GM) issuing short-term IOU's primarily to manage cash flows. While that still accounts for the bulk of volume, there have been a slew of new types of instruments sold through CP market, many of them tied to assets that are illiquid and/or difficult to value. Theirin lies the problem. While it is relatively easy to determine what the chances are that GE is going to repay its CP in seven days, it gets much trickier when trying to value SIV #1 30-day CP when their assets consists of 100% I/O sub prime mortgages.

The market has to work out these valuation problems on its own. While the Fed can assist with extra liquidity to keep things moving, the chips have to fall where they may. Otherwise, this asset bubble doesn't deflate as the players have no fear of future losses. That lack of fear will occur in some other future asset bubble, probably in a market that hasn't been invented yet. Eventually, value will return to the short end and investors will tire of putting their money in 1mo. bills at three percent.

The Fed has a fine line to walk. Who knows what Bernanke says tomorrow? The Fed will probably ease next month, but they need to "ease" the public into the easing. They need to look as if they are active and not reactive to the current situation. Their face-saving out might be to say that as the economy is anticipated to slow down, future inflation will remain subdued, allowing for an ease. The Fed needs to show that it is in charge of monetary policy. The final point to remember is that the Fed has to be thinking whether a Fed Funds cut helps CP at all (which is why they cut the discount rate). If investors aren't going to buy asset backed CP at +250-350bp to bills, what's another 25-50-bps going to do? It will help the top quality financial institutions issue CP at lower rates, making money center banks more profitable, assuming they lend to anyone. Have a good weekend!

Cutting Through the Noise

http://www.cnbc.com/id/15840232?video=490824070

The link above is to an interview on CNBC this afternoon with John Bogle, founder of Vanguard Group. Listen/watch it! There are some classic tidbits in there, including references to Issac Newton and Shakespeare. Here is the bottom line: in his 55 years in the business, he has never seen volatility like this; he doesn't think it means much as turnover in the market has increased from 20% to 150% annually, meaning that this isn't a paradigm shift by real investors but rather speculators "trading pieces of paper; he hasn't made any changes in his portfolio in Six-and-a-Half Years! (60%bonds, 40% stocks...caveat, being John Bogle, all his money is in Vanguard funds, but most of it was in index funds); the Fed is doing the right thing. The concept to take away here is that INVESTORS need to filter out the garbage and focus on what is important. Sub-prime and related sectors are in trouble because credit standards were too easy and people took on more debt than they could handle. This occurred in other sectors as well. Credit risk, in general, abandoned with 'abandon'. Now fear has come back into the market,and, in the case of some players, fear has arrived for the first time. Like Bogle said in the interview, and I've said many times, the market needs to value and revalue all of these assets now that credit risk is back in play. Remember the pendulum; it has to swing from one side to the other before settling on a equilibrium point.

Bill Gross' bailout

I'm almost afraid to admit it, but I read in the New York Times (online) this morning the details of a story I heard about last week. Bill Gross, the world's designated bond guru, thinks that President Bush should design and implement a bailout for people who took out mortgages that they shouldn't have in the first place. Over the past two decades of hearing what Mr. Gross has to say and generally discounting it as being self-serving, it is important to say why this shouldn't happen at this point ( As an aside, his market position has afforded him a free pass to say whatever he wants. If he was an equity fund manager, long ago there would have been a Congressional investigation for market manipulation. But, since it is the bond market that most pundits don't understand or care about, Mr. Gross gets away with it. He is not an independent analyst and should not be treated that way). Mr. Gross cites the S & L bailout as precedent, calling them buccaneers. While that may be true, the reality is that the government had a legal obligation to bailout S & L's via the FDIC. He also cites LTCM. He should remember that it was the Fed that stepped in in 1998. They have done that here and probably will again. If the government comes in here now and re-structures these loans, then the appropriate advice going forward would be to wait a year for the market to forget, take out the largest mortgage you can get, and let the taxpayer take care of you if there is a problem. While it maybe painful in the short run, this period will help bring real estate values back to some semblence of reality.

summer bank holiday

The slowest of slow summer weeks kicks off with a made up UK holiday. Summer Bank Holiday, a Depression-era holdover, is a excuse to give jealous Brits their own three day weekend in front of the Labor Day holiday in the US. Consequently, very little happens this week. There isn't even much market data coming out, although existing home sales is released today and 2nd Qtr GDP is released Thursday, two backward-looking figures. With liquidity oozing back into the market, barring any external influences, markets should remain relatively placid. Not the equity rallies and wild swings in the front end that occurred last week, just calm. The only market-generated excitement this week may come from month end window dressing trades, particularly by the publicly traded firms whose quarters end on Friday. Next Tuesday is when the fun begins.

