bondguy1824

Goodbye, So Long, Farewell...

2008-10-02T11:28:00.004-04:00

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

2008-09-19T15:45:00.002-04:00

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

2008-09-18T12:09:00.002-04:00

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

2008-09-15T20:01:00.002-04:00

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

2008-09-05T11:55:00.002-04:00

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...

2008-07-29T08:57:00.002-04:00

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...

2008-07-16T15:11:00.004-04:00

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

2008-07-03T08:40:00.002-04:00

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...

2008-06-18T09:22:00.002-04:00

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

2008-05-02T09:57:00.002-04:00

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

2008-04-14T11:38:00.003-04:00

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

2008-04-10T11:17:00.002-04:00

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

2008-04-02T08:51:00.002-04:00

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!

2008-03-31T14:44:00.002-04:00

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

2008-03-26T10:17:00.004-04:00

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

2008-03-21T09:25:00.002-04:00

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

2008-03-17T08:22:00.002-04:00

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...

2008-03-11T11:46:00.002-04:00

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

2008-03-07T13:57:00.005-05:00

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

2008-03-03T13:39:00.002-05:00

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

2008-02-26T19:00:00.002-05:00

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

2008-02-24T14:13:00.002-05:00

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

2008-02-15T12:55:00.002-05:00

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...

2008-02-14T14:09:00.003-05:00

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

2008-02-13T11:37:00.003-05:00

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

2008-02-08T16:06:00.000-05:00

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

2008-02-07T06:13:00.000-05:00

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

2008-02-01T12:34:00.000-05:00

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

2008-01-30T13:19:00.000-05:00

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.

2008-01-28T11:06:00.001-05:00

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

2008-01-22T14:50:00.000-05:00

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

2008-01-22T13:37:00.000-05:00

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

2008-01-21T14:46:00.001-05:00

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

2008-01-20T13:40:00.001-05:00

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

2008-01-19T06:17:00.000-05:00

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?

2008-01-16T06:08:00.000-05:00

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

2008-01-12T17:08:00.000-05:00

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

2008-01-11T09:51:00.000-05:00

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

2008-01-09T12:50:00.000-05:00

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

2008-01-08T11:54:00.000-05:00

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

2008-01-07T07:29:00.000-05:00

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

2008-01-03T14:15:00.000-05:00

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.

The Fed Vs. The ECB

2007-12-27T20:36:00.000-05:00

The talk started last week in the media, only to be ramped up today with the equity market down and the economic news weaker. Look what the ECB (and a few others) are doing! They're out throwing gobs and gobs of liquidity at the markets in the hope that something beautiful will grow. The Fed, on the other hand, is performing more surgical strikes, trying to get at the root cause of the problem, the stagnation of the money markets. The pundits here are screaming up and down, "Why can't the Fed be more like the ECB?" My answer would be, "Why should they be?"

The ECB's policy of flooding the market with short-term liquidity is uninspired and, for all intents and purposes, ineffective. The ECB is like an army with only one weapon. It's not entirely their fault; the problem derives from the EU's inherent political weakness. Different growth rates and differing political agendas among the EU's member states makes the ECB's job (whatever it might be) difficult. Their policy is akin to city looking to solve its crime problem by calling in a carpet-bombing air strike. Sure, the crime problem is solved but no one is around to benefit. The problem with throwing liquidity at the situation is that it is not targeted at the areas in trouble, it has a diminishing marginal return, and the markets become dependent on its continual occurrence. The end goal is to create a smoothly functioning market, not a socialist welfare state for the banking system.

The Fed's goal seems to be to nudge the money markets back to normal function. They have made moves toward that end, being as minimalist as possible. Listening to some, you would think it is 1932 and that the New Deal needs to be recreated immediately. Take a look around, it is not that bad. Let the excesses wring themselves out of the market and let's see what happens.

Pardon the language, but the throwing of shit on the wall to see what sticks isn't the answer here. Smooth out the money markets, remove the excesses, and restore market confidence will go a long way to putting us back on track.

Merry Christmas and Happy New Year

2007-12-24T11:42:00.000-05:00

I know it isn't PC, but Merry Christmas and Happy New Year!

The Fed Weighs In On Changes To Reg Z

2007-12-18T13:54:00.000-05:00

I debated today whether to write about Goldman Sachs' remarkable quarter/year or about the Fed's proposed rule changes. On the former topic, for all those analysts out there that were blind to fact that credit markets were way overvalued for sometime, Goldman's results prove that at least one group out there knew what was coming, had the right controls in place and executed a successful strategy in very difficult markets.

Let's move on to the Fed, shall we? I have stated many times in this forum that the blame in this situation (if blame is the appropriate word) needs to be spread around to all parties involved, not just the mortgage originators/sellers. The Fed's pronouncements today don't really help out on that front. Deceptive and illegal practices should, without saying, be addressed by authorities. If these practices were so rampant, why was there no clamor to change/investigate them six months ago or a year ago? It has been tacit policy of every Administration over the past 60 years to increase the level home ownership in the United States. It has been the desire of most Americans to own a home for long before that. Over the years, home financing has become more creative and complex to accomodate more and more buyers. This market is no different than any other speculative market situation over the past 500 years. Loans were made to people and/or against properties that should not have been made. Due diligence had fallen by the wayside. When home values ceased rising, the whole scheme unwound.

Most of the attempts on the Federal level to remediate the current situation will, in my opinion, lengthen the time will take the market to resolve this mess. Loans need to default or restructure, homes need to foreclose, housing prices need to fall to a market clearing level, whatever that happens to be on a local basis. Some owners will revert to being renters, most likely people that shouldn't have been lent money to buy a house in the first place. Lenders will go out of business, or, more likely, be taken over by strong/opportunistic players.

The Fed's actions on Reg Z today, if implemented, will effectively shut down the sub prime mortgage market, at least until someone finds a way around the new rules. I don't think that should be the answer. For a price, people and companies should be allow to accept those risks, on both sides. Otherwise, what is being said is that this market shouldn't have existed in the first place. That's OK by me, but let's have the Fed, the Treasury, and Congress come out and state they were wrong to allow this to develop. That's not going to happen, nor should it as some, on both sides of the homeownership coin, benefitted from the existence of a sub prime mortgage market.

Do The Right Thing

2007-12-14T15:20:00.001-05:00

Vikram Pandit made a bold move last week, particularly in light of short tenure on the job. Taking the approximately $50 billion of SIVs and placing them on Citi's balance sheet is the right thing to do. It recognizes the seriousness of the festering credibility issue that the credit markets find themselves. For months now, market experts have been chiding the US Government and the Fed to take some action, primarily in the form of a lower Fed Funds rate. The Fed has obliged with 100 bp (so far), with little effect on the problem at hand (as predicted in this and other learned forums). They have, however, propped up the stock market. The reason why a lower Fed Funds rate isn't helping the credit markets is that rates weren't too high to create tight lending conditions. Fear, uncertainty, and the re-realization of the existence of credit risk put the market into its present state, something that even a 1% Fed Funds rate would ameliorate significantly. The way to move forward is recognize the problem, and Mr. Pandit's move goes a long way for Citi. On balance sheet makes the SIV mess more quantifiable for the rest of the investing world, which, in turn, makes it easier for the investing world to evaluate the risk. This is what the market is all about, evaluating and taking risks, with the potential for being rewarded for that risk.

To borrow a line from Spike Lee, it is time for the rest of Street to do the right thing. Citi maybe the biggest single player, but there needs to be some follow through from other big players for this credit situation can come to a resolution.

As a final note, let us not forget that, in the aggregate, markets are generally positive as compared to the start of 2007. There are certainly market sectors that are down for the year, but all the major averages are higher. The rate cuts in the pipeline plus a presidential election will go a long way to helping out the market in 2008, unless we get more inflation numbers like we saw last week.

Here We Go Again...

2007-12-11T11:57:00.000-05:00

The Fed shouldn't ease at this point. The equity market has become addicted to rate cuts. It is time to stop. The same pundits that are crying for a rate cut today are also saying that the real problem is in the money markets. They are correct on that count, that is where the real problem is. Seventy-five basis points worth of Fed Funds rate cuts haven't helped there; further cuts are unlikely to do anything on that front. If the Fed cuts rates back down to 1% and LIBOR trades at 3.5%, would these pundits consider that a success? At 250 bps spread, I would consider it a failure. The Fed need to deploy other weapons, specifically discount rate cuts combined with encouraging language to allow for use of the discount window. Here's a idea: Let the Fed cut the discount rate 75bp today and leave funds where they are. Then, we will see it that has an effect on the money markets. The Fed Funds cuts will have no effect, other than an artificial boost to stocks, leaving the markets in the same situation as we have been in since August. Lending needs to free up on the most basic level, overnight and short-term between banks, in order to open up markets and stimulate the economy on a more macro scale. This being said, I'm sure that Bernanke and Co. will not listen to me and go with the path of least resistance

Trust Your Government Redux

2007-12-07T10:09:00.000-05:00

I think the best thing I can say about this plan to freeze rates for some mortgages is that, for the time being, Congress isn't sticking its head in this mess. It seems to be a huge leap, and a blind one at that, to thing that this will stabilize home prices. It remains to be seen whether this helps anyone. Many of these loans were on houses where the buyer's equity investment was zero to start. Freezing the rates on loans on properties where there is a negative equity situation may keep the payments manageable, but why as a borrower would you want to do so? The best thing would be A) restructure and refinance the loans to reflect reality and B) streamline the foreclosure process to allow property values to adjust to the appropriate (read: lower) level more quickly to the country and markets can move beyond this crisis. I understand the political expediencies behind this move, but, in the long term, the borrowers won't be helped. Using history as a guide, these homeowners will be stuck in their houses for an extended period, waiting for the time when their home equity will turn positive. Look at the late Eighties. If you bought a house in 1986, you would have had to wait until at least 1996, on a nationwide average, to get back to the 1986 (absolute, not inflation adjusted) level. People at the margin, the sub prime borrower in trouble, are just locking themselves into a situation they probably shouldn't have bought into in the first place. The Band-Aid approach is better. It hurts a lot to rip it off, but it's over with quickly.

Followed By the UK

2007-12-07T10:07:00.000-05:00

In all fairness, the BOE has legitimate reasons for cutting rates.

Canada Caves First

2007-12-04T09:47:00.000-05:00

The Bank of Canada (BoC) this morning cut its overnight rate 25 bps to 4.25%. This was in response not to a slowing economy (au contraire) or rising unemployment (it is at a 30+ year low), but rather to a hue and cry of Canada's manufacturing sector and the provincial premiers. The BoC used for cover the idea that future inflation will be lower; present inflation however is still pretty high. Canada was the first to cut rates to prop up exports, but they won't be the last. I don't blame them; Canada is acting in its national self-interest, ostensibly. However, the world, including many Americans, need to stop treating the United States and the rest of the world with a double standard. Let the rest of the world become more competitive rather than relying on the crutch of currency devaluation. Everyone and their brother is touting the success of the Brazilian economy. However, most of these touters either have too short of experience there or have chosen to ignore the fact that Brazil got to this point by devaluing its currency, which was one of the contributing factors to Argentina's bankruptcy. The Brazil real is still significantly weaker versus the US dollar than in was in 1999, even after the big run up this year.

