Tuesday
Mar292011

A Chinese view of sovereign credit risk & solvency

Updated on Thursday, March 31, 2011 at 01:51PM by Registered Commenterhb

The Dagong Global Credit Rating Co. Ltd. is a credit rating and risk analysis research institution founded in 1994 upon the joint approval of People‘s Bank of China and the former State Economic & Trade Commission,  People’s Republic of China. Think of it as an informational and policy utility.

They have published their 2011 Sovereign Credit Risk Outlook which contains important perspectives, that is if one chooses to listen to one's investor base. It's an interesting document in it's own right, and highlights with some liberties follow:

Review of 2010

  1. The credit quality and in some cases solvency of key developed debtor countries declined sharply
  2. They accuse the United States, "the world's largest debtor country" of waging "global credit warfare"presumably by excessive monetary expansion (printing money) and excessive debt issuance. One infers that they appropriately fear a declining US$, a rising Yuan, and an inflationary collapse of the US bond prices, in essence a devaluing of their holdings.

Click to read more ...

Tuesday
Mar082011

The USA as a business: say it with pictures

Kudos to Ms. Mary Meeker and her firm, Kleiner Perkins Caufield & Byers. They have done a public service by putting together a comprehensive analysis, USA Inc., that tries to answer the question, "What if we looked at our country as a business and applied some related analytics & disciplines?"  I only wish it had gotten more visibility.

Some of the analysis is compelling, and stunningly, much of this basic data is simply not surfacing from the imbecilic cacophony of mugwumps in media, policy or politics. We can understand why the politicians don't want these pictures to see the light of day. Broad understanding would reveal the great unpleasantness and failure of political leadership that brought us here. They communicate quite clearly what our problems are.

Entitlements alone consume nearly all revenue, and it will get dramatically worse going forward:

 

 

Our balance sheet is fraudulent in that it does not disclose all liabilities. When we put those liabilities on the balance sheet we become book insolvent. So the next time a politician says the words "trust fund" make sure that he means that an independent, non-governmental third party trustee will hold the funds for your benefit.

 

 

 

And our debt outstanding only reflects what's the on balance sheet!  Through the wisdom of governmental accounting orange stuff above isn't reported as a real obligation on the balance sheet! In the private sector this omission would be garden variety 10(b)(5) fraud but as Marilyn Monroe once said, "It's different for girls..." so when you start thinking about the debt crisis, don't forget to put the orange stuff on the balance sheet.  The omission is a fraud: a game of 'Hide the ball' that government has played so long. Game over.

 Lastly, while we're spending a lot on defense it does not appear to be out of line historically.

 

 

Spend some time with the study & share it with fellow citizens. I'm not buying into all the recommendations as some obvious private sector solutions have been given short shrift (more on that later), but defining the problem is a first step to solving anything.

For context of the magnitude of this problem consider that: 

Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., eliminated government-related debt from his flagship fund last month as the U.S. projected record budget deficits

And folks, that's the home team voting with their feet.

Thursday
Jan132011

Let's think about this: a good and free example

WWB states it's bias in favor of beta driven returns and longer term asset allocations (i.e. construct portfolios of various asset classes and execute through low cost indexed product). Of course, this approach is based on a variety of assumptions, and it is certainly possible, if not probable, that some assumptions vary as to degrees of reliability or confidence over time and circumstance.

We do not live or invest in a perfect world.  There are limits to information and analytic & computational capacity, and it is unlikely that any retail or small institutional investors are anywhere near them. We would argue that most medium to large institutions are nowhere near them.

Here's a good and free example  of the lower end of what's available. Here Google Domestic Trends charts the number of web inquiries against DAL.  We stipulate it's pretty cool, but bear in mind this is so primitive, its free ... the lowest grade of analytics available. And what you do with this is not clear: do rising inquiries foretell more passenger/miles? Or a change in consumer elasticity providing less revenue/mile/passenger? Does cancer cause smoking or vice versa?

I recall a hedge fund manager once showing me a similiar chart of entirely different variables. He closed his presentation with "It's a no brainer. I can trade that. Anyone can trade that."  Perhaps, but nevertheless we declined to pay him for the priviledge of testing his hypothesis with our money and granting fees that vested as his call option with asymetrical treatment of our downside risk (heads I win, tails you lose). 

