Goodbye, So Long, Farewell...

After over a year, I'm bringing this blog to a close. I hope you have enjoyed reading it as much I have loved writing it. I have also enjoyed the comments and feedback I have received. However, it's time to get back to the real world now.

I've decided focus my efforts on financial planning and investment advisory. I believe that people's long-term financial health in integral to their well-being. I specialize in intelligent wealth management, partnering with clients to develop a comprehensive financial plan, implementing the customized proposal and engage in continual monitoring and review to ensure our strategy remains on track.

The reason for this is that during my career, I witnessed too many investors being taken advantage of by salespeople whose interests were not aligned with their client. Many times it was adversarial. That model is dying, and should have died a long tine ago.

If anyone wants to find out more (or wants to give me a referral!), please feel free to drop me an email at bondguy1824@gmail.com.

Thank you very much.

PS: If you are looking for some tremendous insight to the markets, please click on this link. http://mksense.blogspot.com

the right thing

Now that the government has stepped in and backstopped all markets, it is time for Congress to pass regulations that will allow the markets to function on a more normal basis. In April 1998, when Travelers and Citicorp merged, dooming Glass-Steagal regulations, they replaced it with basically nothing. We need regulations that are flexible, helpful, and provide adequate protections. Let's hope that the momentum we have now isn't forgotten after election day.

Lost in the Shuffle

I've watched and listened to a lot of the financial media this week (too much, probably). Here's a few observations about things that have gotten lost in the shuffle. On the media itself, I have to give CNBC credit for breaking much of the big financial news of the week. As a trader, I should be glued to that channel. As an investor, if all I watched was CNBC, I'd be jumping out the window. That is why I am keeping an eye and ear on Bloomberg and Fox Business. Fox is talking about the the real economy (doing OK as a reality check) and Bloomberg has an international focus (doing worse than here).

That brings me to my next point. Lost in the shuffle is that international markets, especially emerging markets, are getting killed. Russia has shut down their stock markets. Closed, not operating. Russia made it worse with all of this Georgia nonsense. Pundits should not be surprised in light of this move and the situation in other markets that the price of gold is up $100 in the last two days. In the vast majority of the world, gold and other hard assets are the only option for those involved in the financial markets.

Lost in shuffle of all of the action by the Fed and Treasury is the culpability of Congress. I think it was summed up by Harry Reid yesterday when he said, "I don't know what to do". It was probably the most accurate statement he ever made. Instead of trying to legislate a solution, Congress is going on a break for the election. Hopefully what won't get lost in the shuffle is the cheap political trick that the Congressional leadership is engaged in. They need to act now to stem systemic financial risk by giving the government the tools to help fix the problem.

There is more, but I will end it here

Reality Sets In

Not much to say about today. Many of the pundits said that the last hour in the equities market was the capitulation trade that everyone is waiting for in this market. Even a broken clock is right twice a day. The Fed meets tomorrow amidst the hue and cry for rate cuts. If they are going to do it, it better be big, meaning in excess of 50bps. Otherwise, we are back to watching the Fed ,meeting after meeting, trying to devine what they will do next. Not that I thing it will do very much. Rates have come down 325bps in the past year and even accounting for the lag time, rates that matter to people and companies, mortgages and borrowing costs haven't done very much. Banks don't have any capital to lend, and even if they did, the only ones that want to borrow are doing so out of desperation.

I went back and checked this blog, reviewing the numerous entries screaming for transparency in the credit markets. Here we are a year+ later and the books are still as opaque as ever. This is the real problem. Things will not get better until all involved come clean about where they have their crap marked. When I couldn't find a price for something and didn't have a reasonable (not a black box model) basis for where I had something marked, I marked it at ZERO. Of course, I wasn't levered 40 to 1.

The good news is that we are finally seeing the beginnings of the resolution. While I was genuinely sorry to see Lehman go (they were my first employer, starting in 1981 right on through to 1994), they had the chance to do the right thing. I learned my lesson; I have some of their wallpaper stock now. The faster the rest of them go, the better in the long run. We may need a RTC-like vehicle to unwind all of this. Congress should start on this now. The longer it goes, the worse it gets.

A "Gross" Miscarriage of Justice

Enough is enough! How many more decades is Bill Gross going to get a free pass to go on national television and talk up his book? Is it because the media is so afraid that he won't dispense his wisdom to them anymore? Is it that the media doesn't really understand the bond market? Is it both? (probably). The bottom line here is that if Bill Gross was an equity fund manager, he would be in jail right now. Stop treating him like the altruistic oracle soothsaying from his fixed income Delphi.

A Few Quick Musings...

Merrill effort to "lance the boil" shouldn't be surprising. If they survive, and they will, the question is in what form, this will be seen as the bottom for Merrill re: this crisis. As any good trader does when a position is foisted upon him/her, the position is evaluated and quickly as possible, dumped. Perhaps if Mr. Thain inherited the CDO position at 22, he might have been more inclined to keep it. Perhaps not. As the new guy in town, Mr. Thain has had a free shot to do whatever he wants, but that window only stays open for so long. Merrill isn't Goldman Sachs and if he didn't know it before, he knows it now. They shouldn't try to be, either. Fortunately for Merrill and Thain, the company has a lot of assets it has accumulated over the years that it can offload to others. Even at depressed prices, these assets are at much higher levels than what Merrill paid for them; look at its stake in Bloomberg for example. When the CDO position increases in value over time, and it will because Lone Star isn't paying $6.7 billion looking for a tax writeoff, Thain can either say: 1) Oops, I made a mistake. Here is my resignation.; 2) We are taking Merrill in a new direction and CDOs are no longer part of our core business. It was necessary to get them off the books so that we can focus on returning to our roots. I think choice 2 is more likely, of course, as it is what Merrill does best.

Next up is the Treasury weighing in on speculation in the commodity markets. Their verdict, along with a raft of other so-called experts, is that speculation is non-factor in the run up in commodity prices. It is hard to believe, to say the least. The value of every commodity, save potatoes and wine (good news for me on both counts) has shot skyward. This, according to the aforementioned raft, is solely due to supply and demand factors. Now I sat through all the microeconomics courses and understand that the cost at the margin determines the price at the physical commodity (otherwise, oil would be $10/barrel as it costs the Saudis $2 to pump it out of the ground), but there is more going on here than the physical commodity market. I agree completely that it is supply and demand driving prices, but it is the supply of futures contracts, not commodities, that is the problem.

The pundit world says that the futures market in its present form is necessary for hedging , price discovery, speculation, etc. Up to a point that is true. However, when the futures market usurps the cash market as the primary driver of value, then it has gone too far and changes need to be made (The same could be said about the fixed income market, where derivatives have dwarfed the cash market, exacerbating the problem there). Not to sound paranoid, but it is in the best interests of the participants to perpetuate this fantasy regarding prices. The reason is that everybody wins and losers are the non-professionals and commodity consumers (most people in the world). The thought is that there is an open ended supply of futures, so prices will be constrained by the physical commodity level. The problem occurs when a bunch of new participants get involved, funds, hedge funds, ETFs, etc., that have no stake in the physical commodity price. Right now, money has been pouring into this space at a torrid pace, causing a one-way movement. Couple that with easing of market entry and low margin requirements and you are left with situation that currently exists in that market. Changes, especially in relation to margin requirements, need to be made.

It's Too Late To Privatize...

To change things up a bit, I'll start with the conclusion. Fannie Mae and Freddie Mac should have went the way of Sallie Mae years ago. Alas, it is too late to do that now. First and foremost, let's forget about what might have been. That's in the past and shouldn't be dwelt upon. That leaves two other options. The first is to leave them as a they are now, some kind of public-private hybrid. However, that model is what created the problem. This isn't the UK or a Commonwealth country. We don't have Crown Corporations. If it wasn't for the Treasury and Fed, FNM and FRE common equity would be worthless. They should be worthless. If the common equity went to zero, there would be very little hue or cry about stockholder bailouts or moral hazard. The government would just take over the debts and wind down the two organizations to the size they should be. Note to common stockholders: this is what is going to happen so you might as well bail out of FNM and FRE now.



It didn't have to be that way. Fannie and later Freddie were set up to make sure that there was enough liquidity in the mortgage market so that it would function smoothly. Somewhere along the way, they became more like the investment banks that were profiting so handsomely off Fannie and Freddie securities. They even became publicly traded corporations to make them look like investment banks. Congress, with one notable exception, went along with this charade, fuelled by the political contributions that these two entities pumped into the legislators. This is not to say that the functioning of Fannie and Freddie were not without critics. The commercial banks complained vehemently to anyone that would listen that Fannie and Freddie were engaged in unfair competition given their, implied or otherwise, government backing. The Wall Street Journal has written a steady stream of editorials questioning their practices and their raison d'etre.

As a bond trader for the past 20+ years, we always listened to the party line about implied government obligation, the Treasury credit line, etc. of the agencies. But, it was always assumed that when push came to shove, the government would step with explicit backing. That push came Monday. The government should just take the next step , at this point, and take Fannie and Freddie completely.

What gets lost in the hype of this situation is that, in all likelihood, the government will come out ahead on this whole deal, it probably won't cost anything, and have the ancillary benefit of stabilizing the market. The only problem is the matter of the stockholders. Get over it. Take your lump and move on.

