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.

 

 

 

More Writing

I have heard through the grapevine that I need to write more.  I try to write as often as possible, but I guess everyone can always do better.  If anyone has any ideas, please send them in.  There are topics I would love to write about, but am contractually restricted, so please don’t suggest those.  Besides, if I write on those topics, you won’t buy my book when I get around to writing it.

 

The "R" word

Is it possible for the for a recession to occur just by talking about it incessantly? It certainly can't help. The sad part is that the media seems to want a recession to occur, for whatever their motivation (the list is endless). If the US is in a recession (it remains to be seen), all interested parties seem to be doing the right thing: the Fed is lower interest rates (For all you Fed bashers out there, you know who you are, the Fed has already brought the Funds rate down 100bps in the last four months. More on this later.); the government is talking fiscal stimulus; interest rates that matter are moving lower (The alleged geniuses out there seem to think that the Fed should lead the market up or down. In a capitalist system, it should be the other way around. This is what is happening.); and stock prices should go down, despite numerous calls for the Fed to lower interest rates to prop up prices, to reflect lower earnings growth or bad decision making.

Whether or not we are in a recession, the pieces are in place (listed above plus, hopefully, tax reform) to get the economy growing again. Regardless of how many more eases come out of the Fed, the groundwork is in place for recovery. This can be seen in the increase in the number of refinancings over the past few weeks. Given where the 10-yr is now, it is estimated that 40-60% of mortgages are refinancable, assuming of course there is enough equity in the house. The 100bp of Fed Funds rate reductions take time to work through the economy, but it is now being seen in lower HELOC rates and a lower prime rate. In addition, once again, the Fed is getting little public credit for restoring the money markets to normal function. It's funny, people that couldn't spell LIBOR a year ago were coming out of the woodwork decrying the Fed for not doing anything about the seize up in money market liquidity. Now that things have normalized, these same people are nowhere to be found.

Yesterday, I had the privilege of attending a lunch where the speaker was Tony Crescenzi, chief bond market strategist for Miller Tabak. Tony was there ostenibly to speak about his new book, an update of the seminal The Money Market by Marcia Stigum. However, he spent most of his time speaking about recession and gave some very clear and concise arguments on why if there is one, it will be probably be short. He had ten points, some of which I'll recap here. First, inventories are low, part of a continuing trend of better inventory control and management. Second, sovereign wealth funds investing here are a good thing. It is a sign of confidence and they aren't looking for control, yet. Third is a longer term item, demographics. New housing starts last month fell to a 1 million annual rate, which Tony explained should be adjusted downward 300,000 to account for teardowns. With at least 1.1million new households forming annually combined with an increase number on baby boomers buying second homes, it is only a matter of time before the excess housing supply is absorbed. Finally, productivity gains and technology implementation during this super-cycle have yet to run their course.

It is important in this uncertain environment to filter out noise and attempt to focus on what is real and important.

Isn't It Ironic?

Isn't it strange (not really) that the people that are now jumping all over Alan Greenspan for leaving rates too low too long earlier this decade (as it was the primary cause of the current deflating housing bubble) are the same people now screaming for the Fed to lower interest rates, primarily to bail them out of their falling equity positions. Where were these people six months ago? You (or I) don't have to answer that; we know the answer. These same people are also criticizing Mr. Greenspan for taking a job with Paulson & Co, as it was some kind of quid pro quo from Paulson for making billions betting against subprime. That's some conspiracy theory! If you want to criticize Mr. Greenspan it should be for talking to much, second guessing Mr. Bernanke's moves publicly. I'm sure Mr. Greenspan wouldn't have appreciated Paul Volcker hovering over him, questioning every move.

The other ironic item that hasn't received much press is that the Fed's actions in the front end of the curve are having the desired effect. LIBOR is back in its historical range and money market function is beginning to return to normal. Yet, as it is not propping the Dow, the Fed's success receives little publicity. The "experts" continue to attack the Fed for not lowering rates fast enough to keep the US out of recession, saying that inflation isn't as important as helping the economy (one notable TV ranter comes to mind). Talk a bout being a Monday morning quarterback. The Fed has to look at all of their mandated items, balance them out, and assess the short and long-term impacts. Somehow the idea the the Fed is supposed to do whatever it can to keep equity markets on a one way ride to infinity has become part of the mainstream consciousness (I know how, but there isn't enough time to go into it). That is just plain wrong.