The next time you want to buy an individual security, think about this example, but extend it to every asset class and security around the globe and do it on a real time basis. What do you know that everybody else doesn't? If you don't have a good, hard, and legal answer to that question, you'd better worry about the converse.

As one of our associates commented in a strategy discussion as to the state of analytics and theory, "Look we know that Newtonian physics don't work all the time, but it's pretty tough to build a bridge without them."  And we are looking to build bridges, if not bombshelters, across which we, our families, and clients, can walk.

Lastly, who do you think has better information? Google or the Fed? Hmmm....

Thursday
Jan062011

Swiss reject Irish government debt as valid collateral

The Swiss National Bank (SNB) will no longer accept Irish government debt, and that of several of the country's major lenders, in its repo operations. This is a significant adverse credit judgement. We look for others to follow and ultimately other weak countries will be added to the list. Some one will have to finance this stuff... just not the Swiss.

Evidently, the Swiss do not see their primary role as protecting the Irish government or selected Irish banks from the consequences of bad policy. 

"You just made the list, buddy" -  Francis, aka Pyscho, in the movie Stripes

Tuesday
Jan042011

European nations start to confiscate private pensions

The Adam Smith Institute reports that European nations have started to sieze private pension assets: Hungary, Poland, Ireland, and Bulgaria have all joined the party, although by slightly different means. It is an example of financial oppression of citizens by governments. 

This is a preview of coming events in the US. One suspects that given the massive underfunding of many state & municipal pensions and the pending insolvency financial stress of various municipalities & states, politicians will give it a go. 

Morgan Stanley put a bold warning in the public domain and to their credit used the exact words, "financial oppression" which we noted in our posting The Last Chance Saloon of Sept. 1, 2010. They were spot on. The trend will accelerate in Europe where portable assets & black markets will soon trade at an even higher premium. 

The US political class will face a hard choice: non-trivial real reductions in transfer payments and government spending or take a shot at this kind of oppression. 

These economic wheels grind slowly, but very finely. Watch your exposure to the estate and effective marginal tax rates at the state & national levels.

 

Tuesday
Dec282010

More than half of the Fed's Term Auction Facility went to foreign banks

The Financial Times reports today that more than half of the TAF went to foreign banks. It was an outright transfer of wealth from US tax payers to foreign banks (excerpted below):

Ed Clark, TD chief executive, said that using Taf was logical even though his bank never had a liquidity problem. “That wasn’t how we made a lot of money. But you make a dollar here, you make a dollar there. What’s the spread you make on a billion dollars?” he said.

In the summer of 2008, TD was borrowing $1bn from TAF at rates of between 2 and 2.5 per cent. For that borrowing it used the lowest quality – and hence highest yielding – collateral acceptable to the Fed.

More than 80 per cent of its collateral had a triple B credit rating at a time when such bonds yielded about 7 per cent. TD could therefore have made a notional gross spread of about $4m a month during 2008.

Mr Clark said the authorities were encouraging healthy banks to use schemes such as the Taf so as not to stigmatise their weaker counterparts. In January 2008, Ben Bernanke, the Fed chairman, said the Taf appeared to be succeeding because “there appears to have been little if any stigma”.

“You go through the whole crisis and there were lots of things we did that weren’t necessarily economic but were the right thing to do for the system,” said Mr Clark. “So I’m not embarrassed by this at all.”

One presumes not, given that Mr. Clark played by the Fed's rules, but the Fed has no such cover. It ought to be embarrassed.  The US taxpayer lent at 7% to non-US AAA rated banks (or banks including RABO) based on putatively BBB quality collateral.  And presumably the collateral were paying cash. This wasn't however a loan: it was the provision of contingent equity capital to foreign banks (Canadian, European and Asian) for no consideration, all courtesy of the US taxpayers.

WWB understands bank liquidity, solvency, and systemic risk. All should know that the melding of sovereign and trans national bank risk leads to reckless underwriting (QED), more risk, and then to a vitiation of contract & property rights and ultimately to democracy itself. Managing systemic risk is not hard, but you have to forgo some of the social agenda that has been attached to it. If you want to reduce systemic risk, break it down into its components and start taking them off the table, piece by moral hazard piece.

