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.