Here's the Previous Post Translated Into Italian

It is amazing what you can find on the internet...

Casalinghi vs Countrywide Redux

Lungo tempo i lettori possono ricordare quando ha scritto su questo ultimo anno. Diverse crisi, ma simile situazione e sembra essere un risultato simile. Basta ricordare, c'è sempre un prezzo per ogni attività; cercando di capire il prezzo corretto è il delicato compito. Io non sono una fusione arb ragazzo, ma questo appare come un buon affare per BAC. Il $ 2billion in autunno, $ 4 miliardi di adesso, e diciamo $ 6billion a raddrizzare CFC, che è ancora solo il 50% del valore di libro. Anche se si crede che il valore di CFC è una sciocchezza, vi è un certo valore per BAC, probabilmente più di $ 12 miliardi. Infine, il mercato immobiliare e tornerò BAC sarà il numero di un giocatore da un lungo tiro. Ricorda, a meno di un anno fa, che sarebbe costato a cinque, e probabilmente più simile a sette o otto volte di più. Il tempismo è tutto.

Household vs. Countrywide Redux

Long-time readers may remember when wrote about this last year. Different crises, but similar situation and looks to be a similar outcome. Just remember, there is always a price for every asset; trying to figure out the correct price is the tricky part. I'm not a merger arb guy, but this looks like a good deal for BAC. The $2billion in the fall, $4 billion now, and let's say $6billion to straighten CFC out, that is still only 50% of book value. Even if you believe the book value of CFC is nonsense, there is some value for BAC, probably more than $12 billion. Eventually, the housing market will come back and BAC will be the number one player by a long shot. Remember, less than a year ago it would have cost at five and probably more like seven or eight times as much. Timing is everything.

Step Back on Housing

In case you haven't heard, the housing market in this country is having its problems. No need to rehash it here. However, there is one point that seems to get lost in all the discussion about foreclosures and people being forced to live in cardboard boxes. Prices and sales are down, in most places and inventories are higher, again in most places. There has been an exhaustive and continual analysis of the mortgage market and how it has changed in the last nine months; the range of mortgage products and the availability of money has declined precipitously. What hasn't been talked about is that the speculation bid has left the market.

In many of the high-flying real estate markets this decade, speculators were major players in many of them. They're gone. Prices are going down and money isn't available. The only speculation now is coming from vulture and distressed investors, not the speculators we had seen over the past few years, and the distressed buyers aren't coming in in any significant way at this point. It really surprises me that so-called experts are confounded about sales dropping as much as they have. In some markets, speculation accounted for 25+% of sales. With that number hovering around 0% of sales, coupled with everything else going on, and sales will be lower.

All real estate is local. Here in North Jersey, while prices aren't ratcheting higher, they aren't falling off a cliff either and sales are getting done. In Manhattan, prices are ratcheting higher, propelled by a foreign bid willing to pay what seems like stupid prices (at least now, they are). The point is, like every other asset, prices are driven by supply and demand (if you question this, try to buy Guitar Hero III or a Wii). The real estate asset price bubbles need to be worked out (This is a common theme in this blog). The sooner the better for everyone.

The Secretary of the Treasury

I promised some follow-up and highlights of yesterday's Q & A that Hank Paulson did with the NYSSA members. If you watch it live on CNBC or saw him this morning on that same channel co-hosting in the eight-o'clock hour, this won' be a surprise. What was surprising is that it took until the very last question yesterday for someone to ask Sec. Paulson about his stance on the dollar. On CNBC this morning, that question was asked, in different ways, at least four times (It was getting to the point where you think that CNBC hoped that Hank would have a stroke or the immediate onset of Alzheimer's and start blathering on that a weak dollar is a great thing!). Where Mr. Paulson's response differs from previous Treasury Secretaries, with the exception of perhaps Alexander Hamilton, is that he goes to explain why the dollar strength is a good thing and to not fret over month-to-month or year-to-year weakness.