The alternative is to manage systemic risk as the Fed has done, and apparently will continue to do, by aggregating it into larger and larger amalgamations of undefined, hence unmanageable, risk structured as an uber asymetrical option in favor of rent seeking financial institutions and underwritten by the taxpayer. And all US taxpayers know what that means: "Heads, I win. Tails, you lose."

Lastly, if gas hits $5/gallon in 2012 as the former President of Shell Oil today predicts, will the energy sector be declared to pose a systemic risk under Dodd-Frank? Well, are volatility and duration the primary drivers of option value?

Wednesday
Dec152010

If you're looking for a primer on municipal finance & bankruptcy...

Look no further: Fiscal Stress Faced by Local Governments of December 2010 by the Congressional Budget Office is a good summary of the state of affairs.  One might read portions of it to be constructively supportive of bankruptcy as an option in many instances. Coming soon to a theatre near you...

Make sure you know what you own.

Monday
Nov152010

Maybe the Fed doesn't have Yahoo or Google finance?

Here we see the price behavior over the last 3 months of certain proxies of asset classes of interest:

  • energy (via the proxies XOM and OIL),
  • precious metals (GLD and SLV);
  • commodities (GSG),
  • 30 yr US Treasury yield (^TYN); and 
  • US $/EURO rate (EURUSD).

Those of us who are color blind may have difficulty discerning the finer points, but in some sense the colors don't matter. The blink test is sufficient. Annualize the gains, and you get some non-trivial numbers.  

 

The only things going down are the US $ and the credibility of the Fed. Oh, we forgot, short US interest rates too ... with thanks to Johannes Gensfleisch zur Laden zum Gutenberg who invented the essence but not the jargon of 'quantitative easing'.

We have, once again, Nassim Taleb tearing a very public and much deserved strip off Bernanke (its worth the full viewing), and Bill Gross in Run Turkey Run uses the failing credibilty of the Fed to induce fear:

Check writing in the trillions is not a bondholder’s friend; it is in fact inflationary, and, if truth be told, somewhat of a Ponzi scheme.

which Gross then turns into a marketing ploy:

We hope to be your global investment authority for a new era of “SAFE spread” with lower interest rate duration and price risk, and still reasonably high potential returns. For us, and hopefully you, Turkey Day may have to be postponed indefinitely.

Oh, my.  We don't necessarily disagree with his analysis, but find the style a little heavy handed... but that was before the Asian finance ministers cut loose with the 12 guage OO buck shot.

The spread between nominal bonds and TIPS (inflation indexed bonds) is a quick proxy for inflation expectations, and we note the same trend as the picture above:

 10 year constant maturity treasuries less 10 year TIPS:

 

Of course, over the weekend, right in the middle of this drafting, all hell broke loose in a Fresh Attack on Fed Move . 

The good news, though perhaps not for the Fed, is that important new independent sources of inflation data are making their way into the public arena.  Wal-Mart's data would appear to be more current than the Fed's and reflective of actual sales to the consumer:

A new pricing survey of products sold at the world’s largest retailer  [WMT  53.99    -0.14  (-0.26%)   ]  showed a 0.6 percent price increase in just the last two months, according to MKM Partners. At that rate, prices would be close to four percent higher a year from now, double the Fed’s mandate. Source: http://www.cnbc.com/id/40135092 

Meanwhile the Financial Times reports Google to map inflation using web data  We have every expectation that whatever eventuates from this initiative will be better, faster, cheaper, more precise, and, dare we say, potentially less biased, than the Fed's. Call it a measure of  just in time inflation...

We confessed our bias to short duration some time ago and suggest everyone watch the 10 year Treasury. We suspect there will be some credit turbulence in Europe.  Let's just hope it stays there. Pending sensible resolution of some of the major fiscal, trade & regulatory issues, there is still a fair amount of risk that could quickly compound or boomerang. We don't believe the nominal rise in equities is a panacea, although we'll take it, and we think there is still a fair bit of political & policy risk implicit in  these price levels.

If the Fed and Congress have gotten a whiff of the smelling salts, it will have been a good start. One suspects the Fed has already damaged its credibility, and if they keep pushing the Gutenberg agenda as a proxy for the failure of tax and fiscal policy, the public may very well ask the bald question: "Why do we need more monkeys throwing darts?"