The final point is that, no matter what happens, Fannie and Freddie can't go back to what they were doing. They need to return to their roots, become more Ginnie Mae-like (granted, Ginnie Mae's mandate is much more restrictive, but you haven't heard of any significant problems surrounding them).

An Independence Day Wish

In my last post, the final point was to state that Fed needs to move higher, and quickly. Today, as the ECB has pushed up rates 25bps and the US economy lost another 60,000+ jobs, it is even move imperative. While this seems counterintuitive (certainly to the Fed it is), a further at the reasons for slower economic growth make higher rates necessary. A wise corporate bond trader told me many times over that it is all about perception, and perception becomes the reality eventually. That is where we are now. Fuelled by an overactive media (A note to the media: When you start interviewing each other, meaning "reporters" interviewing other "reporters", and passing them off as experts, the line has been crossed. CNBC/NBC are notorious for this practice, but they are all starting to do it.) individual and market psychology has changed to the point where doom and gloom have become a self-fulfilling prophecy.

The most fundamental reason for lowering interest rates is to create conditions that will stimulate economic growth. If it wasn't apparent last year that economic growth didn't need to be stimulated in any meaningful way, it should be now. This blog argued vehemently that interest rates should not have been lowered last year. The problems last year were a response to excesses in various markets (housing, credit, etc.), all interrelated to some degree. In the credit markets, the appropriate response would have been to put in place measures to increase liquidity. In fairness, that did happen, along with the sledgehammer of a lower Fed Funds rate. Housing was even easier. It was and is one of the few markets with too much supply. Prices and supply needed to come down. The market is in the process of doing that. Yes, it is painful, but it is the best way to bring the situation back to equilibrium. It can be argued, and is here, that if the Fed Funds rate hadn't been lowered, banks and other players funded by banks would have more incentive to restructure loans as they would not have had the Fed prop of paying out virtually zero on deposits.

Which brings me back to why rates need to be higher. All of those deposits earning nothing, in a normal stimulative phase, would start to be plowed into other markets in search of higher returns. That isn't happening because the negative psychologies of fear and loss have taken hold. The only funds flow that is occurring is out of losing markets into ones that are overheated, commodities for example. (For the last time, probably not though, the rules on commodity futures trading need to be brought in line with that of equities. I realize this isn't the Fed's bailiwick, but you would think that Ben Bernanke, student of economic history that he is, doesn't talk about the parallels between the Crash of '29, helped by overly liberal margin use in equities, and the current situation in commodities.) Despite rising inflation, investors are willing to accept zero return in exchange for safety. The cycle won't change until the inflationary bias is removed from the equation.

That brings me to my Independence Day wish. This problem can solved in reasonably short order if this country would put aside its differences, look at solutions objectively, be willing to work together and, most importantly, realize that there will have to be some sacrifice to get there. First and second, raise rates and change futures margin requirements. This will ease the pressure in the commodity and currency markets. Third, develop a comprehensive energy policy, one that increases near-term supplies AND focuses on long-term sustainable alternatives. (yes, this can be done) If there needs to be some kind of sliding scale carbon tax to encourage and foster this, then so be it. Fourth, provide certainty to the tax situation in this country. Perhaps if they would stop calling them the Bush tax cuts, Congress might be more inclined to make them permanent. Why this is still being debated is unbelievable!

The last fifteen years has been marked by a Congress doing whatever it can to bide time until a change in the Presidency. We can no longer afford that type of obstructionism/inaction. Whomever gets elected needs our support to do the right thing for the USA. That person also needs to put the needs of this country first.

Just Some Random Thoughts...

Sorry for the long break, but I've been busy trying to put a few things together. Reading the paper this morning, I have come up with some random thoughts, which I would like to put forth at this time. Very little is directly fixed income related, but, as I engage in new endeavors, I am seeking to broaden my horizons.

First, I don't think I need to go into the details of the extreme level of irony that is conjured up by the raft of Missouri politicians clamoring for anti-trust protection for Anheuser-Busch, a company that holds roughly 50% of the domestic beer market. As much as I'd rather not see A-B sold off to the Brazilians (it is also ironic that the popular press, not the financial press, keep referring to InBev, as a Belgian company even though senior management all came from AmBev and are Brazilians), anti-trust isn't the way to go. Here's a thought: How about coming up with a plan where A-B would be better off on its own and convincing the stockholders that they should side with current management. It maybe too late for that, but that would be the free market way to handle it. Hiding behind anti-trust means they can't compete effectively. That speaks volumes with regard to A-B as a company.

Next we have Barack Obama criticizing John McCain on changing his mind on offshore drilling. The reason Sen. Obama given is weak, but at least it was different from the tried and true objection of the potential environmental disaster potential of offshore drilling. I think that no one would want to see an environmental problem, but some comfort should be taken in the fact that during Hurricane Katrina, certainly a significant event, no real environmental damage occurred. Sen. Obama stated that offshore drilling won't help lower prices for five years, so it should be allowed. For a guy that is holding himself out as an agent for change in America, that is an odd stance. At $10/barrel, it was easy to say don't drill offshore (or in ANWR, or in the Rocky Mountains, where the largest reserves of oil in the world is trapped in shale) because it didn't make economic sense. The Cubans have already sold drilling rights to the Chinese 60 miles off Key West. The technology is much better than it was almost 30 years ago when most drilling on the Continental Shelf was banned. Just announcing the opening of the shelf to drilling will take some of the speculative bid out of the oil market, the real cause of the spike in oil prices. However, the decision to drill shouldn't be made in a vacuum (which it will, for now). It needs to be part of a comprehensive national energy policy, one that focuses the nation on a day when we are not utterly dependent on foreign oil. If that means a sliding-scale carbon tax, then so be it.

Finally, the Fed needs to raise rates now. For those of you that are regular readers of this blog, you would recall that I was opposed to the easing in the first place. The tangible benefits, of which there really haven't been any, have been far outweighed by the detriments, most notably being a significant contributor to global inflation. Rates at which money is lent hasn't changed in any meaningful way. Even the banks haven't benefited, although maybe their results would be worse if they weren't able to pay virtually zero percent on deposits. Take the cuts back, and use other means to help out the financial system.

Recap

I apologize for the hiatus. I took some time to explore the natural beauty of the United States. In the meantime, judging by the level of the stock market, everything seems to be OK in the financial world. Corporate bonds are tighter as are MBS, although both are still ridiculously cheap on purely a historical basis. Munis look better, although, here again, still look like a good value. Treasuries have backed off their "Get me in at any price!" levels, but there is still room to move there. Even Bill Gross went on CNBC on Wednesday exhorting individual investors to call their broker and buy preferreds (of course, that means he is looking to develop a bid for the securities he bought when the market was 10-15% lower). All in all, to steal a non-word from President Harding, the markets are returning to normalcy.

Months ago, I made the case the case that the Fed should have left rates alone. I would still make that case. The lowering of Fed Funds hasn't really helped. Real rates where actual borrowing occurs hasn't dropped that much. HELOCs are lower, but the people that would access that type of facility have little or negative equity in their homes. Lower rates should have helped banks make money, but I don't think observed experience bears that out. Banks have been helped much more by the other Fed actions than a lower Funds rate. Lower Fed Funds should have drawn more money out of money funds, but with the uncertainty around markets and the continual economy bashing going on in the media investors have been reluctant to do so. Maybe with more certainty which leads to greater confidence that will happen, as is normal in a rate cutting cycle. What lower rates have caused is less interest income to people that could use it, less incentive to invest, especially in housing as buyers wait for lower rates and price bottoming, and the acceleration of a trend out of dollar assets and into foreign currencies and commodities. Now that the Fed is done (hopefully), the rate cuts can have the stimulative effect.

The commodity price inflation was helped along by Fed actions, but they weren't the cause. Just because demand somewhere or in aggregate is 10% higher does not justify 100-400% increases in raw commodities. Supply at the margins isn't that bad regardless of how many experts are paraded on TV saying that this is the cause for high prices. These are the same that benefit from the increases: commodity traders; commodity investors and commodity producers. It is really a masterful propaganda job; Goebbels would be proud. Speculation is the cause of high prices, pure and simple. Take the speculative bid out of the market, and prices mover back to real levels. Everyone was up in arms when it was disclosed the Bear Stearns was levered 30 to 1. Commodity speculation is even move highly levered and quite easy to do. The more people investing allows the relative small futures market to be easily propped up. Hedgers are the major players anymore., it's hedge funds. Changes need to be made as how this market operates. I would suggest having the same margin requirements as they do in the equity market. This alone would bring prices back to reasonable levels.

This sounds like some kind of left wing drivel along the lines of "Workers of the world, unite!". It isn't. Rules are necessary to maintain some kind of order in markets. When market problems spill over into the real world, that is when disaster strikes. The Crash of '29 and subsequent Depression were started by an overlevered equity market that fell apart (leading to margin rules against it) and bad decision making later on that helped it along. The commodity price spiral could push the world into the same type of bad decision making that would be ugly. Better to do the right thing now than to forced into action later.