Accrued Interest: This is our most desperate hour...

Accrued Interest: This is our most desperate hour...

A good post on the Countrywide situation...

Countrywide=Household Finance Corp (HFC)

The situation with Countrywide reminded me of what happened to HFC five years ago. Back then, HFC, the consummate sub-prime lender, got into trouble and was eventually sold to HSBC. In late 2002, the US was coming out of recession and credit spreads were relatively wide. HFC tried to issue more debt to keep itself going, but investors finally balked. Unable to sell debt, including retail-target notes and preferreds, at any level, HFC rushed into the waiting arms of HSBC, which was just beginning a large US expansion. The end came very quickly.

Perhaps this is what Mr. Mozilo has on his mind when he sold $2 billion of convertible preferred stock to B of A. His desire to remain independent, and nominally in charge, must have influenced his decision to grant B of A such favorable terms. Or, maybe the company is in worse shape than is generally known. Either way, this ends up being a great deal for B of A.

For now, this effectively creates a floor on how low Countrywide's debt will go. It is not likely that B of A is going to let it deteriorate further. Unless there is a quick turnaround from the housing market "recession", it looks like B of A will absorb another bank, barring any regulatory hurdles

CDS

I promised to follow up on CDS a few weeks ago, but got sidetracked by the hoopla of the market recently. The point I wanted to make is as follows. The notional value (the amount outstanding) of CDS on an individual company (credit) usually far exceeds the amount of bonds that company has outstanding, certainly for credits that might require insurance. So when a default occurs, you, as the bond holder, would go to the credit default swap counterparty and say, "Here are $10mm face amount of bonds, give me my $10,000,000." The problem occurs when there aren't enough bonds to tender into the swaps, creating a short squeeze. Although unlikely, it is conceivable that the bonds could be worth more after a default than before, as market participants scramble to get their hands on bonds. Before the recent turmoil, hedge funds traded individual CDS to get exposure, long or short, to a credit because the CDS market was more liquid than the cash bonds, could be done with less capital (i.e. more leverage), and didn't require the fund to go out and borrow securities, in the case of a short position (there are a host of other reasons, not worth going into).

The problem is that is market is relatively new and hasn't been tested significantly in a stressed market. So far, no significant credit has defaulted. When (not if) that happens, it is only then we will see the true extent of the problems in the current market.

In the end, it is important to remember that not every investor or investing entity was engaged in risky, questionable, or highly leveraged strategies (that is just what you hear about). This isn't 1929, the markets will right themselves, the foolish will get punished (until the next hot idea) and we'll all be better for it in the end.

not over yet

The same talking heads that were screaming that the end of the financial world is nigh, are now (for the most part) calling for everything to be OK, meaning that markets will go back to they way they were. That isn't happening, nor should it. To parphrase Gordon Gekko, "Fear is good". Fear, meaning acknowledgement of the existance of credit risk, is going to be with us for some time, or at least until the quants out there create new products and strategies to allegedly eliminate it. Since the advent of the cheap computing age, the credit markets go through this five year boom/bust cycles, sometimes in concert with the equity markets. Look at 1987, 1994, 1998, 2002, and now 2007.