Friday
Nov122010

GM and friends of Angelo

The WSJ writes in China's SAIC Finalizing Plans to Buy GM Stake:

The issue of foreign investors buying GM shares in the company's IPO is a sensitive one for the U.S. government, which will reduce its 61% stake in the auto maker in the IPO. Treasury also is worried about the political reaction if non-U.S. investors, such as sovereign-wealth funds or a Chinese company, are allowed to acquire a significant stake in GM after U.S. taxpayers spent $50 billion to assist the company through bankruptcy reorganization.

But like everything else with a government deal lately, you have to read the fine print and follow the money. The allocation of the IPO is just one of the long line of wealth transfers in this process, and the list and process by which it was managed should be made public. The list of sovereign investment funds and now familiar large domestic institutions would be of interest. One suspects the IPO will be carefully staged, dramatically under priced, such that it has an initial pop, thus pumped as a huge success.  Who gets the money? Check the allocation. If it does pop, you know the taxpayer has been shorted for the sake of publicity.

if that happens, it would be good news for the Obama administration, which could find itself under fire for pricing the deal too low—thus shortchanging taxpayers—if GM's post-IPO price rises sharply after the offering.

Last we heard the retail shops, the Schwabs, AmeriTrades et al, were shut out. One wonders why... perhaps if you want your ticket punched it should be suitably large and you have to hang around a bit?

The other element to follow the taxpayer's money is the special treatment accorded GM's NOL's, the net loss carry forwards. Typically these are expunged in a bankruptcy, but we understand special treatment allowed them the be carried forward into the new entity which means that the taxpayer subsidy is even greatly understated. If the new entity is profitable, it will likely pay no taxes... just another wealth transfer.

For the record, we don't like the process. We don't like it when it seems the 'fix' is in ...  bought and paid for with taxpayer's money and seemingly manipulated without regard to costs for non-economic outcomes. But that seems old hat these days.

This smells like an Angelo Mozilo friends & family deal. Just watch.

_______________________

Hate to do this, but we need some disclaimers & fine print on this one:

For sake of clarity, this is an opinion, which we urge you to consider as possibly uninformed or misguided, on a process, not a security.  We make no recommendation whatsoever on this particular security nor do we express an opinion of any kind on any particular price and nothing herein shall be so construed.  We have no  position (other than that which may or may not exist in broadly based indexed product) or economic interest in the offering.  We have never subscribed to an IPO and don't intend to start, so we're not sour graping about the allocation. We make no representation or warrantee whatsoever as to the accuracy of any information posted herein. Nothing herein shall be considered to be an offering of any security; an endorsement or recommendation of any particular security; or an opinion or recommendation as to the suitability or appropriateness of any particular investment strategy. WWB does not offer legal or tax advice and nothing herein shall be so construed. No kidding.

 

Monday
Nov012010

Predictive markets: Intrade and the market for Senate control

Monday
Oct252010

If you wanted your own copy...

Here it is: Office of the Inspector General for the Troubled Asset Relief Program of Oct. 26, 2010. 

We particularly like the snappy 1984ish, Brave New World style of jargon:

Advancing Economic Stability Through Transparency, Coordinated Oversight & Robust Enforcement

 

Thursday
Oct142010

3 was a lucky number

Amity Shlaes wrote a fascinating article in the WSJ on FDR and the notion of confidence, part of which is excerpted below:

Over the summer of 1933 ... Roosevelt launched a novel gold purchase program. The plan was to drive up the general price level by buying gold. Each morning, FDR set the gold price target, personally ... theoretically, Roosevelt's idea of reflating can be defended... 

But the exposure to investors that Morgenthau was getting through the gold purchase project of 1933 was already teaching him something. Investors didn't like the arbitrariness. It took away their confidence. One day Morgenthau asked FDR why the president had chosen to drive up the price of gold by 21 cents. The president cavalierly said he'd done that because 21 was seven times three, and three was a lucky number.