I have said here many times that the risk of lower rates is higher inflation. If the reason for the Fed lowering rates was to prop up exports, I would be vehemently opposed to them. As it is now, I don't think a lower Fed Funds rate is justified, but at least a credible case can be made. Other countries, even those with independent central banks, lower rates all time in order to make exports competitive. My point is that these same countries shouldn't complain when a consequence of lower US rates is stronger US exports. However, no one people are as altruistic as Americans are. Maybe it is time to be more selective in our altruism.

Trust Your Government

2007-11-30T15:24:00.000-05:00

I know the title isn't particularly descriptive, but let's hope Hank Paulson is really trying to do the right thing. The idea is good, getting all the lending-side parties together in order to speed up the process of potential mortgage restructurings. It is reasonable to assume that as long the process isn't co-opted by some other part of government (Congress would be a disaster), the best possible outcome can occur. Secretary Paulson is one of those "smart guys" from Goldman Sachs and knows what needs to be done. If, however, a wave of populist sentiment overtakes this process, the outcome would would devolve into something far worse than taking no action.

Certainly the banks and other financial players involved know what is involved in restructuring. That can't be said for most homeowners. Remember, many of these homeowners are now complaining they weren't informed of what could happen (Last word on this: the blogosphere is full of people with strong opinions on both sides, however if there was fraud involved in the mortgage creation, then prosecute the involved parties. Otherwise, admit you made a mistake, didn't read what you signed and live with the consequences). How are they supposed to negotiate in a restructuring? The information that is coming out so far is limited to freezing rate increases, but there has to be more to it. A rate freeze may help a few that can't make month to month payments and keep a few in their homes. However, it doesn't help the increasing negative equity situation caused by falling housing prices. I'll wait and see, but I'm optimistic that the Treasury does the right and necessary thing.

The Sound You Hear The Fed's Credibility Draining Away

2007-11-28T15:15:00.000-05:00

It is truly amazing to see how much the media influences what is happening in the market these days. It would have been thought that the Fed would be immune, but it is beginning to look like that is case less and less. In the last two months, the Fed has cut the Fed Funds rate 75 basis points, the true (not the market rallying euphoria) effect has not been felt nor will it be for the next several months. The suggestion that another cut is coming in December has propelled equities much higher. This is exactly what the talking heads on TV have been espousing for weeks. Now they have convinced people who matter to go along with this idea, regardless of the longer term consequences. Perhaps they should listen to their guests who, almost uniformly, think that the economy will continue to plug along without cuts. The real problems now are in the credit market. Lowering Fed Funds in and of itself will not necessarily help the credit market. Seventy five basis points hasn't helped out the LIBOR situation much, a rate that actually means something in the real world. If the Fed wants to help there, cut the discount rate to below the Fed Funds and take other steps (maybe reserve requirements) to get lending going. Have the Fed apply some moral suasion (before they lose it) to all the players involved to grease the wheels. Otherwise, the market will just become addicted to continuous rate cuts and the US will end up like Japan.

The Fed still has a chance to do the right thing, but it is looking less promising.

Uncertainty Rules The Waves

2007-11-26T20:19:00.000-05:00

In the this shouldn't continue category, the markets will continue to slowly implode until all the players disclose all the material information regarding their exposure to the credit markets. Just as nature abhors a vacuum, the market hates uncertainty. Uncertainty creates illiquidity, illiquidity creates risk aversion, and risk aversion creates the slow slide to valuation oblivion. It is really as simple as that. The Fed can cut rates until the cows come home, but it won't make a difference until the investors regain confidence in the markets. The sad part is that the economy is in pretty good shape, and the equity (and credit) markets should really be doing better. It is really amazing to me that there are a disproportionate amount of analysts looking at the Treasury market and predicting where Fed Funds should be. Those days are over. Risk aversion has push Treasury rates to unrealistically low levels, and the market watchers dip into their old playbook to have something to talk about. It can't be reiterated too many times: disclose and take your lumps. Let's all move forward.

More Fallout...

2007-11-24T14:19:00.000-05:00

Many items related to the credit crunch/housing bubble have been written about and discussed ad nauseaum (including here), but surprising little has been mentioned about how to make money from it. Perhaps everyone has become too politically correct to discuss this, afraid of offending anyone, even those that made poor financial decisions. The reality is that opportunities abound in markets like this. Frankly, there more attractive investment options now than there were one year or even six months ago. Are the markets more inherently risky than six months ago? Probably not, but investors perceptions of the risk is much greater than then. These risks have manifested themselves in higher volatility measurements like the VIX index.

On TV, the answer on everyone's lips is twofold. Either buy tech stocks or invest internationally is the cry. Both strategies as a general rule have probably run their course. Where were these people a year ago, when both ideas were much more attractive than they are now on a valuation basis, especially international investing (I beat my brains out for years trying to get people to put there money in foreign currencies, to little avail). Certainly there have to be better options out there now than putting money into appreciated assets of perceived safety and immunity. It is understandable that Treasuries and other credit risk-free assets have benefited from a flight to quality, but the others may just be the next cycle in the fallout. It is time to look at other assets and overlooked areas for investment ideas.

The first thing I am not going to write is buy financials, but it stands to reason that the entire financial system isn't going away. Most of the sector has gotten beaten up badly. However, not being an equity analyst I'll leave those calls to them. The investment grade corporate bond market has not been a participant in this rally, however, with some notable exceptions, absolute yields haven't changed much either, pushing spreads back to '02 levels. High yield bonds and preferreds have done worse, mainly due to a fear-induced buyers strike. However, this is a baby with the bathwater situation. Here again, not everyone (and perhaps not anyone) is going out of business. It is time to start looking and locking in yields at the currently available levels. Remember, many corporate bonds today are trading at a discount, so a significant component to yield will be derived from price appreciation.

The other item I wish to touch on is real estate. All real estate is local, so you need to know well the market being considered. There may be significant price declines before stabilization. Also, real estate isn't very liquid and transaction and other costs are relatively high. However, here are two methods to keep in mind: foreclosures and bank sales. Foreclosures occur generally occur in a method not seen much any more, an open outcry auction usually handled by a county sheriff. It can be a cheap way of getting a hold of a property, but keep in mind that few properties ever make it foreclosure as both parties come to some agreement beforehand. Bank sales come about after a bank forecloses on a property it hold the mortgage on. They are usually "motivated sellers" as banks don't want to tie up capital in real estate. Contact banks for lists of property they may have for sale. The final item is tax liens. While this segment hasn't grown due to market fallout, by this time next year tax liens should be more plentiful as property owners fall behind on the taxes. A tax lien is created when someone is delinquent on their property taxes/other fees the owe to a governmental entity. The government wants its money, so it sells the right to collect that tax in the form of a lien to the highest bidder. Each state has its own method of doing this, so it is important to find out the rules well in advance. You may be able to foreclose on the lien and end up owning the property for practically nothing, but the real benefit here is the rate of interest you can charge the property owner. As it is a tax lien, your priority claim on the property comes right after the IRS. Again, the liquidity here is fairly low, so be prepared for the long term.

The Retail Fixed Income Professional's Lament

2007-11-20T11:10:00.000-05:00

For those of you involved in the fixed income market, this will be no surprise. On the web, there are hundreds of posts like the one below. I decided to respond on behalf of all responsible members of the fixed income community.

Post:

Looking for some constructive suggestions.I am a fixed income investor. Whole Gamut (Broker CDs, Agency Paper, Corporates, US Treasuries, Mortgage-backed, etc)As any fixed income investor knows, the "spread" in these (mostly) over-the-counter investments can be as much as 3%on any given day. This is probably the last "full price commission" investment type out there.To me its really inconceivable that no one has yet sought to discount these "mark-ups" particularly since the fixed price wall fell on equity trades 30 yrs ago.I've thought about an "exchange" similar to a bulletin board where individuals could post what they have or want,kind of like an eBay of fixed income trading.To those unfamiliar with these mark-ups, it works kind of like this:Investor A owns a $50,000 Freddie Mac Bond with certain interest rate and maturity characteristics. This bond is given a CUSIP number which makes it "unique." This bond (like nearly all others) is held by Investor A's broker in "book entry" within his brokerage account.For whatever reason, Investor A would like to sell this bond. Looking at his statement, Investor A sees that the bond isworth (according to a computer pricing model called a "matrix") 99.25. Thus, Investor A's $50,000 bond is theoretically worth $49,625.Such matrix pricing is used for all sorts of reasons. The IRS accepts it. Margin maintenance is calculated from it.etc. etc.However.here is the rub.When Investor A calls his broker to sell it, his broker will say..."let me get you a bid"Invariably, the borker will get back to Investor A and tell him:The best I can get for you is (for example) 97.50, or $ 48,750.Now..multiply that my the billions of dollars of fixed income securities that trades each day.Where does this "difference" go? It goes to the trading desk of the brokerage firms.So my thought is, how to bypass the trading desk?If a bulletin board was established and Investor A finds Investor B, Investor A would instruct his broker to deliverthe security to Investor B once Investor B delivers the agreed payment amount.Now I'm sure the borkers who read this will flame me.....as this is pure herasy.But you know....it's about time someone told the emperor he's not wearing any clothes.

Reply:

There are a lot of problems with what you suggest, some of which are listed here. Not the least of these problems is your premise that the matrix price for the bond on your account is accurate. They rarely ever are. Don't think of bond pricing like equities. There are roughly 8000 listed equities in the US; maybe half of them trade actively. There are literally millions of bond issues, some of which never trade. If you are really concerned about the bid, ask the broker to offer you the bond, or if not available, something similar. If they are not willing to do it or are unwilling or unable to provide you with a reasonable and understandable explanation, move your account to a firm that will do it. Then you can judge for yourself as to its accuracy. As a person that ran a fixed income trading desk dealing with individual investors at a major firm for many years, that is the information I was more than happy to provide as it showed our desk's professionalism and competitiveness. It is also what I advise my fixed income consulting clients. Finally, the trading desk makes its money on the bid-offer spread, but you are assuming that for bond you sell back to the trading desk, there is a ready buyer on the other side of the trade. That rarely happens, particularly when dealing with individual investors. The bid-offer spread should reflect the amount of risk in any given security. With what is going on in the credit markets, liquidity is lower and bid-offer spreads will be wider to reflect that increased risk as well as other risks.

A Rate Cut Too Far

2007-11-17T07:16:00.000-05:00

Fortunately for us, the Fed is still independent enough to rise above the noise and chatter of the market pundits. In the last two months, the Fed has cut the target Fed Fund rate 75 basis points. The effect of these cuts has yet to be felt, and won't be until at least the end of the first quarter. Fed members have been out speaking publicly over the past week, preparing the market for a meeting that will not produce a rate cut. The equity market, and increasingly the money markets are becoming addicted to rate cuts. The wild market swings this past week prove it. However, the Fed must hold the line here and wait to see what happens.

There are several reasons for this; one I have already mentioned (effects yet to be felt). Second, the Fed doesn't want to use up all of its ammo now. It needs to save some to use later if necessary. Third, the Fed doesn't want to be int the same situation a few years from now as it is in now. A strong case can be made for the idea the current situation in the markets were at least exacerbated by Fed policy on rates earlier in this decade, when rates were left too low for too long. Fourth, and most important for the Fed as it is part of their mandate, is the level of inflation. If we are truly in a global economy, some of the global inflation is going to be imported to this country. Here again, there is a lot of market noise, particularly on the commodity front. You can't open your eyes or ears without seeing the price of gold or "black gold", which given the speculative pressures in the oil market, seems to be the inflation hedge of choice these days. However, price stability is the Fed's job and they know that continual rate cuts will eventually become problematic on the inflation front.