It is going to be tough going for the markets, probably for the rest of the year at least. Until liquidity reaches some equilibrium (what Sec. Paulson called yesterday "normal liquidity", not what has existed recently) there are going to be wild swings in many different market. However, it is these swings that create anomalies. Not every entity has been affected, and some who have, have the wherewithal to get by this easily and quickly. Financials have been beaten up, but there are companies that have a variety of businesses away from the market turmoil that will continue to do well. Not every firm is Bear Stearns or Countrywide. Pick and choose spots in out of favor markets. If income is important, take a look at preferreds. Perversely, since preferreds are generally listed on an exchange (not all) and are usually purchased by individual investors, the lack of institutional focus on that market creates pricing discrepancies. Sometimes these descrepencies exist within different issues of the same company. A good broker should be able to help you with this. If not, reply to this post .

It's the Treasury market, stupid

I don't want to contunally belabor this point, but since the mass media, print, TV and otherwise, keeps on it, it needs to be addressed. Over the past month (yes, it has been just a month), the investing world has reawakened to the concept of risk, especially credit risk. Judging by the reaction, it would be thought that many people had never heard of it before this period (perhaps that is true). The reaction is to this is to completely avoid credit risk, therefore US Treasuries and the sovereign debt of other developed countries are the flavor of the month, so to speak. Other high-quality assets, ones with a small amount of credit risk, have treaded water. Citi brought a 5yr bond yesterday, their 4th offering this month, at +122, an almost unheard of spread for a company of that quality. However, if the 70 to 80 basis point rally in the 5yr Treasury over the past month is taken into account and subtracted, the spread is more like 40 to 50 off. The point here is that coupon Treasuries and Treasury bills have rallied on the flight to quality. The high quality credit risks out there have remained stable, just their spread relationship to benchmarks (Treasuries) have blown out. Even items with considerable credit risk, such as Brazil 10yr debt, is only 12 basis points higher in yield now than 1 month ago. It is the bonds that are more difficult to value, sub prime, high yield,structured notes, anything that derives its value from something in an out of favor space, is being punished an rightfully so. Remember the pendulum analogy; markets, like a pendulum, overreact one way or another before coming back to a more normal level. This does create opportunities and anomalies. If you think that the Fed is bringing rates down, then this high quality corporate paper is a tremendous value as the market experienced the spread widening in a relatively short period. It probably won't tighten as fast, but if you are a long term investor, this is one of the better entry points we've seen in years, particularly in preferreds.

Bernanke's back

The media world and hedge fund/defenders should get off Ben Bernanke and the Fed's back in general. The action on Friday was the appropriate first response to a liquidity crisis in the front end of the curve. If you want to blame anyone at the Fed, go find Alan Greenspan for leaving rates too low for too long, creating the asset bubbles and credit risk ignorance that put the market in this situation.

The next two weeks are traditionally the slowest of the year, with Europe out for the entire month of August and the US wanting to get in the last two weeks of vacation before Labor Day. It remains to be seen how many people came back to the market. There has been strong volume in the equity markets. In the fixed income markets, volumes remain weak. Going forward, once the crisis/volatility settles down, expect market efficiency to return (it could be awhile). That means the bad will be punished and the good rewarded and all will be well, until the next bubble. Remember the musical chairs analogy; smart people recognize the bubbles coming and play it safe knowing the music stops. Arrogant people think they are smarter than everyone and the market in general and get overly burned during these corrective actions. I suppose as long as capitalism is with us, there will be these cycles.

4.25% Fed Funds?

On Larry Kudlow's show last evening, he had his cadre of ex-Fed guys all agreeing with him that because T-bills had dropped to 3.5%, that the real funds rate should be 4.25%. That misses the real point about why bills are at 3.5%. Investors are panicked, and in the past few weeks, it is more akin to game of musical chairs. Everyone not only wants a chair when the music stops, they want one made out of stone so that it doesn't collaspe when you sit on it. The problem is there aren't enough stone chairs to go around. For those of you that took and remember that microeconomics class, this is what those supply and demand graphs were referring to (Maybe the Treasury should take a page from the Bob Rubin school of government financing; stop issuing long bonds at historically low levels and push all the issuance into the front end). It has been said in this forum before, but this is part of the same liquidity problem. In this case, many investors want the same asset (bills) because they have no credit risk. Investors aren't going to start buying other money market instruments just because the funds rate is lower, at least in the near-term. The markets are finally getting around to working the excesses created by years of ignoring credit risk. A lower funds would help bail out (yes, bail out) the overlevered hedge fund and the guy in Podunk that took out mortgage he shouldn't have and couldn't afford.