Sound familiar?  Arbitrary decisions make for uncertainty which now permeates the entire  process of our nation's allocation of capital and paralyzes the wealth creation process. Consider arbitrary nature of 

  • Cash for Clunkers, why cars? Why not computers? Or your children's education? Lawn mowers? Dishwashers or drilling equiptment? Hogs? Who knows? Why should you subsidize your neighbor's new car when your elderly parents need financial support? And why the $4,500 rebate? Why not $4,600 or $4,450?
  • The first drilling moratorium, opposed by the presidential commission but misrepresented by the administration, was reversed by the courts leading to a second moratorium, no doubt to be litigated but wait now its "OK, guys go ahead!" But wait, you need extensive recertification. Do you think owners of scarce rigs will hang around and wait for the drama or hit the bid to go abroad?  
  • Or consider the pure whimsy of estate tax, an inverse case of 'now you see it, soon you won't', 0% today, 55% Jan. 1, 2011, or maybe not.  
  • Or consider the unfathomable complexity of the entire code which according to CCH the US Tax Code now approximates 67,505 pages.
  • Or consider the whimsy of administration: as of this writing no one knows the tax rates to be effective for personal rates next year.
  • What happened to the rule of law governing status of the senior secured creditors of Chrysler debt? Extra legal persuasion? Danny Ortega style?
  • The full 100% payout of counterparties of AIG's credit default swaps courtesy of the US taxpayer.
  • The mysterious & all powerful Fed and the current structure of manipulated interest rates that penalize risk averse savers, among them particularly the elderly and those who can not prudently tolerate higher risk assets?
  • Rationing and arbitrary benefit decisions under the new national health care plan.
  • The arbitrary reallocation of some 34% of US corn production to ethanol corn which had the unintended consequence increasing commodity prices (~doubling corn farm prices) & inducing starvation in emerging countries that relied on non-ethanol corn.
  • The unfathomable complexity of Dodd-Frank: 2,319 pages requiring multiple new federal entities yet to be created and 248 regulations yet to be written (nearly 100 at the SEC alone) and 67 studies to be conducted. Plan around that, my small business friend.
  • The destruction of the value of the US$ and the incessant mau-mau'ing of impending trade wars.
  • Congress exempting itself from compliance of law & regulations imposed on the citizenry.
  • The wanton and willful destruction of the most important element of our economy, small business and farms, by operation of  the inheritance tax. No business survives the loss of half of its capital every generation.

Our problems arose from the cumulation of distortions and mis-allocations of capital mostly induced by the corruption of law, regulation, and leadership. We concede some base level of manifest error, but in our view it is corruption operating in absence of appropriate checks and balances. When countries mis-allocate capital badly over time, the standard of living declines. Productivity counts. The primary problem is that our tax code and budget process have become instruments by which Congress monetizes its ability to dispense economic favor. You don't need 67,505 pages and the K Street lobbying industry to treat people equally. And everybody knows it.

Consider the sheer magnitude of the unproductive burden of tax compliance on citizens and business alike. We now have whole industries and legions of tax lawyers and accountants dedicated to intermediating an unfathomable, incomprehensible extraction of wealth by the government where by compliance is impossible by virtue of complexity, so enforcement becomes discretionary. And out of this process comes not one wit of real production, not one loaf of bread, not one bucket of bolts, not a single chip or Ipad. Nothing but sludge and friction and now sobering, if not heartbreaking, macro costs. Keep it simple, so everyone can understand the deal without engaging a Wall Street law firm.  Eliminate  Congress' ability and inclination to corrupt itself and the process so essential to the well being of our country.

Until then three is still a lucky number.

Tuesday
Oct122010

The small matter of unfunded state & municipal pension liabilities

The fraud of Social Security becomes the fraud of General Motors becomes the fraud of California and moves soon to a theatre near you. Owners of municpal paper take note.

The FT today reports US cities face big public pension deficits excerpted below.

Big US cities could be squeezed by unfunded public pensions as they and counties face a $574bn funding gap, a study to be released on Tuesday shows.

The gap at the municipal level would be in addition to $3,000 bn in unfunded liabilities already estimated for state-run pensions, according to research from the Kellogg School of Management at Northwestern University and the University of Rochester.

Now how could that have happened?

Thematically, its the same old stuff.  Shall we take a little flashback to General Motors? Kudos to Tony Jackson of the Financial Times for his article GM is just a hedge fund in disguise (Aug 22, 2010 also excerpted below).

As public offering for GM rev’s up, one might well ask, “How is this going to work?” Well, it’s not going to. The US government, or rather the current & future US taxpayers, have provided us with another opportunity to short a pig. Let’s set aside the sobering competitive reality that we as consumers already know well. No one buys their cars. That’s why they went bust. Let’s further set aside the sobering global competitive threats of Ford, Honda, Toyota, and Hyundai.

