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.
Tuesday, July 29, 2008
Wednesday, July 16, 2008
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).
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).
Thursday, July 3, 2008
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.
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.
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