The Rational Market

It is probably a good thing that the masses don't follow/care/understand the fixed income market in any great numbers. If they did, perhaps it to would be infected by manic depressive response that is pervasive in other markets. Not to say the bond markets haven't been volatile, but after the initial illiquidity-driven shockwave, that markets' actions have followed a pattern that is rational. The variables in the fixed income markets have all been reassigned different weightings in the value calculation mix, but, in general, it is the response expected given what has happened. Credit risk, fear of loss, the value of liquidity have all pushed their way to the front of the line after a long hiatus (Some have said that since this author has removed himself from active participation in fixed income, the market collapsed. I would say that is just speculation and coincidence, albeit uncanny.). The same cannot be said about other markets.



I can hear it already, what about the auction rate market, what about the muni market. Here is the response. The auction rate market isn't a true bond market. It is a bond market disguised as a money market. Money markets have had their own problems, particularly with how to value credit risk. While they are comings to grips with it, money markets may never return to the manner in which they had previously operated. The muni market is, and has always been, a completely different ball of wax than the rest of fixed income. Buyers are motivated by how much they can avoid paying to governments rather than sound financial judgement. The market even made it easier for investors by trying to stamp a AAA imprimatur on every security, reducing the investment decision to one based on tax rates. When the credit risk leg was kicked out from under the muni chair, the market searched frantically for a floor. Given the wide variety of muni issues and issuers, widespread mispricings overcame the market. When absolute (non-tax adjusted) yields reached rational levels as compared to other fixed income investments, buyers emerged providing that floor. In munis, the game has changed for the better, in the long run, as the market and its investors will need to value securities on the same basis as other fixed income investments. No longer will an outside guarantee, regardless of who is providing it, be looked at in the same way as before. Better credits will come out ahead, as the market will reward them for fiscal discipline and sound management. The rest will need to adjust their priorities to reflect the new market reality. From my standpoint, the credit crisis of the past year will end up being positive for the muni market. The old way of doing business there will end. Entrenched constituencies won't like it, but that has been the case in every market change to date.

I have spent many postings addressing the commodities and futures markets. They are both far from rational these days. They can be likened to rush hour at Penn Station. As soon as the track for a train is posted, everyone rushes to the stairs, trying to squeeze through the doorway. Getting through the door early means getting a seat, a valuable commodity for those facing an hour train ride standing at the end of a long day. The futures market is like that doorway; everyone that passes through pushes up the value on the remaining train seats for those still waiting in the station. What the gate rushers seem to forget is that there are usually more seats than riders, some are only going a short distance and will get off, and there is another train leaving in a few minutes. Still, the rush is on. What the riders seem to forget is that sometimes the train breaks down, or is taken out of service, then the rush is to get off the train. What's worse then is that there will be two train loads on people trying to fit on one train. When the speculative bid is removed from the market, and that will happen, it will be like the people leaving that train, scrambling for any way home. Some will get on the next train, some will take a car, and some will go to the bar and wait for a later train. Either way, it will cost the riders/investors something. Nine years ago, oil was at $10/barrel. When the pundits say it can't go down, watch and see the rationality flow back to that market.

Finally, the equity market has been on a roller coaster ride during all this. What is strange to me, but not surprising, is that all of the experts that have been going out of their way to say the US is in a recession are dumbfounded when corporate earnings come in weaker than expected or negative. Why? Of course they are weaker. By their estimation, there is less economic activity so they should be weaker. The problem here is that the people making the estimates are the same ones that are surprised when the estimates are inaccurate. In this market, you have to be a long-term investor or a short-term trader (you can be both, if you can mentally and physically separate the two). The long-term investor doesn't care week-to-week or month-to-month action. The short-term trader is usually a technician, in and out at predetermined level over a very short period. The equity market, however, has been dominated, publicly at least, by the analysts, making a living forecasting quarter-to-quarter earnings. With the uncertainty around credit markets and economic activity, the old rules are less applicable. In the Sarbanes-Oxley world, no company wants to overstate anything. In a perverse twist, the quality of corporate earnings have declined as a result of that legislation. When I first started trading European corporate bonds, it was difficult to get a handle on a company's earnings as they were able to hold earnings in reserve against nothing specific, which they would then reverse during a bad reporting period. This is no different really. There is enough uncertainty surrounding valuations to get away with it. Given that expectations are so low anyway, does it really matter that earning come in a little lower? I guess you can't blame equity analysts too much; it is just garbage in, garbage out. However, the market's rationality and the analyst's raison d'etre will remain in question for some time to come.

Get Real

The "I told you so" crowd is out in force, decrying right and left everything about the United States: its government; its economic system; its regulatory bodies; on and on et.al. I'm not looking for a backlash so I will refrain from naming names, but it is the usual US bashing cadre; you know who they are. Fortunately, the pilers on, the stock jockeys that were all over the Fed for not cutting rates to zero back in August, have stayed on the sidelines (In fact, those people are now engaged in a love affair with the Fed). This time it is inflation that is the bee in the bonnet.

Inflation is a problem. Certainly, it is much higher than the official statistics being reported. However, the United States and its economy are flexible and resilient. Competition, the availability of substitute goods, etc. all help out. Clearly, not everything is substitutable, but the US will manage. Other countries have fewer options, particularly poorer ones. At the margins, faced with the choice of filling your car with gas or eating, guess what wins out. Serious unrest is certain to occur, and then no one wins. The standard mantra coming out of "the crowd" that emerging market growth is driving prices higher is almost completely nonsense. There is no reasonable justification for the meteoric rise in the price of commodities. It is time for this inflationary burst to be exposed for what it is, a plain old bubble.

Commodity futures were initially established to allow cash market participants the ability to hedge themselves against adverse market moves. Later on, a price discovery function developed, again with the idea of supporting the cash market. In recent times, as futures markets participation became easier, more and more investors jumped in, considering the small investment (relative to the cash market, the investment is negligible) required. Derivative and related securities became available, increasing the number of players. Meanwhile, the markets size and liquidity hasn't to the same degree as the level of participation. Given the pain that commodity price moves have caused and will cause, why hasn't there been the hue and cry from the usual sources as to the root cause of the problem? The reason is that all the players involved in the market are benefiting, a classic bubble scenario.

First, "the crowd" keeps telling everyone these moves are demand driven. Either they are quite naive, or they are trying to manipulate the market. Given that "the crowd" are the largest speculative element out there, I would choose the latter. Second, demand in the largest market, the US, is declining. Some of the declines are greater than reported. For example, the oil component of gasoline is down more than the absolute numbers gasoline usage. Why? The use of ethanol in gasoline is steadily increasing. Ethanol is significantly cheaper than gasoline. This is why refiners keep producing gasoline, even though the widely reported "crack" spread is hovering around zero to negative (if it was negative, there would be little incentive to produce gasoline). Fewer houses being built means far fewer of the commodities used in their production are being consumed. I won't even go into agricultural commodities, where price rises have been dizzying. There isn't that much ethanol being produced to justify a quadruple increase in the price of wheat. Third, and most important, is that everyone in the market is making money. As a trader, it is not hard for me (or anyone) to make money in a one way market. Producers simply lift their hedges or don't put them on in the first place. Consumers go long the contracts, benefiting from the price rise. As supply of contracts from fewer actual hedgers goes down while demand for contracts are increasing, guess what to the contract price? Big speculators go along for the ride, pushing contracts even higher, and then go out to the real world and sell the worldwide demand idea. This is a trader's paradise: put forth little effort and capital, and ride a one way market.

It is time to get real. For example, if the real price of oil should be $110, then the US would be self-sufficient in oil, tapping all of the shale reserves out West at $75-$80/barrel. The government is stepping in everywhere else these days. It needs to expose what is going on publicly,and take the speculative bid out of commodities (significantly raise the margin requirements for not cash market participants). Otherwise, there will be a massive inflationary spiral, which hurt all or a bubble bursting deflationary scenario that, while wouldn't be such a bad thing for the US, would be disastrous for the rest of the world.

Musical Chairs

A former colleague of mine from Lehman wrote on his website yesterday "The value of liquidity is still underappreciated." Those of you that are regular readers here know that this is a central theme of this blog. As the fixed income markets slog through the "great unwind", liquidity will remain at a premium for years (probably) to come. Fixed income traders know this, if they know what they are doing. The problem has been that many people have jumped or been allowed into this marketplace, backed by vast pools of highly levered capital, that really didn't know what they were doing. It isn't hard to make money in a one way market (ask anyone involved in NASDAQ in 1999). The liquidity issue still isn't focused on in the popular press primarily, I believe, because they don't understand it. Most of the media that claims to have some sort of financial background had exposure to the equity market. On the liquidity front, that market is a completely different ball of wax from the fixed income game. The easiest way to explain it to people is to liken the situation to a game of musical chairs.

This game of musical chairs, up until last summer, was one where there were 20 players and 50 chairs. The music never stopped and the only time you sat down was because you were tired. Sitting was never a problem, however, because there were many more chairs than players. Finally, someone read the rules and realized that the music was supposed to stop and chairs were to be removed. So, the market removed 40 of the chairs and stopped the music. Twenty people tried to sit down, and some not knowing any better, fell on the ground. Those who got chairs found out that some of them only had three legs. The music was turned back on but the people in the chairs were tired from all the walking, were afraid of losing their chair, and didn't get up. The music kept playing but still no one got up. The party organizer (aka the Fed) then stepped in and tried to get the players up and moving again by offering treats (lower rates). Some though about getting up, but quickly sat down again. Then, the organizer tried adding a few chairs back to the game, and that seemed to make the players feel better and start to want to play again.