GM has pension liabilities of some $100 billion, funding of which is well, running a bit short. Quelle surprise! The stated deficit of some $27 billion bananas is, of course, based on the assumption that the existing pension assets earn 8.5% for the rest of time in eternity AND that GM operates with sufficient profitability and cash flow to fund its pension expenses and everything else.

Well, good luck with that 8.5%. What…? You need a bigger number, no problem? Just pop the asset mix and up risk a bit. Why not? 

The reality of all this is that GM…is in economic terms a hedge fund, with its operations a mere sideline. And as a hedge fund, it is fairly racy.

Mr Ralfe calculates that only 35 per cent of its assets are in investment-grade bonds, either Treasury or corporate. The rest is spread across real estate, equities, hedge funds, private equity and so forth.

This poses an interesting question. Why would investors put their money into GM, rather than into regular hedge funds that are not distracted by the vexing business of selling cars in competition with the giants of Asia?

Oh, good. But wait, there’s more. The first half operating earnings of GM were about $2.9 billion (the highest since 2004) so let’s double it to ballpark 2010’s annual operating earnings, well, call it a little less than $6 billion. Let’s set aside the hockey stick earnings forecast by management and soberly assume that the 8.5% sustainable investment return on the pension assets is overly aggressive, at least at the front end of the period. GM then has to dedicate at least all of its operating earnings for the next 6-8+ years minimum to merely funding the pension liability. Forget about growing warranty expense or debt service or funding unsold inventory. Kaboom! We’re all shareholders on this bus.

Now, let's now move our gaze to California which is now in a funding crisis, acutely short of cash with limited financing options...  all dressed up, sitting by the phone at 7 pm on prom night. CALPERS, being helpful sympathetic types, lob in a call. They know a good deal when they see it, the opportunity to buy every politician in the state with make a prudent bridge loan to a large politically & economically important state whose pensions they run.  CALPERS is, of course, the California Public Employee’s Retirement System. They’re proposing to lend to the state. The cash, of course, comes from the pensions of the state's employees.  Oh, did we mention that many of the CALPERS' pension plans have funding deficits also? Something about understated liabilites and under performance of investment assets…

 Flash back to GM: GM’s annual payments to its US pensioners are running at $9.3bn. On US fund assets of $85bn, that ostensibly requires a return of 10.9 per cent.

Flash back to the Social Security trust fund: there is no social security trust fund.

Systemic risk, anyone?

 


 

Wednesday
Sep082010

Expense ratios as predictors

Morningstar just came out with a nifty analysis of mutual funds: cheaper is better. We believe by proxy the same analysis & concepts extend to ETF's, although liquidity and transaction costs need to be considered.

"Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two quintiles, and you’ll be on the path to success." - How Expense Ratios and Star Ratings Predict Success, Russell Kinnel, Director of Fund Research & Editor, in Aug. 2010 Fund Investor

Wednesday
Sep012010

The last chance saloon

We recommend the analysis of Ask Not Whether Governments Will Default But How? (Mares of Morgan Stanley: Aug 25, 2010) as an important work for those who wish to understand the nature of the problem with global sovereign finance. It proposes the notion of “financial oppression” of citizens (or more broadly holders of capital) as a viable strategic alternative available to central banks and governments in lieu of default. This is bold language for Morgan Stanley, a mainstream global house, to use publicly in our brave new regulatory world. We commend them. The analysis is spot on.

For those with a tolerance of flippancy (if not rude language) but who also appreciate clarity of logic, we also suggest  A Termite Riddled House.  It complements Mares’ line of thought for those who might need to grok differently and also happens to have a link to one of the most instructive graphs, a time series, of the Fed’s balance sheet

The graph demonstrates the back end of the cycle. In the front end, as prelude,

  • Congress manipulates housing market (a chicken in every pot becomes a house & mortgage for all for all courtesy of Fannie & Freddie and the Community Re-investment Act);
  • Wall Street brings analytics, derivative technology, and leverage to the party;
  • the GSE’s (Fannie & Freddie) spend at least $171 million on lobbying Congress;
  • encouraged by $171 million of lobbying funds, Congress encourages regulators go to sleep;
  • CMO’s & CDO’s go global and wild, record issuance;
  • then the catalytic event; 
  • the Fed buys out the AIG counterparty book and the “toxic assets” from the banks;
  • Feds force short rates to zero; and finally, and mutually,
  • the banks buy treasuries and ride the yield curve to profitability.  