The Fed should continue doing what is has been doing. It should wait and see the result of the discount rate cut, cut it again if necessary, and encourge borrowers to use this facility in this period of illiquidity. Once the supply/demand imbalance in the money markets has stablisized, then make a decision on funds. Barring some external event, it seems unlikely they would move more than 50bps.

One final note: A point that doesn't get much press is that is August and many of the risk takers and decision makers aren't in, especially in Europe. Even in the era on instant communication, it isn't the same as being at the desk.

the discount rate

The 50bp cut in the discount rate (strange it is still called that as it is set a premium to Fed Funds) is the right move to help calm the markets. The talking heads were saying why not 100 bp, but if they do that it would be tougher to come in again if necessary. Hopefully, this will free up the CP market, which is the real problem here.

kung fu grip trade

Today, in the stock market, you saw the kung fu grip trade. For those of you that remember the movie Trading Places, Eddie Murphy's character tells the Duke brothers that the pork belly market is tanking because in was Christmastime and everyone was selling so they would have enough money left to buy their kids the GI Joe with the kung fu grip. The market tanked, they got their 10% down move so they can call it an official correction, and then it went back up and ended unchanged. Tomorrow is option experation, which always generates some crazy moves so stay tuned. The real problem is in the front end of the credit market. No money funds want to buy anything other than t-bills. Now the moves there recently are crazy. It is a classic supply and demand problem. Everyone wants bills and nothing else (CP, CDs, BAs, etc.) The talking heads want the Fed to ease, lower discount rate, and have the Fed accept any old crap as collateral for repos. That might bail out their mortgage and hedge fund friends, but it will do little to restore the confidence the money markets. The people who could spell credit risk a few weeks ago are now hiding under a rock to escape it. Remember, the pendulum always swings one way or the other to the extreme, so there is more to come. But, the market will find its value level and go form there. With t-bills 300 bp through other short-term assets, it won't take long for investors to get back in.

One final note. With the volatility back in the market (look at the VIX index), options finally look attractive again. You don't have to put on some complex strategy, just some commonsense moves. The volatility just makes the pricing more attractive. On the other hand, your investment could become worthless (or worse) so be sure you understand this kind of investment first.

25 standard deviation move

In an FT article today, Goldman talked about their fund that lost 30% last week. They claim it was as a result of not one, but several 25 standard deviation events in the market. In more common terms, that is a 1-in-100,000 YEAR event, and they had many of them! That is ridiculous, of course (After statements like that, it is amazing that the market isn't even lower). All of this comes about because this type of trading is driven by complicated computer models that some PhD quant guys developed in some windowless room in the basement of every bank, brokerage firm and hedge fund. The problem is three-fold. First, many of the models account for variables in similar ways, resulting in a herd mentality with everyone trying to put the same trade on at the same time (and trying to get out at the same time, hence the problem). This is the same problem with technical analysis, but at least with technical analysis there are generally clear signals to buy and sell (of course, everyone knows them). The second is that the people developing models generally have little experience in the financial markets, coming from fields like mathematics and physics, where human nature is not a variable. However, the most important is the inability to predict liquidity levels. Liquidity, in this case, means the ability to buy and sell. Like anyone in the real world knows, something is only worth what someone else is willing to pay for it, whether it is a used car, a house, the price of IBM stock, a mezzanine tranche mortgage security, etc. The models have a difficult time valuing that risk component (I have read some serious studies on the topic; most of it is nonsense). Fear has bounded back into the market and it is a good thing. For the past few years, fears went away as investors became more confident that nothing bad could happen and, even if it did, it could be accounted for and reduced/eliminated. This move is what should happen, and the market will be better off in the long-term (until the next time).