In this game of musical chairs, the players are the investment/commercial banks, you know who the Fed is, the chairs are liquidity and the music represents transactions. However, the goal of this game isn't to have one player left at the end, but rather to keep the game going as long as possible. The music stops once in a while, and someone find themselves odd man out. That's OK, this is a normal function of the checks and balances of the system. On the flip side, there are new market entrants, in which case chairs are added to the game. The organizer watches over the game, sometimes controlling the music and sometimes not, making sure there are the appropriate balance of players and chairs so that the game functions normally.

That balance got out of whack in the past few years. Unfortunately, to bring it back to a harmonious state will cause some of the players to cry and throw tantrums. That is too bad, but perhaps they shouldn't have been playing in the first place.

And The Winner Is...The Bond Market!

If only one thing comes out of all of this market turmoil, it should be the universal acceptance that the bond market is the primary financial market in the world. Stocks go up and down, commodities sometimes have their day, but when the bond market doesn't function properly, the whole world is affected. This isn't surprising to those of us that have toiled away in relative obscurity for years, but now everyone is forced to take notice. This should be of special importance to those that try to impose equity market-like solutions on to a vastly different bond market. That's it, nothing profound, nothing earthshattering in today's post as it is March 31st, always a strange day in the markets as it is quarter end and Japanese financial year end.

PS: To all of you working on the Presidential campaigns that have been reading this blog and incorporating some of its musings into candidate's speeches, I'd like to say that I am available for the Treasury Secretary's position regardless of who wins.

The Value of Information and Advice

It is always quite amazing that every time the markets go through one of these periods of upheavals, investors learn little from them. People seem very content to go ratcheting from bubble to bubble, blithely unaware of the consequences. As information becomes more accessible, transaction costs decline, and an investor's ability execute trades becomes easier, this problem has become worse.





What prompted me to blog about this today was an article in the Personal Journal section of the WSJ. It referred to a product being referred to a reverse convertibles. As with most items in the investment world, I've seen the term reverse convertibles applied to other, not so similar, products. In this instance, they are referring to a bond sold primarily to individual investors that provides an above market coupon payment. The issuer is usually a bank, investment bank, or a special purpose vehicle (not like the ones that have gotten banks and others into trouble), the maturity is generally, but not always, a year or less, and the bond's return is tied to the performance of a single stock. Basically, if the stock stays above a "barrier" level set at the time of the pricing of the reverse convertible (usually some percentage, say 20%, below the current stock price), you receive the coupon promised plus the initial investment at maturity. If the stock breaks the barrier price, then you would receive the coupon promised and the number of shares in the stock that the initial investment represented (hence the term convertible), regardless of where the stock is priced at the time of maturity of the bond. I have attached the table (above) from the WSJ for more clarity.



The point is not to denigrate reverse convertibles but to make a point about investment information and advice. This product can be appropriate for some and not others. Labeling it as a "CD alternative", as one firm in the article did on the basis of both of them being an interest bearing instrument, is disingenuous at best, but it highlights the kind of advice unsuspecting investors may receive. A simple rule of thumb is that if the person trying to get you to invest in something can't explain it to your satisfaction, like Nancy Reagan, just say no. It still may be an appropriate investment, but find someone who knows your circumstances, your goals, your risk tolerance AND can explain it. Ultimately, you are in charge of your own finances. Even if you turn control over to someone else and they don't serve your best interests, the buck stops with you.

However, what if the information, explanations, and advise sound plausible? Don't be afraid to get a second opinion on your investments and investment strategy. I don't mean just searching the Internet for validation or further description. As mentioned in the first paragraph, technology and the Internet have opened up a vast array of options to the investor, but just having information doesn't mean it is understood or should be acted upon. I'm sure I could find information online how to perform bypass surgery, but it doesn't mean I should do it or could it myself. This, of course, is an extreme example, but history is littered with the stories of people that turned over tremendous sums of money to people the barely know to invest in things they don't understand. If you were going to have surgery, unless it is an emergency, you would most likely get a second opinion. Feel free to to that with your money. This will most likely cost something, even if it is just you time, but it is well worth it.

PS: I know the old adage, "You get what you pay for." On that basis, coupled with what I wrote above, why should anyone listen to me? I'm not charging for this information, so how good is it? Here is my response: I'm not providing specific information (buy x, sell y), I'm not selling a service (yet), and I'm not even making any ad revenue (my astute readers don't click on the ads). The point of this is to shed light on an opaque area of the investment world to most people, the fixed income market. In 20+ years of being involved, I saw many people placed in investments that probably weren't appropriate, given the circumstances of the individual. Wall Street generally ignores the individual fixed income investor. With all of the turmoil surrounding fixed income markets today and all of the bad/mis-/inappropriate information out there, especially on TV, I try to explain market happenings and put them in perspective for readers. However, like any advice, you can do what you want with it.

Forward

The markets, with a lot of help from an under appreciated and imaginative Fed, are finally starting to plow through the serious issues that have faced it over the past almost one year now. This can be seen tangibly in narrower spreads, greater clarity over sticking points out there, and earnings that are starting to trickle in. With respect to earnings, of course they are lower. However, it isn't all dire. The traditional profit makers over the past few years are gone (for now), but there are other items taking its place. Foreign operations (LEH reported that 62% of its revenue came from outside the US), private client divisions, and trading have all held up well. Somewhat lost in all the hysteria recently is that with all volatility out there, this has been one of the greatest trading environments in years, particularly in equities and equity derivatives. I deliberately left commodities off that list; it really doesn't take any trading acumen to make money in bubble markets. I'm sure many pilers on got crushed this week when the bottom dropped out of commodities as speculators took off or were forced out.

This post, however, is about what happens next. As what is now known as the "Great Unwind" continues, more hedge funds will go under. Without changes in regulations with respect to hedge funds, new ones will spring up in the ruins of the old. For the short term, all hedge funds will actually have to earn their substantial fees as the easy, follow someone else's strategy returns are gone.

Speaking of regulation, the current regulation system in the US needs to be overhauled, and perhaps scrapped, in favor of one that is more a reflection of today's market. Most US regulations date back to the Thirties. When Glass-Steagall was repealed, the '33, '34, and probably the '40 Act should have been adjusted or replaced to reflect the changed role of banks and investment banks. The tinkering of those laws over the years, including Sarbanes-Oxley, haven't helped in the long run, and in some way exascerbated the situation. A pretty clear link can be established between Sarbox and the rise of all of the offshore, off balance sheet vehicles that are at the crux of the current problem, in addition to the other Sarbox issue around corporate executives understating all forward looking statements for fear of being thrown in jail. It would be nice that while the government is focused on the current market problem, that they take some bold initiatives that give us some common sense, rules-based regulation that actually works. (wishful thinking). How about one regulator, one that is not the Fed, to deal with all securities market issues?

The final note here goes to Bear Stearns investors and employees. There is no other outcome where you end up in a better situation. The Fed took its action to stem a potential financial panic caused by a lack of confidence in Bear Stearns. There would be no lending facility otherwise, there would be no engineered JPM buyout of Bear Stearns. Bankruptcy would have meant locked doors, no jobs and significant dislocation. Go blame company management for allowing the firm to get into that predicament in the first place. Your anger is misguided and misplaced.

Liquidity Always Equals Solvency

So, the Bear Stearns name passes into history, joining the likes of Drexel Burnham Lambert and EF Hutton, two firms that passed out of existence in similar stressed circumstances. It can't be said often enough that in the financial world, without liquidity, without entities willing to lend you money, you are out of buisness. This is a de facto bankruptcy; the $2/share offer by JPM is a placeholder, a way for JPM to get control of this company without a long and drawn out Chapter XI proceeding, something the market doesn't need right now. This price is very much like the price ING paid for Barings in 1999 (1 pound), although Barings swift end came about as a result of fraud (BSC looks to be a case of poor management/risk management).

Here's my take on the going forward. With respect ot the Fed, this Fed has done more than any other Fed in the 95 years of its existence. They have been creative, active, and will to do what is necessary to try to help. The naysayers and critics should get a grip (you know who you are). The people out there that were clamoring and ranting for faster Fed Funds rate cuts, do you really think it would have made a difference? The best case scenario there would have been to postpone for a little while the inevitable that has occurred. Funds are 225 bps lower than seven months ago (and maybe as much as 325 bp tomorrow) and there hasn't been much help. The problem was never the cost of capital, but rather the amount of leverage employed and the transparency related to that borrowing. If there is a criticism of the Fed, it was they left rates too low too long, which allowed for the housing market and lending market to get way ahead of itself and that they didn't raise the flag early enough in either market (not that anyone would have listened).

With respect to govenrnment regulation, the repeal of Glass-Steagal a few years ago allowed banks to operate like investment banks. This pushed investment bank to operate more like hedge fund, levering up to the hilt. This has come home to roost. Going forward, the has to be more transparency and better capital regulation, which will require new legislation.