That’s where we are. The toxic assets are still there, still hanging around. Look at the balance sheet of the Fed. Look at the increase of federal debt.

The strategy of the Fed is very clear. The nature and magnitude of the macro economic problems are so large and complex that resolution of the problems is not feasible from their perspective as a practical or political matter[1]. Scale, complexity, and time make for diverging rather than converging sets of solutions. The cone of possible outcomes they see gets wider and more chaotic.

So, the strategy of the Fed is not to solve large scale, complex problems but rather to avoid several specific bad outcomes

  • a US$ dollar crisis
  • a US bank liquidity crisis
  • a US Treasury market crisis
  • a systemic crisis of foreign bank liquidity

in favor of inducing controlled, chronic inflation to buy time and stability. Default is off the table. The Fed has no more ideas, options or ammo. That’s it.

What does this all mean?  It means we anticipate the Fed will induce structural inflation, which they hope will be moderate, as a best case outcome. We wouldn't go long duration just right now or anytime soon. Those who follow us know we've been inclined to shorter duration and investment grade credits in fixed income for some time. We concede the spread party is over but are content with investment grade spreads for now. We like TIPs as a segment of fixed income strategy. We have been following the muni market with some concern, noting that capacity to repay declines dramatically when you no longer have either cash or a viable tax base. We'll re-consider when we see the risk premia reset (note Harrisburg defaulted on a payment of a general obligation bond today). If we could buy renminbi bonds, we'd think about it.   

As things currently stand we do not anticipate deflation. However, here we come to the uncertainty part,  the 'as currently stands' part. It's unclear on the margin how much more imprudent policy and uncertainty we can tolerate without setting off a chaotic response. The lack of experience in the executive and leglislative branches now adds risk. They don't understand that if you push it hard enough, it will fall over.

The bi-polar mind sees two ways to hit the reset button: a hard reset to equilibrium by crisis of either inflation or deflation. The temperate and optimistic see that with sensible & timely reform we can fix this. When was the last time you saw sensible & timely out of Congress? November might well be the last chance saloon.

Funny how the equity market goes up when the dividend yield exceeds the 10 yr Treasury rate, isn't it?

 


[1] We will leave for another day the consideration of the hypothesis that in the main the citizenry lacks the capacity to understand what got us here, and therefore we lack the political capacity to resolve it (c.f. dependency ratio > 50% and failures of the educational system). [2] Also thanks JS for correcting the error of 'grock' to 'grok'.

 

Friday
Aug062010

Inflation or deflation: 5 yr TIPs go negative

From today's Financial Times Even Bondholders Have Deflation Doubts (excerpted below):

But something weird happened this week in Treasury inflation-protected securities, or Tips, US inflation-linked government bonds. For only the second time in history, the five-year Tips offered a negative real yield; that is, buyers get back less than inflation.

Why would anyone want to buy an inflation-protected bond that is guaranteed not to protect fully against inflation? Perhaps if inflation were expected to be very high, prompting a rush for even partial protection. But that is hardly the case today. Rather, it is because Tips investors expect inflation to be higher than nominal bond yields: only by one hundredth of a percentage point, but enough to make it worth buying Tips with a definite real loss rather than straightforward bonds.

The substance of this phenomena is worth thinking about. Seems to us this analysis is just about right, although risk preference may come in to the calculation as well.  Deflation, of course,  brings a whole new meaning: "I would gladly pay you less on Tuesday for a hamburger today." 

What to do? We think not much and certainly nothing rash. The key is the longer term strategy. Those, including ourselves, who have genetic disposition to chronic fear of inflation, would do well to consider the substance of the market view that any pick up in aggregate demand may not eventuate in the near to intermediate term...or even later. The bond vigilantes counter argue that the only actionable solution is to monetize the debt by inflation (check the CBO report below).  Certainly, in the context of fixed income portfolios, the quest for real value will chafe against the avoidance of risk (do no harm), and the uncertainty in the markets once again suggests that the basics of diversification and risk management are essential.