There are two problems in the market/economy today. One is housing. The housing market was in a bubble and is now being deflated. Too many houses and too much speculation needs to be worked out of the market. As much as everyone would not like to see people kicked out of their homes, many homeowners bought properties they couldn't afford. The media and politicians have focused on the cases of fraud that occurred in the mortgage market. The reality is that this is a small percentage of cases. A large percentage of defaults and foreclosures are in investment properties, which need to be viewed like any other investment that has declined in value. The rest were properties that were bought at the height of the market, sometimes using mortgage instruments that the buyers did not fully understand (sometimes they did). The housing situation is such that it would be in the best interest of all parties to try to restructure the mortgages to more realistic levels. Banks do not want to want to foreclose on a bunch of properties they can't easily sell and don't want to expose themselves to the public relations nightmare of kicking millions of people out of there homes. Homeowners don't want to have a mortgage default on their credit history. Both sides need to take their lumps and move on.

The other problem is the bubble being deflated in the credit markets; I have already written at length on this topic. The Fed can help here and have already tried. However, they need to specifically target the liquidity situation directly. Cut the discount rate, remove the stigma of doing so, and stop making it a penalty rate for now ( the Bank of England actually calls its rate at its emergency lending facility a "penalty rate"). This will free up liquidity in the front end of the fixed income market and will allow banks to lend more freely to the "real" economy. The Fed could also look at reserve requirements, but given the turmoil and uncertainty in the banking sector currently, I'm not sure this would help at this time (I'll leave that to the Fed to decide).

A Manic Market

2007-11-14T21:45:00.000-05:00

Just a short comment today. Yesterday's rally and today's inaction, following what happened on Monday is just another sign of the uncertainty in the equity markets. The ironic thing is that base interest rates have remained benign. In the credit markets, bonds are getting brought to market, albeit at levels not seen in years. For example, Citi brought $4 billion 10yrs at +190, the widest spread ever for that issuer in that maturity. Yet, in absolute yield terms, it is only about 15 basis points higher that the last 10yr Citi brought in August. It is realities like this that show we are living through a manic market. Stocks will lurch from story to story and the bond market, especially anything with credit risk, will remain hostage to the uncertainty of valuations. Only in a crazy market do you see a Bear Stearns announce they are taking a charge equal to one-tenth of their market cap being viewed as a good thing. Well, at least they reduced their exposure; they claim they're net short sub prime now. I guess we should hope in doesn't rally...

PS. This blog went over 1000 hits today. Thank you!

A Different Comparison

2007-11-13T14:03:00.000-05:00

To begin with, I apologize for my extra long hiatus. Save today, the financial markets have been taking a beating largely due to the unknowns in asset valuations held on the books of a variety of institutions. As referred to in a previous post, the sooner we get to accurate and full disclosure on the situation, the sooner that all the markets can return to normal function. It has been posited by many, including myself, that the current credit market problem has parallels in the LTCM crisis of 1998. Certainly from liquidity standpoint, there were segments of the market that suffered from a liquidity seizure this summer, although I would make the case that liquidity in general was worse in 1998, but the issue wasn't dragged out as long as it currently has been. Of course, the size and scope of the problem is much larger. That leads us to make a different comparison, one whose size is more in line with the dilemma.

The NASDAQ market index peaked in 2000 at a level over 5000. Back then, after an 80+% increase in prices in 1999, fear/greed coupled with the reality that companies with no revenue should have market capitalization greater than most of the Dow 30 came roaring back into the market and the bubble burst. The current market of SIVs, CDOs, ABCP, and every other acronym you can think of is no different than the NASDAQ was in 2000; just an overheated market where valuations (and value, for that matter) got way, way ahead of itself. The credit risk component was ignored and thrown out the window. Goldman announced today that they are net short this market. It wouldn't surprise me in the final review of all this that it was when Goldman went short and set up hedges in this market that the other market participants realized what was going on and tried to get out. The window, however, closed very quickly. Think of it like a game of musical chairs, where there are four chairs, one hundred players and one of the players controls the music.

There is one significant difference, which is why the NASDAQ comparison isn't made. When the price of Pets.com fell from $100 to 2 cents (or whatever) there was price transparency and the markets functioned well. In the current market for all the acronym products, there is not price transparency nor an agreement on what methodology should be used in determining value. Here's my suggestion on how to speed up the resolution of the problem (this won't happen, by the way). Get all the players, the top 50 say, to disclose in an unambiguous manner what they hold and how they are valuing it and let the chips fall where they may. This may create a sharp dislocation in the market, but it should go a long way toward transparency. The equity markets traded sideways for years until recently, but the bubble needed to burst and sound valuations needed to return to the market. Remember, the NASDAQ today at 2650 is still only half the level of March 2000.

P.S. In the giving credit where credit is due category, yesterday I had the privilege of attending a ceremony at the French consulate in New York where nine US WWII veterans, including my father, were inducted into the Legion of Honor for their service to France. It took a "regime change" in Paris and came 63 years after D-Day, but, still, the ceremony was moving and the words of President Sarkozy and his representatives were heartfelt and genuine.

Market Dislocations Create Opportunities

2007-11-06T15:51:00.000-05:00

Whenever the bond market encounters these periods of dislocation, like it is currently experiencing, opportunities often present themselves. Given the state of the fixed income market, I'd like to highlight one segment that has been particularly hard hit. What area of fixed income has long stated maturities, relatively small institutional participation and is heavily weighted in bank/finance paper? The sector is preferreds.

Although there are now preferred funds and ETFs, preferreds are generally the bailiwick of individual investors. They're created to look like stock, and some have tax advantages like stocks, but they should be viewed and treated like fixed income instruments. A typical preferred will have a $25 par amount, pay quarterly, and is listed on the NYSE. Preferreds usually have a 30yr or longer maturity, with a par call feature that generally comes into play after five years. With the hybrid nature of their structure, preferreds are usually rated a notch below other debt instruments of a given company. Without going too much into arcane details, the majority of issuers are bank and finance companies, but there are also utilities, industrials, etc. The characteristics of the product make it more attractive and easier to understand for individuals. Except for the natural buyers listed above (funds and ETFs), institutions (hedge funds and the like) don't participate in the preferred market to the degree of other fixed income instruments. Let's just say it gets overlooked by that group of investors.

These factors (long maturity, low institutional participation, structure, nature of issuer) combine to create pricing anomalies in the preferred market. However, there is one counterintuitive element of preferreds that exaggerates the pricing anomalies; the fact that they are listed on the NYSE. Unlike most fixed income instruments, preferred trades either occur on an exchange or are reported to it on a timely basis, like a stock. Unlike a stock, a preferred issue doesn't have a specialist maintaining an orderly market. Dealers and customers are providing bid and offer prices on the floor via orders. If news comes out or the market is in turmoil, the bids on the floor get hit or pulled in rapid fashion, which can produce wild price swings. For example, (oversimplification for illustration purposes) if a preferred bid gets hit at 25, the next bid lower might 24. If the 24 bid is then hit, that is the equivalent of a 4 point move on a bond, given the $25 par value of the product. While the market will eventually step in and smooth out all the price discrepancies, that may take a considerable period of time (days, weeks, months) given the nature of the market problem.

Before putting any money into this, let me remind everyone that the current market condition is not something everyone should be involved in. It is certainly not for those of the faint of heart or for those who don't realize that an investment in most anything can lead to a loss (yes, there are people like that out there). As for the preferred market, it would be advisable to seek out the advice of someone who is very knowledgeable about this market in particular. Finally, the above discussion refers solely to the secondary market in preferreds, not new issues which has different market characteristics.

P.S. This will be my last entry this week. For those of you that live outside of New Jersey, Thursday and Friday is the state teachers convention. For those with kids, it is basically a holiday here.

Mark to Model=Best Guess

2007-11-05T12:59:00.000-05:00

The current credit market situation would be laughable if it wasn't so serious. It is playing out like a bad daytime soap opera. The latest buzzword that is entering the everyday lexicon is mark-to-model.

All bond traders to some degree price securities using models, even one that trades a benchmark security like Treasuries. The simplest model would be a straight yield spread to Treasuries. As time marched on and increasing amounts of data could easily be processed, models became ever more complex. Synthetic benchmarks were used with increasing frequency, adding to the mix. It seemed that no amount of variables could stop some mathematical genius from developing a model to calculate the exact value of X. However, there are three variables that could never accurately be taken into account by the models. Those three variables are fear, greed, and liquidity.

Fear and greed are the two that create outsized moves in the market, either ends of the pendulum swing, as it were. Greed usually takes effect more slowly, building up to level of overvaluation. That is the point that the credit market reached in June over a buildup of several years. Then, fear took over, as investors sold and exited markets in an attempt to lock in what they had gained. Fear takes hold very quickly, like being hit over the head with a sledgehammer. It was at this point when traders were reporting "10,000 standard deviation" market moves. Finally, a second kind of fear kicked in, observed in the market as illiquidity. This is when the market players said "No mas" and brought the CP market, especially the asset backed CP market, to a standstill. With models used to calculate values starved of accurate input data, marking or pricing to model became a best guess scenario.

The faith that Wall Street and the investment community has placed in these models has been shaken. Almost daily now, new "best guesses" as to the carrying value (as it doesn't look like many of them have been sold or unwound) of these assets are released. It is one thing to interpolate the spread of a GE 6yr maturity bond, when the value of the GE 5yr and 10yr is known. However, in the current environment, it is near impossible to determine what value an asset has when the underlying securities have been repackaged four times and have uncertain cash flows going forward. To paraphrase last week's post, mark-to-market (or mark-to-worst case scenario) already.

Mark To Market, Already!

2007-11-02T11:24:00.001-04:00

In July, I had a breakfast meeting with two gentlemen who are quite well versed in the bond market. They asked me whether the credit situation that was just coming to light would be prolonged and would it spread elsewhere. My answer was that this was the healthy move for the credit markets given how overvalued they had become. I went on to say that I didn't think that would spread to the rest of the economy and precipitate a recession (I'm not sure my colleagues agreed with me). Up until recently I agreed with that assessment. However, in making that assessment, I assumed (that word!) that the appropriate rules and laws of trading and valuation would apply. Now I'm now so sure.

The problem with my premise is that the valuation issues that began to come to light in summer are still lingering and perhaps they are getting worse. What I mean by getting worse is story out today on Merrill Lynch that they acted in concert with hedge funds to hide or defer losses. If this is true, it is almost a certainty that that type of activity occurred elsewhere. This is a major trust issue. Let's face it, financial firms don't have vast amounts of real assets backing up their market capitalization. When trust is eliminated from the equation, value and the ability to do business dries up. There are many examples; E.F. Hutton comes to mind about a firm where the market lost confidence. It cannot be emphasized enough that all the players need to determine their exposures, value them as conservatively as possible (there were many times in my career when I marked bonds to distressed levels, even zero, if I couldn't determine the value by usual means.) or get them off the books. There is a market clearing value for everything. You would get the impression when reading/listening to the popular press that these SIV assets are worthless. That is because when it is discussed, the exposure level is mentioned implicitly as an all-or-nothing value; either a SIV is worth face value or it is worth nothing, like a coin flip. The reality is that the value is somewhere in between. It's time for the banks, brokerages, and other involved parties to move to those levels come clean about the losses and move on. Otherwise, the markets face continuing levels of volatility, slowly deteriorating week by week, trading lower on rumor and innuendo.