With respect to the markets going forward, Bear Stearns was clearly (all along) the weakest player in all this. They had the most exposure to the weakest part of the market and employed the greatest amount of leverage in that area. Bankruptcy is part of the capitalist system, and if there was more confidence in the economy and markets right now, that is where BSC would be. There may be more consolidation moves out there, and that would be good as it places stronger players in the market.

As a final note, the big winner here is Jaime Dimon. Forced out of Wall Street almost ten years ago, he has returned to become the savior of the day and now the go-to-guy for the Fed. Well done!

People In Glass Houses...

I don't usually make a foray into politics here, but today I will make an exception. What was Eliot Spitzer thinking? I think I know what he was thinking, but, come on. Here's a guy that made his whole life on being holier than thou gets mixed up with prostitution, and money laundering to boot. I think Ken Langone, major Spitzer target over the years and probably the only one that didn't back down in the face of his prosecutorial harassment, said it best when he said something to the effect that he hoped that Spitzer's hell would be a little hotter than everyone else. He has to go, he should do it voluntarily and do it now. This morning, the comparison was made on TV to Bill Clinton lying under oath. While the general public (not me) was under the opinion that lying under oath on matters not of national security was acceptable, I would generally agree with the panel that what Spitzer did was worse. With Bill Clinton, his supporters (again, not me) accepted or at least tolerated the idea that he was morally challenged from day one and were willing to operate on that basis. Spitzer, on the other hand, made his mark going after corruption and ethics violations, and made a lot of enemies in the process (In an ironic twist, it was a top-down degradation of standards in the Nineties that gave rise to a crusading Eliot Spitzer.). Spitzer, by always operating from the moral high ground, had and has to be cleaner than everyone else out there.

Eliot Spitzer's actions over this decade forced a lot of change on Wall Street. It cost a lot of business in the United States, as operations were shifted offshore to less restrictive environments. As mentioned before, he made a lot of enemies. Still, many of the changes have now become accepted practice. There is no going back. Part of the market mess today can be traced back to the movement offshore of a lot of this business. The lack of rules and transparency have been a major contributor to the uncertainty in the markets, particularly fixed income. There should be some effort, now while this is fresh in everyone's mind, to standardize the rules of the game globally.

Eliot Spitzer will always be remembered for the actions of the past few days. His methods of achieving results were at times zealous and, at other times, harassing. In some cases, he went too far. However, he did shed light on Wall Street procedures that needed to be illuminated. It is too bad that he couldn't maintain those high standards in his personal life.

The "D" Word

The "D" word, in case you aren't aware, is deleveraging. It is a fancy buzzword for something that has been discussed here many times, risk reduction. The risk in this case is borrowed money. Entities borrowed a lot in the market run up to "leverage" their equity, hence the term deleveraging as those loans are being called out, paid off, or otherwise being removed from the market. The sad part about this (from my standpoint) is that over the past few years, there were a few of us out there that saw what was happening to the market, particularly in cash bonds, couldn't do much about for a variety of reasons, got frustrated with the situation, and left the active participation of the market.

There have been many vocal critics of the Fed over the past eight months (you know who they are), saying they haven't done enough and/or were too late to respond. In retrospect, they were too late, by about three years. If, in the waning years of the Greenspan Fed/early days of the Bernanke Fed, the Fed had taken some action to stop the "leveraging" from ramping up so rapidly in the first place, maybe the current mess could have been avoided. However, I can just imagine what the criticism of such action would have been, ranging from "you are hobbling business", to "you are killing economic growth", to finally " you are accelerating the decline of New York as the financial capital of the world" (A note of this criticism: For all of you out there that are big proponents of principle-based regulations, as is the norm in London, over rules-based regulation, as exists in the US, most of these opaque CDO and the like entities set up to issue these difficult to value securities, were set up and issued offshore, outside everyone's purview in the US).

The LTCM crisis in 1998 is an excellent example of rapid deleveraging. At the time, the market seized up as no one could figure out, or was willing to tell, what their exposure to LTCM was. The Fed stepped in, got all of the relevant people involved, and set up a facility to oversee the orderly liquidation of the fund. While it would have been thought, certainly by me, the LTCM's method were discredited after their debacle, in fact, their methods were duplicated and replicated by everyone and everybody over the past decade. The LTCM "crisis" was a drop in the bucket compared to today's problems (This should also shut up the Fed naysayers who simultaneously hold up the Greenspan Fed's action in that situation as why Bernanke isn't up to snuff. As I said , today is much worse.).

Art Cashin this morning called what is happening now potentially a death spiral for the markets. He is correct. The more this uncertainty goes on with respect to asset holdings and valuation, the less likely anyone is going to lend to anybody for any reason. The deleveraging going on now is necessary and healthy, but it needs to be done in a systematic way so that the baby isn't thrown out with the bathwater. We've seen the spillover into markets where there really shouldn't be any meaningful spillover. Full and complete disclosure of holdings is needed now. The Fed's action today to increase the TAF helps, but they need to open it to all financial institutions, not just banks, so the banks just don't sit on the money to improve their own positions. We're rapidly approaching a situation where the only way out is to establish a RTC-like facility for crappy assets in order to establish a clearing price for them. Using that type of facility, those that have cash will do quite well cherry picking good assets. Current participants will not do well in that scenario, which is why they need to (again) come clean.

The Headless Chickens Rule the Roost

Commodity prices have had a speculative bid for years now helping prop up their prices, especially oil. In the last few months, that bid has ramped up to ridiculous (yes, that is the appropriate word) levels. As mentioned in a previous post, is there any real world justification for the price of wheat to be four times higher than last year or for silver to be three times higher? The middle class of emerging markets, the alleged driver of the current price moves, couldn't possibly be demanding that much of everything simultaneously to cause this kind of move. It isn't often that you get to see a bubble form, so take advantage of the opportunity. Money looking for a home these days (take a look at the money flooding into money markets recently and you can see that there is plenty of liquidity, read the Fed has done its job, floating around. However investors are shying away from risk, hence the buyer's strike in non-commodity markets.) is being attracted to the only way is up market, commodities. The "big" money is playing the futures and the "small" money is playing the futures and ETFs (as a side note, if I had recommended making an ETF that used a single bond, say the 10yr Treasury as its backing, I would have been vilified in the press and brought up on charges by the SEC for ripping off the small investor. In the commodity world , it is OK.). Hedge funds especially love this because of the 100 to 1 leverage (or gearing, for my British friends) available in futures. To quote a popular radio ad, it is the biggest no-brainer on Earth, particularly when you figure the market only moves in one direction.

Here's the problem. The players in the commodity futures market has changed recently, but the structure of the market has not. Originally, these markets were set up by producers and users of the commodities as hedging vehicles. While that still occurs, the vast majority of action happens due to speculative moves by the various participants. Considering how little real money must be put up, there is a strong parallel today between commodity futures and gambling. At first, it is somewhat surprising that this market situation, as a problem, isn't being talked about in more detail. However, here a parallel can be drawn to my own area of expertise, the fixed income markets. In the media, both fixed income and commodities are treated as some sort unfathomable black hole. Right now, the media loves to talk about commodities because it gives them a positive market amidst all the negatives. Their experts they bring on validate their points all work for commodity trading houses (or trade themselves) and talk up the market. This is what Bill Gross has been doing for years. I don't blame any of them for anything because there are no rules or guidelines in place preventing them from doing so, like the ones that came into being in the equity market after the last stock market bubble.

Before any real damage is done to the economy, the government (you won't often hear me say this) needs to step in to reduce the speculative bid to a reasonable level. While I'm all for people being allowed to throw their money away on stupid investments, there is real risk to the worldwide economy. I would suggest that the CFTC step in and do whatever is necessary to increase margin requirements for speculators (it can do what it wants with hedgers). The futures market was supposed to provide price discovery for cash market participants, as well as providing a hedging vehicle. That isn't happening anymore; the futures just drag the cash higher, regardless of supply and demand. In a perverse way, market forces are being co-opted by the speculation crowd. Investors are piling in to relatively small commodity markets, pushing them ever higher and therefore creating more equity for those in first. Because of the extreme leverage, it behooves the market players to get more and more investors at ever higher prices. I have yet to hear anyone say that these are the correct prices for any commodity currently, only making vague statements in reference to the abovementioned EM middle class. I wouldn't want to liken the commodity markets to a Ponzi scheme, but this and every other bubble in the history of mankind have had similar characteristics.

The "I" Word

There is a much-hyped editorial in the WSJ today regarding inflation. The first part of it talks about the effect of inflation on the value of money over time. While accurate, it is certainly not earthshattering or groundbreaking (unless you believe the talking heads on TV). Perhaps the editorial is getting so much attention is that inflation hasn't been a real problem here for a long time. Maybe inflation is high due to the efforts earlier this decade by the Greenspan Fed to "re-inflate" the economy (remember that?)? It certainly has almost nothing to do with the current Fed attempts to lower rates, although that may nudge inflation higher down the road.