Thursday
Jul292010

Hakuna matata: our best advertising

Updated on Wednesday, September 1, 2010 at 07:56AM by Registered Commenterhb

Updated on Friday, November 26, 2010 at 12:00PM by Registered Commenterhb

Updated on Tuesday, January 18, 2011 at 05:06PM by Registered Commenterhb

We thank a reader for bringing to our attention a newsy story on MarketWatch covering the municipal bond markets, Municipalities on the brink, but muni bonds hang in there. The article is worth a read if only for a bold market call.

We are given to understand that

All state governments "will pay principal and interest in a timely fashion, even the states that are most in the news." said Gary Pollack, head of fixed-income trading and research at Deutsche Bank Private Wealth Management...States in particular are generally safe because they can't really file for bankruptcy and most are required to pass a balanced budget every year..." (exerpted)

We beg to disagree with just about every dimension of this perspective. 

Click to read more ...

Wednesday
Jul282010

CBO provides an historic view of federal debt: why this won't work

The Congressional Budget Office just released an important study, Federal Debt and the Risk of a Fiscal Crisis, July 27, 2010.  The good news is that we have the analysis. The bad news is akin to the cart before the horse. The country needs this analysis before of the decisions get made, so citizens may make informed, reasoned decisions. Congress and the Administration turn a willful blind eye to such nicities, by operating in such a way that prohibits the free, open, and timely dissemination of such information to the citizens.

Read the fine print and learn that Alternative Fiscal Scenario is where we're heading. Its ugly.

 

 

 The CBO points out the consequences of growing debt might include

  • crowding out of private investment
  • need for higher taxes
  • need for less spending
  • reduced ability to respond to domestic or international problems, and
  • an increased probability of fiscal crisis

What options does CBO present as available to cure the problem? Three out of four are problematic... at least for economic viability.

  • restructure debt
  • induce inflation
  • increase taxes
  • reduce spending

No, we're not making this up. Read the article, learn of government debt/gdp of Argentina (50%), Greece (110%), and Ireland (70%).

Now square the picture above with the current US Treasury rates.

 

Monday
Jul262010

More unintended consequences: insurance companies cease writing new health care policies for children

The AP today reports:

"WASHINGTON (AP) -- Some major health insurance companies will no longer issue certain types of policies for children, an unintended consequence of President Barack Obama's health care overhaul law, state officials said Friday.

Florida Insurance Commissioner Kevin McCarty said several big insurers in his state will stop issuing new policies that cover children individually. Oklahoma Insurance Commissioner Kim Holland said a couple of local insurers in her state are doing likewise.

In Florida, Blue Cross and Blue Shield, Aetna, and Golden Rule -- a subsidiary of UnitedHealthcare -- notified the insurance commissioner that they will stop issuing individual policies for children, said Jack McDermott, a spokesman for McCarty.

The major types of coverage for children -- employer plans and government programs -- are not be affected by the disruption. But a subset of policies -- those that cover children as individuals -- may run into problems. Even so, insurers are not canceling children's coverage already issued, but refusing to write new policies..."

Many are of the view that this phenomena is not an unintended consequence, that it is by design of policy. It is a logical and predictable response to cost structures and burdens imposed by the new 'health care reform'.  We predict more insurers will follow and that health care providers across different sectors in increasing numbers will start to limit treatment or otherwise refuse to accept reimbursement schedules that cause them to incur losses.

Monday
Jul262010

S&P indices vs actively managed funds

The March 2010 issue of Research Insights from S&P Indices puts forth some interesting results of an analysis of 5 years of data ending 12/31/2009:

"The S&P Indices Versus Active Funds (SPIVA) Scorecard reports performance comparisons corrected for survivorship bias, shows equal- and asset-weighted peer averages, and provides measures of style consistency for actively managed U.S. equity, international equity, and fixed income mutual funds... The CRSP Survivor-Bias-Free U.S. Mutual Fund Database provides the underlying data…

 Over the last five years,

  • the S&P 500 has outperformed 60.8% of actively managed large-cap U.S. equity funds;
  • the S&P MidCap 400 has outperformed 77.2% of mid-cap funds; and
  • the S&P SmallCap 600 has outperformed 66.6% of small-cap funds.
  • results are similar for actively managed fixed income funds. Across all categories, with the exception of emerging market debt, more than 70% of active managers have failed to beat benchmarks.
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