The Deficit

2007-11-01T16:01:00.000-04:00

Given my background, I get a lot of questions on the the dollar's value. Many of them are related to the trade deficit. Here is the bottom line. The US has been shipping dollars out of the country in mass quantities to pay for imports for years. The US is a large country with a history of steady growth. The dollars come back to this country to take advantage of those growth opportunities. Lately, there have been growth opportunities elsewhere as well, in sufficient amounts that some of that investment goes to other countries, lessening demand for dollars. Hence, the "price" goes down. This make goods here cheaper and if all things were equal (which rarely occurs in trade), consumers will demand more, which they have. US exports are increasing at 3 times the rate of imports, and would be increasing faster if the single largest US import, oil, wasn't being driven higher by speculators (I know, I know, the supply figures were lower. It shouldn't be a real surprise that companies don't want to buy oil here when they think it will be cheaper later on. Supply number measure oil in storage, not what's being produced. In addition, gasoline prices have lagged oil, squeezing margins. Here again, it shouldn't be a surprise that less in being produced and capacity utilization is down.). As long as inflation remains under control, we shouldn't be overly concerned about a weaker dollar. Our trading partners, however, that have made a living off of a stronger dollar, have much more to be worried about. But that story is for another time.

So ends the micro- and macro-economic lesson.

The Fed Did the Right Thing

2007-10-31T14:45:00.000-04:00

Not because they agreed with I posted yesterday, but because they told investors, as much as they can, what they are going to do going forward. They have rightly adjusted expectations while giving themselves flexibility.

Caveat Emptor

2007-10-31T11:17:00.000-04:00

This is another in the series of pre-Fed postings, while we wait for some discussionable (is that a word?) news.

Last night, while cleaning up, I was flipping around the channels and I came across Jim Cramer and his Mad Money show. He was pounding the table, in a less-than-usual animated fashion, on Brazil, and specifically Banco Bradesco (BBD). He rattled off a whole host of reasons why you should buy Brazil, all of them valid. He stressed buying the ADRs, rather than the local (ordinary) shares, also sound advice, for the most part. He even admonished himself for a Brazilian pick earlier in the year, Bradesco vs. Itau.

What Cramer neglected is the history of investing in Brazil. Investors with little experience in Brazil and elsewhere in emerging markets don't realize how fast money can exit these markets. To be fair, I don't know what Mr. Cramer's experience is relative to Brazil. I do, however, know mine. I know that a good chunk of the gain is currency-related (Yes, ADRs have currency risk. You are buying a dollar-denominated proxy for the local shares. Even if the underlying shares don't move in price, the ADR value will fluctuate with change in value of the US dollar relative to the local currency) The BRL is up a ton this year vs. the USD; that probably won't happen again, at least to the same degree. It wasn't that long ago that the BRL was devalued in order to bail out the economy. This, among other things, helped push Argentina over the edge into bankruptcy, as they are large trading partners. Finally, Brazil is one of the most opaque markets in the world. The rules of normal business practice and laws to protect investors are nowhere near the level of transparency that you would find in a developed market. Locals control much of the business and information flow in Brazil, and that isn't going to change anytime soon. The bottom line here is also the title line: Caveat Emptor.

For The Record...

2007-10-30T15:53:00.000-04:00

As is now customary, I will go on the the record about what I think the Fed will do tomorrow. So far, I'm 0-for-1, for those of you keeping score. The Fed will cut both rates 25bps, really for no other reason than they have primed the market with that feeling. Fifty basis points looks aggressive here, especially give equity prices, but, in fairness, I said that last time. Postponing a cut until December is inconsistent with Fed actions in general. Rarely does the Fed do one and done. What will be most important about tomorrow's announcement will be what they say going forward. The Fed needs to throw something to currency market, to at least keep the decline of the dollar steady. What would work would be a statement to the effect that the Fed is going to gauge the effectiveness of recent cuts on the economy, markets, etc. They can get away with this because it is generally accepted that it takes some time for these moves to filter through the economy. Then they throw in the boilerplate language about standing ready to act if necessary, yada, yada, yada, to keep equities from selling off 10%.

With one more meeting this year, the Fed is in a tough spot. They don't have as much room to maneuver. Next year, being an election year, the Fed will be more hesitant to act. There is no incumbent up for re-election, so it does give them more flexibility. They may not need to do much more anytime soon. However, the Fed need to telegraph its thoughts now that it can't solve the subprime crisis or bail out homeowners that bought more than they could afford by themselves; market-based solutions are what is needed in both cases. Otherwise, it will be a tough '08.

The Next CEO of Merrill Lynch Is...

2007-10-29T13:22:00.000-04:00

Since there is a Fed meeting this week that has meaning and given the dearth of other news in the financial world (Riding on a plane with Warren Buffett on his trip to China does not qualify as breaking financial news, sorry CNBC), all eyes are focused on Stan O'Neal's departure from Merrill. Whether or not you think his exit is justified, his leaving has become a foregone conclusion now that he went behind the board's back, the same board that put him into that job over other, some would say, more qualified candidates. Merrill seems to go through these gut-wrenching fits every five years or so. They get into trouble when they stray too far away from what they do best, catering to the needs of private clients. That certainly what has happened here with these massive credit market exposure writedowns. It happened back in '98 after another fixed income blow up, Russia. Then, they exited a fixed income sector that I traded at a large competitor. I had one of the best months of my career, picking up Merrill's inventory on the cheap and having one less major competitor to deal with. For Merrill, this cycle is nothing new. What's different is that this time it goes all the way to the top. Stan O'Neal never enjoyed the unquestioned support of the 15,000 financial advisors as previous CEOs did. He wasn't one of them.

Who's next? Page C1 of today's Wall Street Journal has the pictures of the likely candidates: John Thain; Greg Fleming; Bob McCann; and Larry Fink. I'm going to shoot all of their candidacies down, knowing full well by the time I finish writing this one of them may have already accepted the job, and make my own suggestion. John Thain already was president of Goldman; why would he want the Merrill job? Besides, Thain wants Chuck Prince's job. Fleming knows the markets, but as far as the Merrill FAs are concerned, he's just another Stan O'Neal. He didn't come from their ranks and would not be acceptable to the FAs. Bob McCann would fit that description as far as Merrill's brokers are concerned, but he know little about that troubles the firm currently faces. Still, McCann would be the safe choice by placating the salesforce. That leaves Larry Fink. He certainly is the best all around candidate, but he has it pretty good over there at BlackRock. I'm not sure he wants to leave to take the Merrill job. It is also questionable how much of an outsider, which seems to be the consensus as to whom would be best for Merrill, Fink is , as Merrill owns 49% of BlackRock.

Having said all that, and not trying to be too self-serving, but I would like to put forth yours truly for the Merrill CEO position. I am definitely an outsider, certainly have the fixed income experience, and am very knowledgeable as to the workings of a large retail brokerage firm. So, if anyone on the Merrill board is reading this, except Stan O'Neal and Bob McCann of course, feel free to contact me at your convenience.

Foresight is 20/20

2007-10-26T12:09:00.000-04:00

http://www.bloomberg.com/apps/news?pid=email_en&refer=rates&sid=axTqfaTiLf4I

Just a quick note on a Friday. The above link is to a Bloomberg article on Argentine debt. Surprise, surprise that the value of these securities are in question. This is an "I told you so". All I can say is caveat emptor. There can't much sympathy for those that bought these securities and the accompanying warrants given the bankruptcy, the lengthy restructuring, the hardball tactics, the opacity of the structures' valuations, the limited convertibility of the currency, and the headlong rush into the arms of the likes of Hugo Chavez. Well, greed can be blinding. Have a good weekend.

The Demise of the Bond Trader

2007-10-25T15:23:00.000-04:00

The big losses being racked up by the banks and brokers these days can be directly attributable to one thing: the demise of the bond trader. More specifically, it is the demise of the art of bond trading in favor of the science of bond trading. Since the advent of widespread use of computers on Wall Street for valuation purposes, the art of bond trading has been pushed into slow but steady decline. Twenty years ago, the most sophisticated piece of equipment on a bond trader's desk was a Lane or Monroe bond calculator. It was the explosive growth of repackaged MBS pass-thrus (CMOs) that created the need for more sophisticated methods of determining value. Back then, the real prestige item for Wall Street firms was a Cray Supercomputer (do they even exist anymore?), used in calculating all the cash flows and other variables that went into structuring a CMO. The rest is history. There have been hiccups along the way, most notably in 1993-4 when the mortgage prepayment models didn't adapt to the changing interest rate/product environment and in 1998, when genius failed, as the book was so aptly titled, to account for reduced liquidity. It turns out, or perhaps more correctly, will turn out that 1998 was just a warmup for 2007. When the art of trading finally pushed back against the science, liquidity ran for the hills.

I'm no Luddite. My writing this blog should prove that. Nor am I suggesting that the world go back to writing prices and spreads down on little pieces of paper taped all over the desk. The problem comes about when a mathematical model completely supplants common sense. Management, for the most part, loved this because a model provides a definitive answer. Management could then take the model-derived answer and show it to the CEO, Board of Directors, major investors, regulators, etc. and say "See, here is our exposure, here is our risk, and here is what we've done to mitigate it. You may rest assured, now." As is publicly known now, and privately talked about for awhile, the inputs that were used to generate these model-derived values, particularly with regard to liquidity, were faulty to say the least. The models, generally very complex mathematical formulas taking into account a whole host of variables, are developed by some of the finest technical minds in the world, but have little practical market experience. Many are PhDs in the "hard" sciences, Physics and the like. Most of the people that use the models are not finest technical minds in the world, but have some or much practical market experience. Therein lies the disconnect. The consumers of information, always looking for better and faster ways to make money (a good thing, by the way), have become so reliant on the neat answers that models provide them that they ignored common sense and forgotten how to trade and the risks of trading.

If there is one lesson learned by all of this, it should be that the decision makers and risk takers need to get in touch with their trading roots and apply good old-fashioned common sense to the model equation. Securities that are packaged and repackaged and repackaged and repackaged again deserve more scrutiny, on all levels including rating, then they have received in the past. Values need to reflect all the risks, including the risk that the value may not be able to be determined. Maybe then, the trader's "bid out" would have happened sooner, sparing many the problems of the past few months. Probably not, but it is a wishful thought. The good news is that some happy medium will develop, new methods will arise, and the bond market will go on its merry way.

Back to August

2007-10-24T10:10:00.000-04:00

Merrill Lynch announces a much larger than expected loss, coupled with weak home sales numbers and the pundits are coming out of the woodwork, falling all over themselves to demand that the Fed cuts rate 50bps next week. An analyst on CNBC went further this morning, saying that Hank Paulson's involvement in the creation of the SIV buying facility (designated M-LEC, or designated by me as BOSTONS-Buyers Of SIVs That Others Nevertheless Spurned) was really his way of begging the Fed to cut rates. Not surprisingly, Fed Funds futures are now leaning toward a 50 bp move. What is ironic about this is that the same people who were up in arms about the government (including the Fed) not acting fast enough are still up in arms or at least suspicious, about the government trying to help. Even with videotape and YouTube, TV has a short memory.