The second part of the editorial regarding the the author's calculation of inflation using the price of gold is nothing short of nonsense. Gold, the most overvalued commodity given its lack of intrinsic value, is a misplaced measure of anything. People have turned it into a measure of inflation expectations, but it's relative lack of real uses (I don't count jewelry as a real use) makes it a poor measure. If the oil or copper were used, then maybe this calculation would have credibility. In addition, the author only goes back to 1999. That works conveniently for him, but he seems to have forgotten that the price of gold was $850/oz. in 1981, not much lower than it is now. Using his calculation going backward, this country would have experienced deflation through the '80s and '90s that would have made the Depression look like a picnic.

Commodity prices have increased over the past decades partially due to worldwide growth and globalization, both of which have come about due to the policies and beneficence of the United States. The rest of the move is due to the massive amounts of speculative capital that have rushed into these markets. Electronic trading has made it much easier to trade and to execute complex strategies on a global basis. Remember what happened when equity markets opened up similarly in the '90s? I'm not calling for a crash like the NASDAQ disaster, but there are some parallels. Let's face it, should the price of oil be double what it was last year? Should wheat be four times higher, and then drop 11% yesterday? These markets have gotten ahead of themselves and price adjustments will come. Using only one of them to come up with an inflation calculation is irresponsible, to say the least.

Part of the reason for the run up in inflation recently is the uncertainty in the United States about the future, both economically and politically. While what can be done is being done on the economic front (it has to run its course) and the election won't be decided for eight months, Congress could act on future tax policy now, specifically making the 2001 tax cuts permanent, which would go a long way to reducing the uncertainty. That's not going to happen. The other option would be for all the Presidential candidates come out and say they are committed to not allowing tax rates to rise, but that isn't going to happen either. I guess we're stuck with the uncertainty, higher commodity prices, and higher inflation for the foreseeable future.

A Few Random Observations

During my week-long hiatus, I stumbled across a few random observations during my travels. First of all, the demise of the US economy has been greatly exaggerated. Judging by the number of Americans willing to shell out fairly obscene amounts of money to take a February vacation, it would seem to me that things are not as bad as the instant gratification media would have you believe. The corollary to this that things on Wall Street aren't as bad as we are being led to believe, as most of the people I ran into during my time off make a living on the Wall Street gravy train. After being intensely wrapped up in the investment world for over 20 years, it is necessary and positive to step back from it all and see what is going on elsewhere.

The second observation is that the current value of the dollar is really paying off for this country. Sure, I know your thinking, "What about the imported inflation that a weaker dollar is creating?" Of course, it's something that needs to be monitored, but, with economic globalization it is dubious as to what can be done about it, short of throwing the worldwide economy into recession. What I'm referring to is the relative to the export boom; the number of foreigners visiting here, and spending money, is skyrocketing. Even in my little corner of Vermont this week, I met numerous foreigners, and not just Canadians. People from far-flung places like South Africa and Australia, as well as many Europeans. Let's face it, these people could probably go skiing anywhere, but chose the US, and in particular, Vermont. Certainly the Europeans have closer, easier to get to, and probably better (sorry, Vermont) ski options than Vermont. This is just a testament to the strength and attractiveness of the US.

Finally, as a few of you may already know, people with serious and insightful fixed income knowledge are being treated like rock stars, after years of being shunned to the periphery of the investment conversation world. For the past six months, the media has bombarded the world with overly complex definitions and acronyms, making all bonds and all bond markets seem sinister. Unfortunately, those people being interviewed are the same one that dumped us into the current situation. This past week, I had numerous conversational snippets with all sorts of people. Without exception, I was thanked for providing a straightforward and common sense explanation for what is happening, followed by the handing out of my business card. The bottom line is that the market for valuable advice regarding current market conditions is vast, and the supply is limited because the "experts" concentrated all their efforts on equities and basically ignored what is really important.

How the World Has Changed...Or Not

Here's a quick note before the long weekend. According to Bloomberg, GE 10yr paper is trading at the same absolute yield today as it was one year ago. GE is about the best corporate credit there is, certainly of any issuer that is consistently in the market. Other credits are generally trading at higher yields than one year ago, despite the decline in rates. The difference is the much wider risk premium being demanded now. The point of this is that the Fed can cut rates until the cows come home, but until investors are willing to commit capital and liquidity returns everywhere, the markets, particularly fixed income, will languish here in the netherworld. That will only happen once there more certainty around asset valuations. As mentioned yesterday, the mindset of the major players hasn't changed, and we're stuck here until that happens.

Just an Observation...

Here's a couple of quick notes on the auction rate market. First, it is truly amazing to me that there are so many people that call themselves market professionals claiming to have never heard of this market. It's been around for a long time. I remember back in the late Eighties when my bonus got dinged because of a truly "failed" auction (the issuer filed Chapter XI). Back then, the dealer-manager of these things had to eat the failure. Second, other than the Port Authority, who is really upset about being "stuck" accepting a 20% tax-free yield? Put it in perspective, that's almost +1700 to Libor. Are the buyers really concerned about the Port Authority going bankrupt? Are they only willing to accept 20% if it has a bond insurance wrapper? Do the buyers have all their liquidity tied up in this product? (if the answer to this one is yes, then that is their mistake, especially in this environment). I'm not a table pounder, but if someone wants to assign me their Port Authority auction product, send me an email and we'll discuss it.

This morning, Hank Paulson paraphrased me (probably not directly) regarding the pricing of risk. He said that risk had been underpriced and now it had probably swung back too far the other way. This is similar to the pendulum swinging too far one way and when it comes back, it swings far in the other direction. It is hard to describe, but if you weren't involved in it, you can't believe how far risk had been mispriced. I think a lot of that had to do with the concept, which unfortunately is still prevalent and valid on Wall Street, that it is possible to completely define and quantify all risks in some mathematical formula. My last observation in this piece it is a shame that this concept hasn't been supplanted everywhere (it does exist in a few places, look at the successful firms) with one that actually works and makes sense.

It's Different for Bonds

Given all the failures in the auction market recently, I'd just like to highlight, for those of you out there that aren't aware of it, that the bond market is not the stock market. Stocks are generally exchange traded securities driven by sophisticated order matching networks. The difference in the number issues can best be described, for those of you more familiar with equities, as imagining the entire universe of equities as being the 30 stocks of the DJIA. The bond market would then be all other stocks that exist in the world. With a nod to Joe Jackson, I've written some new lyrics to his song It's Different for Girls to explain further.



What the hell is wrong with bonds today?

There are no bids on any at all

Sellers say that this just isn't right

Dealers pass, and shun every seller's call



They say, we can't believe it

You can't, possibly mean it

In stocks, this doesn't happen

In stocks

Well, who said anything about stocks?


No, not stocks they said

Don't you know that it's different for bonds?

(Please give me bids...)

No, not stocks they said

Don't you know that it's different for bonds?

They're not the same



Buy side talks about a level field

Transparency and e-lectronic exchange

Sell side says without risk capital

Fixed income ain't worth more than loose change



Why's this? There's order matching

Networks, they are a-hatching

Dealers say, we're not buying

Not at all

Well, at least give us a throwaway bid



No, not a throwaway

Don't you know that it's different for bonds?

(At least this time)

No, no, no, no, not stock they said

Don't you know that it's different for bonds?

They're not the same

They're not the same

etc.

Decoupling

A good friend of mine and of theis blog wrote a piece yesterday on the decoupling of the US from other world economies. Here is the link http://mksense.blogspot.com/ . Since this topic is of interest to me, I have decided to put forth my two cents here.



Today, I listened to an interview with Mohammad El-Erian, formally of the IMF, Citi, Harvard and now co-CEO and co-CIO of Pimco. He shares that role with Bill Gross, of course, and their relationship has quickly developed into Mr. Inside/Mr. Outside relationship. (no, I am not old enough to have seen Davis and Blanchard play). Mr. El-Erian rarely speaks in public, so when he does it is usually worth listening to given the amount of money he controls. Mr. Gross, on the other hand, is available everywhere talking about the fixed income market as if he were an independent observer rather than the world's largest bond fund manager. While he has gotten better recently, if Mr. Gross had been an equity fund manager saying the types of things he does, let's just say he wouldn't enjoy the unimpeachable reputation he seems to have in the market.



Anyway, Mr. El-Erian was speaking on the topic of decoupling. His expertise is in the area of emerging markets. He had one very good point on decoupling. Mr. El-Erian made a strong and logical case that there are two components of decoupling: markets and economies. His point was that as markets are so interwined, one cannot truly decouple from the other, particularly when the one market is the United States. Where he misses the point, in my opinion, is that he believes the economies, particularly emerging economies, can decouple from the US indefinately. Mr. El-Erian gives all the standard answers for this that have been bandied about for months: continuing growth elsewhere; increasing domestic demand; yada, yada, yada. He maybe right in certain circumstances, but not everywhere.

My abovementioned friends writes on his blog about the developed countries turning downward. If anyone questions this, I suggest you read the front page article in the WSJ from Thursday (here's the link, but the WSJ isn't free http://online.wsj.com/article/SB120234240716748807.html ) about the UK. The emerging markets will be affected as well. They have experienced market declines so far, although, in general, not to the degree of developed markets. If it wasn't for the the speculative bid propping up commodity prices to artificially high levels, the selloff in EM would be much worse.