Sec. Paulson's prepared remarks lasted about 20 minutes. The vast majority of that time was spent on what Treasury is doing with regard to the housing market, giving updates on where the process stands (Not too far along, given that it has been only two months). He did comment on the Fed (thought they doing the right thing in their targeted liquidity moves), the President (still deciding on what fiscal stimulus, if any, is necessary), Congress (need to act on FHA reform, and in the medium term, taxes) and one more point. This final concept again cropped up more than once in the Q & A. The point is, and I am paraphrasing, that the United States remains the strongest economic country in the world, that despite the relative growth rates now, the US is more competitive than anywhere else in the world over any given time frame. He went on to say that the US has fewer structural problems related to growth than anywhere else and implied that we ourselves are the biggest obstacles to further growth, specifically singling out tax policy. Time and time again he cited the resiliency of the US economy, using historical and other examples (the recent upsurge in foreign investment here was one he repeated over and over, saying this wouldn't occur if they had no confidence in the US) to buttress his argument. It is an argument made in this forum time and again, but Mr. Paulson did it eloquently without coming off like a rah rah cheerleader.

The question and answer segment has its bizarre moments, starting with the first question. A gentleman in the front row stood up and handed Sec. Paulson a reply to a letter the questioner had sent to Energy Sec. Bodman, instructing him to address it with Sec. Paulson. He wanted to know if the Treasury, and Mr. Paulson specifically given his background with Goldman Sachs, could start taking positions in the oil futures market, preferably on the short side. After the laughing died down, Sec. Paulson gave him a very succinct answer on why that wasn't going to happen. I was asked to ask him about quasi-bailout of the banking system and the moral hazard that represented. While I didn't have that opportunity, someone else asked moral hazard of bailing out homeowners. His answer was quite good: certain people will be helped, ones deserving of help; others will not. The process being set up is designed to streamline the system, not eliminate foreclosures. It is all about separating the good, salvageable situations from the bad. Finally, on the question regarding the dollar, he did say that economic fundamentals should determine currency values, and then reiterated the strong underlying US fundamentals. As a student and participant in foreign markets for decades, I would say that rarely happens. Take a look at the value of the Euro.

I left the meeting with a renewed sense of optimism about the US. It is good to see that the people in charge have level heads, unlike the ranting and raving that is demonstrated by the headless chickens on TV. Once the uncertainty around the Presidential election and the future tax policy has passed, thing will look brighter here.

Questions

Today I will be attending a Q & A with Hank Paulson. If anyone has any questions they'd like answered, please feel free to post them. No guarantees, however. More on this later.

Fitch Move Signals Change In Ratings Concept

This item was overlooked, for the most part, when it came out the week before Christmas, but it bears mentioning. Basically, what Fitch said was that they would take other, non-credit-specific factors into account when producing a rating for a security. More specifically, they would consider a security's liquidity in rating derivation.

Deep down, I've always had a soft spot for Fitch. The third man in in essentially a two-man race, Fitch has been willing to take an outlier stance on things. When this is done and you're right, everyone thinks you're a hero. If you're wrong, well, the market, like most things, has a short memory. Fitch has to be given credit for trying.

Here's why they shouldn't do it. First, credit ratings should be just that, a rating of credit or, put is simpler terms, the risk that a security will default. In recent months, the rating agencies haven't done that well on that score. To make the simple letter/number ratings be burdened by greater amounts of variables would make the less useful and less predictive. Second, why would we think that a rating agency liquidity value would be valuable? What do they know about liquidity? In general, no one has been terribly accurate at valuing liquidity, so why would we believe a rating agency, which doesn't trade anything, be good at it? Fitch (and Moody's/S & P), stick to what you know.

This doesn't mean it couldn't be done, but it would be a tremendous undertaking requiring vast amounts of continuous real-time data, complex algorithms with an ability to process all that information and teams of real people with in-depth trading knowledge monitoring all of it for reasonableness (Who would pay for it, maybe a new government agency? Better still, the UN.). If you could do it, then maybe you could have simple 1 to 10 scale for liquidity, with the number constantly changing to reflect market conditions. Then it could be taken to the next step, a centralized location for all fixed income trading. Type in the bond, bid/offer, size, and the matching could generate a liquidity number, which in turn, can be passed electronically to the market makers (this is ridiculous, of course). Better yet, maybe the system could produce a liquidity "thumbs up or down", similar to FFIEC test on Bloomberg for MBS.