The bottom line here is that there are assets on the books of many firms that still have the valuation problems. At this point, that should have been worked out. When a valuation problem occurs, it is imperative to mark an asset to an appropriate level. Sometimes it is difficult what that level might be. At the end of the day, something is only worth what someone will pay for it. Too many times in my career did I come across the theoretical values guys out there, saying a security is worth X because the model says so. This Merrill announcement, and probably more to come from others, tells us that the model devotees are still holding sway. The value of Google stock is readily quantifiable, but the value of SIV-123abc isn't. When in doubt, mark it to a conservative level. When there is no real bid for an asset, the mark should represent the worse case scenario if that asset had to be sold. Clearly, the owners of these assets haven't gotten to that level yet. They are hoping the market bails them out, which is why they set up the M-LEC as a transitional facility until previous liquid market condition return. Then, M-LEC is a home run as it was able to pick up cheap assets.

In the end, it is the role of capitalism to punish entities that get valuation wrong. There is still a way to go, but the system will work and, in the end, economic growth will continue.

The Case For Sound Advice

2007-10-23T09:56:00.000-04:00

'Sell all your mutual funds and stop being ripped off'.

Here is the link to this article http://www.marketwatch.com/news/story/sell-all-your-mutual-funds/story.aspx?guid=%7B4B8CD1AC%2DE5B4%2D46E0%2D9C24%2D03B45347A67F%7D

Basically, the author says that the fees they charge are not justified by returns. He also goes into a rehash of the mutual fund scandals of a few years back. He suggest index funds (ironically, offered by mutual funds) and ETFs. With these investments, the embedded fees are low (not including commissions charged at the point of sale). The case could be made that in these index-type investments, you get what you pay for. Owning an S & P 500 index fund maybe great for low expenses, but does it fit with your goals?

The point here is to get a hold of some sound advice. Work with an advisor and develop an investment policy statement, outlining your goals and objectives while taking into account your risk tolerances. Planners and advisors charge for the value of their information. If they do a good job, as defined by your investment policy statement, they should be compensated a fair amount. Mutual funds may be part of this mix, in some cases they may be the only way to get involved in certain sectors. However, take the time to understand the all the costs and loads involved.

Finally, mutual funds may be the best way to execute an investment policy. For example, if your total investable funds are only $50,000, you probably can't get financial planner for a reasonable fee (many have minimums). Putting together a diversified portfolio of investments may not be possible without use of mutual funds. Be mindful of the costs. If professional help is not practical, draw up your own honest and common sense-filled investment policy statement, delineating what you are trying to do and what you are willing to do (how much risk are you willing to take on) to get there. Stick with it, refer to it, and update it from time to time as needs goals, and risk tolerances change.

The Patron Saint of Bond Traders

2007-10-22T20:13:00.000-04:00

Just a picture from the shrine of the patron saint of bond traders, Santoliquido.

What To Do, What To Do....?

2007-10-22T09:29:00.000-04:00

The stock market goes up, then it goes down, then it goes up, and then it goes down. The main concept that needs to be remembered in this environment is the difference between being a trader and an investor. Although many of my friends are employed as traders, when it comes to their personal financial situation, they are investors, either voluntarily or by corporate mandate (you know who you are). While this is a great time to be a trader (if you know what you are doing, of course) as traders love volatility (the way to make money as a trader is to buy at one price and sell at a higher price in a relatively short period of time), it is an unsettling time to be an investor. With the amount of financial information and commentary available to people, a filter needs to be put in place to regulate what is really important. Here a just a few things to keep in mind, regardless of your situation. First, what is your time horizon for any given investment? If you are 43 and the money is in an IRA, you really shouldn't be concerned about day-to-day, week-to-week, or month-to-month moves, as long as you are comfortable with your investment plan. If it is money being used to buy a house in three months, that is a different story. Second, what is your risk tolerance? Some people are very comfortable to be invested 100% in equities and real estate. Others don't want to put there money in an FDIC-insured CD. Only you know your risk tolerance. A good financial advisor should be able to define and quantify that for you. Finally, what percentage is in what? Even you are the most conservative investor, you might 5% of your money in a hedge fund with massive sub-prime exposure. At the margin, this is your most risky asset. Are you prepared to lose it? Are you prepared for that investment to take ten years to rebound? Again, only you can answer that question.

While you are watching CNBC and the market is moving up and down, keep in mind who you are, what you are invested in, and what your time horizon is. These periods of volatility are good times to review strategies with your advisor to determine if you investments are properly positioned for your needs.

It's The United States, Stupid

2007-10-19T10:34:00.000-04:00

Well, it finally happened. CNBC, specifically Mark Haines, admitted this morning that they change their views more than daily depending on their guests' opinion. Today, amongst all the positive earnings from US industrial multi-nationals, they had a series of guests bashing the US economy. Guess what, the US economy is weak, led by housing. Foreign economies are showing signs of strength, but it is not the monolithic picture that it is made out to be. The worst guest of all, an American no less working for Credit Suisse in London, made a self proclaimed unpopular statement that the US is no longer the center of the universe, that it is the middle class of emerging markets driving the world economy. It is sad that CNBC puts people like this on without presenting a balanced view or asking the guest hard questions (they do, when it suits the host's personal agenda, on both sides of the spectrum).

There is only one question that needed to be asked of this analyst. Here it is: What created the conditions that allowed a middle class to form in these emerging markets, or the developed markets, for that matter? It's the United States, stupid. Is there really anyone sane out there that thinks the world's economic situation (or political) would be better off if the US hadn't acted the way it did over the past 60 years? Before I get 1000 posts, yes the US made mistakes along the way. The worldwide benefits of a global economy are starting to be realized, particularly since the fall of the Soviet Union. Emerging economies, sources of raw materials and cheap labor, starting from low bases are of course experiencing faster growth. The US created the conditions that allowed for this growth. The US continues to grow rapidly. There is no other country on Earth that approaches the size of the US that is as dynamic as it is here. Sure there is emerging market growth now, but what happens when these markets mature? Will they foster a spirit of openness and free trade? Will they resolve their massive domestic problems? When Brazil runs out of trees to cut down and iron ore to dig up, will the masses go back to accepting the massive wealth disparities that have and continue to exist there? When China runs out of cheap labor, brought on more quickly by a "one child" policy, will they retreat into another Cultural Revolution? Will Russians continue live with (or not) a declining life span and turn further back toward dictatorship? If the world is relying on any or all of these scenarios to take the place of the US in world leadership, it would be overly optimistic, to say the least.

As for the commentating world fretting about US domestic demand, that story plays well somewhere, however not CNBC's audience. If the US economy makes up 20% of the world's economy, then Caterpillar, Honeywell, etc. should be selling 80% of their products elsewhere. They can, thanks to the conditions created by the United States.

Just Walk Away...

2007-10-18T10:07:00.000-04:00

It took longer than expected, but finally an article appeared about people walking away from real estate as their equity turned negative (Wall Street Journal, page D1). The story chronicles two people that got caught up in the real estate price frenzy, only now to consider defaulting in their mortgages and/or filing for bankruptcy. In many ways, it parallels the situation that occurred in the US in the late Eighties and early Nineties. In many ways, it doesn't. Before the various governments here start bailing everyone out, a few points need to be kept in mind.

The first is that, in many cases and certainly in the high growth bubble real estate, is that many of the "walkers" today are not owner-occupiers, but rather investors that got overextended. Fifteen, twenty years ago most people got in trouble were in their own homes, caught up in an extended downward move in real estate prices, exacerbated by over building. The market eventually worked its way out of that (helped in areas like Florida by Hurricane Andrew) but it took time. These days, with information flows much faster, the up and down cycles are shortening. There is a concern that these foreclosures and bankruptcies will force the renters in these investment properties out on the street. If the governments want to step in with moral suasion here (not legislation), go right ahead. Banks should be convinced kicking these people out on the street isn't in their best interest. At least they are receiving income while the market adjusts to new levels.

The second point is that all the new mortgage options coupled with reduced/ignored credit quality/issues has helped facilitate the problem. While the popular press has focused on the 89 year old homeowner duped into taking out the mortgage they didn't want or need, the reality is that most people, investors or homeowners, overextended into houses and mortgages they could not afford. If there is fraud involved, by all means go after them. If not, the parties involved need to take their lumps. Again, here is case where the moral suasion of government should be used to renegotiate the terms between mortgagor and mortgagee. Like the other credit issues in the market, there has to be an accounting and a reckoning of the risks taken, on both sides.

Score One For The President

2007-10-17T14:02:00.000-04:00

Everyone knows, courtesy of Bill Murray, that the Dalai Lama is a big hitter, but the fuss being generated worldwide over the ceremony today is over the top. The Dalai Lama is being awarded the highest US civilian honor, the Congressional Gold Medal. The ruckus in Beijing over this is nothing short of ridiculous. The Chinese are starting to believe all the press written about themselves if they were under the delusion that the could order (yes, order) or threaten (yes, threaten) President Bush into not attending the ceremony.

Let's, for the moment, forget that the leaders of this Congress (the ones with single digit approval ratings) are giving the Dalai Lama this honor specifically to irk the Chinese and embarrass the President (why do you think it is happening during their five-year party congress?), this Dalai Lama isn't even advocating a separate state for Tibet, much to the consternation of many Tibetans. Why are the Chinese so upset? First, it take the focus away from their show. There isn't any real concern on their part about a Tibetan separatist movement or the US support of it. Second, and more important, it is the Chinese tit for tat regarding the US (and others now) constantly berating them about the value of the Yuan. Finally, as mentioned above, they think that because of their size everyone is going to back down. They go Mattel to apologize to them, unbelievably, why not the US government.

Fortunately, President Bush isn't going down that road. Instead, he took the high road, saying the honor is for the Lama's religious works and gave those who tried to back him into a corner nowhere to hide. On CNBC, the buzz was what this might to do US-Chinese trade relations. The answer is nothing. The Chinese aren't going down that road with the US. Without the 8-12% growth provided by exporting here, the Chinese government wouldn't last very long.

It Was Twenty Years Ago...Fri-day

2007-10-16T15:28:00.000-04:00

Nothing to do with Sgt. Pepper or the Beatles, but Friday is the 20th anniversary of the '87 market crash. Back then, market professionals were huddled around their Quotron and Bunker-Ramo machines frantically hitting the Enter key to see how much the Dow dropped. The long bond traded up with 5 different handles as investors ran for cover. The NYSE's new electronic system, which could handle all of 95 messages per second, was quickly overwhelmed, not that it mattered as almost all trades were done by pencil and paper. The tape was hours behind. The specialist system was strained severely, but didn't break or collapse.

Over the past few weeks, the equity markets, ex NASDAQ, have traded to new highs. The last few days, reality has set in as stocks have weakened. The battle out there still continues over who is right on the economy, the stock or bond market. The answer depends on who you ask and when you ask it. For a couple of weeks, since the brokerage firms reported earnings, the market seems to have forgotten about housing/mortgage/sub-prime situation as those brokerage numbers came in at or above expectations. The euphoria has ended with the reality of the banks' earnings. It may change later this week as more tech earnings come out.