In this selloff, sovereign wealth funds have been falling all over themselves to invest in Western companies, especially the US. I'm not trying to make the case that these funds are the most astute investors out there, but they do have long time horizons. Why not plow more money into EM? The growth rates are higher and they already have big investments in developed countries. I'm sure they could find suitable EM investments. The reason is simple, and one the Mr. El-Erian discounts way to much. These investors, more than funds' investors, are concerned with return OF capital in addition to return ON capital. What seem to get lost in the discussion (or isn't discussed at all) is that the much badmouthed and reviled United States of America has created a worldwide environment where these types of investments can occur. Without that environment, who knows how many Hugo Chavez's we'd have running around? The largest of the EM countries, the so-called BRICs, do not have a long history of democratic rule, or any history of democratic rule, with the notable exception of India, of course. The legal systems in EM countries do not offer the same protections as in the West. Anybody that invested in APP and got their head handed to them knows this well. Even the bigger players in EM, as they done for decades, have invested the bulk of their funds in the West.

But, I digress (or decouple). The market declines worldwide will have a noticeable effect on worldwide demand. Like Reaganomice, it eventually trickles down to everyone. Does that mean worldwide recession? Probably not, but like in the US where the quarter to quarter growth rate went from 4.9% to 0.6%, it will feel like one. If the post-Olympic growth rate in China drops, to say, 5%, wouldn't that feel like recession there to? For better or for worse (I think for better), both markets and economies are entwined to some degree, leading to mutual growth or weakness.

Give It Up For Lent

Yesterday was Ash Wednesday, the first day of Lent. As all good Catholics know (and do, of course), during the season of Lent, in additon to the fasting each person is supposed to abstain from something that has meaning to that individual. I'd like to extend the opportunity to abstain to the Federal Reserve Board, to abstain from cutting the Fed Funds rate further during this season of Lent.



As often happens in the market, and this one is no exception, the market has gotten way ahead of itself. This can be seen most notably in the Fed Funds futures market, where the front month contract (February) is pricing in a rate cut this month. The problem with this is that the Fed doesn't have a meeting this month, so, in effect, Fed Funds futures are pricing in an intra-meeting move, one that would occur before the expiration of the contract. (On a related topic, at some point I will elaborate on why the Fed Funds futures is basically akin to placing a bet in Vegas. Suffice it to say that futures usually for hedging or price discovery, the former doesn't generally apply and the latter shouldn't be possible as the rate is set by the Fed, a theoretically independent body. But, I digress...). It really shouldn't be difficult for the Fed to stand pat here on Funds. There is only one meeting and it's just a few days before Easter.



However, what about all of the pundits and experts crying (in some cases, literally) for more rate relief? One of the biggest cheerleaders of this movement (both figuratively and literally) was on TV this morning asking one of his guests (another reporter of the news jumping over the fence acting as an expert), "Is there no light at the end of the tunnel?" (The answer was no). If what we're in is a tunnel, the light won't be seen until we are speeding out of it at 75 MPH, only to have to slam on the breaks at the expensive toll barrier on the other side (read: rate hikes). It has been said here many times, the market needs to work out its excesses before it can move forward. A one-time selloff does not portend a new 25 year secular bull run. The technical analysis mentality that most players seem to have fallen prey to does not fit in with the larger macroeconomic problems we are experiencing.



Why should the Fed stay put? I'll list some reasons. The first should be obvious. Since mid-September, Fed Funds have already been cut 225 bps, the effect of which has yet to be felt. The marginal benefit of further cuts now is dubious. Second, and even more important than the first, is that the markets must be weaned off of its addiction to continual Fed Funds cuts. I can point to Japan as an example of where that policy didn't (and doesn't) work. Ask the "experts" why stocks are lower and the answer you will get is that there won't be Fed Funds rate cut today. The markets need a market-based solution to this problem. If that means something (s) go bankrupt to resolve things, then so be it. That is capitalism. Government can and should try to soften the blow, but at the end of the day, companies, markets, and people, etc. need to succeed or fail without being completely propped up by outside forces. My final point here, and there are many others, is that the Fed has to keep something in reserve on the Fed Funds front in case it is really needed down the road.



The Fed has done a good job at keeping the markets moving in this period of credit crisis and illiquidity. What the vast majority needs to remember is that markets need to be aable to move in both directions in order to function properly.

Hey, It's Triple-A

By far, the title of this blog was the most common phrase I would when being asked to bid on some unknown piece of paper that I didn't sell to a client. Generally, my response was either A) pass-ola; B) tell me who you bought it from and I'll ask them to bid on it; C) sell it back to whomever sold it to you: or D) I'll put it out to the street and work it on a best efforts basis. Not to pat myself or my colleagues at the firm where I used to be employed on the back, but we didn't sell these CDOs, et al to our investor base (Full disclosure: the department I worked for did sell structured products to individual investors, the structures were straightforward, the risks generally quantifible by the lay person, and the buyers were subject to some serious scrutiny before being allowed to purchase such a product.). Our reasons were threefold. First, there was little liquidity in this product (even before the meltdown), particularly in the sub-$10 million amounts we would normally deal in. Each one of these instruments was basically a proprietary product of the firm that created it. That brings me to reason number two, which was that we had no way of valuing it. In retrospect, this is the crux of the problem for the market (I wish I had written this two years ago, then I could be on TV every day). Just because these items (I hesitate to call them bonds as many had non-bond like features) had an ISIN that one could type into a Bloomberg terminal didn't mean that there was any meaningful information (read: information used in generating a value) available. Finally, and I thank God (or the Securities Act of 1933) for this, most of these things were not registered in the United States, putting their purchase out of the reach of most of our primarily domestic investor base.

That brings me back to, "Hey, It's Triple-A". That nugget of information was the one thing that usually was available to us. It was probably the one piece of information available, along with expected return and purported cash flows, to the unsuspecting, yet allegedly sophisticated, foreign high net worth investor that would ask me for a bid on $100,000 face value of this stuff. This investor class had been buying triple-A bonds for years (in some places in the world, triple-A would be the only bonds available) so the thinking in general was that was no different than buying some German Landesbank paper, with an implicit or implied government guarantee. For the most part, this type of buyer doesn't have the most rudimentary notion of how the US mortgage works, and certainly has little clue of how something as complex, as these structures had become, works. (Point of Information: Mortgages and mortgage market vary widely around the world.) As it turns out, very few people understood the workings of these products.

Which brings me back to, "Hey, It's Triple-A". I would have thought that when someone sticks a rating on something, that some significant amount of due diligence was done to arrive at that rating. The pressure has been on the bond insurers, which for a fat fee, certainly more than they were getting from insuring a municipal bond, were extending their triple-A imprimatur on this stuff. However, the real problem here is the rating agencies, which grant those ratings based on thieir due diligence. The bond insurers can only operate successfully with the triple-A blessing of the raters. Unless there is a massive and conspiritorial fraud being purportrated, the blame needs to rest with the Big Two. This is just another instance in a long line of lax standards that got us into this market mess.

A Quick Note on the Fed Today

In keeping with short-standing tradition, I will predict that the Fed moves both rates 50 bps lower today. This is not because the have to. The 175 bps of moves over the past four months has yet to hit the economy. However, since Mr. Bernanke seems to be front-loading rate cuts in a, to paraphrase Admiral Farragut damn the inflation, lower rates ahead, fashion, another 50bps today seems logical. But where do they go from here?

Today, we also got the first look at 2007 Q4 GDP, which came in at +0.6% annualized. While not great, it is still a positive number. This figure is subject to revisions, but it is likely to stay positive. I don't think the US goes into technical recession. If it was going to start, Q4 would have been the time. However, what hasn't been talked about much is the difference between the two quarters. Moving from 4.9% to 0.6% is quite a drop. It makes people think, from an anecdotal standpoint, that activity is slowing much more than it is. Much of the slowness comes from housing, whose construction levels two years ago were much higher than sustainable levels. Everyone should keep that in mind when predicting doom and gloom.

Given all of the uncertainty out there, it is quite remarkable that the economic condition is worse than it is. Aside from all of the economic news buffeting the markets and the economy, there is a wide open race for the the President (and Congress too, which gets overshadowed) and the threat of tax increases out there after 2010 (the rollback of the so-called Bush tax cuts). Solving this tax situation alone, one way or the other (hopefully the correct way!), would do more than handing everyone a check (stimulus package) and go a long way to improving the markets and the economy as a whole.

SocGen=Barings=Kidder, etc.

As the information on the latest "rogue trader" continues to trickle out, I'm reminding of the recent past where there have been similar happenings. Of course, most everyone remembers Nick Leeson, who from his remote location in Singapore, managed to bring down one of the oldest and most venerated banks in England, Barings, which was subsequently sold to ING for a single pound. I'm sure many of you remember Joseph Jett, the STRIPS trader at Kidder, Peabody, whose manipulation of the system there generated at $300 million loss and was the catalyst for then parent GE to sell Kidder to Paine Webber in 1995.

While all the details on Jerome Kerviel's actions are not known publicly yet, his motives in this scenario continue to be a mystery. While Joe Jett was clearly in it for the money (he was the highest paid Kidder employee in 1994) as was Nick Leeson to some extent (he didn't quite see the financial benefit that Jett did), it doesn't seem as if Kerviel was going to make anything on this. Maybe he hated the bank, or his bosses. Revenge can be a good motivator. Perhaps he did it for a same reason mountain climbers climb mountains, because the opportunity was there. It should be interesting to find out.