The last time I addressed this topic it was right after 9/11. I was working for a very large brokerage firm and they asked me to write a series of pieces on risk (if you a client of this firm, Smith Barney, you may able to view them on their website). Back then, corporate bond spreads had widened dramatically and they wanted me to explain it away, which I did. The one piece that got the most attention from our clients was the one on liquidity risk. They felt that we were using this piece as a justification for capitalizing on a bad situation. The reality is that liquidity risk is the "riskiest" risk of all for traders as there is no adequate method to reduce it. Interest rate risk, credit risk, etc. all pale in comparison. The good news is that the world isn't coming to end, only that value and common sense are returning to the market.

cooler heads

Wilbur Ross was on CNBC this morning. Here's a guy who has been around for a long time and has been one of the most successful investors in this type of market. He isn't in the panic selling mode, nor has he been forced to do so (read Thornburg Mortgage). Step back, look for the actual vs. perceived value, and invest prudently. The market, but especially the riskiest parts of the credit markets (high yield, sub-prime, emerging markets) had moved away from any sense of value. That's over, cooler heads have prevailed and reality has set in. Remember Julien Robertson? He thought the equity markets had gotten out of control and unwound his hedge fund in Feb. 2000, one month before the peak. Listen to Wilbur. You can't get something for nothing.

cramer's rant

Don't get me wrong, I like Jim Cramer. He's been around a long time. seen a lot of markets and knows many players. But, to make a comparison to 1929 is over the top. For years, pushed by a over-accommodative Fed, Cramer's friends and others plowed billions in to markets and strategies without very little concern for risk. Now, the chickens are coming home to roost and Cramer expects the Fed to ease to bail these people and companies out under the guise of helping out the overburdened homeowner (some were duped, most just overextended themselves). This is healthy repricing. This is capitalism. There is risk. You can lose money. For now, the days of easy money are over. The quants and hedge fund crowd will have to work for a living. It's good for them and good for the economy.

By the way, the Fed's add was a technical one. With funds at 6% and the target at 5.25%, the Fed had no other choice. To paraphrase Kevin Bacon's character from Animal House, "Don't panic, remain calm, all will be well".

credit default swaps-the unspoken danger

As alluded to in the previous post, credit default swaps (CDS) are being held up as the great insurance policy against loss in the credit markets. CDS liquidity and standardization have made them the trading vehicle of choice for hedge funds wanting to increase or decrease their exposure to the credit market, a particular segment of that market or to an individual company. Basically, CDS allows the investor to insure against default of a company's bonds (or loans, but that is another market) or a group of companies' bonds for a particular period of time (usually in increments of $10 million for periods of one to ten years). Think of it like term insurance. Like insurance, the ability to collect on a claim is only as good as the insurance company's ability to pay. CDS markets are so intertwined that, in a period of stress, the idea is that the market is akin to a chain-link fence; if a few links break, the whole system won't collapse. The problem is that the system hasn't been under stress yet as it is relatively young. Securities firms and banks are regulated by various agencies. Their financial status is generally ascertainable. Many of the counterparties in CDS are unregulated hedge funds, whose financial status and ability to pay can't always be determined and may fluctuate radically, giver their use of leverage. As we push through the third quarter and into the fourth (rarely does anything good happen in October) keep your ears open to the happenings in CDS.

Next post: Why a CDS default could spark a bond rally.

current market turmoil

All of the talking heads are up in arms over the selloff in the markets over the past few weeks. The current scapegoat is subprime lending, but what has really happened is that the investing community, including many who consider themselves professionals, have awakened to the realization the market has risk. Like a pendulum, markets tend to overreact one way or the other (add in a slower summer market which exaggerates moves) before settling. For years now, investors, fuelled by an overly accomodative Fed, acted as if risk, particularly credit risk, didn't exist or could be insured away (the subject of another post). Hedge funds and dealer prop desks, using generous amounts of leverage, hired quants to develop complicated models that increase the speed and efficiency of executing a specific sttrategy. The problem is the models generally don't work when markets become nervous and people don't want to bid on securities (I would refer you to 1998 and Long-Term Capital for a more in-depth discussion). It is very difficult to value liquidity risk (the ability to transact and at what level) but, in times of turmoil, it is the most important component of risk. The bottom line is that the excesses are being wrung out of the market, as they should be. Maybe the free ride is over and investment professionals will have to go back to plain old hard work to make a living. At some point in every market (that point has been reached in some), attractive relative valuations will return. But, remember the pendulum.