The real answer is that, ex housing, things are looking pretty good in the US. There is a lot of excesses that need to be worked out in that space. Individual companies may or may not do well in this environment. Certainly banks are having issues. Banks and brokerages make up most of the liquidity in fixed income markets. Other entities like hedge funds that might normally step in here are restrained by tighter credit, valuation problems, and redemption events. The real, meaning not Wall Street, economy must be kept in focus through the noise.

SMLEC

2007-10-15T14:11:00.000-04:00

That isn't one of the easier acronyms to pronounce. Usually the financial geniuses come up with better names that roll off the tongue like REMIC, Iboxx, or ToPrs, the more complex the structure, the easier it is to pronounce. For example, the raison d'etre for SMLEC (or M-LEC if you read the Wall Street Journal) is to create a orderly (aka not free-falling, not unpriced) market for SIVs and SIVs-lite, which, as can be surmised, is easy to pronounce, yet all the kings horses and all the quants on Wall Street can't get a handle on their value. My thinking is that this came up so suddenly, that the marketing teams didn't have time to produce something catchier.

Just so no one trips over themselves, SIV stands for Structured Investment Vehicle and SMLEC means Single-Master Liquidity Enhancement Conduit. Personally, my choice would be BOSTONS-Buyer Of SIVs That Others Nevertheless Spurned. It is a little more accurate and definitely more descriptive. On the face of it, if this "buyer of last resort" helps liquidity in the front end of the market, it will be a success. The Wall Street Journal seemed to be somewhat in a snit that the Treasury was involved in this in some way. As long as they aren't putting up tax money to finance it, this is the kind of action they should be doing to get markets moving.

The other concern is that is just another way for the big banks to keep this stuff off balance sheet. This maybe true, but these items are already off balance sheet. I seriously doubt that J.P Morgan and B of A are going to create a fund for the sole purpose of bailing out Citi, the most heavily involved bank. It must kept in mind that this is a work in process. It also must be remembered that this isn't the RTC, the entity set up to restructure S & L's and their assets/liabilities. The very existence of this fund maybe enough to stabilize this market, without much of the fund being used. The should help the cream rise to the top, leaving SMLEC to unwind the rest, at a tidy profit for its investors.

$29 Billion

2007-10-11T08:38:00.000-04:00

Yesterday, the Commerce Department released the trade deficit figures for August. Even though the number came in better than estimates at $57.6 billion, it is still a huge outflow that must be offset by capital account inflows. However, there are many positives to look at here. It could be much worse, given all negatives floating around. The most serious long-term negative is the increasing protectionist sentiment in Congress. They seem to be most insistent on pushing the US back to the economic glory days of the Jimmy Carter era, or worse by foisting upon us a Herbert Hoover-era, Smoot-Hawley-like, Depression-creating tariff. It shouldn't be surprising that Congress has an approval rating approaching the single digits. Maybe they should stick to censuring the current Turkish government for the ninety-year-old actions of the Ottoman Empire, but that is the subject of another post.

Which brings me to $29 billion. The figure represents the total value of petroleum products that the US imported in August. I'm no mathematics expert, but that works out to about $1 billion a day. That number also works out to almost exactly one-half of the trade deficit number. Given that the price of oil has moved higher at a fairly regular pace over the past few years, that deficit number has grown. None of that part of the deficit is with China; they make up a large part of the other half. The biggest single recipient, surprisingly or not, is Canada, which explains the 30-year high in the C$. The rest of it goes to the usual suspects in no particular order: Saudi Arabia; Mexico; Venezuela; etc. Every time the price of oil goes up, the deficit will get worse, despite all of the Chinese-bashing tariff that can be put in place. The weaker dollar contributes too (even though commodities are priced in dollars, as the dollar weakens, producers adjust their prices accordingly to make up for the reduced purchasing power), although it is far less significant and is probably more than offset by increasing exports.

It is this side, the energy side, of the trade deficit that is the real problem. It is the one that needs to be addressed, not the politically expedient goods side that gets all the attention. Of course there are problems with the goods deficit that need to be addressed, but the discussions need to be limited to the high value goods that can be profitably competitive with area of the world that have unlimited supply of cheap labor. Let them make the cheap stuff (And don't apologize to them when they are in error, call them out on it. This means you, Mattel). As stated in previous posts in this forum, $80 dollar a barrel oil opens up many opportunities for alternatives in the US that weren't feasible at $30/barrel. Conservation, cleaner coal, oil shale, solar, the list goes on and on. The US government should embrace this opportunity and lead the nation into the post-imported oil epoch.

Another Follow-Up

2007-10-10T09:50:00.000-04:00

Long-time readers here know that several posts on the blog have been devoted to the relative price movements between oil and gasoline. Oil has skyrocketed while gasoline hasn't moved this year. This relationship is beginning to manifest itself in lower earnings for domestic suppliers and refiners. If the cost of raw materials (crude oil) goes up and the finished product (gasoline) stays the same, margins get squeezed. Yesterday in the Wall Street Journal there was an article on whether the next move for oil is $100 or $50. While this is obviously important, it is really the price of the finished product (gasoline) that really matters.

Here's why I think oil should be capped around this level (barring some external shock). First is slower US growth. While the rest of the world seems to be doing well, the US still makes up a large percentage of the world economy. Second, with oil sustained around the $80 level, more supply will come on line. This takes time however. The longer the price stays up here, the greater the chance for increased supply. While the Saudis will want to push the price down to a level where they can keep this additional supply off the market as their cost is below $10/barrel, it won't get to that level soon. The good thing is that much of this new supply will be domestically produced. Similar to oil sands of Alberta, the Western US has huge reserves of oil, although much of it is trapped inside of shale. At $80/barrel, this can be produced profitably and without the externally generated political risks. The third point is that at these price levels, substitutes, primarily ethanol, are attractive and coming on line in an increasing rate. If the government lifted the 52 cent/gallon tariff on imported ethanol, its price would come down and use increase. The last point, plus the expansion of domestic refineries (finally), will help keep gasoline prices down.

In The Short Memory Department (Redux)

2007-10-10T09:18:00.000-04:00

Well, look at the stock market now. For example, on Aug 15, Goldman Sachs' shares could have been had for roughly $165/share; yesterday the stock closed above $239/share. I pick Goldman for two reasons. The first is that being a financial powerhouse, it was in the center of the credit market maelstrom. The second is that as a well-run organization, Goldman has weathered the storm. A 75 point move, or 45%, in less than two months is nothing short of spectacular. Critics would state that Goldman was down almost that much before the credit market crisis, which is true. Most financial firms were down, and many have not come back. It is not worth listing them; you know who they are. The same critics would also say that Goldman is really a hedge fund, not a Merrill Lynch or Lehman. That may also be true, and they may take on more risk than their competitors. Goldman also seems to manage it much better than their competitors. At 9+ times earnings, it is certainly not out of line with these same competitors.

The bottom line here is a theme that has been stressed many times here, don't panic in times of crisis. During these times, there are always winners and losers. If you are a long-term investor, this kind of event is going to happen periodically. If it works, stick with your plan and adjust it if necessary. Try to rise above the noise. Step back from the constant stream of financial information if it helps you focus on what is important.

Little Montenegro down on the Adriatic Sea

2007-10-09T09:09:00.000-04:00

To begin with, anyone that guesses what book the title of this post came from gets extra credit. The EU's finance ministers warned Montenegro not to unilaterally "Euro-ize" as it is incompatible with EU law. In order to adopt the Euro, countries must meet certain financial criteria, although the EU has bent the rules before. When Montenegro split from Serbia last year and became independent, using the Euro was the most effecient and expedient thing to do rather than create its own currency. In fairness, the warning was less directed at Montenegro than at EU member states that may try to backdoor their way into using the Euro without meeting the criteria.

On the other hand, it would be thought that the EU would happy, nay thrilled, to have some legitimate entity wanted to use their currency. Until now, only rogue states (Saddam Hussein, Iran, Venezuela, etc.) looking to thumb their nose at the US and criminals (the 500 Euro note, being highest value, widely circulated paper currency in the world) looking for portability of assets were only ones voluntarily adopting the Euro.

For all of Europe's talk about becoming the world's next reserve currency, this is just another point, along with an underdeveloped bond market, showing they have a way to go. If Montenegro wants to use someone else's currency, they should try the US dollar. They would be welcomed with open arms.

reader update

2007-10-09T08:21:00.000-04:00

Yesterday, this blog received it 500th hit, which may not seem like much but it puts it in the top 2% of blogs worldwide. I've had readers from as far away as Europe and Asia, but the vast majority have been from the US. For those of you that are regular readers, thank you. Finally, for those of you that think I'm getting rich off of this, Google tells me that this blog has generated $3.80 in ad revenue over the past two months. They don't pay out until it reaches $100. I always thought Google was overvalued, but maybe I was wrong. With all of this blog ad cash they are sitting on, perhaps the stock deserves to be at $600/share.

Told You So...

2007-10-05T08:34:00.000-04:00

Instant analysis. This is a textbook example of why not to look at these month to month headline numbers. A minus-4 to a plus 89? You don't want to know what that difference is on a percentage basis (In fact, it can't be calculated). The trend over 2007 of about 100k job gains per month is probably weak enough to give the Fed cover to cut 25 bps on Halloween, especially with the dollar moving higher. On the other hand, they might go back to worrying about inflation and take a wait and see attitude. I'm inclined to think the former, as the Fed doesn't want to appear as being too indecisive, given their last statement, lurching from number to number. Have a good weekend.

Another Month, Another Employment Number

2007-10-04T14:00:00.000-04:00

Here we go again. Just by observing some anecdotal, very unscientific evidence, the 100k gain in jobs the consensus is looking for seems to be too high (I have a lot of time these days to conduct these surveys). Add in the announced job cuts and factor in that new home construction has fallen off the map, the number should be weak. Yet, who knows? Those of you who know me or have been regular readers (I got a page hit from Qatar yesterday, goin' global) know my feelings on the employment numbers. In a nutshell, in and of themselves, employment numbers are next to nonsense. We are relying on the 50 state bureaucracies, plus assorted commonwealths, territories, and districts, to provide timely and accurate information to be complied by another bureaucracy. Any number where the revision gets as much attention as the headline has to suspect. In the aggregate, looking over months of data, employment figures become useful in spotting trends.

The bond market thinks it is going to be weak, judging by the recent move in rates, all but assuring future cuts. The equity market isn't so sure. After taking the major averages, ex NASDAQ, back to their recent highs, the rally stalled. A weak number probably means further Fed rate cuts, especially since this is the last monthly number before the next meeting. It also means slower growth, at least domestically, capping further earnings gains. What a conundrum!

How, in general, should you play these numbers? Investors should basically ignore them, using them only to determine the direction of long-term trends. Trying to trade the bond market based on the hot number of the month, whatever it is, will most likely give you whiplash. Let the professionals lose money in the half-hour after the number (although it is a zero-sum game, somebody wins). If a number (or revision) prints that few expect, there will be wild swings in prices, exacerbated by the lower, albeit increasing, levels of liquidity in the fixed income market. The hour after a big number can be irrational. Trader's years can be made or broken during that time. By the time the equity market opens at 9:30, instant analysis has been completed and the direction for the rest of the day can usually be figured out, unless there is another big number tomorrow. Happy employment Friday to all, and to all a good night.

The Dollar's Falling, The Dollar's Falling!!!