What is similar in these, and a few other situations, is that there was one guy that knew not only the systems and procedures of the firms they worked for, but also knew the markets. Being a market professional, that is an increasingly rare combination. This is good news and bad news. The good news is that there aren't that many people that could pull something like this off. The bad news is that there are few people that could recognize what is going on. These days, most traders come out of firm training programs, which may help them prepare by loading them up with product knowledge but gives them little, if any, exposure to operational elements of the business. In addition, few people stay at firms long enough to get the comprehensive background necessary to be a scam mastermind. Of course, a team of people could do it, but as past history shows, it doesn't seem to work that way.

The sad part about these three examples was that they weren't caught by some routine checks and balances inherent in the system, but because the fraud became so large that each firm's viability came into question. I'd like to say it can't happen again, but I think everyone realizes that isn't the case. It can't happen everywhere, because some firms do their job in this area very well. One final note: To all those people out there that said to me over the years that this couldn't happen in a European bank, you should stop throwing stones from your glass house.

Counterparty Risk

One topic that has been hinted about on the periphery during the current market difficulties is counterparty risk. As a person in charge of running a fixed income trading desk in emerging market and international securities, counterparty risk was always at the forefront of most of our dealings, even after the concept fell out of vogue elsewhere in the investing world. When I was dealing with counterparty risk on a daily basis, my primary concern was whether the firm on the other side of the trade was going to be there to pay/deliver on settlement date. The problem was that many of the firms in my area of the business were not subject to the laws or rules that you would normally take for granted when dealing with counterparties in developed markets. We would look at financials of a counterparty and make decisions on how much we were willing to trade with them accordingly. The financial statements we were given, however, were generally unaudited and not-GAAP compliant. There was always some leap of faith when doing a transaction such as this, but if we stayed on top of things and remained constantly vigilant, I felt we were doing the right thing, even though it probably cost us some business. (As an aside, we had very few problems over the years. Given the KYC issues we had to plow through, that stands as a testament to the people that worked for me.)

Today, however, we have an altogether different problem. The counterparty risk that exists in the multitude of derivative markets, particularly the credit default swap market, is of a different order. For example, if I bought $1 million of bonds from a counterparty who later was unable to deliver, my risk was somewhat limited. If this counterparty did the same thing to 20 others, all of the risk was spread out. We may not like the short-term consequences, but business would go on. Ten years ago, when LTCM was teetering, the concern was that a failure of a counterparty of that magnitude would have a cascade effect on the rest of the market. For a time, liquidity seized up and rumors were rampant. Then the Fed stepped, engineered a bailout and an orderly liquidation of LTCM. This worked because, despite the rumors, the rest of the financial system was sound.

Fast forward ten years to today and counterparty risk is taking center stage once again. The notional amount of derivative products outstanding, even after the so-called reduction of risk that has occurred over the last six months, is mind boggling. The numbers that are floated around, in the trillions of dollars, are probably low estimates. Think of counterparty risk in this instance as a very long chain. The chain is only as strong as its weakest link. If a small link fails, the rest of the chain can get together to weld it shut. If a big link fails, or importantly, a bunch of different links fail simultaneously, the whole the chain falls apart. The consequences of such a failure would be quite unthinkable.

The Fed started to get serious about this a few years ago when it put together a framework that would clear up the settlement backlog. At one point, trades would go months or years without being confirmed. While there is a better handle on this now, my problem of KYC from the first paragraph has moved to center stage. The number of derivative counterparties has exploded with the growth of hedge funds. Given the reduction in leverage that has occurred already, it is amazing that a truly market debilitating situation hasn't already occurred as a result of lax controls of counterparty risk. Hopefully that means all that are responsible for monitoring counterparty risk out there are doing their job as well as we did.

The CNBC Cut

It looks like that the Fed gave into the screaming media this morning and executed an intra-meeting Fed Funds rate cut of 75 bps. I happened to be a forced watcher (don't ask) of CNBC this morning prior to, during and just after the Fed announcement. Prior, the daily roundtable discussion managed to use the term "behind the curve" 15 times in a 15 minute period, including twice in one sentence. After, the gang was grousing the about them being behind the curve (This, based on where Treasuries are. If that is the case, then the market has already eased and the Fed is irrelevant), not doing enough (?), and one gentleman making a case that rates should go back to 1%, even as he admitted that it was the last move there that was a major contributor to the current problem and another move to 1% could create another bubble (in what?). This same person also alluded to a point that he knew the Fed was going to make this surprise move, which, if true, the Fed should look into that kind of leak of information.

That brings me to the next point. The Bernanke Fed was supposed to be the more open and transparent Fed. Maybe they shouldn't be. All it has gotten the Fed is people that couldn't spell Fed a year ago coming out of the woodwork lobbing complaints at them. Maybe Ben should rein in the governors, and force them to cut back on their public speaking engagements. It is quite disturbing to see the direct correlation, albeit lagging, between what is said on television and what actions the Fed takes. Perhaps it was always that way and I just didn't have the time to notice it. If this is what the Fed has become, then let's abolish it in favor of fiscal policy decisions arrived at by daily, nationwide consensus polling. This way, we would get instantaneous decisions and no one with which to lay the blame on but ourselves.

For awhile today, I thought that perhaps my interpretation was wrong. However, reading the Fed's statement led me to this conclusion. The Fed's action was based on risks to the financial system, not the overall economy. Over the past few months, Fed actions have place the money markets on more normal footing (Hear the crickets chirping? That is the lack of acknowledgement that the Fed did the right thing). Now there was a global selloff in stocks, an event that was way, way overdue. There must have been quite a few overseas calls placed to Ben Bernanke yesterday (Maybe US equity markets should be open 24/7, to avoid this problem). No one has been talking moral hazard lately, using the excuse that the problem was to big. This, too, was provided by TV, giving the Fed the reason to cut.

The moral of this continuing story is that equity investors will get bailed out because it makes for good television, regardless of the consequences (because that will also make for good television).

A House of Cards

I’ve often thought of bond insurance as a waste of time.  Long the mainstay of the muni market, bond insurance has crept into other fixed income markets as well.  The reason for this should be obvious, money.  I’m no expert on the topic, but I guess it was easy money putting an insurer’s imprimatur on esoteric products with complex and sometimes indiscernible cash flows (A lot of SAT words in that sentence).    While bond insurers have ventured from munis before, it was usually into related areas where they could have a good handle on what the potential risks were.  In my days trading international bonds, it was quite common to see insured tranches of dollar-denominated sovereign issues.  There were (and are) several Quebec issue with these tranches, but in the past, there were issues as far afield as Thailand and Italy that were part of this market.  The reason for doing this was to help facilitate a sale of bonds to US individual investors, many of whom were quite familiar with the insured bond concept.  It was an easy money maker for broker-dealers (because they could buy bonds at the uninsured spread level, purchase insurance for some nominal amount, and sell them as if they were triple-A rated, which they were thanks to bond insurance) and easy money for the bond insurers (Was Italy really going to default?  They could, and have in the past, print more money to pay off the bondholders).   The bond insurers also got involved providing somewhat dubious credit support to some mortgage-backed securities, although it was never really clear help they would provide other than sticking their good name on some bonds.

 

It shouldn’t be a surprise then that the bond insurers moved into other and more lucrative areas of the fixed income world.  However, the sale of complex financial instruments would be different than selling munis to Mr. and Mrs. Smith.  In some ways, it would be easier.  After all, the buyers were sophisticated financial entities that had armies of analysts doing their own in-depth research on these products.  They looked at the models and developed their own.  The bond insurers looked at the models and came up with their own models.  Everyone’s models were stressed tested, and performed well.  What could possibly go wrong?  The bond insurers were only too happy to put their triple-A stamp on these products.  There were a lot very smart people that said everything was OK.  Those people had developed better and more sophisticated ways of measuring risk and valuing securities.  Hedging techniques were more numerous and readily available.

 

Here’s the problem.  Most of the people involved here had a large amount of technical knowledge and access to vast quantities information.  Some, but not many, had requisite experience and market savvy to understand what the potential problems were.  The game kept going until a fear-driven liquidity crisis forced change on us all.  Many, including myself, were quite surprised that it took as long as it did for the crisis to manifest itself.  The bigger question going forward is how long will the investing community learn its lesson.  My guess is that it depends on how long the current players stay involved in the market, how good their memories are, and how well they learned the lesson.  The one good thing this market has learned is that when investing in anything, there is risk, some known and some unknown.  The market had moved away from that in recent years, focusing on easily definable risks like the political risk of investing in Venezuela or Iran.  In the future, bubbles will form and pop.  The trick is to avoid them or minimize the exposure when thing turn bad.

 

The bond insurers were just another piece of this unraveling puzzle.  There will be bond insurance in the future, but it can almost be guaranteed that it will look more like the bond insurance of 20 years ago (at least in the short term), will have different/restructured players, and will cost more.  Like the aforementioned Italy, municipalities rarely blow up, and when they do, they usually get bailed out, ultimately by taxpayers.  In the insurance game, it was a low risk business.  What wasn’t noticed by the market in general was that the risk profile changed, and according adjustments weren’t made.