2007-10-03T18:09:00.001-04:00

If I had a dollar for every time since 1980 I read or was told about how it was all over for the US dollar, I could permanently retire with all those greenbacks, despite their fluctuating value. Given its current level, you would have to be blind and deaf to not be aware of the demise of the currency. Today, there is a piece on page C1 of the Wall Street Journal regarding this topic. The columnist tries to inject as fear and doom and gloom as possible right off the bat with the title, “Why the Dollar Won’t Regain Its Past Strength”. He quotes professors from Harvard and Berkeley and trots out some model they developed saying the dollar has 20% more to go. If that is case, then I suggest you call your broker immediately and buy some short-term, non-dollar government bonds. They make it sound like it is a no-brainer, and, who really knows, maybe it is. It can’t hurt to have that kind of exposure and diversification in a portfolio generally.

There have been several posts in this forum regarding this subject. The biggest risk to a weak dollar is inflation. If inflation gets too high, we have problem, and so does most of the rest of the world. There are benefits to a weaker dollar, which are detailed in previous posts. If I had to bet on the US adapting to a weak dollar or the rest of the world having to adjust to stronger dollar, I think everyone knows where I stand. Already, the Europeans are screaming for currency relief.

The other points of the piece are somewhat dubious. The rest of world catching up in productivity isn’t a real surprise as they chuck their electric typewriters for PCs. There doesn’t seem to be any lack of demand for US Treasuries, judging by where they are trading. Finally, the point regarding EM spreads doesn’t mention the supply and demand issues in that market, and it remains to be seen whether EM doesn’t suffer the fate as the rest of the credit market.

Finally, after an informal and unscientific poll of traders, I have yet to find anyone that read this “required” reading on Wall Street desks.

Remain Calm, All Is Well

2007-10-02T14:43:00.000-04:00

That was Kevin Bacon's character's line from Animal House just before he was stampeded by the crowd into a two-dimensional figure. It was also the general point this blog was trying to make during the market's nadir in August. Certainly the equity market has taken it to heart. If you had been out of touch for the last three months and looked at the current level of the stock averages, you would think that the market just went into the summer doldrums and was just now beginning to emerge. Technicians will tell you that the stock market is a leading indicator of economic performance. Based on that, we can expect a sharp economic downturn, followed by an almost as sharp economic boom. It seems hard to believe that the housing market in general is going to turn around quickly, given the nature of the market (the transaction costs and time involved are radically different) and the amount of excesses that need to be worked out, although some depressed local markets, Florida for example, could be helped by the weak dollar bringing in foreign buyers. Likewise, the fixed income markets sustained significant damage in the recent turmoil. Banks are starting to disclose the effects of the past three months, taking their lumps and hoping that liquidity flows back in. Like in the housing market, it is hard to believe that appropriate valuations now exist for all these credit and structured products that no one had a clue on a month ago (the only real appropriate valuation is what someone is willing to pay for x or y, not what some model says it is worth). It will take some time for the bond crowd build up their appetite for risk again.

The bottom line is that in this instance, hindsight will be 20/20. If the economy goes into a general (one not limited to housing and related sectors) recession, then the bond guys were right. If not, then the equity guys were right. As a life-long bond guy, I'm inclined to believe the equity guys. The events that occurred in the bond markets over the past few months were strange, to say the least, pushed forward by a blind ignorance of credit risk and the resulting liquidity risk, and aided by the absence of key players during the usual summer slowdown.

Follow Up

2007-10-01T14:58:00.000-04:00

No one guessed what those two lines on the graph are. One is the USD/CAD relationship and the other is the USD/BRL relationship. Notice, as the quant guys would say, how they have a high degree of R-squared.

Let Someone Else Worry About The Dollar

2007-10-01T08:34:00.000-04:00

As stated many times in this forum, the biggest risk to a weak US dollar is the resulting inflation. It's the Fed's job to figure that out. Let's say that doesn't happen. So, what's the problem? The mass media will tell you about how expensive to go to Europe on vacation. There are three ways to solve that: don't go; economize; or be prepared to spend more. Is this really a problem. Of course not! Here's a better idea, go on vacation in the United States. The money stays here, helps employ people here, and you don't have to go through the hassle of getting a passport, a real problem these days. Foreign tourists, spurred on by a weak dollar, are coming here in droves despite all the complaints about security, visas, etc. They are spending money too, buying things here that are cheaper even without the currency adjustment. If you need immediate evidence of this, take a look inside any book jacket and see the difference between the US and Canadian price. Hop in your car and drive up to the Woodbury Common Outlets north of New York City and watch the busloads of Asian tourists disembarking on shopping junkets (For further proof, the local airport there is gearing up to accept international charter flights specifically for this purpose).

Some of the above is tongue-in-cheek, but in all seriousness, let someone else worry about the dollar. For decades, the world benefited from a strong dollar, exporting anything and everything to the US. These countries decry the low US savings rate despite the fact it is the main driver of their export-based economies. Export growth is triple the rate of import growth. This is occurring without a strong national policy championing exports as exists in other countries. There is even serious talk of exporting ethanol from the US now until domestic distribution infrastructure catches up with supply increases. (As an aside, the price of ethanol has dropped 40% from its peak. This will help the inflation numbers going forward, not so much on the energy side but on the food side as production costs, farmers a big users of ethanol, and supplies balance out).

These foreign countries should push to spur domestic demand rather than rely on weak currencies to bail them out. The US dollar is weaker than it was, but there isn't anyone seriously stating that it is undervalued at this point. In fact, against dollar-pegged currencies, like China, it has a ways to go.

Have a happy Fourth Quarter, 2007.

O Canada

2007-09-28T09:39:00.000-04:00

The Canadian and US dollars are trading at parity, bringing full circle a cycle that lasted almost 31 years. Back in 1977, I won a $100 (US) bet with a Canadian on whether the C$ would see $1.1o or parity first (Guess what side I picked; if I had only invested that money in Microsoft, Intel, Google, etc.). Now that we are back to this level, I'd like to propose something quasi-radical, a US-Canadian dollar currency union.

Let's not make any mistake here. The reason the C$ has strengthened is the commodity boom. Canada is one of the largest exporters on raw commodities in the world. While they have always been a major commodity exporter, it is the mix of exports that has propelled it higher. Eighty dollar-a-barrel oil makes hard to produce Canadian oil profitable generating huge royalties for provinces involved and the national government, monies that weren't generated exporting wheat and nickel (Maybe diamonds. Watching Ice Road Truckers has led me to believe that companies must be making large profits, given the costs involved in production). These royalties have allowed Canada to post a record budget surplus, reducing the debt-to-GDP ratio by more than half over the past 11 years (Of course, if the US spent as little on defense as Canada, which spends somewhere around the amount that New York State spends, every citizen here would be getting a dividend check from the federal government).

Canada is a boom and bust economy. Currency union would force them to invest, in the good times , in businesses and technologies that would see them through the resource bust times. Historically, Canada has allowed the C$ to depreciate to be more export competitive. People seem to have forgotten that it was just over five years ago that the C$ traded at $1.60. Oil has been the great equalizer this time around, but I don't think Canadians want to go down the road Middle Eastern sheikdoms. Eventually, the oil party will end, either in lower prices, increasing use of substitutes, or a combination of both. It would help the US as well, as new legislation here would help reinforce monetary discipline, either through a merged or overriding central bank and create some fiscal discipline as well, as budget deficits would have to be restrained. I would even go farther as to invite other countries that have adopted the dollar around the world to at least have some observer status in the new central bank.

Parity just makes the mechanics easier, as well as making the explanation easier to all involved parties. It is a long-term positive for both countries.

PS: One line in the previous post shows the US$ fall vs. the C$ this year. Can you guess the other line?

A Little Friday Fun

2007-09-28T02:47:00.000-04:00

Just a little Friday fun to close out a long week. Can anyone guess what the graph above represents? A hint: it is currency related. While there will be no prizes awarded for correct answers, you will have the satisfaction of doing a job well-done.

The Next Bubble

2007-09-26T13:20:00.000-04:00

A wise man (whose name escapes me) said that burst bubbles do not re-inflate. For proof, please look at the NASDAQ and the Tokyo Stock Exchange now as compared to their all-time highs. But that doesn't mean that new bubbles aren't looking form all the time. For the record, the current housing price declines has less to do with the few subprime borrowers that defaulted and more to do with a world reawakening/reacquainting itself with credit risk coupled with funding/liability mismatches (using CP to finance long-term obligations, the carry trade). Many pundits are serving up Emerging Markets as the new bubble candidate. They certainly qualify. Investments pushing to succession of new highs driven by investors trying to eke out any sort of incremental return. Over the past two months, there were many people calling emerging markets the "safe haven" from the credit market turmoil, Russia, now nine years out of bankruptcy, in particular.

Are the emerging markets the safe haven? It boils down to two very fundamental arguments. The first is no, that credit risk has not been repriced and reevaluated in those markets. The second in the new paradigm argument, that emerging markets are experiencing sustained higher growth rates brought on by global acceptance of capitalism creating free markets that didn't exist. This growth and openness has allowed the massive pools of liquidity invested in developed economies, at ever lower returns given the 25+year secular decline in interest rates, to flow to emerging markets. The answer is somewhere in between, with the no argument being more relevant over the intermediate term and the yes side more important tomorrow and five years from now.

The problem with trying to come up with an answer is the emerging market are viewed generally through developed market glasses. It must be kept in mind that business practices, legal protections, investment diversity, and state involvement are usually quite different. The way investments are made in different regions of the world can vary, although with the opening of capital markets, they are becoming more similar. For example, direct investment used to be more common in Asia than Latin America, but that is changing. It is very difficult to make investments in many countries, China for example. Because the investment scope is limited, investors tend to put money to work in items that will give them market exposure, but allow for necessary liquidity. This provides a constant bid for investments that can easily be trading, propping up the market. However, it can be a small door if everyone exits at once.

Short of a global recession or commodity price correction, emerging markets in general are probably OK. Investors have become much at looking at individual circumstance rather than viewing them as a whole. There are exceptions, China for one. Chinese securities firms and banks hold many places in the top ten in market capitalization worldwide. This has a lot to do with domestic Chinese investors having few other options for there money, especially with inflation there above 6.5%. Twenty years ago, the largest securities firm by market cap was Nomura, now not in the top 15. But, remember where the Tokyo exchange was then.

Isn't It Ironic?

2007-09-25T18:59:00.000-04:00

A quick note to point out a some ironies of today's world; please indulge. It is strange (not really) that whenever there is a problem in the US, everyone in the world comes out of the woodwork to jump on the bandwagon. In the pre-Ronald Reagan era, this was common. Maybe with a strike at GM, people think that Jimmy Carter is still President (On that note, the anti-union guy on a midday CNBC debate told the GM workers to "suck it up and face facts). But entities living in glass houses, the IMF and Carlos Slim come to mind as recent bandwagon jumpers, should probably not throw stones. The IMF, struggling for relevance in credit risk-free emerging market world, is trying to justify its existence by coming after the US. Carlos Slim, world's richest man created by having monopoly power in Mexico, is warning the US on this and that. Enough already! Mr. Slim, please donate your billions to a foundation dedicated to reforming the Mexican economy. They could start by breaking up monopolies and selling off Pemex, taking advantage of the worldwide oil boom (Take a look a Petrobras for an example). As for the IMF, I'm sure you could put all your knowledge and resources to helping countries that could actually use it. There's a few countries in Africa that may appreciate your advice.

The $90 Billion Question

2007-09-24T08:36:00.000-04:00

Ninety billion dollars is the amount reported in the Wall Street Journal this morning that the Big 3 US auto manufacturers owe their current retirees in future health benefits. Now, the auto industry is on the eve of arriving at an agreement with the UAW to shift this obligation to some off balance sheet trust; GM is the first one up. On the surface, this looks better than the one way ticket to liquidation that GM, Ford and Chrysler seem to be headed. However, it will take much more than this to turn these companies around.

The US auto industry is a case study on how not to run businesses. Once holding a virtual monopoly on the domestic auto market, now 1 in every 2 new vehicles sold in the US is produced by foreign manufacturer. The positive thing here is that a large percentage of those "foreign" cars are actually built in the US (and Canada, which is considered a domestically produced car due to the 40+ year old auto free trade agreement between the two countries). Big 3 employment has dropped by over 40% since 2003, exacerbating the retiree situation. The truly sad thing is that it didn't have to be that way. Most of the innovations in auto industry over the past 30 years came out of the Big 3. This is evident in the fact that most auto manufacturers worldwide have design operations in the US. The Big 3's costs and fairly rigid structures did not allow, however, the "nimbleness" necessary to capitalize on them over the long term. GM. for example, has and had different divisions selling basically the same vehicle to the same customer.

So, the $90 billion dollar question is: Does this move finally help them turn the corner? Well, yes and no. This agreement does nothing to get buyers into showrooms, which is the real problem now with the not so Big 3. If they can convince buyers that there product is competitive (which isn't the case currently on price, as any recent shopper will attest to) and reinvent themselves as smaller, leaner companies, then this agreement will help to some degree. The more likely scenario on how this will help is that it will make it easier, from a public relations standpoint if no other, to file Chapter 11 to force renegotiation of contracts and a restructuring of operations.

We Won The Battle...And The War

2007-09-21T08:24:00.000-04:00

The US dollar is getting a lot of press lately, but when you see Maria Bartiromo on the Today show talking about her bar bill, it has really pushed into the mainstream (By the way, it was a incomplete example. Her EUR 70 bill for two drinks in a hotel bar is high, but without equating it into a US dollar equivalent, it is just a EUR 70 bill). Today's hot topic is the parity level of the US and Canadian dollars. Yes, it has been 30 years since that has occurred. What is forgotten is that prior to that time, the Canadian dollar traded at a premium to the US dollar. I'm a very big believer that market forces should set currency levels based on purchasing power parity. When central banks and governments get involved, market players get involved to capitalize on those actions. George Soros and the Bank of England and the breaking of the ERM come to mind.

That brings me to the title of this post. We won the war. With the exception of Venezuela and North Korea, capitalism rules the roost. No need to look any further than Russia or China to see that. The consequence of winning is this war is a more competitive global environment. The US and its currency at at a crossroads. We can either continue down the current path and live with the consequences or change. There is no one option for change, but they must all start with putting domestic US interests first. This isn't meant to be xenophobic. On the contrary, the US should engage our friends and enemies more energetically. The phrase "Freedom isn't free" doesn't apply in most places in this world. The US taxpayer pays for it and the US military enforces it. Since there is very little chance of cutting entitlement spending (let's hope there can be a lid on future entitlements), the only other viable option is to reduce the defense budget. The billions around the world that have benefited now need to foot the bill, in more ways than one. The US could then balance the budget and couple that with a realistic domestic energy policy, one that isn't dependent on the whims of unstable regimes, and the dollar will take care of itself. The US is still the most dynamic country in the world, but it is time to put aside our differences on the critical issues and focus on the task at hand.

Quantitative versus Qualitative

2007-09-20T11:41:00.000-04:00

For regular readers of this blog, you know it to be one that has a qualitative bent. That is, a dialogue dedicated to provide some amount of insight garnered from years of experience in the fixed income markets. This is not to say that I ignore quantitative methods. In fact they are quite useful to me, but that information, ex proprietary models, is readily available elsewhere and is used by the author to help draw a conclusion. I have no interest in producing that kind of information, as it would put me into a coma. The basis for what is written here is common sense. In general, if something doesn't meet the "smell" test, there is usually a problem.

Having prefaced this post with the above, it is my contention that the current troubles in the financial markets were caused by an over-reliance on quantitative models, the abandonment of common sense, as it were. Common sense and experience acts as a check on models that can't possibly account for variables like liquidity and fear of loss accurately. Certainly Long-Term Capital could have used more common sense back in 1998. Certainly, the guy that made the highly questionable statement about his model, as mentioned in a previous post, having several 25-standard deviation moves (once-in-100,000-year event). I guess that model will be pretty boring over the next million years!

Unfortunately, it remains to be seen if anything has or will change given what has happened over the past two months. I don't want this to sound like sour grapes (those of you that know me know that I have felt this way for years) but if the job boards are any indication, it looks like the financial world is ready to pile back into the models. If you have a PhD in physics, there plenty of positions open, some with seven figure compensation (guess what I'm telling my son to major in). Physics, however, won't help you when there is no bid. I've had more than one intelligent colleague tell me that the theoretical value of this or that is higher or lower than where it is trading. Sometime anomalies do exist, and there is a definitive reason for them. Market efficiencies usually take care of them quickly. The theoretical value usually doesn't take into account intangibles. That is where common sense comes in. We can hope that fear has instilled some common sense, but I wouldn't bet on it.

Moving Forward

2007-09-19T09:08:00.000-04:00

When the world gets caught up in these Fed movement cycles, the fixed income world gets stuck waiting from meeting to meeting to see what will happen. It remains to be seen if the equity market gets stuck in that rut as well, given the primary driver of the Fed Funds rate cut. It looks like Bernanke and Co. want to show that he could be Alan Greenspan too, opting for 50bp cut when 25bp would have been enough for now. Ben is betting that inflation remains low (anyone that has been to a supermarket recently would question that). He is also betting that despite lower rates, the markets will punish those that made bad decisions, particularly on credit issues. Both will probably hold for now, but as mentioned in this blog yesterday, it is the period a few years out that may be the problem. Left to its own devices, the economy will do fine and any excesses will work themselves out. From now until the end of 2008, that will be the case. The Presidential election next November will have tremendous impact going forward. Many of our current tax schemes expire in 2010 and it remains to be seen what we'll have after that date (Look at New Jersey as an example of bad tax policy; imagine that on a national level). The Fed itself can't change everything; many items domestically and an increasing number of foreign items are beyond their control. But over-stimulation leading to inflation could push politicians in the wrong direction.

Now What?!

2007-09-18T15:15:00.000-04:00

The half point move was a surprise (read previous post), but now what.? It is certainly good for the equity market and I do appreciate the Fed trying to bail out people in my situation. I don't know if that will be the thought two to three years down the road, but more on that tomorrow.

For The Record...

2007-09-18T05:45:00.000-04:00

Since the Fed is meeting today, I want to put my thoughts down on paper, so to speak, about the outcome. The Fed will cut the Fed Funds rate 25bps to 5% and, more importantly, cut the discount rate at least 50 bps. The move lower in the former represents the Fed's acknowledgement that economic conditions are softer and the process toward moving to a more stimulative stance needs to begin now in order to have a payoff six to twelve months down the road. While futures are suggesting 50bp move, that is only going to occur in times of real crisis, not an awakening to the reality of credit risk. (Someone yesterday suggested a cut of 3/8 of a point, an interesting prospect). If the Fed thought things were in crisis mode, they would have made an intermediate cut to express their concern. Which brings us to the latter point, the discount rate. Here, the Fed does think there is at least a mini-crisis going on, as evidenced by the Aug. 17 move 50bps lower in the discount rate. The money markets, while better than four to six weeks ago, are not truly functioning normally. Hence, a further cut in the discount rate is warranted to bring that market back to an acceptable level of liquidity. There is a risk, at some point down the road, that the money markets become too dependent on the discount window, but that possibility is remote. Away from money markets, other credit markets are returning to normal function, albeit at much wider, more realistic levels. We'll all see at 2:15 this afternoon.

I'm Not Euro-Bashing

2007-09-14T19:04:00.001-04:00

I'm often accused of Euro-bashing, but I like to think of it highlighting flaws in the system. Those of you who are familiar with this author know my views of European mechanisms. Basically, the problem with the European Union's institutions is that they do not have the political will to be effective, with many items requiring unanimous approval of all 27 countries. Now we are in the throes of a credit market crisis and once again Euro institutions come up short. The ECB has done what it can, flooding the Euro-denominated money markets with liquidity. However, the ECB, always walking a tightrope between the high and low growth countries, is limited to what it can do on rates nor does it have much influence outside of rates (Gillian Tett, one of the FT's best writers, wrote a piece on this on Friday. It is worth a read). It is my contention that the current problem in credit has been made worse by the heavy involvement of European institutions that have little experience in these credit issues.

If you speak with Europeans involved in the fixed income markets, (as an aside, and for the purposes of this post, the UK is not considered part of Europe) they present themselves as very knowledgeable and sophisticated. In fact, many derivative and structured products originate or find homes in Europe. Their cash bond markets are dominated by governments, Pfandbrief, and covered bonds, all triple-A or highly rated, with the latter two being secured loans with various credit supports . The European experience with credit risk is tiny, compared with the US and elsewhere. Their high yield market is relatively small and new, with little comparables on how it will perform in a crisis situation.

Herein lies the problem. Maybe part of the reason is that there isn't a culture of credit risk in Europe, brought on by generations of a welfare state mentality. Part of the problem certainly lies with rating agencies, doling out AAA ratings on products that don't meet the accepted criteria of AAA, and the over reliance on those ratings. Secured loans in the US, with its various tiers of support, is not the same as secured loans in Europe, like Pfandbrief.

Soon enough, the market here will work through these troubles, value items appropriately, punish those that were foolish, and move on. Hopefully, the same will happen in Europe, unless governments step in to bail out the banks, which is tantamount to rewarding bad behavior.

Who's the Anchor Now?

2007-09-14T16:49:00.000-04:00

For weeks now, the word on everyone's lips is recession. Is it going to happen, when is going to happen. how deep will it be, and on and on. The one thing that everyone is sure of is that global growth is strong, it's the US that is the problem. How strong is this growth? If the US does go into recession, what is going to drive global growth? In the past, it has been the US consumer. The pundits say the consumer won't be there this time, that everyone is weighed down by there ever-increasing sub-prime mortgage payment (By the way, it is incredible how many people are living in houses with sub-prime mortgages. If you have watched or read the media over the past two months, it would thought that the percentage is somewhere around 96%). The pundits also say that other areas of the world will pick up the slack. This maybe true and I'm not from Missouri, but you will have to show me that if the US is the anchor holding back the world's economic growth, that the rest of the world doesn't slow down too. Japan just posted a quarter of negative growth, however they are the poster child for stagnation (For those of you old enough to remember the Eighties, the same thing that was being said about Japan then, is the same thing being said about China now. In 1989, the Japanese stock market drove off a cliff, never to be heard from since). Europe will be next, then the commodity countries.

Continued global growth would be a better scenario then what is in the previous paragraph. It would be good for this country to be more export-focused; look how it has helped every other country in the world. However, if the $290 billion the US sent out of this country slows down, somebody has to be affected. It's not so easy to develop markets away from the US as US markets are generally open to all.